Controllership: The Work of the Managerial Accountant (Controllership)

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CONTROLLERSHIP THE WORK

MANAGERIAL ACCOUNTANT SEVENTH EDITION

OF THE

JANICE M. ROEHL-ANDERSON STEVEN M. BRAGG

John Wiley & Sons, Inc.

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CONTROLLERSHIP

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BECOME A SUBSCRIBER! Did you purchase this product from a bookstore? If you did, it’s important for you to become a subscriber. John Wiley & Sons, Inc. may publish, on a periodic basis, supplements and new editions to reflect the latest changes in the subject matter that you need to know in order to stay competitive in this ever-changing industry. By contacting the Wiley office nearest you, you’ll receive any current update at no additional charge. In addition, you’ll receive future updates and revised or related volumes on a 30-day examination review. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service. To become a subscriber, please call 1-877-762-2974 or send your name, company name (if applicable), address, and the title of the product to: mailing address:

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CONTROLLERSHIP THE WORK

MANAGERIAL ACCOUNTANT SEVENTH EDITION

OF THE

JANICE M. ROEHL-ANDERSON STEVEN M. BRAGG

John Wiley & Sons, Inc.

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This book is printed on acid-free paper. Copyright © 2004 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

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ABOUT THE AUTHORS Janice M. Roehl-Anderson, MBA, is a principal with Deloitte, with over 20 years of consulting experience. She specializes in information systems security; financial and cost accounting system analysis, design, selection, and implementation; long-range information systems planning; and information management reviews/audits. She has also worked for US West. In addition to earning her BA in Business at the University of Washington, and MBA in Accounting and Information Systems at the University of Southern California, Jan has successfully completed the CPA exam, and has co-authored over 10 books, including The Controller’s Function: The Work of the Managerial Accountant. Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief financial officer or controller of four companies, as well as a consulting manager at Ernst & Young and auditor at Deloitte. He received a master’s degree in finance from Bentley College, an MBA from Babson College, and a Bachelor’s degree in Economics from the University of Maine. He has been the two-time President of the 10,000-member Colorado Mountain Club, and is an avid alpine skier, mountain biker, and rescue diver. Mr. Bragg resides in Centennial, Colorado. He has written the following books: Accounting and Finance for Your Small Business (Wiley) Accounting Best Practices, 3rd Edition (Wiley) Accounting Reference Desktop (Wiley) Advanced Accounting Systems (Institute of Internal Auditors) Business Ratios and Formulas: A Comprehensive Guide (Wiley) Cost Accounting: A Comprehensive Guide (Wiley) Design and Maintenance of Accounting Manuals: A Blueprint for Running an Effective and Efficient Department, 4th Edition (Wiley) Essentials of Payroll: Management and Accounting (Wiley) Financial Analysis: A Controller’s Guide (Wiley) Just-in-Time Accounting: How to Decrease Costs and Increase Efficiency, Second Edition (Wiley) Managing Explosive Corporate Growth (Wiley) Outsourcing: A Guide to...Selecting the Correct Business Unit...Negotiating the Contract...Maintaining Control of the Process (Wiley) Sales and Operations for Your Small Business (Wiley) The Controller's Function: The Work of the Managerial Accountant, 2nd Edition (co-authored with Janice M. Roehl-Anderson, Wiley) The New CFO Financial Leadership Manual (Wiley)

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ACKNOWLEDGMENTS With the rapidly changing business environment, it was essential that the material contained in this volume be accurate, up-to-date, and relevant. Accordingly, in addition to the chapters written or revised by the two co-authors, these contributing authors, listed alphabetically, wrote or revised the chapters indicated: Alan R. Arnold, Manager Ernst & Young LLP, Irvine, California Chapter 42, Systems Performance Management Karen L. Bassett, Manager Ernst & Young LLP, Denver, Colorado Chapter 39, Software Testing E. Edward Bassett III, Senior Systems Security Engineer Denver Technological Laboratories Chapter 43, Information Security Systems Chapter 46, Digital Signatures Kevin Church, Senior Manager Deloitte, San Francisco, California Chapter 51, Organizations Embrace Shared Services—Big and Small David Drach, Director of Business Analytics FRx Software Corporation, Denver, Colorado Chapter 44, Enforcing Information Security Policy Pak Fong, Senior Manager Deloitte, San Francisco, California Chapter 50, How to Implement a Successful CRM Solution Marty Gold, Senior Manager Ernst & Young LLP, Denver, Colorado Chapter 61, Tax Records and Procedures Susan Hogan, Principal Deloitte, Atlanta, Georgia Chapter 51, Organizations Embrace Shared Services—Big and Small Sara J. Moulton-Reger, e-Business Strategy Consultant IBM Global Services, Denver, Colorado Chapter 47, Change Management Chapter 48, Project Risk Management Chapter 49, Effective Project Communications Jill M. Weisbrod, Manager Ernst & Young LLP, Denver, Colorado Chapter 39, Software Testing Tanya Whiteing, Senior Manager Deloitte, Foster City, California Chapter 38, Testing Strategies for Financial Systems vi

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PREFACE Since the first publication of this book in 1952, the role of the controller has greatly expanded. It has moved from that of a simple technician who must properly process transactions to a business executive with a wide-ranging knowledge of total business operations, best practices, and corporate strategy. To address these changes, Controllership has evolved into a comprehensive guide to accounting management, planning, computer systems, and administration—in short, a repository for all the skills that a modern controller needs. While the sixth edition addressed such key issues as the fast close, best practices, information security systems, outsourcing the accounting function, and software testing, we felt it necessary to issue a new edition that addresses a wide range of additional topics that have become more important in the last four years. The following new items are addressed in depth: • Logic steps for ethics-related decisions • Summaries of essential GAAP pronouncements • Cost accounting systems and methodologies • Throughput costing • Composition and role of the audit committee • Taxation strategy • Business cycle forecasting • Payroll compensation and tax issues • Management reporting formats • Reporting to the Securities and Exchange Commission • Acquisition due diligence checklists • Accounting manual preparation and maintenance These new topics address many of the concerns of the modern controller: what information to examine during an acquisition due diligence review, how to integrate throughput costing decisions into the financial analysis toolbox, and how to alter accounting systems to take advantage of taxation strategies. We have attempted to include in this volume practical commentary on the various aspects of controllership. Given the growth in complexity and the rapid changes taking place in the many functions of accounting, we have secured assistance from a number of knowledgeable practitioners and writers in the relevant fields of endeavor. These contributing authors are identified in the Acknowledgments section. In short, the seventh edition of Controllership is the complete business advisor for today’s controller. Janice M. Roehl-Anderson Cherry Hills Village, Colorado Steven M. Bragg Centennial, Colorado January 2004

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CONTENTS

PART 1

THE BROAD MANAGEMENT ASPECTS

OF

CONTROLLERSHIP

1 Accounting in the Corporation Tasks of the Accounting Function 3 Role of the Accounting Function 5 Role of the Controller 6 Impact of Ethics on the Accounting Role Evolving Role of Accounting 9

1 3

7

2 Controller’s Responsibilities

11

Variations on the Title 11 Planning Function 12 Control Function 12 Reporting Function 13 Accounting Function 13 Additional Controller Functions in Smaller Companies 14 Controller’s Job Description 16 Relationship of the Controller to the Chief Financial Officer 18 Future Changes in the Controller’s Origins and Responsibilities 19 Managing Explosive Growth 20

3 Chief Financial Officer: From Controller to Facilitator of Change Understanding What Chief Executive Officers Want 23 Task of the CFO 24 Develop and Communicate a Compelling Finance Agenda Build a Commitment to Change within Finance 26 Change Executive Management Practices 29 Enlist the Support of the Chief Executive Officer 30 Mobilize the Organization 31 Institutionalize Continuous Improvement 32

4 Accounting Principles and Standards

23

24

35

Committee on Accounting Procedure 35 Accounting Principles Board 36 Financial Accounting Foundation 36 Financial Accounting Standards Board 36 Government Accounting Standards Board 37 International Accounting Standards Board 38 Accounting Standards 38

Because of the rapidly changing nature of information in this field, this product may be updated with annual supplements or with future editions. Please call 1-877-762-2974 or email us at [email protected] to receive any current update at no additional charge. We will send on approval any future supplements or new editions when they become available. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service.

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Contents

Accounting Research Bulletins 39 Opinions: Accounting Principles Board 39 Interpretations: FASB 41 Statements of Financial Accounting Standards: FASB 44 Statements of Financial Accounting Concepts: FASB 53 Technical Bulletins: FASB 54

5 Cost Accounting and Costing Systems

57

Purpose of Cost Accounting Information 57 Input: Data Collection Systems 58 Processing: Data Summarization Systems 60 Processing: Job Costing 62 Processing: Process Costing 66 Processing: Standard Costing 69 Processing: Direct Costing 71 Processing: Throughput Costing 73 Processing: Activity-Based Costing 76 Processing: Target Costing 79 Outputs: Cost Variances 80

6 Ratio and Trend Analysis

85

How to Use Ratios and Trends 85 A Caveat 86 Measures for Profitability 88 Measures for the Balance Sheet 90 Measures for Growth 94 Measures for Cash Flow 96 Measures for Nonfinancial Performance 97 Interrelationship of Ratios 110 Setting Up a System of Ratios and Trend Analyses

7 Internal Control Systems

110

115

Objectives 115 Responsibility for Internal Controls 116 Examples of Internal Controls 117 When to Eliminate Controls 119 T ypes of Fraud 121 Preventing Fraud 122 How to Deal with a Fraud Situation 125 Foreign Corrupt Practices Act 126

8 Internal Audit Function

129

Reporting Relationships 129 Composition of the Audit Committee 130 Role of the Audit Committee 131 Internal Audit Objectives 132 Internal Audit Activities 134 Managing the Internal Audit Function 136

9 Globalization: Complexities and Opportunities Changing Nature of International Trade

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139

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Contents

Impact of Global Trade on Segments of the U.S. Economy 140 Determining and Implementing Successful Global Strategies 142 Organization Structure in a Global Enterprise 143 Virtual Corporation 145 Technical Aspects of the Controllership Function under Globalization

146

10 Recruiting, Training, and Supervision Recruiting Sources 159 Factors to Consider when Recruiting 162 Factors to Consider When Promoting 163 Importance of Reduced Turnover 164 Importance of Developing Career Plans for Employees Importance of Communications with Employees 169 How to Motivate Employees 171

xi

159

167

11 Controller’s Role in Investor Relations

173

Objectives of the Investor Relations Function 174 Evolving Nature of the Function 174 Communication Vehicles for Investor Relations 174 Investor Relations Message Recipients 175 Information Needs of the Financial Analyst 176 Information Needs of Other Groups 178 Disclosure Policy 178 Organization Structure for Investor Relations 179 Role of the Controller and Other Principals 180 Changes in the Capital Markets 182

PART 2

THE PLANNING FUNCTION

OF

CONTROLLERSHIP

12 Business Plans and Planning: Interrelationship of Plans, Strategic Planning Business Planning Defined 188 Framework for Business Planning 188 Time as Related to Planning 188 Planning Period: How Long Is “Long Range”? 189 System of Plans 190 Strategic Plan: An Overview 190 Corporate Development Plan 191 Operations Plan 191 Basic Elements in Any Plan 191 Planning Process 192 Plan Frequency 194 Plan Guidelines 194 Who Should Do the Planning? 195 Supplemental Planning: Alternative Scenarios 196 Planning Timetable or Schedule 196 Strategic Planning: An In-Depth Review 196 Environmental Analysis 198 Critical Success Factors 199 Business Mission or Purpose 200 Long-Range Business Planning Objectives 202

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Developing Strategies 205 Strategies and the Planning Period 208 Role of the Controller 208 Improving the Strategic Planning Process

210

13 Financial Impact of the Strategic Plan: Long-Range Financial Plan Key Elements Of A Strategic Plan 211 Contrast Of Strategic Plan (Financial Aspects) with the Annual Plan Capital Investments 213 Risk Analysis 214 Key Relationships 215 Objectives of the Long-Range Financial Plan 215 Consolidation and Testing Process 216 Representative Financial Content of a Long-Range Plan 216 Illustrative Financial Exhibits in the Plan Presentation 217 Role of the Controller 230

211

212

14 Profit Planning: Annual Plan

233

Profit Planning Defined 233 Purpose of Budgeting 234 Planning Benefits 234 Coordination Benefits 235 Control Benefits 236 Annual Planning Cycle : Illustrative 237 Supportive Financial Statements and Budgets 238 Sales Budget 239 Production Budget 240 Purchases Budget 240 Direct Labor Budget 241 Manufacturing Expense Budget 241 Inventory Budget 241 Operating Expense Budget 243 Capital Expenditures Budget 243 Cost of Goods Sold 243 Statement of Estimated Income and Expense 243 Cash Budget 245 Statement of Estimated Financial Condition 245 Approval of Budget 246 Control Function 247 Controller’s Role: A Key Player 247 Management Approval of the Plan 253

15 Profit Planning: Supporting Financial Analysis for the Annual Plan Basic Approach in Profit Planning 255 General Comments on the Cost–Volume–Profit Relationship Break-Even Chart 256 Changes in Sales Revenue 258 Changes in Sales Mixture 259 Changes in Sales Price 260 Changes in Costs 261 Marginal Income Ratio and Margin of Safety 262

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xiii

Analysis by Product 262 Application of Cost–Volume–Profit Analysis 263 Selecting the Most Profitable Products 265 Minimum Selling Price 266 Unit Costs at Different Volume Levels 266 Increased Sales Volume to Offset Reduced Selling Prices 266 Most Profitable Use of Scarce Materials 267 Advisability of Plant Expansion 267 Break-Even Analysis to Evaluate a Forecast 269 Workable Statement of Income and Expense 271 Some Practical Generalizations 272 Statistical Techniques for Planning 272 Program Evaluation Using Discounted Cash Flow 277 Financial Analysis of Unacceptable Operating Results 277 More Sophisticated Analyses 294

16 Taxation Strategy

295

Accumulated Earnings Tax 296 Cash Method of Accounting 297 Inventory Valuation 297 Mergers and Acquisitions 297 Net Operating Loss Carryforwards Nexus 299 Passive Activity Losses 300 Project Costing 300 Property Taxes 301 S Corporation 301 Sales and Use Taxes 302 Transfer Pricing 303 Unemployment Taxes 305

PART 3

PLANNING

AND

298

CONTROLLING OPERATIONS

307

17 General Discussion of Accounting/Statistical Standards: Benchmarking Meaning of Accounting/Statistical Control 309 Extent of Accounting/Statistical Control 310 Need for Standards 310 Definition of Standards 311 Advantages of Standards 312 Relationship of Entity Goals to Performance Standards Types of Standards Needed 314 Trend to More Comprehensive Performance Measures Benchmarking 320 Balanced System of Performance Measures 321 Setting the Standards 322 Use of Standards for Control 323 Procedure for Revising Standards 326 Recording Standards 327 Application of Standard Costs 328 Management Use of Standard Costs 328

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18 Planning and Control of Sales

329

Sales Management Concerns 330 Controller’s Assistive Role in Sales Management Problems 331 Controller’s Independent Role in the Planning and Control of Sales Control of Sales 334 Sales Analysis 334 Sales Planning: Basis of All Business Plans 338 Steps in Developing the Near-Term Sales Plan/Budget 339 Control Phase 341 Methods of Determining the Sales Level 341 Useful Sources of Forecasting Information 344 Forecasting the Business Cycle 345 Sales Standards 350 Sales Reports 354 Product Pricing: Policy and Procedure 355

333

19 Planning and Control of Marketing Expenses

371

Definition 371 Significance 372 Factors Increasing the Difficulty of Cost Control 372 Sales Manager and Marketing Expenses 373 Basic Approach in the Planning and Control of Marketing Expenses 373 Marketing Expense Analysis 373 Types of Analyses 374 Planning Marketing Expenses 386 Special Comments on Advertising and Sales Promotion Expense 392 Control of Marketing Expenses 397 Marketing Expense Standards 397

20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor General Aspects of Manufacturing 403 Direct Material Costs: Planning and Control Labor Costs: Planning and Control 416

403

408

21 Planning and Control of Manufacturing Costs: Manufacturing Expenses Nature of Manufacturing Expenses 425 Responsibility for Planning and Control of Manufacturing Expenses Approach in Control of Manufacturing Expenses 427 Proper Departmentalization of Expenses 427 Variations in Cost Based on Fixed and Variable Costs 428 Variations in Cost Based on Direct Labor 429 Variations in Cost Based on Batch Size 431 Variations in Cost Based on Overhead 433 Variations in Cost Based on Time 435 Cost Estimation Methods 436 Normal Activity 439 Allocation of Indirect Production Costs 440 Budgetary Planning and Control of Manufacturing Expenses 442

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xv

Revision of Manufacturing Expense Budgets 446 Securing Control of Overhead 449 Indirect Labor: A More Precise Technique 451 Other Aspects of Applying Budgetary Control 451 Other Control Procedures 453 Role of the Controller 454 Reports for Manufacturing Executives 455

22 Planning and Control of Research and Development Expenses

463

Research and Development Activities 463 Impact of R&D Activities on Corporate Earnings 464 R&D Activities in Relation to Corporate Objectives 464 Integration of R&D with Other Functions 465 Organization for the R&D Financial Functions 466 Accounting Treatment of R&D in Financial Statements 466 Elements of R&D Costs 468 Role of the Financial Executive in R&D 469 General Budgetary Procedure 470 Determining the Total R&D Budget 470 Information Sources on R&D Spending 471 Establishing the R&D Operating Budgets 472 Detailed Budgeting Procedure 476 Other Control Methods 477 Effectiveness of R&D Effort 481

23 Financial Planning and Control in a Service Company

487

Organizational Considerations 488 Data Classification 489 Cost of Services; Activity-Based Costing 490 Cost Accounting in a Service Organization 490 Planning System 492 Strategic Planning 498

24 Planning and Control of General and Administrative Expenses

499

Components of G&A Expense 499 Control over G&A Expenses 500 Reducing G&A Expenses 505 Budgeting G&A Expenses 509

25 Payroll Compensation 513 Federal Income Taxes 515 Social Security Taxes 517 Medicare Tax 517 State Income Taxes 518 Payroll Taxes for Employees Working Abroad Remitting Federal Taxes 519 Payroll Deductions for Child Support 520 Payroll Deductions for Unpaid Taxes 520 Unemployment Insurance 521

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Contents

PART 4

PLANNING

AND

CONTROL

OF THE

BALANCE SHEET

527

26 Planning and Control of Cash and Short-Term Investments Objectives of Cash Planning and Control 530 Duties of the Controller Versus the Treasurer 530 The Cash Forecast 530 Cash Collections 542 Cash Disbursements 546 Internal Control 547 Reports on Cash 550 Cash Flow Ratio Analysis 553 Impact of New Information Technology and Organizational Structures Investment of Short-Term Funds 555

27 Planning and Control of Receivables

529

554

559

Granting Credit to Customers 559 Customer Margin Analysis 561 Collections Task 562 Measurement of Accounts Receivable 564 Control over Accounts Receivable 566 Budgeting for Accounts Receivable Balances

568

28 Planning and Control of Inventories

571

Costs and Benefits of Carrying Inventory 571 Role of the Controller 573 Material Requirements Planning Systems 575 JIT Manufacturing Systems 576 Inventory Reordering Systems 580 Obsolete Inventory 581 Reducing Inventory 583 Inventory Cutoff 584 Budgeting for Raw Materials 585 Budgeting for Work-In-Process 590 Budgeting for Finished Goods 591

29 Valuation of Inventories

595

Significance of Proper Inventory Valuation 595 Controller’s Responsibility for Inventory Valuation 596 Emphasis on the Cost Basis 596 Inventory Characteristics and Effect of the Valuation Base 597 Selection of the Cost Base 598 Departure from the Cost Base 599 Consistency in Valuation 600 Federal Income Tax Considerations in Valuing Inventories 600 Interim Statements 601 Other Inventory Valuation Problems 601 Inventory Reserves 602

30 Accounting and Reporting for Selected Investments and Employee Benefit Plans Improving the Investment Decision Process

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603

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xvii

Relevant Financial Accounting Standards 604 Role of the Controller 605 Accounting Records for Selected Investments 606 Financial Reports On Selected Investments 609 Accounting and Disclosure Requirements and Practices for Employee Benefit Plans 609

31 Planning and Control of Plant and Equipment or Capital Assets

623

Impact of Capital Expenditures 623 Controller’s Responsibility 624 Capital Budgeting Process 625 Establishing the Limit of the Capital Budget 626 Information Supporting Capital Expenditure Proposals 627 Methods of Evaluating Projects 628 Payback Method 629 Operators’ Method 630 Accountants’ Method 630 Discounted Cash Flow Methods 632 Hurdle Rates 636 Cost of Capital—A Hurdle Rate 637 Inflation 638 Foreign Investments 638 Impact of the New Manufacturing Environment 639 Impact of Activity-Based Costing 639 Classifying and Ranking Proposed Capital Projects 639 Board of Directors’ Approval 641 Project Authorization 645 Accounting Control of the Project 648 Postproject Appraisals or Audits 648 Other Aspects of Capital Expenditures 649

32 Management of Liabilities

659

Liabilities Defined 659 Objectives of Liability Management 660 Direct Liabilities 660 Illustrative Provisions of Credit Agreements 662 Planning the Current Liabilities 666 Standards to Measure and Control Current Liabilities Corrective Action 668 Risks of Too Much Debt 668 Some Benefits from Debt Incurrence 669 Sources of Information on Debt Capacity 669 Standards for Debt Capacity 669 Bond Ratings 670 Leverage 671 Contingencies 671 Long-Range Financial Plan 672 Managing Liabilities: Some Practical Steps 672 Accounting Reports on Liabilities 673 Internal Controls 674

33 Management of Shareholders’ Equity Importance of Shareholders’ Equity Role of the Controller 686

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685 686

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Contents

Growth of Equity as a Source of Capital 687 Return on Equity as Related to Growth in Earnings Per Share Growth in Earnings Per Share 688 Cost of Capital 688 Components of Cost of Capital 690 Calculating the Cost of Debt 691 Calculating the Cost of Equity 692 Calculating the Weighted Cost of Capital 694 Dividend Policy 695 Long-Term Debt Ratios 697 Other Transactions Affecting Shareholders’ Equity 698 Long-Term Equity Planning 698 Short-Term Plan for Shareholders’ Equity 704 Other Considerations 704

PART 5

FINANCIAL

AND

687

RELATED REPORTS

709

34 Internal Management Reports

711

Rules of Reporting 711 Status Reports 714 Margin Reports 714 Cash Reports 719 Capacity Reports 728 Sales and Expense Reports 730 Payroll Reports 730 Graphical Report Layouts 737

35 Reports to Shareholders

743

Purpose of the Annual Report to Shareholders 744 Controller and the Annual Report 744 General Contents of the Annual Report 744 Report of Management’s Responsibilities 755 Importance of Form 757 Standardization in Annual Reports 758 Other Reports to Shareholders 758 Information for Security Analysts and Investment Advisors

36 Securities and Exchange Commission Securities Act of 1933 762 Securities Exchange Act of 1934 762 Public Utility Holding Company Act of 1935 Trust Indenture Act of 1939 763 Investment Company Act of 1940 764 Investment Advisors Act of 1940 764 Regulation S-X 764 Regulation S-K 767 Regulation S-B 768 Regulation FD 768 SEC Forms 769 EDGAR Filing System 773 Going Private Transaction 775

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761

763

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Contents

PART 6

COMPUTER SYSTEMS

AND

RELATED TECHNOLOGY

37 Selecting a Financial Information System

xix

777 779

Reasons to Purchase Software 780 Ways to Define Systems Requirements 780 Existing System Documentation 782 Joint Sessions 783 Preparing the Request For Proposal 785 Distribution of the RFP 786 Review of the Vendor’s Completed Proposal 788 Reference Calls 792 Demonstration 792 Site Visits 793 Cost of the System 793 Final Selection 794 Contract Negotiations 794 Appendix: Vendor Evaluation Criteria 794

38 Testing Strategies for Financial Systems Testing Duration 797 Use of Real Versus Mock Testing Data Test Scenarios 798 Security Testing 799 Volume Testing 799 Issue Tracking and Resolution 799 Sign-Off Criteria 799 Testing Participants 800

797 798

39 Software Testing Testing Considerations 801 Testing Packaged Financial Systems Test Strategy 803

801 802

40 IT Support Models for Finance Organizations Inadequately Trained End Users 815 Need for Mixed Skill Sets 816 Geographic Challenges 816 Month-End Close Support 816 Staff Retention 816 Complicated Systems Architecture 817 Lack of an Established Escalation Process 817 Lack of Documentation 818 Changing Management Reporting Requirements

815

818

41 How Much Is Too Much? Asset Ledger Detail in ERP ERP Systems 819 Integration of the ERP and EAM Systems Grouping Approach 821

820

42 Systems Performance Management Define Your Organization’s Performance Methodology 824 Six Essential Steps: A Performance Methodology 825

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Performance Details 827 Flow of Performance Information within the Organization

828

43 Information Security Systems

831

Types of Security Threats 832 Basic Security Principles 833 Components of an Effective Security Program 834 Enterprise Security Strategies 840 Controller’s Role in Information Security 841

44 Enforcing Information System Security Policy

843

Creating an Enforceable Information System Policy 844 Implementing Information System Security Policy 845 After an Information System Security Infraction Occurs 846

45 e-Commerce Security

851

e-Commerce Architectures 851 Critical Security Measures 854

46 Digital Signatures

861

Digital Signature Technology Overview 862 Demand for Digital Signature Technology 866 Legal Issues 867

47 Change Management

869

Defining the Change Management Challenge

870

48 Project Risk Management Project Risk Categories 880 Project Risk Management Approach

879 881

49 Effective Project Communications

887

Communication Program Overview 888 Communication Strategy 888 Communication Campaign Definition 891 Communication Plan 895

50 How to Implement a Successful CRM Solution Define a Business Case to Drive Shareholder Value Clearly Communicate the Change Imperative 900 Building a Winning Team 901 Prepare for the Worst 902

899 900

51 Organizations Large and Small Embrace Shared Services Executive Summary 904 About the Survey 904 Business Case 905 Implementation 906 Operations 908 Customer Relations 908 Next Steps 911

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Contents

PART 7

SOME ADMINISTRATIVE AND SPECIAL ASPECTS OF THE CONTROLLER’S DEPARTMENT

xxi

913

52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

915

History of Acquisitions and Mergers 916 Relation of Acquisitions to Corporate Objectives 916 Reasons for Divestments 917 An Overview of the Acquisition Cycle 917 Acquisition Criteria 919 Sources of Acquisition Information 920 Acquisition Team 921 Evaluating the Prospect: In-Depth Analysis 922 Objectives of Financial Analysis 928 Impact of Differing Accounting Policies 929 Valuation of an Acquisition 929 Comparing the Values 938 Multinational Business Valuation 939 Leveraged Buyouts (LBOs) 941 Accounting for a Business Combination: Purchase Method Tax Considerations in Acquisitions and Mergers 947 Financial Impact of an Acquisition 949 Financial Report on a Potential Acquisition 950 Mistakes by Management 962 Effective Integration 964 Divestments 965

53 Advanced Accounting Systems

943

967

Process Centering 967 Partnering 969 Internet 973 ISO 9000 976 Paperless Office 977 Electronic Cash 980 Virtual Corporation 982 Data Warehousing 984

54 World-Class Accounting Systems

985

Overview 985 Manufacturing Resource Planning 985 Integrated Distribution Management 988 Just-In-Time 993 Product Design 997 Computer-Integrated Manufacturing 1001

55 Accounting Best Practices Sixty-Six Best Practices

1005 1005

56 Reporting Period and How to Close It Selecting the Fiscal Year 1021 Selecting the Number of Interim Reporting Periods

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Reasons for Accelerating the Closing Period 1024 Value of Interim Reports 1024 How to Achieve a Fast Close 1025 Typical Fast Closing Schedule 1029 Reconciling Accurate Reporting against a Fast Close

1033

57 Outsourcing the Accounting Function

1035

Finding a Supplier 1035 General Advantages of Outsourcing 1037 Function-Specific Advantages of Outsourcing 1039 Risks of Outsourcing 1040 Contractual Issues 1042 Outsourcing Costs 1044 Personnel Issues Related to Outsourcing 1046 Management of Outsourcing Suppliers 1047

58 Preparation and Maintenance of Manuals

1053

Work Steps for Constructing a Procedures Manual 1054 Suggested List of Procedures 1057 Maintaining Accounting Manuals 1059 Responsibility for Maintenance of Manuals 1060 Specifications for Maintenance of Manuals 1060 Physical Construction of the Manual’s Binder 1061 Creation and Storage of the Master Manual Copy 1062 Creation and Maintenance of the Distribution Mailing List 1063 Physical Distribution Process 1064 Issuances to New Employees 1065 Manual Retrieval 1066 Benefits of Using Electronic Manuals 1066 Disadvantages of Using Electronic Manuals 1068 Basic Electronic Manual 1069 Electronic Manual with Embedded Hypertext 1069 Electronic Manual with Advanced Indexing Features 1072 Electronic Manual with Built-In Help Information 1073 Writing Tips for Electronic Manuals 1074 Example of Comprehensive Electronic Manual Features 1075 Using the PDF Format for Electronic Files 1076 Maintaining an Electronic Manual 1077

59 Records Management

1079

Record-Keeping Costs 1079 Record-Keeping Policies and Procedures 1080 Required Tax Records 1084 Computer-Based Record Keeping 1086

60 Inventory Tracking Differences Between Perpetual and Periodic Inventory Systems Setting Up a Perpetual Inventory System 1091 Auditing and Measuring a Perpetual Inventory System 1094 Physical Inventory Procedure 1095 Physical Inventory Complications: The Cutoff 1098 Reconciling Inventory Variances 1099

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Contents

Obsolete Inventory 1100 How to Avoid the Inventory Tracking Problem

1101

61 Tax Records and Procedures Tax Organization 1106 Centralized Tax Department 1107 Functions of the Tax Manager 1108 Tax Communications 1109 Tax Records in General 1109 Tax Calendar 1110 Tax Information Records 1110 Tax Working Papers and Files 1111 Internal Revenue Code and Record Requirements 1111 Differences Between Income Tax Accounting and Book Accounting Proper Classification of Accounts 1114 Other Taxes 1114 Income Taxes and Business Planning 1115 Special Tax Reports 1115

62 Risk Management

xxiii

1105

1113

1117

Risk Management Policies 1117 Risk Management Procedures 1118 Trends in Insurance Coverage 1121 Manager of Risk Management 1121 Types of Insurance Companies 1122 Claims Administration 1123 Insurance Files 1124 Annual Risk Management Report 1125

Appendix A

1127

Interest Tables Simple Interest Table 1127 Compound Interest (Future Amount of 1 at Compound Interest Due in N Periods) 1127 Compound Interest (Present Value of 1 Due in N Periods) 1128 Present Value of Ordinary Annuity of 1 per Period 1128 Future Amount of Ordinary Annuity of 1 per Period 1128

Index

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PART

THE BROAD MANAGEMENT ASPECTS OF CONTROLLERSHIP

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CHAPTER

1

ACCOUNTING IN THE CORPORATION 1.1 INTRODUCTION 3

1.4 ROLE OF THE CONTROLLER 6

1.2 TASKS OF THE ACCOUNTING FUNCTION 3

1.5 IMPACT OF ETHICS ON THE ACCOUNTING ROLE 7

1.3 ROLE OF THE ACCOUNTING FUNCTION 5

1.6 EVOLVING ROLE OF ACCOUNTING 9

1.1 INTRODUCTION Before a controller can delve into the specifics of the controller job description, it is first necessary to determine how the accounting function fits into the rest of the organization. This used to be a simple issue; the accounting staff processed transactions to support business operations — period. This required a large clerical staff managed by a small cadre of people trained in the underlying techniques for processing those transactions. In this environment, the stereotypical image of an introverted controller pounding away at a calculator was largely accurate. The role has undergone a vast change in the last few decades, as technological improvements, the level of competition, and a shifting view of management theory have resulted in a startlingly different accounting function. This section describes how the accounting function now incorporates many additional tasks, and can even include the internal auditing and computer services functions in smaller organizations. It then goes on to describe how this functional area fits into and serves the needs of the rest of the company, and how the controller fits into the accounting function. Finally, there is a discussion of how ethics drives the behavior of accounting employees, and how this shapes the way the accounting staff and controller see their roles within the organization. In short, this chapter covers the high-level issues of how the accounting function and its controller fit into the modern company, not only to process its transactions, which was its traditional role, but also to provide additional services.

1.2 TASKS OF THE ACCOUNTING FUNCTION The accounting function has had sole responsibility for processing the bulk of a company’s transactions for many years. Chief among these transactions have been the processing of customer billings and supplier invoices. Though these two areas comprise the bulk of the transactions, there has also been a long history of delegating asset tracking to the accounting function. This involves all transactions related to the movement of cash, inventory, and fixed assets. Finally, the accounting staff has been responsible for tracking debt, which can involve a continuous tracking of debt levels by debt instrument, as well as the payments made to reduce them. These have been the transactionbased activities of the accounting staff. A multitude of changes in the business environment have altered the role of the accounting function. One change has been the appearance of the computer services function. In a larger company, this function is managed within its own department and does not fall under the responsibility 3

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of the controller. However, it is common for the computer services group to fall under the management umbrella of the controller in a smaller company. Likewise, the internal auditing function frequently falls under the controller’s area as well. This function has expanded in importance over the last few decades as companies realize the benefits of having an internal watchdog over key controls. Though it should report directly to the board of directors, it is common for a small internal auditing staff to report instead to the controller. It is becoming more common for the computer services and internal auditing functions to be integrated into the role of the accounting staff, especially in smaller companies. Besides adding new functional areas, the accounting staff has other new responsibilities that have arisen due to the increased level of competition. With worldwide barriers to competition crumbling, every company feels the pinch of lower competitive prices and now asks the accounting staff to provide analysis work in addition to the traditional transaction processing. These tasks include margin analysis on existing or projected product lines, geographic sales regions, or individual products. In addition, the accounting staff may even be asked to serve on new product design teams, so that they can determine the projected cost of new products, especially in relation to target costs. Further, the accounting staff must continuously review and report on nonproduct costs, which can range from advertising to utilities. This level of cost review and reporting calls for a different kind of accounting staff than the traditional kind that did nothing but process large volumes of transaction-related paperwork. It now requires highly trained cost accountants and financial analysts, almost always with college degrees and professional certifications, to conduct the work. In addition, technology has drastically altered the skill levels required of the accounting staff. For example, employees must now know how to implement and operate accounting software, electronic data interchange systems, paperless systems using digitized documents, and electronic cash. Because most of these elements of technology directly impact the transaction processing staff, it is necessary to raise the standard of knowledge for these people. Consequently, the education level of even the lowest people in the accounting hierarchy must be improved to deal with changing circumstances. The world of business has become more international. Many companies are doing an increasing volume of business with companies based in other countries. This greatly increases the complexity of accounting, for a company must now determine gains and losses on sales to other countries. There may even be bartering transactions with organizations that do not have ready access to currency. In addition, if there is no separate finance function, the accounting staff may be called on to handle letters of credit and hedging transactions that are designed to reduce the level of risk that goes with foreign dealings. All of these issues call for a level of skill that was not required in the days of simple transaction processing. In the face of more intensive competition, many companies are also merging or acquiring subsidiaries. This adds a great deal of complexity to the accounting staff’s work, for it must now coordinate a multitude of additional tasks in other locations. This includes setting up standard procedures for the processing of receipts, shipments, and cash. Also, closing the financial books at the end of each reporting period becomes much more complex, as the accounting staff must now coordinate the assembly and consolidation of information from multiple subsidiaries. Even if a company decides to consolidate all of its accounting facilities into one central processing location to avoid all this trouble, it still requires the management expertise to bring together the disparate accounting systems into a smoothly operating facility. This is not an easy task. The environment of mergers and acquisitions greatly increases the skill needed by the accounting staff. The tasks of the accounting function are itemized below. The tasks that belong elsewhere—but are commonly given to the accounting staff in a small company—are noted under a separate heading. • Traditional accounting tasks
Accounts payable transaction processing
Accounts receivable transaction processing
Asset transaction processing
Debt transaction processing

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• New accounting tasks
Bartering transactions
Coordination and consolidation of accounting at subsidiaries
Currency translations
Margin analysis
Nonproduct cost analysis
Selection, implementation, and operation of accounting software and related systems
Target costing • New tasks assigned to the accounting function of smaller companies
Computer services systems installation and maintenance
Hedging and letter of credit transactions
Internal auditing programs Given today’s highly volatile and ever-changing business environment, the only safe statement to make about the new activities presented in this section is that they will only become more complex, requiring even greater skill by the accounting staff to be accomplished in a manner that is both efficient and effective.

1.3 ROLE OF THE ACCOUNTING FUNCTION Having noted the expanded number of tasks now undertaken by the modern accounting function, it is important to also note how the role of the accounting staff has changed in relation to the rest of the company. When the number of accounting tasks was more closely defined around transaction processing, it was common for the accounting staff to be housed in an out-of-the-way corner of a business, where it would work without being impeded by other functions. Now, with a much greater number of tasks, the accounting staff finds itself involved in most major decisions. For example, the cost accountant is expected to serve on product design teams and to let other team members know if new designs will have costs that will meet targeted cost goals. An accounting analyst may be asked by the sales manager to evaluate the profitability of a lease deal being extended to a customer. The controller is frequently asked to sit in on executive committee meetings to give opinions on the cash flow issues for acquisitions or purchases. The accounts receivable clerk may work closely with the sales staff to collect overdue invoices from customers. For these reasons and others, the accounting function now finds itself performing a variety of tasks that make it an integral part of the organization. A particularly important area in which the role of the accountant has changed is related to processes. When another area of the company changes its operations, which is increasingly common, the accounting staff must devise alterations to the existing systems for processing transactions that will accommodate those changes. For example, if the manufacturing function switches to justin-time production or computer-integrated manufacturing, this has a profound impact on the way in which the accounting staff pays its bills, invoices customers, monitors job costs, and creates internal reports. Also, if the materials management staff decides to use material requirements planning or integrated distribution management, these new systems will issue information that is of great use to the accounting staff; it should connect its systems to those of the materials management staff to access that information. To alter its processes, the accounting staff must first be aware of these changes, requiring the accounting staff to engage in more interaction with other parts of the company to find out what is going on. The most historically important role that the accounting staff must change is that of being a brake on other activities. Because most accountants are trained in implementing controls to ensure that assets are not lost, the accounting staff tends to shoot down changes proposed by other departments — the changes will interfere with the controls. The accounting personnel must realize that changes put forward by other functions are not intended to disrupt controls, but to improve the

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company’s position in the marketplace or to increase its efficiency. This means that some controls must be modified, replaced, or eliminated. It is very helpful for the accounting personnel to have an open mind about altering systems, even when the new systems interfere with the accounting staff’s system of controls. In today’s increasingly competitive environment, it is very important for companies to develop strong relationships with their key suppliers and customers. These business partners will demand extra services, some of which must be fulfilled by the accounting staff. These changes may include using electronic data interchange transactions, providing special billing formats to customers, or paying suppliers by electronic transfer. If these steps are needed to retain key business partners, then the accounting staff must be willing to do its share of the work. Too frequently, the accounting staff resists these sorts of changes, on the grounds that all transactions must be performed in exactly the same manner. The accounting department must realize that altering its way of doing business is sometimes necessary to support ongoing business relationships. Altering the focus of the accounting staff from an introverted group that processes paper to one that works with other parts of a company and is willing to alter its systems to accommodate the needs of other departments is required in today’s business environment. This is in great contrast to the accounting department of the past, which had a minimal role in other company activities, and which was its conservative anchor.

1.4 ROLE OF THE CONTROLLER The controller has traditionally been the one who manages a few key transaction cycles, monitors assets, and delivers financial statements. Though the details of the position are covered in Chapter 2 suffice it to say here that the position has expanded to a great extent. As noted earlier in this chapter, the accounting function as a whole is now required to take on additional tasks, to work with other departments more closely, to continuously offer advice to senior management, and to alter systems to match the changing needs of other areas of the company. All of these changes have had a massive impact on the role of the controller within the organization. The key factor is that, due to the vastly increased interaction with other departments, the controller must be highly skilled in interdepartmental dealings. This involves constant interactions with fellow department heads, attendance at a swarm of meetings, and the issuance of opinions on a variety of topics regarding the running of functions with which the controller previously had no connection. Because of this changed role, the controller must now have top-notch interpersonal and management skills — the former to deal with other departments and the latter to oversee the changes needed by the other departments. In addition, the controller must govern a group of employees that is much more educated than was previously the case. This requires constant attention to the professional progress of each person in the department, which requires goal setting, mutual discussion of training requirements, and continuous feedback regarding employee performance. This clearly calls for management skills of an order far higher than formerly required of a controller that presided over a clerical function. Also, the wider range of functions managed by the controller now requires a wider range of knowledge. Besides the traditional training in accounting, a controller now needs at least a passing knowledge of computer systems, internal auditing, and administrative functions (because this area frequently falls under the controller’s area of responsibility). In addition, traditional accounting functions have now become more complex; a controller must know about outsourcing accounting functions and managing in a high-speed growth environment, as well as the increasing complexities of tax laws, Securities and Exchange Commission (SEC) filings, and generally accepted accounting principles. It would take a perpetual student to have an in-depth knowledge of all these areas, so it is more common for the controller to manage a cluster of highly trained subordinates who are more knowledgeable in specific areas, and who can advise the controller as problems arise. In short, the role of the controller has expanded beyond that of a pure accountant to someone with broad management and interpersonal skills who can interact with other departments, as well as manage the activities of an increasingly well-educated group of subordinates, while also working

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with them to further their professional careers. This is a much more difficult role for the modern controller, requiring someone with at least as much management experience as accounting knowledge.

1.5 IMPACT OF ETHICS ON THE ACCOUNTING ROLE With the globalization of business, competition has become more intense. It is possible that the ethical foundations to which a company adheres have deteriorated in the face of this pressure. There have been innumerable examples in the press of falsified earnings reports, bribery, kickbacks, and employee thefts. There are vastly more instances of ethical failings that many would perceive to be more minimal, such as employee use of company property for personal use, “smoothing” of financial results to keep them in line with investor expectations, or excessively robust sales or earnings forecasts. The controller and the accounting staff in general play a very large role in a company’s ethical orientation, for they control or have some influence over the primary issues that are most subject to ethical problems—reported earnings, cash usage, and control over assets. This section discusses how the accounting function can modify a company’s ethical behavior—for good or bad. The accounting function can have a serious negative impact on a company’s ethical standards through nothing more than indifference or lack of caring. For example, if the controller continually acquiesces to management demands to slightly modify the financial statements, this may eventually lead to larger and larger alterations. Once the controller has set a standard for allowing changes to reported earnings, how can the controller define where to draw the line? Another example is when the accounting staff does not enforce control over assets; if it conducts a fixed-asset audit and finds that a television has been appropriated by an employee for several months, it can indirectly encourage continuing behavior of this kind simply by taking no action. Other employees will see that there is no penalty for removing assets and will then do the same thing. Yet another example is when the accounting staff does not closely review employee expense reports for inappropriate expenditures. Once again, if employees see that the expense report rules are not being enforced, they will gradually include more expenses in their reports that should not be included. The accounting staff has a significant negative influence over a company’s ethical standards simply by not enforcing the rules. The previous argument can be turned around for an active accounting department. If the controller and the rest of the accounting staff rigidly enforce company policies and procedures and acquire a reputation for no deviations from these standards, the rest of the corporation will be dragged into line. It is especially important that the controller adhere closely to the highest standards, for the rest of the accounting staff will follow the controller’s lead. Conversely, if the controller does not maintain a high ethical standard, the rest of the accounting staff will have no ethical leader, and will quickly lapse into apathy. Accordingly, the controller is a company’s chief ethics officer, for the position has such a strong influence over ethics. It is a rare week that passes without some kind of ethical quandary finding its way to the controller for resolution. It is not sufficient to merely say that the accounting staff must uphold high ethical standards, if the standards are not defined. To avoid this problem, the controller should create and enforce a code of ethics. This document may not originate with the controller—many chief executive officers (CEOs) prefer to take on this task. However, the controller can certainly push for an ethical code to be developed higher in the organization. Some illustrative topics to include in a code of ethics are: • Bidding, negotiating, and performing under government contracts • Compliance with antitrust laws • Compliance with securities laws and regulations • Conflicts of interest • Cost consciousness • Employee discrimination on any grounds • Gifts and payments of money

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• Hazardous waste disposal • International boycotts • Leave for military or other federal service • Meals and entertainment • Political contributions • Preservation of assets • Restrictive trade practices • Standards of conduct • Use of company assets • Workplace and product safety The wide range of ethical topics, some going well beyond the financial arena, make it obvious that the CEO really is the best source of this document, rather than the controller, though the controller can certainly contribute to those portions relating to financial issues. Once the code of ethics has been created, it must be communicated to all employees. Once again, this is the CEO’s job, but the controller should constantly reinforce it with his or her staff. It is especially helpful if the controller visibly refers to the ethical code whenever an ethical issue arises, so that the accounting staff knows that the controller is decisively adhering to the code. A code of ethics becomes the starting point in the series of judgments a controller must follow when confronted with an ethical issue. The logical series of steps to work through are: • Consult the code of ethics. Having a corporate code of ethics is a great boon to the controller, for he or she can use it as the basis for any ethics-related decision. A senior company officer would have difficulty forcing the controller to adopt a different course of action than what is prescribed by the code of ethics, since this would go against a directive of the Board of Directors. If the controller feels it is necessary to take a course of action contrary to what is stated in the code, then the reasons for doing so should be thoroughly documented. If there is no code, then proceed to the next step. • Discuss with immediate supervisor. The controller’s immediate supervisor is probably either the Chief Financial Officer (CFO), Chief Operating Officer (COO), or CEO. These are the most senior positions in the company, occupied by people whose behavior should be at an ethically high standard. Consulting with them for advice is a reasonable second step in the absence of a code of ethics. However, if the supervisor is the one causing the ethical problem, then skip this step and proceed to the next one. • Discuss with a trusted peer. There is usually someone within the company in whom the controller places a great deal of trust. If so, consult with this person in regard to the proper course of action. Be more circumspect in doing so with a person outside the company, since this runs the risk of spreading information elsewhere, with possible deleterious consequences. If there is no one with whom to discuss the issue, then proceed to the next step. • Discuss with the company’s ethics committee. If there is an ethics committee, this is a good forum for discussion. Unfortunately, many companies do not have such a committee, or it meets so infrequently that the immediate needs of the controller may not be met through this approach. In either case, proceed to the next step. • Discuss with the Board’s audit committee. Many boards have an audit committee, which should be comprised entirely of independent directors. If so, the controller should take his or her concerns to this group. Keep in mind that this is a serious step, since the controller is now going around the corporate reporting structure, which may have unenviable consequences later on if the controller chose not to tell senior management of this action. • Consider leaving the company. If all these avenues are untenable or result in inadequate advice, the controller should seriously consider leaving the company in the near future. Reaching this final step probably means that the ethical issue is caused by senior manage-

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ment, and also that there are no outside checks on their ethical behavior, such as an audit committee of the Board of Directors. It is extremely important that the controller issue consistent rulings on ethical issues, so that employees know they are being treated fairly. Though it may seem like a vast increase in paperwork, it may be useful for the controller to record all ethical rulings in a single document, so that there is a good reference source in the event of future ethical problems. This allows the controller to go back and see what judgment was given in previous cases, thereby giving the controller adequate grounds for treating new issues in a similar manner. In summary, the accounting staff has a large role in enforcing ethical standards throughout a company, since it has such strong influence over several key areas that require ethical judgments, such as the quality of reported earnings, control over assets, and the uses of cash. Accordingly, it is very much in the controller’s interests to have a code of ethics that the accounting staff can adhere to in enforcing the appropriate ethical standards.

1.6 EVOLVING ROLE OF ACCOUNTING Though there are many variables that can impact the direction of the accounting function and the controller’s role in the future, there are a few broad trends that are likely to continue, and from which one can predict the evolving role of accounting. The accounting function is in the midst of a fundamental change from being a clerical group without significant training to a cadre of very experienced technicians and managers. Though there will always be a need for clerical help (indeed, this group will continue to comprise the majority of the department), there will be an increasing focus on bringing in more experienced personnel. This prediction is based on the technological trend that brings continued levels of automation to the accounting function, thereby reducing the need for clerks. Also, the same trend toward more technology means that a greater proportion of the accounting employees must have better training in how to use the new hardware and software. These trends will force the accounting department of the future to stock up on highly trained personnel with good management skills. The accounting department is likely to become a more common route to top management positions. The accounting area has always been a fertile one for training people in the nuts and bolts of transactions, and how they must function. This is useful for a lower-level manager, but now that the department also handles a multitude of additional tasks, such as cost analysis, target costing, and advanced finance functions, it becomes a much better training area for higher-level managers. The company of the future will not only see large numbers of well-trained people advancing out of accounting, but they will also see a large proportion of new recruits clamoring to get into it, so that they too can receive the necessary training and experience. This section discussed some evolutionary changes to expect in the role of the accounting function and the controller. It is likely that there will be a decrease in the proportion of purely clerical positions in the accounting area, in favor of more senior personnel with extra technical and management skills. Also, because of the greater breadth of responsibility to be obtained in this area, it will become more common for senior management personnel to come out of this area.

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CHAPTER

2

CONTROLLER’S RESPONSIBILITIES 2.1 INTRODUCTION 11

2.8 CONTROLLER’S JOB DESCRIPTION 16

2.2 VARIATIONS ON THE TITLE 11 2.9 RELATIONSHIP OF THE CONTROLLER TO THE CHIEF FINANCIAL OFFICER 18

2.3 PLANNING FUNCTION 12 2.4 CONTROL FUNCTION 12 2.5 REPORTING FUNCTION 13

2.10 FUTURE CHANGES IN THE CONTROLLER’S ORIGINS AND RESPONSIBILITIES 19

2.6 ACCOUNTING FUNCTION 13 2.7 ADDITIONAL CONTROLLER FUNCTIONS IN SMALLER COMPANIES 14

2.11 MANAGING EXPLOSIVE GROWTH 20

2.1 INTRODUCTION A controller’s job can vary dramatically based on a company’s size and whether it has other managers in place who handle related functions. If a company is small and there are few other managers, the controller may end up with a formidable list of tasks on the job description. However, as a company grows in size, the role becomes more precisely and narrowly defined. This chapter covers the full range of the activities that may be assigned to a controller, beginning with the classical management areas of planning, controlling, reporting, and maintaining key accounting processes, and expanding into ancillary functions that may become part of the controller’s job, depending on the circumstances. In addition, the chapter touches on variations in the controller’s title, and why the term controller, though most commonly used, is perhaps not the best description for the job. The chapter concludes with a review of the relations between the controller and chief financial officer (CFO), the future job description of the controller, and how to manage in an explosive growth environment. This wide-ranging discussion gives the reader a comprehensive view of the controller’s job.

2.2 VARIATIONS ON THE TITLE Numerous titles can be applied to the position of the chief accounting officer; however, the most common title used is controller. The duties are sometimes assumed by a chief accountant, office manager, comptroller, treasurer, assistant treasurer, or secretary. However, with the increased emphasis on accounting control, increased management duties, and for additional statistical and financial decision-making information, the duties of the position are more frequently being segregated into the role of a separate manager called the controller. This is especially true in larger organizations, where there is much more specialization. The term controller is an unfortunate one, for it seems to emphasize the control function only; as the reader will find after reading this chapter, there are a number of other basic functions this person performs, such as planning, reporting, and management, that are just as important as the control function. The chief accounting officer (CAO) title is a more complete description of the position; however, due to common usage, the term controller will have the same meaning as CAO in this book. 11

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2.3 PLANNING FUNCTION The establishment and maintenance of an integrated plan of operation is a major function of the controller. The business objective is profit, and planning is necessary to fulfill it, for profits do not “just happen.” Visualize, then, the role of the modern controller in business planning. First, there is a responsibility to see that a plan exists and that it is supported by all levels of management. The implication of an integrated plan is that all parts will link together to support the business objective. For this reason, all members of management must participate willingly and contribute to the information in the plan. It must be the company’s plan and not the controller’s plan. The controller’s primary task is to act as the coordinator who assembles and maintains the plan, which results in a statement of forecasted income and expense, as well as a set of supporting schedules and assumptions. In more detail, the following points describe the controller’s key tasks related to the plan: • Verify that the sales plan or forecast supports known corporate policies and objectives, such as geographic areas to enter and types of products to sell. • Verify that the sales plan appears to have realistic assumptions, such as an expected sales amount per salesperson that is valid based on past history. • Verify that the production plan supports the sales schedule. This involves comparing the amount projected to be sold to the amount to be produced, while factoring in the amount of finished goods inventory already on hand. • Verify that the production plan is within facility capabilities. This involves comparing projected production volumes to the company’s history of production rates, also factoring in the addition of extra shifts. • Verify that expense levels are in proportion to other activities. For example, the utilities expense must go up if the company is adding a facility, while the travel expense must increase if there will be a larger sales staff. • Verify that there is sufficient funding for the projected activity. If there is not a sufficient amount of debt or equity funding, the plan must be recast on a smaller scale. Once the plan has been completed, the controller should test or appraise its adequacy and report to the CFO or chief executive officer (CEO) on the results of this analysis. It must be judged based on the following concerns: • In light of past experience, is it realistic? • Does it reflect economic conditions that are expected to prevail in the period of the plan? • Have the related expenses for product lines designated to be discontinued, such as production equipment or inventory disposal, been considered? • Does it meet the company’s requirements for return on investment and such other ratio or other tests as may be applicable? Some of the testing and analysis will be accomplished as preliminary plans are formulated, and the rest will await the total picture. However and whenever it is done, the controller is the counselor and coordinator, extending advice and suggestions to all who need it during the plan preparation. Final responsibility for the plan rests with the CEO, and responsibility for each operating function must be that of the manager in charge of each function. Nonetheless, though responsibility for the plan lies elsewhere, the controller should be deeply immersed in the underlying mechanics and assumptions of the plan; the company relies on the controller to perform this function.

2.4 CONTROL FUNCTION The management function of control is the measurement and correction of performance so that business objectives and plans are accomplished. Management control seeks to compel performance to a plan or standard. The controller assists in this function by providing information to the managers

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of each function, so that they can enforce control-related issues. The controller cannot enforce control issues in other departments, since there is no managerial oversight of those areas, but the controller does correct control-related problems within the accounting function. Activities in the control function absorb a large portion of the accounting staff’s time. Some control information is provided to management by the accounting staff every day; other data are prepared less frequently, as circumstances require. For example, larger companies that are labor intensive may find that hourly or daily information on labor performance may be helpful, or weekly manufacturing expense figures may be needed. However, the controller’s involvement does not end with the mere feedback of reporting information to various parts of a company. Instead, the controller must devote a great deal of time to flowcharting existing systems, examining the results for control issues, and implementing process changes that will eliminate the control problems. Only after all this activity will a controller be able to issue reports on the results of controls. A manager cannot control the past. Instead, one can study past action to determine the place and cause of deviation. Here, as in planning, the best kind of control is forward looking. The controller must keep this orientation in mind while participating in the control function, giving constant thought to steps that might be taken before the operating action to ensure the desired performance level. This is preventive or anticipatory control. A controller must become heavily involved in all stages of the control function, which extends from system analysis through problem identification and change implementation, ending in control reports that note the results of the control alterations. This is one of the most crucial tasks for the controller.

2.5 REPORTING FUNCTION Insofar as it concerns internal management, the reporting function is closely related to both the planning and control functions. Reporting is essential to make planning and control effective. Yet the reporting function is not merely one of presentation of tabulations and is not wholly routine, although some phases can be automated. Moreover, the management that makes decisions often cannot be kept adequately informed solely from periodic statements regardless of how well designed they may be. The reporting function encompasses the interpretation of the figures, and the controller’s duty is not discharged until management actually understands what is being presented. Ensuring that management understands what it reads calls for an entirely separate set of skills than those given a controller in business school. This requires constant informal meetings with all recipients of accounting reports, not only to go over excessively large variances, but also simply to ensure that they understand what they are reading. A good supplemental method is to construct a formal training program that describes the nature and significance of the information being issued, and to constantly update and again present this training to management. Even a quarterly reiteration of the training is not always sufficient. In addition, the controller may be required to report to outside entities, which usually calls for some reformatting of the internal reports. Typical recipients of reports are shareholders, creditors, the general public, customers, the Securities and Exchange Commission (SEC), and the Internal Revenue Service (IRS). The controller is not only responsible for assembling data on a large number of topics into easily readable reports for consumption both inside and outside the company, but also for ensuring that the recipients understand what they are given.

2.6 ACCOUNTING FUNCTION The systematic recording of financial transactions is often regarded as the principal function of the controller. The controller is expected to apply sound accounting principles and practices within the company, as well as to stay current on the latest technological advances, so that this can be done in the most effective and efficient manner possible. The last few decades have revealed fur-

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ther advances in management theory that a controller is now expected to implement in the accounting function, including: • Benchmarking key practices. A controller should regularly compare the performance of the accounting department for various tasks against the results of other accounting functions at other companies, not necessarily in the same industry, to see if anyone else is doing it better, and, if so, to copy their practices into the accounting department. This results in a major improvement in the department’s operating effectiveness. • Converting to electronic transactions. Many of the larger companies now send transactions to each other with electronic data interchange, rather than with paper-based transactions. This is a boon to the accounting department, because the transactions can be automatically entered into the accounting computer system (since it is already in electronic format) without any error-prone manual rekeying of information. • Reducing cycle time. The controller should actively engage in cycle time reduction, so that the time required to complete the primary transactions are greatly reduced. This allows a company to act more quickly, as well as to generate information about the results of its actions, both of which allow it to compete at a higher level. • Outsourcing accounting functions. The controller should look into handing some or all accounting functions over to suppliers who are better equipped to handle key transactions. For example, many companies now outsource their payroll processing to suppliers that calculate taxes, make tax deposits, and pay employees by direct deposit. The controller should review this option for other accounting functions, too. • Reengineering key functions. Some accounting functions may require so much effort to complete that it is best to scrap the system and start with a new approach that vastly reduces the effort, error rate, and cost of the old function. All of these new methodologies ensure that today’s controller will be armed with enough tools to greatly improve the operational effectiveness of the accounting function.

2.7 ADDITIONAL CONTROLLER FUNCTIONS IN SMALLER COMPANIES The controller of a smaller company will find that the position includes a number of additional tasks besides those already enumerated in the last section. This is because a small company cannot afford to also hire a CFO, an office manager, a computer services manager, and a human resources director. Consequently, all of these functions may fall on the controller. When applying for a controller position with a small company, it is useful to see if these other positions are filled — if not, the controller will have a much wider range of job activities. The main activities in each of those areas will probably fall under the controller’s managerial umbrella. The most common additional functions that a controller will take on are those in the finance area. These tasks are normally handled by the CFO, which is a position that many small companies dispense with if they have minimal funding needs or are not publicly held. The primary tasks of the finance function are: • Acquiring insurance coverage • Conducting public offerings • Dealing with investors • Dealing with lenders • Determining customer credit levels • Investing pension funds • Investing surplus funds Of the tasks normally handled by a CFO, the controller usually has little trouble in managing insurance, credit, and investment decisions. However, conducting a public offering is usually well

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outside the experience of most controllers, and so it would behoove a controller to recognize this inadequacy and bring in qualified help if a company decides in favor of a public offering. A small company, usually one with less than 100 employees, frequently does not have a human resources manager. This means that the function, once again, must be managed by the beleaguered controller. Many of these new functions are administrative and procedural in nature — tasks for which most controllers are amply qualified. However, others, such as career planning and recruiting, are not. These later tasks are sometimes shifted elsewhere in the organization, depending on who is most qualified to handle them. The most typical human resources functions are: • Administering changes to the pension plan • Administering new-employee paperwork • Conducting employee safety training • Conducting recruiting for all positions • Devising a career plan for key managers • Maintaining employee files • Processing medical claims • Processing workers’ compensation claims • Updating the employee manual Given the large proportion of clerical tasks in the human resources function, which are similar to the clerical functions of the accounting area, most controllers are fairly comfortable in administering this department. Some tasks, such as safety training and administering the pension plan, require some extra knowledge to handle. The most uncommon tasks for a traditional controller are creating staffing plans and recruiting. These tasks are so different that the CEO sometimes hands them off to someone else in the organization. The most common additional function for the controller to manage is administration. This includes the secretarial pool (if any), the reception function, all office equipment, and the telephone system. Because this area impacts all functions, it is common to have a disproportionate volume of complaints about it that take up an excessive amount of a controller’s time. Accordingly, it is frequently handed off to an assistant controller. In addition, it is wise to outsource the repair and maintenance of all office equipment and the telephone system to a qualified supplier. This reduces the controller’s day-to-day management to contacting suppliers and ensuring that the administrative staff is supplemented by a sufficient number of temporary help to complete short-term projects, such as special mailings, that pass through this area. The most common administrative functions are: • Answering incoming calls • Ensuring that all copiers and fax machines are operational • Ensuring that the telephone system is operational • Managing administrative staff • Planning for the timely replacement of aging office equipment • Sorting and delivering incoming mail • Stamping outgoing mail • Working with temporary help agencies to bring in personnel for special projects Finally, the controller sometimes manages the computer services function. Most small companies maintain only the minimum number of computer applications, and these are usually packaged software, which allows them to avoid a full-time department to handle this function. Instead of a separate department, the controller is in charge of backing up the computer system, ensuring that it is repaired promptly, that the system is expanded as the situation requires, and that new software is implemented in an efficient manner. Due to the highly technical nature of this work, a controller is well advised to outsource as much of this work as possible rather than dealing with it internally; not only does this approach reduce the controller’s workload, but it also brings in much more qualified

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personnel than most small companies can afford to keep in-house. The main computer services functions are: • Backing up the computer system • Enforcing computer security standards • Expanding the systems as needed • Installing new hardware and software as needed • Maintaining all hardware and software • Maintaining and repairing the computer network • Providing system training to employees The controller must be especially careful to make provisions for system crashes. This means that there must not only be daily backups of the software, but also off-site storage of the backups to ensure that they are not damaged if the main facility is destroyed. This should also include power backup systems to ensure that the computers remain operational even if the main power source goes down. The controller should also consider a disaster recovery plan that details how to make the system operational again as soon as possible in the event of a major problem. Though other parts of the computer services function can be outsourced, this one must be handled internally, and correctly — if the controller does not prevent a serious computer crash that renders key systems inoperable, this may have a major, and negative, impact on senior management’s view of how the controller is performing. There are additional areas that the controller of a smaller company may find him- or herself supervising. The most likely areas are human resources, administration, computer services, and finance. The controller is well advised to outsource as much of this extra work as possible in order to put it in the hands of experts from suppliers, while also handing off selected tasks to other members of the organization who may be more qualified to perform them. The remaining tasks must be managed by the controller or a subordinate. Because these are areas in which most controllers are only partially trained, this can involve a very rapid and intensive learning experience.

2.8 CONTROLLER’S JOB DESCRIPTION Though the previous sections briefly discussed a number of the main aspects of the controller’s job, they do not show a complete view of the position’s responsibilities. This section answers that need by showing a complete controller job description. If a controller needs a job description for a company procedures or human resources manual, the description noted here is in sufficient detail to be “lifted” out of this book for immediate use, with some modification based on each controller’s circumstances. The description is summarized into subheadings, so that tasks are noted under such categories as finance, human resources, or computer services, which allows the reader to ignore those broad functional areas that do not apply to him or her. The tasks are noted in the order in which they are most likely to be the controller’s responsibility, starting with accounting, finance, and administration, and then progressing through the computer services and human resources functions. Also, the description assumes that there is a staff handling all transactions, so it does not refer to actually handling specific transactions, only ensuring that they are correct. The description is as follows: • Position Title: Controller • Reports To: Chief Financial Officer • Supervises: All accounting, finance, administration, computer services, and human resources personnel (varies by size of company and presence of other managers). • Tasks:
Accounting Assist in the annual audit as required. Ensure that accounts payable are not paid earlier than required.

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2.8 Controller’s Job Description

Ensure that accounts receivable are collected promptly. Ensure that all reasonable discounts are taken on accounts payable. Ensure that customer billings are issued promptly. Ensure that job costs are calculated. Ensure that the monthly bank reconciliation is completed. Issue interim management reports as needed. Issue timely financial statements. Maintain an orderly accounting filing system. Maintain the chart of accounts. Manage outsourced functions. Manage the accounting staff. Manage the production of the annual plan (budget). Process payroll in a timely manner. Provide financial analyses as needed. Review systems for control weaknesses.
Finance

Arrange for banking services. Arrange for debt financing. Conduct public offerings. Invest excess cash. Invest pension funds. Issue credit to customers. Maintain insurance coverage. Maintain lender relations. Manage the finance staff. Monitor cash balances.
Administration

Bring in temporary personnel for special projects. Ensure that incoming mail is properly distributed. Ensure that office equipment is operational. Ensure that outgoing mail is sent in a timely manner. Manage outsourced maintenance work. Manage the secretarial staff. Upgrade office equipment as needed.
Computer Services

Back up the computer system. Implement hardware and software. Maintain a current disaster recovery plan. Maintain computer security systems. Manage the computer services staff. Manage outsourced functions. Provide system training. Select hardware and software.
Human Resources

Administer safety training.

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Administer the pension plan. Maintain employee benefits paperwork. Maintain employee files. Maintain employee manual. Manage career planning. Manage the human resources staff. Process medical claims. Process workers’ compensation claims. Recruit employees. This generic and very wide-ranging controller job description can be used as the basis for a more customized description that is tailored to individual circumstances.

2.9 RELATIONSHIP OF THE CONTROLLER TO THE CHIEF FINANCIAL OFFICER In a larger company, there is a clear division of tasks between the controller and the CFO. However, there is no clear delineation of these roles in a smaller company, because there is usually no CFO. As a company grows, it acquires a CFO, who must then wrestle away some of the controller’s tasks that traditionally belong under the direct responsibility of the CFO. This transition can cause some conflict between the controller and CFO, which is discussed in this section. In addition, the historical promotion path for the controller has traditionally been through the CFO position; when that position is already occupied, and is likely to stay that way, there can be some difficulty with the controller. This section also discusses that issue. In a small company, the controller usually handles all financial functions, such as setting up and maintaining lines of credit, cash management, determining credit limits for customers, dealing with investors, handling pension plan investments, and maintaining insurance policies. These are the traditional tasks of the CFO, and when a company grows to the point of needing one, the CFO will want to take them over from the controller. This can turn into a power struggle, though a short-lived one, because the controller always reports to the CFO and will not last long if there is no cooperation. Nonetheless, this is a difficult situation, for the controller has essentially taken a step down in the organizational structure upon the arrival of the CFO. For example, the CFO replaces the controller on the executive committee. If the controller is an ambitious one, this will probably lead to that person’s departure in the near term. If the controller is a good one, this is a severe loss, for someone with a detailed knowledge of a company’s processes and operating structure is extremely difficult to replace. The controller should take a job elsewhere if he or she perceives that the person newly filling the CFO position is a roadblock to further advancement. However, this does not have to be a dead-end position. The controller should talk to the CFO about career prospects within the company and suggest that there may be other responsibilities that can replace those being switched to the CFO. For example, a small minority of controllers manage the materials management department; this will become increasingly common as controllers realize that much of the paperwork they depend on originates in that area and that they can acquire better control over their processes by gaining experience in this area. There may also be possibilities in the areas of administration, human resources, and computer services, which are sometimes run by controllers. The fact that there is a new CFO does not mean that a controller should immediately quit; there may be other opportunities involving related tasks that can shift the controller’s career in other directions. The CFO position is one with an extreme emphasis on money management, involving such tasks as determining the proper investment vehicles for excess cash, dealing with lenders regarding various kinds of debt, making presentations to financial analysts, and talking to investors. None of these tasks are ones that the controller is trained to perform. Instead, the traditional controller training involves handling transactions, creating financial statements, and examining processes. The requirements for the CFO position and the training for the controller position are so different

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that it seems strange for the controller to be expected to advance to the CFO position, and yet that is a common expectation among accountants. As noted in the next section, the controller may not want to assume that the CFO position is an obvious next step, and that perhaps the controller position may now lead into other management areas. There can be some difficulty between the controller and the CFO, especially when a CFO is brought in for the first time. This commonly results in the departure of the controller if that person perceives that the next promotion step is the CFO position. This problem can be ameliorated by looking for opportunities to shift the controller into other functional areas. These opportunities are noted in the next section.

2.10 FUTURE CHANGES IN THE CONTROLLER’S ORIGINS AND RESPONSIBILITIES The accounting function has changed drastically over the last half-century, and the controller has changed along with it. Where the position used to require someone with a tight focus on processing transactions and financial statements, the job now requires much more managerial skill, as well as a general idea of such diverse bodies of knowledge as taxation, business process improvement, outsourcing, and computer systems. This calls for a controller with a much more diverse background than was previously the case. It also points toward a different career direction for the controller of the future. The controller of the future will come from a different educational and experience background. Most companies currently call on the “Big Four” auditing firms for their controllers, and many auditors enter the Big Four on the assumption that they will eventually be hired by their clients into that role. However, auditors are trained in the areas of generally accepted accounting principles, verifying the accuracy of financial statements, and reviewing underlying accounting processes to ensure that they function correctly. Though these tasks are still part of the controller’s job description, and will remain so for the foreseeable future, an increasing proportion of the controller’s job now includes tasks for which an auditor is not prepared. These new tasks include computer systems selection, implementation, and management, as well as outsourcing, cycle time reduction, benchmarking, and process reengineering. Because of these new tasks, company management will find that it can fill the position with more thoroughly qualified personnel from other sources. One source will be the certified management accountant (CMA) program, which emphasizes a greater body of knowledge than the certified public accountant (CPA) exam. The better companies will also look to consulting firms for people with a detailed knowledge of process improvement and systems management. Finally, top management will eventually realize that controllers do not have to be CPAs; on the contrary, it will be more important to have good management skills and be surrounded by a team of highly qualified accounting professionals who can advise on the more technical accounting issues. In short, controllers will come from other sources than auditing firms, because that source no longer provides people with a complete set of skills. The future direction of the controller position is probably toward something with much more responsibility. Companies are competing more and more on such issues as rapid cycle times and low costs, and the controller is an integral part of the work required to improve them. As management realizes that the controller has an enormous impact on these most critical competitive areas, it will place the controller in charge of them. This means that the controller of the future will become more of a chief process officer (CPO), with general authority to alter processes. This function will cross department lines as much as the processes that the controller is fixing, so the position must have added authority to make changes. This added authority will raise the controller in the management hierarchy to a point above those of other department heads. We may also find that the controller will be more likely to manage new areas that are heavily driven and influenced by processes, especially materials management. The controller of the future will occupy a more influential position, due to his or her influence over company-wide processes. As the controller position adds company-wide processes to its area of authority, the controller will find that, due to this extra responsibility, promotional opportunities will veer away from the CFO position and toward the chief operating officer (COO) position. This does not mean that there

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will be a wholesale abandonment of the CFO position, since that remains the goal of most controllers, but controllers will have such an in-depth knowledge of all of a company’s operations that they will become the first choice for promotion to be COO, or at least be one of the heavy favorites for the position. There are changes already underway that are preventing many controllers from reaching the coveted CFO position, and which may provide further impetus in the direction of promotions to the COO position. The trouble with the CFO position is that its job requirements are significantly different from those of a controller, and few controllers are trained to take over the job. It involves lender and investor relations, as well as making the proper investments of spare cash. The job requirements for the CFO position really call for someone with experience in the treasury side of the business, or perhaps from Wall Street, to take it over. If we do see CFOs being promoted from directions other than the controller position, this also calls into question the traditional reporting relationship that has the controller reporting to the CFO. If the CFO does not have a background that yields any knowledge of the accounting field, then it does not make much sense to have that person control the function. Instead, it may become more appropriate to have the controller report straight to the CEO, alongside the CFO. Due to the new sources of CFO hiring, there are ample reasons for shifting the controller out from under the management of the CFO. The controller of the future may come from many sources, rather than straight from an auditing firm, and that the promotion path of the position will include the COO position, rather than the usual CFO position. This path will open up because the controller will become more involved in company-wide positions, as well as because CFOs will increasingly be drawn from the ranks of Wall Street.

2.11 MANAGING EXPLOSIVE GROWTH A controller sometimes finds him- or herself in a situation in which a company has just released a “hot” product, it embarks on a massive expansion of sales territories or it goes on an acquisition binge, either of which result in a phenomenal rate of growth. This frequently results in a difficult situation for the controller, because there are never enough resources to handle the flood of transactions swamping the department. This section discusses how to prioritize tasks in such an environment. It also notes the same issues for the finance, computer services, and human resources functions, in case the controller is in charge of those areas as well. In an explosive growth environment, the key focus of the accounting staff is on the conservation of cash. This is because a growing company is constantly investing cash in working capital and facilities, leaving little cash available for further growth or as a reserve in case of a sudden downturn in company fortunes. The controller plays a major part in cash conservation. The following points note the most important areas in which the controller can affect cash flow: • Send invoices promptly. It is difficult to collect cash from customers if they have not yet been billed. To avoid this problem, the controller must pay strict attention to the billing process, especially the speed with which invoices are created and sent. This may also involve a switch to electronic invoicing, an alteration in payment terms to encourage faster payment, or delivery of the invoice with the shipment. Any of these system modifications will result in a faster cash flow. • Collect accounts receivable promptly. Increasing the speed of collections also improves the cash flow. The controller can do this by adding more staff to the collections effort, concentrating the bulk of the collection effort on the largest overdue invoices, working closely with the sales staff to obtain payments, concentrating on issuing accurate invoices that customers cannot complain about, and tightening the terms of credit being offered; all of these actions will slowly improve the speed of collection. • Minimize mistakes. Customers do not pay their bills on time if they are protesting inaccuracies on the bills. To avoid this payment delay, the controller can focus on ensuring that mistakes are eliminated. This can be done by using constant feedback from the collections staff

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to fix recurring problems in the customer billing database (e.g., mailings to the wrong address or target person). Another approach is to have the accounting software flag any invoices that are missing critical information, especially a customer purchase order number. In addition, there can be a mandatory proofreading of all very large invoices prior to issuance, so that there will be no problems with any invoices that can seriously impact cash flow. • Conduct cost accounting promptly. A growing company must know immediately if it is selling a product that is not returning enough of a profit; otherwise, it will not spin off enough cash flow to sustain a high rate of growth. The controller can push for a very rapid costing review of new products, both before they are issued as well as after they have been produced for a short time, to see if there are significant variances from expected margins. The results of these costing studies should be immediately communicated to upper management, so that steps can be taken to revise the product costs or prices to yield better profits. These accounting functions all have the most immediate bearing on cash flow. If there is a question of having to allocate resources away from other accounting activities in order to emphasize these cash flow areas, the controller should consider some outsourcing, which will leave more staff time available for these tasks. For example, the payroll function is normally handled by clerical personnel who are equally capable of becoming involved in billings or cash collections. If the controller also manages the finance function, there are several additional issues to consider in a high-growth environment. The main one is predicting future cash flows. This is because an accurate cash forecast tells management how much extra cash it will need from outside sources, as well as the timing of that need. This becomes the foundation for efforts to acquire additional debt or equity funding. In addition, the controller should keep a close watch over the risk and return of any investments, in order to maximize the company’s investments while maintaining as low a risk profile as possible. Finally, the controller must devise an orderly system for clearing incoming payments through a system of lockboxes, funneling these payments into a central account, and then disbursing the money back out for accounts payable through outlying banks that take extra time to clear payments. This system of lockboxes and controlled disbursements maximizes the amount of a company’s cash on hand, as well as the time period during which it can be used. These are the key finance-related tasks for a controller to manage in an explosive growth environment. If the controller also manages the computer services function, the key factor is not to let problems with the computer systems bog down other company operations that are relying on it. The main reason for this factor is that computer services is a support function that is the linchpin of nearly all transaction processing, and if it is not operational, the company cannot function. This principle requires the controller to take several actions. One is to back up the system regularly, as well as to make provision for rapidly bringing the system back on line if it goes down (usually through redundant systems or rapid on-site servicing). Also, if there is a conversion to new hardware or software, the controller must ensure that some sort of system is still supporting company operations at all times — it may be the old system or the one replacing it, but a growing company must be assured of having some sort of computer system up and running at all times. Thus, the controller’s role in the computer services area is a conservative one: Just make sure that the systems do not fail. A controller may also be responsible for the human resources function in a high-growth situation. If so, the primary focus is on where to find qualified candidates for positions throughout the company. Without enough staff, no company has a chance of continuing its growth, so this is absolutely crucial. There are a variety of techniques available for finding new staff, such as the Internet, recruiting firms, newspaper advertising, paying bonuses to in-house staff to bring in acquaintances, and using targeted publications that are distributed to specific trade disciplines. Also, since the human resources staff is usually overwhelmed by its recruiting work, the controller can ease the work burden by outsourcing other tasks. For example, benefits and pension administration can go to a supplier. In short, the controller must focus on recruiting when in charge of the human resources function of an explosive growth company.

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This section summarized the controller’s management functions in an explosive growth situation. The management goals change drastically in this environment. For example, the accounting and finance areas must focus on cash management. Computer services to key functional areas must not be interrupted. The human resources staff must focus on recruiting new employees, to the exclusion of any other activities. These are the key controller tasks in an explosive growth environment.

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CHAPTER

3

CHIEF FINANCIAL OFFICER: FROM CONTROLLER TO FACILITATOR OF CHANGE 3.1 INTRODUCTION 23

3.6 CHANGE EXECUTIVE MANAGEMENT PRACTICES 29

3.2 UNDERSTANDING WHAT CHIEF EXECUTIVE OFFICERS WANT 23 3.3 TASK OF THE CFO 24

3.7 ENLIST THE SUPPORT OF THE CHIEF EXECUTIVE OFFICER 30

3.4 DEVELOP AND COMMUNICATE A COMPELLING FINANCE AGENDA 24

3.8 MOBILIZE THE ORGANIZATION 31

3.5 BUILD A COMMITMENT TO CHANGE WITHIN FINANCE 26

3.9 INSTITUTIONALIZE CONTINUOUS IMPROVEMENT 32

3.1 INTRODUCTION Years ago, chief executive officers (CEOs) were satisfied with finance chiefs who could manage the analysts on Wall Street, implement financial controls, manage initial public offerings (IPOs), and communicate with the board—in other words, possess strong financial skills. However, in today’s business climate in which competitors appear out of thin air, where e-commerce is changing entire industries, the ability to change quickly has become a necessity for growth, if not for survival. Chief executive officers are no longer satisfied with financial acumen. They are demanding more from their finance chiefs. They are looking for individuals who can fill a multitude of roles: business partner, strategic visionary, communicator, confidant, navigator, and creator of value. Bottom-line CEOs want someone who will drive improvement quickly—a facilitator of change. This chapter focuses on how to drive change in an organization. It is not about running a meeting or facilitating groups, but about implementing critical management practices that will help chief financial officers (CFOs) implement major business changes.

3.2 UNDERSTANDING WHAT CHIEF EXECUTIVE OFFICERS WANT Facilitating change sounds simple until one is in the trenches trying to make significant improvement in how a business operates. Chief executive officers want creators of value, but often do not see that redefining the role of finance from controlling to driving operational improvements requires changing how the senior team operates and interacts with finance and following a systematic approach. In some organizations, line managers see finance as a necessary but unpopular support function that always changes budget numbers. In other organizations, norms have developed within the senior management group where there is an unwritten rule: “You don’t ask too many tough questions about my area and I won’t ask you too many questions about your area.” In one particular case, a relatively new CFO saw large opportunities for improvement. These opportunities just happened to be in the operational areas and the president of those businesses did not need 23

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Ch. 3 Chief Financial Officer: From Controller to Facilitator of Change

“the new guy” telling him what to do. Even though the new CFO had a good relationship with the CEO, any immediate improvement efforts became mired in political turmoil. Moving from controller to facilitator of change is not an easy transition. However, it can be done if CFOs focus on several key concepts.

3.3 TASK OF THE CFO In today’s business climate, the quote “There are the quick and then there are the dead” is quite true. How does a CFO drive change quickly? Creating value and becoming the business partner so many CEOs demand means facilitating change that not only affects finance but also directly impacts the operating units. To accomplish this end, CFOs must become skilled in several key management practices. The CFO must: • Develop and communicate a compelling finance agenda. • Build a commitment to change within finance. • Change executive management practices. • Enlist the support of the CEO. • Mobilize the organization. • Institutionalize continuous improvement. By applying these concepts, CFOs can begin to accelerate the implementation of major organizational changes, as seen in Exhibit 3.1.

3.4 DEVELOP AND COMMUNICATE A COMPELLING FINANCE AGENDA Chief executive officers say they want finance chiefs who can bring their organization to another level of performance. They want CFOs who are strategic thinkers and aggressive implementers, who can execute successfully. Because the finance agenda may affect the operating groups, an important skill is creating commitment around what is to be accomplished. One of the key reasons that

Leadership Team CEO

CEO goals Strategic agenda Leadership team management practices and processes Individual relationships

GM HR

CFO

GM

GM CIO

CFO goals Finance agenda Finance team management practices and processes

Individual goals

Mobilizing the Organization

E XHIBIT 3.1

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B ECOMING

A

F ACILITATOR

OF

C HANGE

GM

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3.4 Develop and Communicate a Compelling Finance Agenda

25

change often fails is a decrease in organizational commitment. This often occurs when senior executives continuously change priorities, do not focus, or do not show their personal commitment to an effort by spending time on managing the effort. To implement and then institutionalize change, senior executives need a constancy of purpose — some stability in a normally chaotic world. The question becomes how do you create stability and yet stay flexible and dynamic to address market changes. The first step in creating a constancy of purpose and building commitment is developing a clear finance agenda. The finance agenda describes the five to seven key outcomes to be accomplished in the next 12 months, stated in crisp, definitive language where there will be no doubt when they have been accomplished. Essentially, the finance agenda is an organization’s objectives for the year. It is a set of objectives that the CFO has memorized and can describe within two minutes at any moment and in any location. For example, a strategic agenda may look as follows: • A fully functional shared services group for finance in the Americas • A simplified and focused rolling budget process • Books closed within three days • A simple value-based scorecard and a value-based measurement system for each business • Return-on-investment (ROI) calculations for any software implementation and process for measuring the ROI on subsequent module installations • Accurate monthly financial summaries for each of the business units Interestingly enough, creating this agenda sounds simple, and many executives say they already have clear objectives. But the key questions are: Are you fluent in your ability to describe them from memory? Is your organization clear? When asked specifically, “What are the five to seven key outcomes that you need to accomplish this year?”, less than 60 percent of the executives can explain what they need to accomplish from memory in specific, crisp language in only a few minutes. Some need to go to their desk drawer to pull out their objectives. If I ask, “How many of the people reporting to you could articulate the key outcomes that you need to accomplish (i.e., those for the organization)?”, the number drops to less than 50 percent. And if asked, “How well do your peers on the executive staff know your specific objectives?” or “How well does the entire finance organization know your overall objectives?”, the number is well below 50 percent. Imagine less than 50 percent of the people or peers knowing what a senior executive (in other words, what their organization) needs to accomplish. Chief financial officers may be thinking that they already have clear goals and wondering why this is so different. On the surface it looks similar to any standard goal-setting process, but in reality it is fundamentally different. The difference is in how fluent one is in describing the objectives, how focused they are, and whether they are “top of mind” or stored in a desk drawer. How does this affect organizational behavior? Competing priorities is a reality in today’s organizations, yet it is an executive’s job to help focus the energy of the organization on what is important and build commitment around those objectives. The first question people ask is whether the executive is personally committed. They draw their conclusions by observing his or her behavior. Communicating a clear set of objectives is critical in telling the organization what is important. However, in today’s information-overload work environment, a few presentations will not suffice. Communication experts say that senior executives often need to use every opportunity to repeat their messages to the point where they are literally “sick of repeating themselves.” Only then do people begin to remember the message. Furthermore, this begins to reinforce the executive’s personal commitment to the objectives. Bob Galvin at Motorola constantly spoke about Six Sigma quality. By communicating this message every opportunity he had, the organization began to believe that he was serious in his personal commitment to the change. This was then followed by actions that continued to reinforce the organization’s belief that Six Sigma was important. Forcing oneself to memorize strategic agenda and carrying it around in his or her head allows one to communicate continuously. Imagine a CFO is standing in the elevator and a new business analyst asks him a question about the finance department. Or the CFO is in the cafeteria and a manager wonders whether what he is doing is adding value. If within two minutes he can clearly, simply,

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and specifically cite what finance is trying to accomplish, the analyst in the elevator knows the focus. That person can then communicate the focus to peers with little translation error. Furthermore, a manager can immediately determine if what he or she is doing contributes to the overall direction of the finance organization, because the manager knows exactly what the CFO is trying to accomplish. This type of clarity, constancy of purpose, and reinforcement helps individuals commit to a direction. Another benefit is that by keeping the agenda focused, specific integration among functions is much easier. For example, if a key objective for finance is implementing a balanced scorecard in the businesses, it is easy to determine whether the line executives also have that on their strategic agenda. If not, there is a disconnection, and it can be surfaced immediately. If a CFO is having lunch with one of the business unit presidents, who asks if the organization could design a new supply-chain reporting mechanism, the CFO can immediately mentally scroll through his or her strategic agenda and understand the implications of this request. If this is not part of the agenda, the CFO can tell the unit president that this will not be possible for another several months or begin negotiating. Because many decisions happen in informal dialogue by the CFO and the organization, by knowing exactly what it needs to accomplish, people can determine trade-offs on an ongoing basis. They can determine the value of activities immediately since if something does not contribute to the overall finance agenda, it may not be worth doing. Eventually, the organization becomes fast and flexible. Several years ago, a general manager strongly believed in this model. He knew exactly what he needed to accomplish and could state his objectives anywhere, anytime. He would use any and every opportunity with people in his organization and his peers to reinforce his message. Over time, everyone knew exactly what the business needed to accomplish. People began to realize how committed he was to accomplishing those objectives. They knew exactly what he wanted to achieve, and could make a personal decision on whether they wanted to be on board. The majority decided to stay and help him meet those objectives; some who did not like where the organization was headed decided to leave. However, no one questioned the direction or his commitment to change. Also, because he was fluent about his objectives and his focus, any time another general manager or the senior vice president asked for help or additional work, he immediately knew how this would affect his goals. Because everyone knew what he was trying to accomplish, any time his organization was asked to do other work, he could use the strategic agenda to negotiate, because there would always be trade-offs. By observing his behavior, the organization began to mobilize around the required changes. There was no question about leadership spending enough time, no question about leadership driving change, and no question about what was important to the business. This organization consistently surpassed its financial, customer satisfaction, and employee satisfaction targets.

3.5 BUILD A COMMITMENT TO CHANGE WITHIN FINANCE Once some thought has been given to the strategic agenda, it is time to build commitment around what the CFO wants to accomplish. If the CFO has developed a compelling finance agenda, the most important step toward commitment has already been taken, clearly describing what the CFO and the function need to accomplish. It is amazing how often this type of clarity is neglected, either because of not understanding how powerful this can be, political maneuvering to keep accountabilities hazy, or just little time to be specific. Yet when people are asked to commit to something, the more they can understand the specific implications, the easier it is for them to make a decision about commitment. Also, a common misunderstanding is that people will only commit to something in which they have been involved in every step. This is not necessarily true. People want to be able to influence the direction (what needs to be done) and the approach (how things will be done) and have an open authentic dialogue around the realism of the objectives. They do not always need to be involved in every step. Some executives exhibit reluctance in communicating their agenda and providing direction because they want it to “evolve from the team.” This often leads to several consequences. First, people often become frustrated by the lack of direction and then make comments like “He’s

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not managing this department” or “She’s getting the executive salary, but we always have to figure out what needs to get done.” Second, people believe that most executives must be goal-driven, and therefore managers know what they want to accomplish; by not stating it explicitly, people begin to wonder. They wonder if the manager has a hidden agenda, if it is a test, or they begin to doubt the manager’s leadership skills. It is much more effective to know what one wants to accomplish, use a straw model to begin the discussion, and openly listen to the staff and allow them to influence the agenda. Another attempt to build commitment is often labeled “team building.” Managers often believe that if they conduct a series of team-building exercises or off-sites, their team will suddenly be committed to driving change. Unfortunately, in most cases, people engage in the team-building exercises, but under the day-to-day pressures the new behaviors are most likely forgotten and rarely reinforced — especially if the senior executive only talks change, but does not reinforce the message with his own behavior. There is a mountain of evidence in the learning and training literature about how little learning transfers from external or simulated learning events back to on-thejob behaviors. Team building can be much more effective if it is integrated into day-to-day work. For example, several years ago, an executive requested team building to increase commitment for his staff. The conversation went like this: Consultant: “I’m sure we could help, but before talking about team building, let’s talk about what are you seeing that suggests team building is the answer? What do you want them to commit to?” Executive: “Our meetings are totally unproductive—all we do is talk and talk with no decisions; no one is on the same page, and we can never wrap up.” Consultant: “What has been the impact of this?” Executive: “We keep revisiting decisions, never coming to closure. Last time, we talked about whether we were going to assemble parts in Taiwan for almost two hours with no decision.” Consultant: “It sounds like there is a lot going on and not something we’re going to address with one team-building session. It sounds like we need to begin addressing how the executive team works together. I have found that most managers hate dealing with all this touchy-feely stuff. They see no value in it. However, if we begin to address some of these issues as part of trying to accomplish an objective, people tend to be more open about the process. What’s pressing right now that you need to accomplish in the short term?” Executive: “We do need to finalize our strategic marketing plan.” Consultant: “Now there is something people can probably sink their teeth into. We can address some of these behavior issues that you’ve cited as part of developing the strategic plan. We can include some team-building activities. Of course, to begin implementing some of these changes, you will need to play an active role and be open to some of my coaching. Are you okay with that?” Executive: “Sure. Why don’t we set aside some time on Friday to think through the agenda and the process.”

Focusing on a clear business objective that is tied to the overall strategic agenda and clarifying that behavior change does not occur overnight; integrating team-building activities into operational issues can help build commitment. A prerequisite to many of these activities is the CFO’s ability to explain what he wants to accomplish and why. The CFO must understand his personal motivations and convictions. He should spend a few minutes reflecting. The CFO needs to understand his personal motivations for why he wants to achieve certain goals. What drives him? Why is he passionate about these goals? If he is not passionate about a certain goal, why is he pursuing it? What will he do to ensure success? After he has had time to develop his agenda and the reasons why it is important, the CFO should think about and practice how he will tell his staff. There are a variety of ways that this can be done. The most critical factor is that the CFO engage in genuine dialogue with the staff, listening to their views and allowing them to influence his opinions. The CFO’s finance agenda literally becomes the finance team’s goals. Because the CFO is the head of the function, the agenda that he creates with his direct reports becomes the agenda for finance. Some executives conduct an off-site in which they discuss the strategic agenda; others embed the discussions in their regular staff meetings.

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Having an open dialogue with the staff is critical. It is amazing how many teams have never had this type of open, honest dialogue, or the dialogue is complex, discussing a litany of actions and no one understands the “big picture.” Following is an adaptation from a director of finance’s (George’s) off-site. “As you see on the agenda today, we are going to spend most of our meeting talking about the agenda for finance and specific goals. I’ve had some time reflecting on what I think we need to accomplish this year and have captured this on my list of goals. Realize that this strategic agenda is what finance needs to accomplish this year. I’d like to spend the next few minutes describing each goal and why I think it’s important. After that I’d like us to have an open discussion on whether these items make sense since your individual and department goals will be tied to this agenda.” The director goes on to explain each of his seven goals. The dialogue around one particular goal is worth highlighting. “One of the items I’ve listed is to create tighter financial controls.” One of the other directors challenges the goal. “George, is that really something we want to focus on. We just spent months decentralizing some of the processes because we were constantly getting complaints that we’re like the audit police, always saying what the business could and could not do.” George replies, “Bill, I understand your reluctance. I struggled with this one myself. But look at our numbers, almost everywhere you look we’re struggling. Look at our new product development, over 50 percent of our new products produce little to no profit. Our travel expenses and miscellaneous expenses are totally out of sync with industry standards. I truly believe that successful businesses have fiscal discipline and rigorous controls. The challenge will be in how we help our operating managers take more accountability for the numbers. We can’t remain in the cop role. That’s why this objective is tied to my second goal, which is the reconfiguration of finance so that we have our best analysts dedicated to different business units providing analytic support. I also intend to raise the issue of ownership of the numbers and finance’s role with the CEO and my peers at an upcoming executive meeting.” Bill responds, “I still don’t like it, but I can understand your point. We’ll see how this plays in front of the executive committee.” “Absolutely,” says George, “we need to think of this as version one, and that’s why I wanted your input. We will probably have to revisit this after my discussions at the executive meeting. We will also have to set more specific targets so that we can tell when we’ve been successful.”

This type of dialogue is important in building commitment. The key factor is how well the CFO maintains the balance between setting a definitive direction and letting the staff have input. The CFO should also help his staff understand that this is not a linear process. After his discussion with them, the finance agenda still needs to be discussed at the executive meeting, where the focus might change. However, it is important to solicit their input prior to that meeting. A key element in obtaining commitment is the CFO’s own behavior. Everyone has heard the cliche, “It’s not what you say, but what you do.” Too often, we forget. In one project, a senior vice president told his team that he would dedicate at least 50 percent of his time to the effort. One week after the effort started, he was spending at most two hours per week on the project. People started to question his leadership and his commitment. His reaction was, “They should know I’m committed. I authorized the effort and I am providing the budget.” Unfortunately, that is not enough. In many organizations, commitment is measured by how much time people spend on what they say is important. Time has become our most precious resource. Needless to say, in this case, people interpreted the executive’s behavior as a lack of leadership, they never fully committed themselves, and the effort stumbled. A CFO is a role model whether he or she wants to be or not. CFOs must remember to demonstrate the outcomes and behaviors that they want, and then clearly set an expectation that their staff will continue the process, for example, clarifying that they are soliciting input prior to the meeting, telling them that once the finance objectives are finalized they expect them to communicate with their staffs. The CFO should clearly state that he or she expects their direct reports to have a similar session with their managers. They should first think about the key goals in their areas, why they want to focus on those goals, and how those goals link to the overall strategic agenda, and then conduct similar meetings where their staff has input. This approach allows the CFO to begin changing the basic operating style of the department.

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3.6 CHANGE EXECUTIVE MANAGEMENT PRACTICES Changing the finance organization is often hard work, but because the CFO has direct responsibility for that function, it is often easier than driving change across the operating units. Yet in many cases, change also needs to occur in those units. To begin this process, the executive team must develop a set of management practices that allows the CFO to implement his or her finance agenda and begin to function as an advisor and consultant to not only the CEO but also the operating units. Unfortunately, many executive teams develop management practices that are often counterproductive to implementing change quickly. Following is an example of several executive meetings that highlight how patterns often develop: • Team 1. The group rarely gets together to discuss operations. When they do get together, there is an unwritten rule that no one points out a deficiency in someone else’s area. The prevailing climate is “don’t mess with mine and I won’t mess with yours.” Executive meetings are characterized by a lot of dialogue, but little or no action. Rarely are action items or decisions documented. Individuals rarely challenge each other and almost never challenge the CEO. • Team 2. This team does get together to discuss operations. However, everyone needs to fully agree with a recommendation before it is acted on. The constant drive to consensus often takes so long that participants turn off and agree just to move on. Rarely is substantive conflict present. The meeting is characterized as nice and cordial. Meeting minutes may be taken, but they are lengthy and difficult to understand. • Team 3. This team also meets, but many one-on-one meetings have taken place before or outside of the meeting either between the CEO and other executives or between executives. There is no common database of knowledge; no one is on the same page. The CEO or senior executive drives the meeting, pushing forward through the agenda. Others participate when their area is up for discussion and spend the time reading e-mail or finishing administrative tasks. Minutes might be taken. • Team 4. These meetings are brawls. Managers get together and fight. Conflict rules the session; people challenge each other and debate each other. Debates are often subjective interpretations of data or opinions. There are no clear processes on how to work through information and come to resolution. Although these are sample meetings, many meetings are similar to one or more of these profiles. For a CFO, the focus is on ways in which to help the management team understand his or her new role, what he or she wants to accomplish, and how they need to contribute to those objectives. Therefore, understanding the management practices of the executive team is important. Changing these practices and the dynamics of the executive team is the first challenge in moving into a change agent role. Executive teams that are able to drive change through the organization, who operate work toward a common agenda, and are able to work through many organizational challenges have the following characteristics (practices): • Regular meetings. The executive team meets regularly to discuss operations. Research and practice have shown that if management teams do not meet on a regular basis to discuss work, the group slowly begins to splinter. Individuals may still be able to run their areas effectively, but cross-boundary issues become harder to resolve. • Constructive confrontation. Because all individual executives are accountable to meet the business or function goals and are accountable as a team to meet the overall business goals, there is a clear expectation to question and challenge each others’ operations. • Listening. All executives actively listen to and are able to stimulate substantive and honest dialogue about issues and potential solutions. • Shared agenda. The executive group reviews and challenges each others’ strategic agenda to ensure consistency and integration across organizations. All of their goals directly and clearly reinforce the CEO’s goals.

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• Clear feedback. Managers have clear review processes in which they review operations, make course corrections, provide feedback, and ensure accountability. • Decisive, fast-paced meetings. Meetings are held regularly to discuss operations in which it is expected that each participant provides input and advice to other areas and solicits input for his or her area. The pace is fast, yet the meeting is comprehensive. Decisions are made; actions are determined, documented, and communicated in a comprehensive manner. • Consensus with qualification decision making. Participants debate and look at all angles of a recommendation or impending decision. If consensus cannot be achieved after listening to all the options, the most senior individual will make the decision and everyone will be committed to its outcome. Decision is data driven and made quickly. • Data driven. Decision making is driven by data, and clear procedures and templates for the type of data needed are developed for decision-making purposes. • Role of support functions. Support functions act as consultants to the operating units, challenging and working with them to improve performance. • Role models. Executive leadership role models desired behavior. • Continuous improvement. The executive team periodically steps back and looks at its own management processes to assess effectiveness. Based on these assessments, continuous improvement actions will be taken. If an executive team does not operate in this manner, if finance is not given the liberty to challenge the operations, or if finance is not seen as a strategic partner, changes in how the executive team operates may be in order. To begin this change, it is important to remember that this is the boss’s team. The CFO is one among many peers, and in some cases, depending on the relationships, the power may be unequally distributed. The CFO might be able to influence some of the behaviors, but few major changes will take place unless the CEO is aware of the improvement potential and willing to play a role. So how does the CFO begin the process of changing the practices of the management team? .

3.7 ENLIST THE SUPPORT OF THE CHIEF EXECUTIVE OFFICER An important step in change is creating the awareness that change is necessary. One of the most difficult areas to change is management process. Most successful executives have honed their managerial skills over many decades and have strong opinions of what works and what does not. Therein lies the opportunity. Today’s business environment is quite different than that of just a few years ago. Often, the management team has new players, or the challenges confronting the organization are more intense. Those organizations that are able to change their management practices are those that have a greater likelihood of success. And those practices start at the top. Consequently, enlisting the support of the CEO in reshaping the management practices of the executive team will be critical. To begin this process, the CFO must find a way to create awareness about required changes. One way to do this is: Step 1. Lay out the agenda for finance. Step 2. Determine what will be required to implement the strategic agenda. Step 3. Determine how the executive team will need to change and what is required from them to manage the implementation of the finance agenda. Step 4. Develop an action plan on helping the CEO see the team’s current dynamics, how they may need to change, and his role in that change effort. Step 5. Meet with the CEO to discuss the strategic agenda and what will be needed from the executive team and from the CEO. Step 6. Jointly develop a way to raise any issues with the executive team. One approach to help create awareness is to look at best practices or use white papers, articles, or other print material as a way to help educate the CEO on what could be. Begin creating an

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awareness on how to improve the senior team dynamics. Discussing an article or summary can be a powerful way to begin the dialogue around change. In some cases, it may be effective to bring in an outsider to counsel the group on how it can be even more effective. Once the CFO understands the CEO’s reaction to reshaping the executive team’s management practices, he or she can jointly develop an action plan on how to introduce these changes. An approach that can be used is to spend a few minutes during the next meeting having people read a brief overview of the new practices and then have a short discussion. Following is an example of how one finance executive addressed the issue. The CFO met several times with his boss to discuss his observations and used an article as a neutral way to begin questioning some of the management practices. After several discussions, the senior vice president understood and agreed that there were improvement opportunities. Given the formal authority of the senior vice president and his ownership of the meeting, they decided that he would introduce the topic and lead the discussion at the next staff meeting. Andre, the senior vice president starts the meeting. Our agenda is quite full today, so why don’t we get started. You’ll notice one of the first items is about our management practices. Several weeks ago, Cathy came to me with an article that she saw in a recent CFO magazine. Based on her reading, she thought that this would be of value to all of us. After a few discussions and after looking at the article myself, I think she’s right. There are some interesting concepts in here. I don’t necessarily agree with all of them, but I think it is something we should discuss implementing. There are some ideas I definitely want to put in place. So, I’d like each of you to spend five minutes reading this article and then we’ll spend another 15 minutes talking about what elements we will implement.

After everyone finishes reading, he talks about the management practices he wants to put in place and solicits people’s input and opinions. The executive group decides to bring in an outside advisor to talk to individual executives, assess the team’s management practices by observing several key meetings, and then facilitate a workshop in which they will decide on some of the recommendations.

3.8 MOBILIZE THE ORGANIZATION Results can be achieved quickly when a large part of the organization is mobilized. Mobilization goes beyond communication, which is often characterized as a two-way exchange of information, to enlisting the active involvement of individuals. Communication is necessary, but not sufficient, in driving major organization changes quickly. Unfortunately, in many change efforts, this concept is misused in several ways: • A project team spends weeks or in some cases months preparing a business case, a new design (new processes, new systems, new structure), and an implementation plan. These are then communicated to the organization through an elaborate communication plan that often involves challenge sessions or other activities to “involve” the organization. The assumption is that the organization is then mobilized and committed to the effort. Unfortunately, this is rarely so. In many cases, the executive team has never had the opportunity to clearly debate the plan in detail, they have not come up the learning curve together, and the most senior executive does not clearly demand that operating executives take accountability for the implementation. Consequently, it is often unclear whether the executive team is fully committed and this message filters throughout the organization, causing a hesitancy to proceed and a lack of commitment. The organization is not mobilized. • In other large change efforts, organizations spend weeks preparing elaborate communication plans incorporating the most advanced delivery mechanisms. In some cases, senior executives will give one or two presentations to show their commitment to the project. Yet the strategic agenda and how the project fits into the agenda is not clear. Maybe the executive team went through several executive education sessions, but few executives have integrated the project into their objectives. Even fewer regularly talk about the project in their regular operations reviews. In some cases, the implementation is managed by a separate steering committee, further separating operating executives from the accountability for project results. The

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project may or may not be discussed at the executive meetings. The organization intuitively senses these disconnects and mobilization becomes much harder. • In some change efforts, communication is often seen as a separate activity. There is a separate communication team with their own charter and work plan. The logic is that if this is not done, communication does not occur. There is some truth to this, and therefore having people focus on communication is important. However, more important is the fact that managers are responsible for communication. Communicating to the organization is one of the primary responsibilities of management, and if managers neglect this task the organization cannot be mobilized. Mobilization occurs around a specific purpose and specific individuals. People do not mobilize around a communications team. The communications team supports, with the exchange of information, an executive’s efforts around mobilizing his or her people around a strategic agenda. People also become mobilized if they see the executive team devoting their attention to these objectives. The CFO has already completed the first steps in mobilizing an organization by clarifying the strategic agenda, using every opportunity to communicate his or her objectives, and working with the executive team to create shared understanding and common management practices. As mentioned before, a primary mode of learning in an organization is by observing behaviors, determining what works and what does not, and then modeling those behaviors. Once the organization understands what the CFO is trying to accomplish and is mobilized, he or she will need to sustain that momentum. This is usually accomplished by ensuring operating executive accountability and involvement, determining specific measures, having clear operations review processes in which the projects are discussed, providing feedback, and communicating as a normal course of action. As mentioned earlier, communication is often seen as a separate activity. To maintain momentum, communication must be seen as an integral part of the managerial process. Communication should not be seen as separate from managing the daily operations, and a key success factor is how well the CFO integrates communications. Several years ago, the general manager of a small $100 million business firmly believed in integrating communications into daily operations. Although she did have a communications manager, she set a clear expectation that communications was the responsibility of each director. This organization had one of the best communications efforts around—measurement-driven, clear expectations around communication, regular senior management involvement, communication events, communications integrated in performance reviews for supervisors and managers, and so on. Because this organization was measurement-driven, they could tell how well they were doing. Communication, however, left some room for improvement. After a brief analysis was conducted, it was determined that the issue was the way in which information received was actually communicated. There was a breakdown in communications after executive team meetings. People wanted to know what was decided. How often are decisions captured from executive team meetings in a way that people can immediately understand what was decided? The decision was made that during the executive meeting all major decisions would be documented, and then prior to the end of the meeting the decisions would be reviewed and the group would decide what could be posted. In some cases, because of the highly confidential nature of discussions or because of the timing of decisions, not everything could be posted. This information was then posted on the intranet, and directors would review these decisions in their staff meetings. By integrating communications as a part of normal operations and making it a managerial responsibility, this organization dramatically improved its communication effectiveness.

3.9 INSTITUTIONALIZE CONTINUOUS IMPROVEMENT Facilitating change is an ongoing process — the more effective a CFO is at instituting a continuous improvement mentality and process, the easier it will be to keep driving change. A continuous improvement mentality suggests that we are constantly reviewing and questioning how we are doing and using a systematic measurement-driven approach to improving performance. Many organizations have implemented processes such as total quality management, Six Sigma, and continuous

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improvement to help sustain changes. The most common methodology is characterized by the following approach: define, measure, analyze, improve, and control. This approach was developed by the manufacturing industry to improve efficiencies given ever-shrinking margins, but it is now expanding into other industries. The philosophy of continuous improvement is: • Define a problem to solve; it should be realistic and doable. • Measure current performance to set a baseline and determine measures. • Analyze what is causing the gap. • Determine a realistic target and then implement the improvements. • Implement control mechanisms to ensure that the new activities become institutionalized. The most effective teams also use this process to continuously improve their management practices. One group of executives periodically reviewed their management practices in an effort to improve how they managed the business. They reviewed how well they made decisions, how well they held each other accountable, how open they were to other opinions, whether their meetings included substantive dialogue, how well they communicated expectations to presenters, and so forth. By institutionalizing a process by which management openly and honestly questions not only what they are doing, but also how they are managing, implementing changes quickly and effectively becomes a core competency.

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CHAPTER*

4

ACCOUNTING PRINCIPLES AND STANDARDS 4.1

INTRODUCTION 35

4.8

ACCOUNTING STANDARDS 38

4.2

COMMITTEE ON ACCOUNTING PROCEDURE 35

4.9

ACCOUNTING RESEARCH BULLETINS 39

4.3

ACCOUNTING PRINCIPLES BOARD 36

4.10

OPINIONS: ACCOUNTING PRINCIPLES BOARD 39

4.4

FINANCIAL ACCOUNTING FOUNDATION 36

4.11

INTERPRETATIONS: FASB 41

4.5

FINANCIAL ACCOUNTING STANDARDS BOARD 36

4.12

4.6

GOVERNMENT ACCOUNTING STANDARDS BOARD 37

STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS: FASB 44

4.13

4.7

INTERNATIONAL ACCOUNTING STANDARDS BOARD 38

STATEMENTS OF FINANCIAL ACCOUNTING CONCEPTS: FASB 53

4.14

TECHNICAL BULLETINS: FASB 54

4.1 INTRODUCTION Who creates the basic rules of accounting that guide the accounting practices of so many accountants? There are several entities that contribute to these basic rules, as will be discussed in this chapter. We also summarize many of the accounting pronouncements that have been issued by these organizations, and describe where to go to obtain more detailed information about them.

4.2 COMMITTEE ON ACCOUNTING PROCEDURE The Committee on Accounting Procedure (CAP) was created in 1939 by the American Institute of Accountants (now known as the American Institute of Public Accountants, or AICPA). It issued a total of 51 Accounting Research Bulletins that responded to specific accounting problems as they arose; this tight focus led to an increasing number of complaints against the CAP over time, because it did not attempt to create an overall accounting framework to which specific accounting pronouncements could then be attached in an orderly manner. Another problem was that it was accused of not conducting a sufficient volume of detailed research to back up the reasoning behind its pronouncements. Yet another issue was the perception that it acted in the interests of the American Institute of Accountants, which was considered a conflict of interest. Furthermore, its pronouncements were not binding on any organizations that issued financial reports. On the plus side, it

* Reprinted with permission from Chapters 4–5 of Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002).

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developed a uniform accounting terminology that was widely used thereafter. Because of the preceding problems, the CAP was eliminated in 1959 in favor of the Accounting Principles Board.

4.3 ACCOUNTING PRINCIPLES BOARD The Accounting Principles Board (APB) was formed in 1958 by the AICPA. Its 18- to 21-member Board and supporting staff was active in conducting research on accounting issues and promulgating standards. Even though it was phased out in 1973, its APB bulletin numbers 43, 45, 46, and 51, as well as 19 opinions still form a part of GAAP. The APB gained more regulatory force than its predecessor, because the AICPA required its member CPAs to identify and justify any departures from the APB’s opinions and statements, while it also gained support from the Securities and Exchange Commission. Nonetheless, it foundered due to its direct support by the AICPA — a more independent organization was needed, which resulted in the Financial Accounting Foundation.

4.4 FINANCIAL ACCOUNTING FOUNDATION The Financial Accounting Foundation (FAF) was founded in 1972. Its 16-member Board of Trustees is expressly independent from the AICPA, since they come from a number of sponsoring organizations, such as the AICPA, the Financial Executives Institute, the Institute of Management Accountants, the Securities Industry Association, and others. It also has a number of at-large trustees who are not tied to any sponsoring organizations. The FAF does not directly promulgate any accounting standards — rather, it raises funds for the operation of the Financial Accounting Standards Board (FASB) and Government Accounting Standards Board (GASB) that conduct this work, as noted in the following sections. Its fund-raising function is enhanced by its being a 501(c)(3) taxable entity, so that contributions to it are tax-deductible. It also exercises general oversight of the FASB and GASB by appointing Board members to them, as well as two advisory councils to those entities. It also approves their annual budgets. The FAF, FASB, and GASB are all located in Norwalk, Connecticut.

4.5 FINANCIAL ACCOUNTING STANDARDS BOARD The successor to the Accounting Principles Board is the Financial Accounting Standards Board (FASB) created in 1973. It has a Board of seven members, each of whom have a five-year term, and who can be reelected once. It has a staff of about 40 personnel. The organization is funded through the FAF. Its mission is to “establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.” It maintains a web site at www.rutgers.edu/accounting/raw/fasb/welcome.htm. The FASB’s authority to issue statements on and interpretations of accounting standards comes from several sources. One is the Securities and Exchange Commission, which designated it as the source of accounting principles to be used as the basis for financial statements filed with it. The FASB received similar support from the AICPA through its Rule 203. However, the FASB has no enforcement powers whatsoever — it needs continuing support from the SEC, AICPA, and state boards of accountancy to ensure that its rules are followed. The FASB works with the Financial Accounting Standards Advisory Council, which is appointed by the FAF. The council’s 30 members advise the FASB about technical issues, project priorities, and the selection of task forces to deal with specific accounting issues. There is a basic flow of work that the FASB pursues when constructing a new accounting pronouncement: 1. Admission to agenda. The FASB’s criteria for inclusion of an accounting issue in its work schedule are that there is diverse practice in dealing with it that causes varying financial reporting results that can be misleading; there must also be a technically feasible solution and an expectation that a solution will be generally accepted.

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2. Early deliberations. The FASB clarifies the issues and obtains opinions regarding each accounting item on its agenda. If a prospective pronouncement appears to be a major project, it will appoint an advisory task force of outside experts to review it, which tends to involve the services of about 15 people. The FASB staff will then write a discussion memorandum with the assistance of this group. 3. Public hearing. The FASB will announce a hearing date that is 60 days in advance. Depending on the issue, these meetings may be very well attended by interested parties. 4. Tentative resolution. Two-thirds of the Board votes in favor of issuing an exposure draft, which includes a proposed effective date and method of transition to the new accounting rule. This document is not the final one, being rather a draft that is made available for public discussion. 5. Final deliberations and resolution. Once responses from the public to the exposure draft have been made, the FASB will make minor adjustments to it and take a final vote. The finalized standard, which includes dissenting views, is then published. 6. Follow-up interpretations. There may be some issues related to a new standard that do not become apparent until after it has been in use for a short time. If so, the FASB may clarify or elaborate on the newly issued statement. These interpretations must also be made available for public comment for at least 30 days before being finalized and published. The process just noted requires a considerable amount of FASB resources, and so cannot be used to address all accounting issues. To provide more rapid resolution to more urgent or minor issues, it may choose to shift them to its Emerging Issues Task Force (EITF). The EITF is a very active group that is mostly composed of public accounting people who are aware of emerging issues before they become widespread. The chief accountant of the SEC attends its meetings. If it can reach a rapid consensus on an issue, then its findings are published at once, and become a basis for GAAP. If there is less consensus, then the issue is shifted to the FASB to be resolved through the more tortuous process just described. The EITF has been criticized because less public discussion is involved in its proceedings than under the more formalized FASB review process. The FASB also issues technical bulletins when it addresses issues not covered by existing standards, which will not cause a major change in practice, which have a minimal perceived implementation cost, and which do not result in a unique new accounting practice — in short, technical bulletins address less controversial topics. A potential problem over the long term is that the SEC, which is a prime sponsor of the FASB, wants it to issue standards that are oriented toward publicly held companies, over which the SEC has reporting control. However, this means that the more onerous reporting requirements intended for larger public companies are also being forced on smaller private firms that do not have the resources to comply with them. Though there would be great inefficiencies involved in setting up a double accounting standard, one for public and one for private companies, this will be an ongoing cause of tension within the FASB as it continues to churn out pronouncements.

4.6 GOVERNMENT ACCOUNTING STANDARDS BOARD The entity that establishes accounting principles for state and local governments is the Government Accounting Standards Board (GASB), which was created in 1984. It is the successor organization to the National Council on Governmental Accounting, whose standards are still in force unless the GASB has issued specific changes or replacements to them. The GASB’s methods of operation (and basic rule-making procedures) are nearly identical to those of the FASB, which is its sister organization. It has seven Board members and a staff of about ten employees. Like the FASB, it works with an advisory council, this one being called the Government Accounting Standards Advisory Council, which is appointed by the FAF. This council consults with the GASB about technical issues, project priorities, and the selection of task forces to deal with specific issues. An interesting variation from the FASB’s council is that this one periodically conducts an annual membership survey to identify emerging issues.

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Its funding comes from the FAF, as is the case for the FASB. The primary source of funding that goes to the FAF is from state and local governments, as well as the General Accounting Office. The GASB’s pronouncements are recognized as authoritative by the AICPA, but there is no entity like the SEC supporting it (which only deals with publicly held companies), and so it tends to have less overall influence than the FASB. Also, since its funding sources are fewer than for the FASB, it has a substantially smaller staff. The GASB maintains a general web site at www.rutgers.edu/accounting/raw/gasb/welcome. htm, as well as another web site at www.seagov.org that is dedicated to the measurement of government performance standards.

4.7 INTERNATIONAL ACCOUNTING STANDARDS BOARD A large number of organizations now do business in multiple countries, and so must deal with different accounting standards within each country where they have subsidiaries. Though a company’s headquarters may be located in the United States, which forces the entity as a whole to report under FASB standards, it may be required to make reports, such as loan-related financial statements, at the local level that require different accounting standards. Also, companies that are based abroad but that want to issue securities within the United States must restate their financial results to comply with American accounting rules. In an attempt to standardize the accounting rules of many countries, the International Accounting Standards Board (IASB) was created in April 2001. It is the successor body to the International Accounting Standards Committee (IASC), which in turn was formed in 1973 through an agreement made by the national professional accountancy bodies of Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, Ireland, the United Kingdom, and the United States. Its 14-member Board members serve five years, which can be renewed once. The IASB is controlled by a parent organization, which is the IASC Foundation, a Delaware nonprofit corporation. Its role is quite similar to that of the FAF in relation to the FASB and GASB — that is, it provides funding and general oversight to the IASB, while also appointing its members. Meanwhile, the IASB is solely responsible for setting international accounting standards, with the support of the Standards Advisory Council and the Standing Interpretations Committee, both of which are funded and supported by the IASC Foundation. The IASB’s staff works on the development of a single set of international accounting standards, coordinating its efforts with the national standards-setting bodies, stock exchanges, and securities regulatory agencies in many countries, as well as such international groups as the United Nations and World Bank. It accounting standards are issued in the form of International Financial Reporting Standards, which are devised through the same process used by the GASB and FASB.

4.8 ACCOUNTING STANDARDS Generally Accepted Accounting Principles (GAAP) come from the pronouncement of the Accounting Procedures Committee of the AICPA (which concluded its operations in 1959), the Accounting Principles Board of the AICPA (which concluded its operations in 1973), and the Financial Accounting Standards Board (FASB), which is now the primary authoritative source of GAAP. Account Research Bulletins (ARB) are the official pronouncements of the Accounting Procedures Committee, while the Accounting Principles Board issued numbered Opinions. The FASB uses a number of pronouncements, including Interpretations, Statements, Statements of Financial Accounting Concepts, and Technical Bulletins. Its Emerging Issues Task Force (EITF) also issues a voluminous number of Abstracts. In addition, the AICPA issues a number of Statements of Position (SOPs). The identifying numbers, titles, and summaries of all of these GAAP sources, with the exception of EITF abstracts and AICPA Statements of Position, are included in the following sections. The summaries noted here are not intended to provide the full range of information needed by the accountant to fully research a particular GAAP issue. Instead, one can peruse the list to see which reference sources are most applicable to the problem at hand. At that point, one should refer

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to the source document to obtain the greatest possible detail. In many cases, source documents also include examples that are invaluable in determining the application of the principles under discussion to actual situations. There are several sources of GAAP documents. One can go to the FASB web site, located at http://raw.rutgers.edu/raw/fasb, to find the complete text of all FASB Statements. A more complete source of nearly all GAAP documents is the excellent three-volume set of Original Pronouncements, published by the AICPA. It contains all FASB Statements, Accounting Research Bulletins, Opinions of the Accounting Principles Board, AICPA Interpretations, FASB Interpretations, FASB Concept Statements, and FASB Technical Bulletins. The documents show only those pronouncements that have not been superseded, and also highlight any text that has been superseded or modified by later pronouncements, thereby eliminating some potential confusion regarding which pronouncements constitute current accounting standards. It can be purchased from the AICPA web store for $99, which is located at www.cpa2biz.com. As of this publication date, the Original Pronouncements could be purchased only by AIPCA members — the membership application can be found at the AICPA web site, which is located at www.aicpa.org. The information contained within the Original Pronouncements is current up until June 1 of each year, and so the most recent year’s publication is not usually available until late summer or early fall. Statements of Position can be ordered separately from the AICPA under the title of AICPA Technical Practice Aids. It is also available through the AICPA Web store, and can be purchased there at an AICPA member price of $80 and $100 for nonmembers. Abstracts published by the EITF are available on an annual subscription basis for $338 per year, or may be purchased individually for $44.75 each. They can be ordered by calling the FASB at 800-748-0659, or by ordering on-line by accessing http://stores/ yahoo.com/fasbpubs.

4.9 ACCOUNTING RESEARCH BULLETINS The Accounting Research Bulletins in Exhibit 4.1 are only those that have not been superseded by later accounting standards. Note that the first one listed, ARB No. 43, is a summary of all preceding ARBs.

4.10 OPINIONS: ACCOUNTING PRINCIPLES BOARD The Opinions listed in Exhibit 4.2 are only those that have not been superseded by later accounting standards. Several of these Opinions, such as APB Nos. 9, 14, 16, 17, 20–22, and 25, are still the primary source documents for key accounting issues. Number

Title

Description

43

Restatement of Revision of Previous Bulletins

45

Long-Term Construction-Type Contracts Discontinuance of Dating Earned Surplus Consolidated Financial Statements

46

51

E XHIBIT 4.1

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Represents a revision and summary of the first 42 Accounting Research Bulletins, covering such topics as the form of financial statements, working capital, inventory pricing, intangible assets, contingency reserves, capital accounts, depreciation, taxes, government contracts, pension plans, and pension plan annuity costs. Describes the use of the percentage-of-completion method and the completed contract method to account for construction contracts. Cancels the dating of an earned surplus following a quasireorganization. Discusses the consolidation procedure, the treatment of minority interests, the treatment of stock dividends of subsidiaries, and the uses of both combined and parent company financial statements

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Number

Title

Description

2

Accounting for the Investment Credit

Discusses the presentation and recognition of the investment tax credit arising from the Revenue Act of 1962.

4

Accounting for the Investment Credit

Discusses the impact of the Revenue Act of 1964 on the investment tax credit, as well as an additional allowable method for reporting the credit, net of reported federal income taxes.

6

Status of Accounting Research Bulletins

Contains revisions to those sections of ARB No. 43 relating to Treasury stock, current assets and liabilities, stock dividends and splits, and depreciation and appreciation.

9

Reporting the Results of Operations

Concludes that net income should include all profit and loss transactions, with the exception of prior-period adjustments. It also specifies the separate treatment of extraordinary items in the income statement.

10

Omnibus Opinion — 1966

Covers the allocation of income taxes among different reporting periods, offsetting securities against taxes payable, and denies the use of the installment method of accounting.

12

Omnibus Opinion — 1967

Covers the classification and disclosure of allowance accounts, depreciation disclosure, and the reporting of changes in equity, and affirms the use of the interest method when amortizing debt discounts and premiums.

14

Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants

Discusses the applicability of accounting for stock purchase warrants separately from attached debt instruments.

16

Business Combinations

Discusses the purchase and pooling methods of accounting for a business combination, and the circumstances under which each one can be used. It also covers the treatment of acquisition costs, contingent compensation, and the amortization of goodwill.

17

Intangible Assets

Specifies the types of intangibles that may be recorded as assets, how to arrive at their cost, and how they may be amortized.

18

The Equity Method of Accounting for Investments in Common Stock

Specifies the circumstances under which the equity method of accounting can be used, as well as how it should be calculated and then disclosed on the investor’s financial statements.

20

Accounting Changes

Discusses the proper treatment of changes in accounting principle, estimate, and reporting entity, as well as of errors in previously issued financial statements, plus how this information is to be disclosed in the financial statements.

21

Interest on Receivables and Payables

Discusses the determination of the proper valuation of a note when it is exchanged for either cash, property, or services. It also covers the selection of an appropriate present value discount rate, as well as the disclosure of discounts or premiums from the face value of a note.

22

Disclosure of Accounting Policies

Requires the disclosure of significant accounting policies alongside the financial statements.

23

Accounting for Income Taxes —Special Areas

Discusses the proper accounting for income taxes in relation to the undistributed earnings of subsidiaries, investments in corporate joint ventures, bad debt reserves of savings and loan institutions, and the policyholders’ surplus of stock life insurance companies.

E XHIBIT 4.2

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4.11 Interpretations: FASB

Number

Title

Description

25

Accounting for Stock Issued to Employees

26

Early Extinguishment of Debt Interim Financial Reporting

28

29

Accounting for Nonmonetary Transactions

30

Reporting the Results of Operations

E XHIBIT 4.2

S UMMARY

OF

41

Specifies the rules to use when accounting for stock awards. The core principle is that the accounting is based on the intrinsic value of the award, which is the difference between the compensation value of the award, measured as the number of shares multiplied by the fair market value per share, and employee value, measured as the employee price per share multiplied by the number of shares. Requires that gains or losses from the early extinguishment of debt be recognized in the current period. Describes the information that should be contained within interim financial reports, including changes in accounting principles and the disclosure of summarized interim financial data by publicly traded companies. Verifies that nonmonetary transactions should be valued based on their fair values, except in a limited number of cases where nonmonetary exchanges are not considered to be the culmination of an earnings process. Discusses the proper disclosure of discontinued operations, as well as the reporting of gains or losses from business disposals. It also defines those transactions that should be categorized as extraordinary items.

C URRENT A CCOUNTING P RINCIPLES B OARD O PINIONS (C ONTINUED )

4.11 INTERPRETATIONS: FASB The Interpretations listed in Exhibit 4.3 are intended to clarify or expand on any accounting pronouncements that have previously been issued, usually addressing very specific topics. Number

Title

Description

1

Accounting Changes Related to the Cost of Inventory

4

Applicability of FASB Statement No. 2 to Purchase Business Combinations

6

Applicability of FASB Statement No. 2 to Computer Software

7

Applying FASB Statement No. 7 in Statements of Established Enterprises

E XHIBIT 4.3

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If there is a change in the costs included in inventory, this is considered an accounting change that must be justified based on some improvement in the level of financial reporting, and not just on favorable income tax results. When using the purchase method to account for a business combination, costs should be allocated to assets both resulting from and to be used in research and development activities of the acquired entity. However, assigned R&D costs must then be expensed at the time of the combination if the related assets have no identifiable future use. Specifies that the purchase or development of a process for internal sales or administrative purposes is not classified as research and development costs. The cost associated with the purchase or lease of computer software for use in R&D activities should be charged to expense unless it has an alternative future use. Software development costs through the preproduction phase are considered R&D costs, while programming and testing costs incurred for the improvement of a production model are not considered R&D expenses. Describes the situations under which a consolidating entity should report the effect of a development stage subsidiary’s change in accounting principle, based on the requirements of FASB Statement No. 7.

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Number 8

9

14

18

Title

Description

Classification of a Short-Term Obligation Repaid Prior to Being Replaced by a LongTerm Security Applying APB Opinions Nos. 16 and 17 When a Savings and Loan or Similar Institution Is Acquired in a Purchase Business Combination Reasonable Estimation of the Amount of a Loss Accounting for Income Taxes in Interim Periods

19

Lessee Guarantee of the Residual Value of Leased Property

20

Reporting Accounting Changes Under AICPA Statements of Position Accounting for Leases in a Business Combination Leases of Certain Property Owned by a Governmental Unit or Authority Leases Involving Only Part of a Building

21

23

24

26

27

28

Accounting for Purchase of a Leased Asset by the Lessee During the Term of the Lease Accounting for Loss on a Sublease

Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans

E XHIBIT 4.3

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Requires the reporting of a short-debt repayment as a current liability if the repayment occurs prior to the incurrence of longterm debt that was intended to pay for the short-term debt repayment.

Disallows the use of the “net spread” method for assigning costs to the assets of an acquired company; it also provides guidelines for assigning costs to accounts receivable and payable, as well as intangible assets and savings deposits due on demand.

Specifies the conditions under which losses can be accrued.

Describes the computation of interim-period income taxes and related disclosures, applies the computation to specific situations, and describes special computations that are applicable to multiple jurisdictions. Describes the specific situations under which a lease provision can be construed as being a lessee’s guarantee of the residual value of leased property, as well as the maximum limitations on the amount of such a guarantee. Notes that any change made to a company’s financial statements under an AICPA Statement of Position (SOP) shall do so in accordance with the requirements of the specific SOP. Notes that a lease’s classification as noted in FASB Statement No. 13 shall not be changed because of a business combination, unless the lease’s provisions have been specifically modified. Narrows the range of leases of government property to be categorized as operating leases, based on the presence of four criteria. Notes that one can reasonably determine the fair value of a partial building lease based on other types of information, if comparable sale data are not available. Specifies that an asset purchase under the terms of a capital lease, and the corresponding lease termination, are covered by a single accounting transaction that may call for an adjustment in the carrying amount of the lease obligation. Allows the recognition of a loss on the difference between a lease and a sublease, and also specifies that this loss is to be included in the overall gain or loss reported on the disposition of a business segment. Specifies that a company must record a compensation expense at the end of each reporting period for the amount by which the market price of its stock exceeds the option price for any stock appreciation rights or similar plans.

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4.11 Interpretations: FASB

Number

Title

43

Description

Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets Applying FASB Statement No. 34 to Oil- and GasProducing Operations Disclosure of Indirect Guarantees of Indebtedness of Others Criteria for Applying the Equity Method of Accounting for Investments in Common Stock

Requires that a gain or loss be recognized when corporate assets are involuntarily converted to cash, even in cases where the cash is subsequently reinvested in replacement assets.

36

Accounting for Exploratory Wells in Progress at the End of a Period

Notes that the costs incurred through the end of a reporting period for an exploratory well that is discovered to be a dry hole prior to the date of statement issuance shall be charged to expense within the period.

37

Accounting for Translation Adjustment Upon Sale of Part of an Investment in a Foreign Entity

Holds that an accumulated foreign currency translation adjustment be recognized upon the sale of part of an investment in a foreign entity in proportion to the amount of the investment being disposed of.

38

Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock

Specifies that the measurement date for award plans involving junior stock is the date when it is known the exact amount of the common stock for which the junior stock can be exchanged.

39

Offsetting of Amounts Related to Certain Contracts

Defines the right of setoff under which an accountant may net assets and liabilities on the balance sheet, as well as its applicability to conditional or exchange contracts.

40

Applicability of Generally Accepted Accounting Principles to Mutual Life Insurance and Other Enterprises

Requires that mutual life insurance and other enterprises cannot state that they have prepared financial statements in accordance with GAAP in cases where they have actually diverted from GAAP in order to comply with other regulatory accounting practices.

41

Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements

Modifies FASB Interpretation No. 39, regarding setoffs of assets and liabilities, to allow this practice in the statement of financial position for receivables and payables that are related to repurchase agreements and reverse repurchase agreements.

43

Real Estate Sales

States that sales of real estate with property improvements or integral equipment that cannot be removed and used separately from the real estate without incurring significant costs should be accounted for under FASB Statement No. 66, “Accounting for Sales of Real Estate.”

30

33

34

35

E XHIBIT 4.3

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Specifies the conditions under which an oil- and gas-producing operation whose assets are accounted for under the full cost method may capitalize interest costs. Specifies that the disclosure requirements noted in FASB Statement No. 5 for guarantees of indebtedness must also be used for indirect guarantees. Describes the conditions under which the equity method of accounting should be used to account for an investor’s stake in an investee’s voting stock of 50 percent or less.

C URRENT FASB I NTERPRETATIONS (C ONTINUED )

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Number 44

Title

Description

Accounting for Certain Transactions Involving Stock Compensation

E XHIBIT 4.3

S UMMARY

OF

Narrows the use of APB No. 25 to just employees, and clarifies the rules for the grant of stock awards to employees of affiliates of the issuer.

C URRENT FASB I NTERPRETATIONS (C ONTINUED )

4.12 STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS: FASB The Statements listed in Exhibit 4.4 are considered to be the primary source of GAAP to the extent that they supersede any previous pronouncements, either by the FASB or any predecessor organization. Number

Title

Description

2

Accounting for Research and Development Costs

Requires one to charge research and development costs to expense when they are incurred, and describes the disclosure of R&D information in the financial statements.

3

Reporting Accounting Changes in Interim Financial Statements

Describes the reporting requirements in interim financial statements in relation to changes to LIFO inventory costing, and to cumulative-effect types of accounting changes.

4

Reporting Gains and Losses from Extinguishment of Debt

Requires that gains and losses caused by a debt extinguishment shall be reported as an extraordinary item, if material. It also describes the disclosure requirements for such transactions.

5

Accounting for Contingencies

Describes how to account for loss contingencies, including the accrual of a loss contingency if there is a probability of loss and its amount can be reasonably estimated. Alternatively, gain contingencies can be recognized only when they have been realized.

6

Classification of Short-Term Obligations Expected to Be Refinanced

Allows an entity to reclassify its short-term debt as long-term debt, but only if it both intends to complete the required refinancing and has the ability to do so.

7

Accounting and Reporting by Development Stage Enterprises

Describes the types of entities that are considered to be in the development stage, and requires them to use the same accounting methods as those of established companies.

10

Extension of “Grandfather” Provisions for Business Reporting

Extends the grandfather provisions of APB Opinion No. 16 that create an exemption from some criteria used to determine the applicability of the pooling of interests method of accounting for a business combination.

11

Accounting for Contingencies —Transition Method

Requires a company to restate its financial statements for preceding periods in order to comply with FASB Statement No. 5.

13

Accounting for Leases

Describes the proper accounting by both parties to a lease, including the determination and treatment of operating and capital leases by lessees, and the determination and treatment of sales type, direct financing, and leveraged leases by lessors.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

15

Accounting by Debtors and Creditors for Troubled Debt Restructurings

16

Prior Period Adjustments

18

Financial Reporting for Segments of a Business Enterprise —Interim Financial Statements Financial Accounting and Reporting by Oil and Gas Producing Companies

19

21

22

Suspension of the Reporting of Earnings per Share and Segment Information by Nonpublic Enterprises Changes in the Provisions of Lease Agreements

23

Inception of the Lease

24

Reporting Segment Information in Financial Statements that Are Presented in Another Enterprise’s Financial Report Suspension of Certain Accounting Requirements for Oil and Gas Producing Companies Classification of Renewals or Extensions of Existing Sales-Type or Direct Financing Leases Accounting for Sales with Leasebacks

25

27

28

29

Determining Contingent Rentals

30

Disclosure of Information about Major Customers

E XHIBIT 4.4

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45

Description Describes the proper accounting by both parties to a troubled debt restructuring, including modifications to the yield of a loan, and the circumstances under which gains or losses can be recognized. Allows prior-period adjustments only if there are material errors or if there are some income tax benefits associated with preacquisition loss carryforwards of a purchased entity. Stops the FASB Statement No. 14 requirement to report segment information for interim periods.

Requires oil- and gas-producing companies to use the successful efforts method to account for the costs of producing mineral resources, as well as such issues as cost capitalization and amortization, property conveyances, income taxes, and financial statement disclosures. Suspends the requirement in APB Opinion No. 15 and FASB Statement No. 14 to report segment information, but only for nonpublic entities. Requires the current recognition of a gain or loss when new debt proceeds are used to retire existing debt, under certain provisions. Alters the lease inception date to the date of lease agreement or any earlier commitment in cases where the property to be covered by a lease has not yet been purchased or constructed. Eliminates the requirement to present segment information in some instances where additional entity financial statements are presented alongside consolidated statements. Suspends the use of some provisions of FASB Statement No. 19 due to some variations between that statement and SEC reporting requirements. Requires a lessor to classify a lease as a sales-type lease if it is an extension of an existing sales-type or direct-financing lease. Modifies FASB Statement No. 13 to allow the recognition of some profit or loss on sale and leaseback transactions if the seller has minimal usage of the property after the transaction, or if the sale profit exceeds the present value of minimum lease payments due. Defines contingent rentals, as well as what payments should be included in the reporting of minimum lease payments due for this type of rental. Requires that an entity report the amount of sales made to a government entity if those sales are at least 10 percent of its total revenues.

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Ch. 4 Accounting Principles and Standards

Number

Title

Description

34

Capitalization of Interest

Describes the rules for capitalizing interest costs in some situations where assets are being acquired, built, or modified, and how the rules will vary if the amount of interest to be capitalized is considered material or not.

35

Accounting and Reporting by Defined Benefit Pension Plans

Describes the rules for the annual financial statements associated with a defined-benefit pension plan, requiring the inclusion of such information as net assets available for benefits, changes in these benefits, and the present value of plan benefits.

42

Determining Materiality for Capitalization of Interest Cost

Deletes language from FASB Statement No. 34 that might be construed as allowing one to avoid interest capitalization, and also points out that the same statement does not contain new materiality tests.

43

Accounting for Compensated Absences

Specifies that a liability be accrued for the future absences of employees under certain circumstances.

44

Accounting for Intangible Assets of Motor Carriers

States that the unamortized intangible costs associated with a motor carrier’s right to transport goods across state lines should be charged against income.

45

Accounting for Franchise Fee Revenue

Describes the primary accounting concepts for franchisors, including the proper treatment of franchise fee costs and revenues, commingled revenue, agency sales, repossessed franchises, and continuing product sales.

47

Disclosure of Long-Term Obligations

Describes the financial disclosures needed in cases where there are unconditional purchase obligations and future payments on long-term borrowings and redeemable stock.

48

Revenue Recognition When Right of Return Exists

Allows revenue recognition for transactions involving a right of return only if a set of minimum conditions are met.

49

Accounting for Product Financing Arrangements

Defines a product-financing arrangement, and requires that it be accounted for as a borrowing transaction, instead of a sale.

50

Financial Reporting in the Record and Music Industry

Describes the accounting practices for both licensors and licensees in the music and recording industry, including revenue recognition for licensing fees, minimum license guarantees, artist compensation, and other costs.

51

Financial Reporting by Cable Television Companies

Describes how to account for the revenues and expenses related to cable television systems, both while under construction, in the prematurity period, and when in operation.

52

Foreign Currency Translation

Describes the treatment of foreign currency translation adjustments in accordance with the operating status of a foreign subsidiary, as well as the treatment of foreign currency transactions with other entities.

54

Financial Reporting and Changing Prices: Investment Companies

Avoids the previous requirements in FASB Statement No. 33 which requires investment companies to make disclosures regarding the effects of changing prices.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

47

Description

57

Related-Party Disclosures

Describes the rules to follow when reporting on related-party transactions.

58

Capitalization of Interest Cost in Financial Statements that Include Investments Accounted for by the Equity Method

Limits the capitalization of interest costs on an investor’s financial statements in a limited number of situations involving the use of the equity method of accounting for an investment in another business entity.

60

Accounting and Reporting by Insurance Companies

Describes the reporting to be used for insurance entities in relation to the treatment of contracts, premiums, claims, and investments.

61

Accounting for Title Plant

Requires that costs incurred to build a title plant be capitalized until activated, and also specifies the treatment of maintenance expenses that are incurred thereafter.

62

Capitalization of Interest Costs in Situations Involving Certain Tax-Exempt Borrowings and Certain Gifts and Grants

Specifies situations in which interest costs are to be capitalized, as well as situations where the capitalization of interest costs is not allowed.

63

Financial Reporting by Broadcasters

Describes the reporting requirements for broadcasters, including treatment of exhibition rights, license agreements, barter transactions, and network affiliation agreements.

64

Extinguishment of Debt Made to Satisfy Sinking Fund Requirements

Specifies that the classification of gains or losses that result from the extinguishment of debt that is required by a sinking fund need not be reported as extraordinary items.

65

Accounting for Certain Mortgage Bank Activities

Specifies that mortgage loans and similar loans be reported at the lower of cost or market. It also notes the treatment of loan origination and commitment fees, loan placement fees, and premiums paid to service loans.

66

Accounting for Sales on Real Estate

Describes the rules for recognizing the profitability of real estate sales. Different standards apply to land sales than to other types of sales, to which the percentage of completion or installment methods may be applied.

67

Accounting for Costs and Initial Rental Operations of Real Estate Projects

Sets forth the rules regarding the types of costs that may be capitalized in relation to real estate projects, as well as the point after which costs may no longer be capitalized.

68

Research and Development Arrangements

Describes the accounting for research and development activities that are performed by a company for other entities. If there is a repayment obligation, its amount must be recorded as a liability.

69

Disclosures about Oil- and Gas- Producing Activities

Describes the disclosures required by oil- and gas-producing entities, and reduces or eliminates many of the disclosures by those entities that are not publicly held.

71

Accounting for the Effects of Certain Types of Regulation

Describes the accounting by most types of public utilities for regulation of the variety that allows utilities to set prices that will recover the cost of and capital cost of services provided.

E XHIBIT 4.4

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Ch. 4 Accounting Principles and Standards

Number

Title

Description

72

Accounting for Certain Acquisitions of Banking or Thrift Institutions

Requires that the fair value of liabilities assumed in the acquisition of a bank or thrift entity over the fair value of acquired assets be amortized by the interest method. Also, any financial assistance obtained from a regulatory agency as part of the combination shall be recorded as an asset if the amount of the receipt can be determined and is likely to be received.

73

Reporting a Change in Accounting for Railroad Track Structures

Requires that railroads change their reporting of depreciation for railroad track structures, including a restatement of this information in prior reporting years.

78

Classification of Obligations that Are Callable by the Creditor

Requires that long-term liabilities callable by creditors be classified as current liabilities on the balance sheet, subject to some qualifications.

79

Elimination of Certain Disclosures for Business Combinations by Nonpublic Enterprises

Eliminates APB Opinion No. 16’s requirement for nonpublic entities to report pro forma results of combinations under the purchase method.

84

Induced Conversions of Convertible Debt

Requires that the debtor recognize an expense equal to the fair value of any extra consideration given to creditors in order to persuade them to convert their convertible debt holdings to equity.

85

Yield Test for Determining Whether a Convertible Security Is a Common Stock Equivalent

Replaces the cash yield test as previously specified in APB Opinion No. 15 with the effective yield test to determine if convertible securities shall be designated common stock equivalents for the purpose of computing primary earnings per share.

86

Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed

States that software development costs shall be expensed as research and development costs prior to the point when technological feasibility has been proven, after which they may be capitalized and then amortized over the remaining estimated life of the product.

87

Employers’ Accounting for Pensions

Establishes new standards for the treatment of pension accounting, superseding previous releases. The primary change is the accounting for a single-employer defined-benefit pension plan.

88

Employers’ Accounting for Settlements and Curtailments of Defined Pension Benefit Plans and for Termination Benefits

Describes the accounting for the settlement of obligations under a defined-benefit pension plan, termination benefits, and the curtailment of such a plan. It also defines settlement and curtailment.

89

Financial Reporting and Changing Prices

Replaces FASB Statement No. 33 and its later amendments. It also specifies that the disclosure of current cost and constant purchasing power information is voluntary.

90

Regulated Enterprises— Accounting for Abandonments and Disallowances of Plant Costs

Describes the accounting for abandonments of utility plants, as well as the disallowance of plant costs by regulators for the calculation of rate changes. Abandoned assets that are to be included in rate-making calculations should be included at their present value, while disallowed costs should be recognized as a loss.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

49

Description

91

Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans

Describes how to account for the costs related to lending, or buying a loan, as well as costs related to leasing activities.

92

Regulated Enterprises— Accounting for Phase-In Plans

Modifies FASB Statement No. 71 to account for phase-in plans, which are intended to reduce the impact of utility rate increases that are tied to the implementation of expensive new power-generation facilities.

93

Recognition of Depreciation by Not-for-Profit Organizations

Requires that not-for-profit organizations disclose depreciation information, though not for some types of art or historical treasures.

94

Consolidation of All MajorityOwned Subsidiaries

Requires that majority-owned subsidiaries be included in the corporate parent’s financial statements on a consolidated basis unless there is no control or control is temporary.

95

Statement of Cash Flows

Describes a new format for cash flow reporting that replaces the statement of changes in financial position and which is to be a key part of all financial statements. It categorizes cash flows by operating, investing, and financing activities.

97

Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments

Describes the accounting for universal life–type contracts, as well as for limited-payment long-duration insurance contracts and investment contracts. It also revises the reporting for realized gains and losses that was originally itemized in FASB Statement No. 60.

98

Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Definition of the Lease Term, and Initial Direct Costs of Direct Financing Leases

Itemizes the types of accounting required by the parties to a sale-leaseback transaction, while also modifying a number of issues originally set forth in FASB Statement No. 13.

99

Deferral of Effective Date of Recognition of Depreciation by Not-for-Profit Organizations

Changes the effective date of FASB Statement No. 93 to fiscal years beginning on or after January 1, 1990.

101

Regulated Enterprises — Accounting for Discontinuation of Application of FASB Statement No. 71

Specifies how a company should report in its financial statements that it is no longer subject to certain types of regulation, including the elimination of any actions by regulators that had been itemized as assets or liabilities in previous financial reports. The profit impact of any such changes should be recorded in the current period as extraordinary items.

102

Statement of Cash Flows — Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale

Exempts some employee benefit plans and certain types of investment companies from following the dictates of FASB Statement No. 95, regarding the presentation of a statement of cash flows.

E XHIBIT 4.4

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Ch. 4 Accounting Principles and Standards

Number 104

106

Title Statement of Cash Flows —Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions Employers’ Accounting for Postretirement Benefits Other than Pensions

107

Disclosures about Fair Value of Financial Instruments

109

Accounting for Income Taxes

110

Reporting by Defined-Benefit Pension Plans of Investment Contracts

111

Rescission of FASB Statement No. 32 and Technical Corrections Employers’ Accounting for Postemployment Benefits

112

113

114

Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts Accounting by Creditors for Impairment of a Loan

115

Accounting for Certain Investments in Debt and Equity Securities

116

Accounting for Contributions Received and Contributions Made

117

Financial Statements of Not-for-Profit Organizations

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

Description Allows banks and similar entities to report in a statement of cash flows some cash flows related to deposits and loans.

Requires that postretirement health care benefits be accounted for by accruing the expected cost of future benefits at the time when employees are still working for the company. Requires all organizations to itemize the fair value of all financial instruments in the statement of financial position, if this information can be determined. Outlines the bases and resulting rules upon which one should account for income taxes, focusing on an asset and liability approach to the presentation of income tax information. Mandates that an investment contract held by a defined-benefit pension plan be stated at its fair value, while only contracts including mortality risk can be recorded at their contract value. Rescinds FASB Statement No. 32, and also makes technical corrections to several other documents. Requires that the liability associated with postemployment benefits be recognized if several requirements are met, as well as that the amount of the liability can be reasonably estimated and it is probable that a liability has been incurred. Describes how insurance entities should account for the reinsuring of insurance contracts, requiring reinsurance receivables and prepaid reinsurance premiums to be reported as assets. Describes the proper accounting for the impairment of some types of loans by creditors, requiring that these loans be recorded at their discounted present values. Describes the different types of reporting for debt and equity securities. Debt that is intended to be held to maturity is reported at amortized cost, while both debt and equity securities to be sold in the near term are reported at fair value, with unrealized gains or losses included in current earnings. Finally, debt and equity that falls into neither category is reported at fair value, with any unrealized gains or losses reported in shareholders’ equity. Describes the standards to be used when making or receiving contributions. Essentially, contributions are made and received at their fair value, while conditional contributions are recognized only when all associated conditions have essentially been met. Describes the reporting format to be used by not-for-profit organizations.

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

51

Description

118

Accounting by Creditors for Impairment of a Loan— Income Recognition and Disclosures

Modifies FASB Statement No. 114 to allow creditors to use existing methods for recognizing interest income on an impaired loan.

120

Accounting and Reporting by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain Long-Duration Participating Contracts

Increases the coverage of FASB Statements Nos. 60, 97, and 113 to assessment enterprises, fraternal benefit societies, and mutual life insurance organizations.

121

Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of

Describes how to account for the impairment or disposition of long-lived assets, some identifiable intangibles, and goodwill related to those assets. The basic requirement is to periodically review these assets for impairment by comparing expected future cash flows to their carrying value.

123

Accounting for Stock Compensation

Describes the required reporting for employee compensation plans that include the use of company stock, such as stock appreciation rights, stock options, stock purchase plans, and restricted stock.

124

Accounting for Certain Investments Held by Not-for-Profit Organizations

Describes how not-for-profit organizations must use fair value when reporting on equity securities whose fair values can be determined, as well as all investments in debt securities.

125

Transfers of Financial Assets and Extinguishment of Liabilities

Describes the reporting requirements related to the transfer of financial assets and the extinguishment of liabilities through the recognition of those financial assets under a business’s control and derecognizing both those over which control no longer exists and those liabilities that have been extinguished.

126

Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities

Modifies FASB Statement No. 107 to make the reporting requirements in that document optional if the business is nonpublic, its total assets are less than $100 million, and the business has not been involved with any derivative-related transactions during the reporting period.

127

Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125

Adds new criteria to those listed in FASB Statement No. 125 for determining whether a sale or a pledge of collateral for debt has occurred when a transfer of assets arises. It also describes how to account for pledged collateral.

128

Earnings per Share

Describes how to compute and report on earnings per share information, replacing the use of primary earnings per share with basic earnings per share. Requires the use of a dual presentation of basic and diluted earnings per share if a business has a complex capital structure.

129

Disclosures of Information about Capital Structure

Itemizes the standards for reporting a business’s capital structure, and spreads this requirement to nonpublic businesses.

E XHIBIT 4.4

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Ch. 4 Accounting Principles and Standards

Number

Title

130

Reporting Comprehensive Income

131

Disclosures about Segments of Enterprise and Related Information

132

Employers’ Disclosures about Pensions and Other Postretirement Benefits

133

Accounting for Derivative Instruments and Hedging Activities

134

Accounting for MortgageBacked Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise Rescission of FASB Statement No. 75 and Technical Corrections

135

136

137

138

139

Transfers of Assets to a Not-for-Profit Organization or Charitable Trust that Raises or Holds Contributions for Others Accounting for Derivative Instruments and Hedging Activities —Deferral of the Effective Date of FASB Statement No. 133 Accounting for Certain Derivative Instruments and Certain Hedging Activities — An Amendment of FASB Statement No. 133 Rescission of FASB Statement No. 53 and Amendments to FASB Statements Nos. 63, 89, and 121

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

Description Describes how to report comprehensive income, as well as related revenues and expenses in the financial statements. Replaces FASB Statement No. 14; describes reporting requirements about operating segments, products and services, geographic area, and major customers, both in annual and interim financial statements. This is not applicable to not-for-profit and nonpublic businesses. Describes the types of disclosures required for employers’ pension and related retirement plans, which include information about changes in benefit obligations, as well as the fair values of plan assets. It also allows nonpublic companies to have reduced reporting requirements. Requires that a business entity recognize all derivatives within the statement of financial position, and that they be measured at their fair value. This Statement encompasses the use of derivatives that are embedded in other types of contracts. Modifies paragraphs 4 and 6 of Statement No. 65 (Accounting for Certain Mortgage Bank Activities) and paragraph 12(a) of Statement No. 115 (Accounting for Certain Investments in Debt and Equity Securities).

Rescinds Statement No. 75 (Deferral of the Effective Date of Certain Accounting Requirements for Pension Plans of State and Local Governmental Entities) in favor of GASB Statement No. 25. It also excludes benefit pension plans sponsored by government entities from the scope of Statement No. 35. Describes the proper accounting for transactions where a donor contributes assets to a not-for-profit entity that then shifts the assets to a donor-specified third beneficiary. Amends paragraphs 48 and 50 of Statement No. 133.

As noted in the title. It is effective for all fiscal quarters and years beginning after June 15, 2000.

Substitutes Statement of Position No. 00-2 (Accounting by Producers or Distributors of Films) for FASB Statement No. 53. It also revises earlier FASB statements related to accounting by broadcasters, changing prices, and the impairment or disposition of long-lived assets. It should be applied to all fiscal years beginning after December 15, 2000.

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4.13 Statements of Financial Accounting Concepts: FASB

Number

Title

140

Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

141

Business Combinations

142

Goodwill and Other Intangible Assets

E XHIBIT 4.4

53

Description Describes the accounting standards to be used for transactions related to the transfer and servicing of financial assets, as well as the extinguishment of liabilities. It retains most of Statement No. 125’s pronouncements, but revises the rules for accounting for securitizations and related transfers of financial assets. Describes the use of the purchase method of accounting to account for business combinations; it eliminates the use of the pooling of interests method of accounting. Describes how to report intangible assets in the financial statements, though not intangible assets acquired through a business combination. It also notes how intangible assets should be accounted for on an ongoing basis.

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4.13 STATEMENTS OF FINANCIAL ACCOUNTING CONCEPTS: FASB The seven Concepts standards that have been listed in Exhibit 4.5 issued by the FASB (of which No. 3 has been superseded) are designed to provide the accountant with a background for the understanding of accounting standards. Number

Title

1

Objectives of Financial Reporting by Business Enterprises

2

Qualitative Characteristics of Accounting Information

4

Objectives of Financial Reporting by Non-business Organizations

5

Recognition and Measurement in Financial Statements of Business Enterprises Elements of Financial Statements

6

7

Using Cash Flow Information and Present Value in Accounting Measurements

E XHIBIT 4.5

Black process 45.0° 133.0 LPI

Description Specifies that financial reporting is designed to allow one to predict cash flows, entity resources and how they are used, and information that the reader can use to make economic decisions. Specifies that accounting information should be comparable and consistent between periods, as well as understandable, reliable, and relevant. Establishes the objectives of financial reporting by nonbusiness organizations, which are similar to those for business organizations. It defines nonbusiness organizations, identifies transactions common to them that are uncommon for business organizations, and notes that financial reports for these entities should provide additional information about the level of services provided and the quality of stewardship by managers. Specifies the types of information to include in financial statements, and the timing of its presentation.

Defines the core elements to be found in financial statements, which are comprehensive income, revenue, expenses, gains, losses, owner investments, owner distributions, assets, liabilities, and equity. Describes why and when present value, fair value, and the interest rate method for amortization are used to provide valuations, and how future cash flows can be used to determine this information.

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Ch. 4 Accounting Principles and Standards

4.14 TECHNICAL BULLETINS: FASB Technical Bulletins, summarized in Exhibit 4.6, are intended to clarify or elaborate on underlying accounting standards. They typically address narrow subject areas that are not directly addressed by existing accounting standards; part of the resulting discussion may lead to some variations from GAAP that are targeted only at the tightly defined areas that are directly addressed by the Technical Bulletins. Any such changes are not expected to create major variations from current GAAP, nor should they be costly to implement.

Number

Title

Description

79-1

Purpose and Scope of FASB Technical Bulletins and Procedures for Issuance

Notes that technical bulletins are intended to provide guidance in applying the opinions, statements, and interpretations previously issued by both the FASB and its predecessors, as well as to address issues not directly covered by those GAAP standards.

79-3

Subjective Acceleration Clauses in Long-Term Debt Agreements

Does not authorize the restatement of long-term debt as short-term debt in situations where there are subjective acceleration clauses in debt agreements, and where there is little likelihood of acceleration.

79-4

Segment Reporting of Puerto Rican Operations

Specifies that a domestic corporation’s Puerto Rican operations should be considered part of its domestic operations, and not a foreign entity.

79-5

Meaning of the Term “Customer” as it Applies to Health Care Facilities Under FASB Statement No. 14

Specifies that an insuring entity is not a customer of a health care facility, for the purposes of reporting on customers who represent at least 10 percent of an entity’s business.

79-9

Accounting in Interim Periods for Changes in Income Tax Rates

Specifies the method for determining the reduction in the corporate tax rate resulting from the Revenue Act of 1978 for those entities not using a calendar year as their fiscal year.

79-10

Fiscal Funding Clauses in Lease Agreements

Specifies that the presence of a fiscal funding clause will not result in a lease being considered cancelable if the probability of the clause being invoked is remote.

79-12

Interest Rate Used in Calculating the Present Value of Minimum Lease Payments

Allows a business to use its secured borrowing rate when determining the present value of minimum lease payments, as long as that rate is reasonable and would be representative of the type of financing used for the lease.

79-13

Applicability of FASB Statement No. 13 to Current Value Financial Statements

Requires that the provisions of FASB Statement No. 13 be applied to financial statements that have been prepared on a current value basis.

79-14

Upward Adjustment of Guaranteed Residual Values

Prohibits the use of upward adjustments of estimated residual values resulting from renegotiations of the guaranteed portions of residual values.

79-15

Accounting for Loss on a Sublease Not Involving the Disposal of a Segment

Describes a loss on a sublease, and specifies that it be recognized as soon as it is expected to be incurred.

79-16

Effect of a Change in Income Tax Rate on the Accounting for Leveraged Leases

Requires that the income effect of a change in the statutory tax rate be recognized in the period immediately after the change becomes law.

E XHIBIT 4.6

Black process 45.0° 133.0 LPI

S UMMARY

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4.14 Technical Bulletins: FASB

Number

Title

55

Description

79-17

Reporting Cumulative Effect Adjustment from Retroactive Application of FASB No. 13

States that the cumulative effect of modifying financial statements to comply with the provisions of FASB Statement No. 13 should not be included in the net income of any presented year unless the year prior to the earliest year presented could not be restated.

79-18

Transition Requirements of Certain FASB Amendments and Interpretations of FASB Statement No. 13

Describes the financial reporting and disclosure requirements associated with the changes required by FASB Statement No. 13.

80-1

Early Extinguishment of Debt Through Exchange for Common or Preferred Stock

Notes that the provisions of APB Opinion No. 26 do apply to the extinguishment of debt through the issuance of common or preferred stock, and also describes its presentation in the financial statements.

80-2

Classification of Debt Restructurings by Debtors and Creditors

Allows different accounting interpretations of the presence of a troubled debt restructuring by debtors and creditors.

81-6

Applicability of Statement No. 15 to Debtors in Bankruptcy Situations

Specifies that FASB Statement No. 15, which describes troubled debt restructurings, does not apply to bankrupt companies that restructure their debt as part of a general restructuring of all of their liabilities, but does apply if there is not a general restatement of the debtor’s liabilities.

82-1

Disclosure of the Sale or Purchase of Tax Benefits Through Tax Leases

Requires that a company engaged in the sale or purchase of tax benefits through tax leases disclose the method of accounting for them, as well as the methods used to recognize revenue and allocate income tax benefits and asset costs to both current and future periods.

84-1

Accounting for Stock Issued to Acquire the Results of a Research and Development Arrangement

Requires that stock exchanged for the results of a research and development arrangement be recorded at either its fair market value or the fair value of the consideration received.

85-1

Accounting for the Receipt of Federal Home Loan Mortgage Corporation Participating Preferred Stock

Requires that the 12 district banks of the Federal Home Loan Banking System record the receipt of participating preferred stock from the Federal Home Loan Mortgage Corporation at its fair value as of the date of receipt, with any resulting income being recorded as an extraordinary item.

85-3

Accounting for Operating Leases with Scheduled Rent Increases

Requires that scheduled rent increases be recognized on a straight-line basis over the lease term unless there is another systematic allocation system available that better represents the time pattern during which the leased property is being used.

85-4

Accounting for Purchases of Life Insurance

Specifies that life insurance be reported as an asset, with the change in cash surrender value during the period being offset against payments made in order to determine the amount of the insurance expense.

85-5

Issues Relating to Accounting for Business Combinations

Specifies that the costs incurred to close duplicate facilities as a result of a business combination shall be charged to expense, and shall not be included in the accounting for the business combination.

E XHIBIT 4.6

Black process 45.0° 133.0 LPI

S UMMARY

OF

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Ch. 4 Accounting Principles and Standards

Number 85-6

86-2

87-2

87-3

88-1

90-1

94-1

97-1

Title

Accounting for a Purchase Specifies that if Treasury stock is acquired at a price significantly higher than its market price, the difference of Treasury Shares at should be accounted for as being consideration for a Price Significantly in other services provided by the company, unless no other Excess of the Current consideration can be identified. Also notes that corporate Market Price of the payments to a shareholder for a standstill agreement Shares and the Income be charged to current expense. Also, any costs incurred Statement Classification to defend against a takeover attempt should be charged of Costs Incurred in to operating expenses, not extraordinary expenses. Defending Against a Takeover Attempt Accounting for an Interest Requires that an unconditional right to own a leased asset at in the Residual Value of the end of the lease term requires the lessee to account for it a Leased Asset as an asset. It also discusses the valuation of the residual value of leased assets for lessees, lessors, and lease brokers. Computation of a Loss on Describes the accounting for deferred income taxes a Abandonment associated with abandonments and the assets remaining thereafter, with separate treatment for regulated entities. Accounting for Describes the accounting treatment for the impact of Mortgage Servicing Fees estimated future net servicing income from a refinanced and Rights loan on the amortization of capitalized costs related to the acquisition of the mortgage servicing rights for the superseded loan. Issues Relating to Describes the proper accounting treatment of leasing issues Accounting for Leases related to incentives in an operating lease, wrap lease transactions, money-over-money lease transactions, the time pattern of the physical use of operating lease property, and the applicability of leveraged lease accounting to a lessor’s existing assets. Specifies that income from a separately priced warranty Accounting for Separately or maintenance agreement be amortized to income on a Priced Extended straight-line basis over the term of the agreement, except Warranty and Product in situations where there is historical proof that some other Maintenance Contracts amortization schedule would more accurately reflect the incurrence of related costs, and also describes the proper treatment of losses on such contracts. Specifies that any restructured loans arising from a troubled Application of Statement debt restructuring are subject to the provisions of FASB No. 115 to Debt Statement No. 115 if it meets the definition of a “security” Securities in a Troubled as defined in that Statement. Debt Restructuring Describes the situations in which the fair value measurement Accounting Under technique is used to value awards under various types of Statement No. 123 for employee stock purchase plans with look-back provisions. Certain Employee Stock Purchase Plans with a Look-Back Option

E XHIBIT 4.6

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Description

S UMMARY

OF

C URRENT FASB T ECHNICAL B ULLETINS (C ONTINUED )

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CHAPTER*

5

COST ACCOUNTING AND COSTING SYSTEMS 5.1 INTRODUCTION 57

5.7 PROCESSING: STANDARD COSTING 69

5.2 PURPOSE OF COST ACCOUNTING INFORMATION 57

5.8 PROCESSING: DIRECT COSTING 71

5.3 INPUT: DATA COLLECTION SYSTEMS 58

5.9 PROCESSING: THROUGHPUT COSTING 73

5.4 PROCESSING: DATA SUMMARIZATION SYSTEMS 60

5.10 PROCESSING: ACTIVITY-BASED COSTING 76

5.5 PROCESSING: JOB COSTING 62

5.11 PROCESSING: TARGET COSTING 79

5.6 PROCESSING: PROCESS COSTING 66

5.12 OUTPUTS: COST VARIANCES 80

5.1 INTRODUCTION Cost accounting is one of the most crucial aspects of the accounting profession, for it is the primary means by which the accounting department transmits company-related performance information to the management team. A properly organized cost accounting function can give valuable feedback regarding the impact of product pricing, cost trends, the performance of cost and profit centers, and production and personnel capacity, and can even contribute to some degree in the formulation of company strategy. Despite this wide array of uses, many controllers rarely give due consideration to the multitude of uses to which cost accounting can be put. Instead, they think only of how cost accounting will feed information into the financial statements. This orientation comes from a strong tendency in business schools to train students in generally accepted accounting principals (GAAP) and how they are used to create financial statements. In this chapter, we will focus on how one can collect data, summarize it, and report it to management with the goal of helping the management team to run the business.

5.2 PURPOSE OF COST ACCOUNTING INFORMATION The cost accounting function works best without any oversight rules and regulations, because, in accordance with its stated purpose of assisting management, it tends to result in hybrid systems that are custom-designed to meet specific company needs. For example, a company may find that a major requirement is to determine the incremental cost that it incurs for each additional unit of production, so that it can make accurate decisions regarding the price of incremental units sold (possibly at prices very close to the direct cost). If it were to use accounting standards, it would be constrained to only use a costing system that allocated a portion of overhead costs to product

* Adapted with permission from Chapter 26 of Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002).

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costs—even though these are not incremental costs. Accordingly, the cost accounting system used for this specific purpose will operate in contravention of GAAP, because following GAAP would yield results that do not assist management. Because there are many different management decisions for which the cost accounting profession can provide valuable information, it is quite common to have several costing systems in place, each of which may use different costing guidelines. To extend the previous example, the incremental costing system used for incremental pricing decisions may not be adequate for a different problem, which is creating profit centers that are used to judge the performance of individual managers. For this purpose, a second costing system must be devised that allocates costs from internal service centers to the various profit centers; in this instance, we are adding an allocation function to the incremental costing system that was already in place. Even more systems may be required for other applications, such as transfer pricing between company divisions and the costing of inventory for external financial reporting purposes (which does require attention to GAAP guidelines). Consequently, cost accounting frequently results in a multitude of costing systems, which may follow GAAP guidelines only by accident. The controller’s primary concern is whether the information resulting from each system adequately meets the needs of the recipients. Any cost accounting system is comprised of three functional areas: the collection of raw data, the processing of this data in accordance with a costing methodology, and the reporting of the resulting information to management in the most understandable format. The remainder of this chapter is split into sections that address each of these three functional areas. The area that receives the most coverage is the processing function, for there are a number of different methodologies available, each of which applies to different situations. For example, job costing is used for situations where specifically identifiable goods are produced in batches, while direct costing is most applicable in situations where management does not want to see any overhead allocation attached to the directly identifiable costs of a product. The large number of processing methodologies presented here is indicative of the broad range of options available to the controller for processing raw data into various types of reports for management use.

5.3 INPUT: DATA COLLECTION SYSTEMS The first step in setting up a data collection system is to determine what types of data to gather. One can simply collect every conceivable type of data available, but this will result in immensely detailed and cumbersome collection systems that are expensive and require a great deal of employee time to collect and record. A better approach is to determine what types of outputs are required, which can then be used to ascertain the specific data items needed to create those outputs. This allows the controller to ignore many types of data, simply because no one needs them. However, the process of determining data requirements from projected outputs must be revisited on a regular basis, for changes in the business will require changes in the required cost accounting reports, and therefore changes in the types of data collected. The process of backtracking from a required output to a set of required data elements is best illustrated with an example. If a company is manufacturing a set of products whose components and assembly are entirely outsourced, then it is logical to create management reports that focus on the prices being charged to the company by its suppliers, rather than creating an elaborate time recording system for the small number of quality inspectors who are responsible for reviewing completed goods before they are shipped out to customers. In this case, the bulk of the data used by the costing system will come out of the accounts payable and purchasing records. Another example is a software company, where the costing focus is on the labor time charged to specific development projects and the ability of project managers to meet their deadlines, rather than on the minor cost of purchasing compact disks, packaging, and training materials that are shipped to customers. In this case, most of the cost accounting data will come from the timekeeping and project-tracking databases. Thus, the nature of the business will drive the decision to collect certain types of data. Once the controller knows what data to collect, there is still the issue of creating a data accumulation system. There are several factors that will influence this decision. One is cost; if there are many employees who will be recording information continuously, then the unit cost of the data collection device cannot be too expensive, or else its total cost will exceed the utility of the col-

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lected data. Another issue is data accuracy; if the data collected absolutely, positively must be correct, then a more elaborate solution, such as bar code scanning, which is designed to yield superaccurate results, should be the preferred solution. However, if the level of required accuracy is lower, then perhaps manual keypunch entry or handwritten data sheets would be acceptable. Another factor is the employees who will use the data collection systems; if they are highly trained, then they can be relied on to use complex keypunching systems, whereas a poorly trained work force that has no idea of what data it is collecting, or why it is being used, should be allowed to collect only data that will be heavily cross-checked for errors. Of additional concern is the timeliness of the data collected. If there is a need for up-to-the-minute transmission of data to managers, then the only solution will be some form of automated data gathering. On the other hand, only an occasional report to management may require a slower manual data gathering approach. Another factor to consider is the existing level of automation within the company. For example, if there is a clear production path for all products that sends every completed item down a specific conveyor belt, then the installation of a fixed bar code scanner on that conveyor is a reasonable approach for recording data about production quantities. However, this would be a poor solution if products were being hand-carried away from a multitude of production processes to the warehouse, since many of the items created would never pass by the bar code scanner. A final consideration is the production methodology currently in use. If it is a lean manufacturing system, such as just-in-time, there will be a strong orientation away from requiring employees to conduct any data entry work, since extremely focused and efficient workflows are the key to success in this environment — which is interrupted if data entry tasks are included. In these cases, one should avoid any type of manual data entry, focusing instead on more automated approaches. Given the above parameters, it is clear that the controller must devise a wide array of data collection tools in order to collect data in the most appropriate manner. The following bullet points describe a number of the more common (and upcoming) data collection tools: • Punch clocks. A data collection tool that is proving to have a great deal of longevity is the punch clock. This is used by hourly employees to record the times when they arrive for work and leave at the end of the day. The process is a simple one; take your time card from a storage rack, insert it into the top of the clock, which stamps the time on it, and return your card to the storage rack. The payroll staff then uses these cards to calculate payroll. The greatest advantage of this approach is that a time clock is very inexpensive. However, it requires conversion of the time card data by the payroll staff into another format before it can be used, which introduces the likelihood of computational errors. Also, it is difficult to use for recording time worked on specific jobs. • Electronic time clocks. This clock allows employees to swipe a badge through a reader on the side or top of the clock. This results in a computer entry for the time of the scan, which is also associated with the employee code that is embedded in the card, through the use of either a bar code or a magnetic stripe. A more advanced version uses the biometric measurement of the outlines of one’s hand to determine the identity of the employee (thereby eliminating the need for an employee badge, which might otherwise be lost or used to make a scan for someone who is not on the premises). This represents a significant advance over the punch clock, because there is no need for secondary calculations that might result in an error. It also yields greater control over the time-recording process, since it gives immediate feedback to supervisors regarding missed or late scans. An additional benefit is that employees can enter job numbers as part of the scanning process, so that time is charged to specific jobs. However, the electronic time clock costs up to $2,000 each, and so is usually restricted to high-volume applications where there are many employees—punch clocks are therefore only used in high-volume locations where they are more cost-effective. • Bar code scanners. A bar code scanner is a device that reads bar code labels with either a fixed or rapidly rotating laser beam, and converts the bar code symbology into a characterbased format that is then stored in the computer system. These scanners come in many shapes and sizes, ranging from a $100 fixed-beam scanner that looks like a pen (but which may require a number of scans to read a bar code) to a $10,000 fixed-position scanner that is bolted to a conveyor belt, and which emits 30 scans per second as bar-coded packages move

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past it. There are also portable scanners, which are heavily used in warehousing operations, that can store scanned information in local RAM memory for later uploading to a computer, or that contain direct radio frequency access to the company computer, and can therefore transmit the data immediately. The type of scanner purchased will depend on the level of automation required, and the budget available for this purpose. Bar code scanning is highly recommended for repetitive data entry situations where the same data is collected many times. On the other hand, it is of less use where the data collected changes constantly, or involves a large quantity of text that would require an extremely large bar code. Nonetheless, some portion of most data entry applications can involve the use of bar code scanning. • Terminal data entry. An increasingly common form of data entry is to not use any new data collection devices — instead, just buy lots more computer terminals and make them available to users throughout the company. Employees can then be given direct access to the computer screens that require input from them, and can enter information directly into the computer system. This avoids the middleman data entry person, as well as the risk that the data entry staff might misinterpret the data on an employee’s form and type in the wrong information. The process can be facilitated by the use of error-checking protocols within the computer software, so that users will be flagged if they make entries that are clearly outside of a narrow band of expected responses. Also, computer screens can be devised for individual users that are designed to assist them in entering only the data they have access to, and in the most efficient manner. However, it can be expensive to rig all locations in a company with computer terminals and all linking wiring, while some employees may move around so much that having them use a fixed terminal is not a viable option. Consequently, this approach may have limited applicability, depending on the situation. • Paper-based data entry. Despite all of the other forms of advanced data entry noted here, the most common method for collecting data is still from a paper document. This approach is inexpensive, requires no web of interlinked electronic devices throughout a facility, and is familiar to all employees as a method of data capture. However, it does not result in a fast flow of data through an organization, since it may be days or weeks before the information contained on a form is re-keyed into the computer system. Also, it is easy to lose forms, especially when they are being used throughout a facility and there is no rigid tracking of individual forms to ensure that none are lost. Furthermore, this approach requires the services of an expensive data entry person to interpret the data on the forms (sometimes incorrectly) and type the results into the computer system. Given these problems, it is no surprise that the proportion of data gathering that uses this approach is shrinking — nonetheless, it still comprises the majority of all data gathering techniques in most organizations. • Electronic pen data entry. A very new data gathering approach is the electronic pen. This is a pen that not only marks in ink on paper, but also tracks its exact position on a pad of “smart” paper (that has a built-in identifying grid that tells the pen where it is touching the paper). The pen transmits its position via the new Bluetooth data transmission protocol to any nearby receiver that is tuned to the pen’s transmission frequency. This results in a digital copy of the writer’s penmanship that can then be converted into text, which in turn can be stored in the company database. Though this is a nascent technology, it may become an important form of data collection in the years to come. Thus, there are a wide range of data entry systems available. In most instances, the controller who is designing a data collection system will need to use a mix of these options to ensure that the correct mix of high data accuracy and low collection cost is achieved.

5.4 PROCESSING: DATA SUMMARIZATION SYSTEMS Having covered the data collection portion of cost accounting, we now move to the various costing methodologies that are available for processing the raw data into a format that is most useful for management consumption. The primary advantages and disadvantages of the systems whose functions are noted in the following sections are:

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• Job costing. This is a commonly used system that is primarily targeted at production situations where customized goods are produced for specific customers. It is very useful for tracking the exact cost of individual products, and is the only valid technique for accumulating costs for cost-plus contractual arrangements. It can also yield accurate results about the ongoing costs of a current job, which is useful for monitoring purposes. However, this system requires a large quantity of detailed data collection and data entry, which is expensive. It also runs the risk of including some inaccurate data, which requires expensive control systems to minimize. Furthermore, there may be a significant allocation of overhead costs to each job, which may be inaccurately applied. • Process costing. This is also a heavily used system, and is most common in situations where large quantities of exactly the same product are created. Costs are collected in bulk for entire time periods, and then allocated out to the volume of entire production runs during that period. This results in a fair degree of accuracy when costs are averaged out and assigned to individual units. However, some degree of estimation is required when determining total production quantities completed, since some units may be only partially completed at the end of the production period. Consequently, there is some room for variation in final production costs. This method requires much less data collection than job costing, but the level of information accuracy is correspondingly less. • Standard costing. This methodology has been installed in many companies as an adjunct to both the job costing and process costing systems. It is designed to set standard costs for all material and labor costs incurred by a company, against which actual results can be compared through variance analysis. This can result in excellent control over company costs, but only if the accounting staff is diligent in uncovering the reasons for variances from costing standards, and the management team is helpful in correcting the discovered problems. It is also useful for budgeting, setting prices, and closing the financial books in a rapid manner. However, it is also time-consuming to set and maintain standards; in environments where this maintenance function is not performed, standards can be so far away from actual results that variance analysis is no longer useful for management purposes. Also, a company that has adopted continuous process improvement principles will find that any standards adopted will almost immediately become obsolete, requiring constant correction. Furthermore, most standards are set at the product level, rather than at the batch level, so there is no basis of comparison when using this method for cost control over production batches. Another problem is that comparisons to actual costs tend to focus management attention on labor variances, which have historically been a large part of the cost accounting report package, even though these costs comprise only a small proportion of total production costs in most manufacturing environments. Finally, it tends to perpetuate inefficiencies, if personnel use the current standard cost as a baseline for behavior; they will have no incentive to improve costs to a point that is substantially better than the pre-set standard, resulting in languishing efficiency levels. For these reasons, standard costing is now used in a more limited role that in previous years. • Direct costing. This is a favorite methodology for those managers who are constantly confronted with incremental costing and pricing decisions where the inclusion of overhead costs in a product’s total cost will yield inaccurate information. Thus, direct costing is an ideal approach for determining the lowest possible price at which to sell incremental units. However, it yields inaccurate results when used for long-term pricing, since it takes no account of overhead costs that must be included in a company’s standard prices if it is to assure itself of long-term profitability. It is also not allowed for inventory valuation purposes by GAAP, which requires the inclusion of allocated overhead costs. • Throughput accounting. A variation on direct costing is throughput costing. This methodology holds that the only direct cost is direct materials, with even direct labor costs being thrown out when making most cost-related management decisions. The main tenet of throughput accounting is that a company must carefully manage the bottleneck operation in its production facility, so that the largest possible contribution margin is created. The main advantage of throughput accounting is that it yields the best short-term incremental profits if it is religiously fol-

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Ch. 5 Cost Accounting and Costing Systems

lowed when making production decisions. However, this can result in production mixes that seriously delay the completion of jobs for some customers, which is not good for customer relations. • Activity-based costing (ABC). The ABC methodology is a much more accurate way to associate overhead costs with specific activities, which in turn can be assigned to product costs. Its main advantage is that it builds a direct correlation between the occurrence of an activity and related overhead costs, so that changes in the activity can be reliably expected to result in corresponding changes in the overhead costs. This results in valuable information for the management team, which uses it not only to gain some measure of control over its overhead costs, but also to gain an understanding of which products use more activities (and therefore overhead costs) than others. The downside of this methodology is that it requires a great deal of costing knowledge, time, and management commitment before a functioning ABC system becomes operational, and will henceforth require considerable upkeep to maintain. It also requires the construction of an ABC database that is separate from the general ledger, which can be an expensive proposition to both create and maintain. It is not really necessary in situations where there are few products, obvious process flows, and minimal machine setups, because a less complex cost accumulation system will still result in reasonably accurate product costs. • Target costing. This costing methodology is the most proactive of all the methodologies, for it involves the direct intervention of the cost accounting staff in the product design process, with the express intent of creating products that meet pre-set cost and gross margin goals. This is opposed to the usual practice of accumulating costs after products have been designed and manufactured, so that managers will find out what a product costs after it is too late to make any changes to the design. This costing system is highly recommended to any company that designs its own products, since it can result in significant reductions in product costs before they are “locked in” when the design is completed. This technique usually requires a great deal of cost accounting staff time, and can lengthen the product development process, but is well worth the effort. This brief review of the advantages and disadvantages of each costing methodology should make it clear not only that they are wildly different from each other in concept, but also that they are all designed to deal with different situations, several of which may be found within the same company. Accordingly, a controller must become accustomed to slipping in and out of a methodology when the circumstances warrant the change, and will very likely use a combination of these systems at the same time, if demanded by the circumstances. In the following sections, we will review the workings of each of these costing methodologies.

5.5 PROCESSING: JOB COSTING Job costing involves a series of transactions that accumulate the costs of materials, labor, and overhead (of which there are two different calculations) to a specific job. For each of these costing categories, costs are accumulated through a series of transactions before they are finally charged to a specific job. In this section, we will trace the journal entries used for all of these costs. The basic flow of journal entries required for direct materials is noted in Exhibit 5.1, which itemizes the general format of each sequential transaction. When raw materials are purchased, they are rarely charged to a particular job upon receipt. Instead, they are stored in the warehouse, so there is a debit to the raw materials inventory and a credit to accounts payable. Once production is scheduled, the raw materials will be sent to the production floor, which triggers another transaction, to be created by the warehouse staff — a debit to the work-in-process inventory account and a credit to the raw materials inventory account. During the production process, it is quite likely that some portion of the materials will be destroyed as part of the normal production process; if so, another entry will be required that creates a debit to the overhead cost pool, and a credit to remove the cost from the work-in-process inventory account. This normal amount of scrap will then be allocated through the overhead cost pool back

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Raw Materials Inventory Accounts Payable

63

XXX XXX

Record Raw Material Receipt

Cost of Goods Sold WIP Inventory

XXX XXX

Charge Abnormal Scrap and Spoilage to CGS

Overhead Cost Pool WIP Inventory

[Job-specific data stored in a subledger]

Charge Materials to Job

XXX

Charge Normal Scrap and Spoilage to Overhead Pool

WIP Inventory XXX Raw Materials Inventory XXX

XXX

Finished Goods Inventory WIP Inventory

XXX XXX

Move Job to Finished Goods

Cost of Goods Sold Finished Goods Inventory

XXX

Accounts Receivable Revenue

XXX

XXX

XXX

Sell Finished Goods

E XHIBIT 5.1

J OB C OSTING T RANSACTIONS

FOR

D IRECT M ATERIALS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

to product costs — we will deal with this issue shortly, when we talk about the cost flow for overhead costs. If there are excessive amounts of scrap, then these will be instead charged directly to the cost of goods sold with a debit, while the work-in-process account is reduced with a credit. Once the production process has been completed (which may be a few moments for simple products, and months for complex ones), it is shifted back to the warehouse in the form of finished goods. To record this transaction, we use a debit to the finished goods inventory account and a credit to work-in-process inventory. Once the goods are sold from stock, a final entry relieves the finished goods inventory account with a credit, and charges the cost to the cost of goods sold with a debit. One of the numerous benefits of a just-in-time system is that materials are in the production process for such a short period of time that there is no point in creating transactions that move their cost in and out of work-in-process inventory. Instead, a single transaction shifts raw material costs from the raw materials inventory account to cost of goods sold (though there may be an extra entry to record the cost in finished goods inventory if completed products are not immediately sold). This greatly reduces the number of potential problems that can arise with the recording of transactions. The recording of labor costs follows a slightly different path than what is typically seen for material costs. Instead of taking a direct route into the work-in-process inventory account, labor costs either can be charged at once to the overhead cost pool or go into work-in-process inventory. The charge to an overhead cost pool is done if there is no direct relationship between the incur-

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Ch. 5 Cost Accounting and Costing Systems

rence of the labor cost and the creation of a product — this results in a debit to the overhead cost pool and a credit to the wages expense account. However, if there is a direct tie between the incurrence of labor costs and the production of specific products, then the debit is instead to the workin-process inventory (or a separate labor) account. These cost flows are shown in Exhibit 5.2. If the wages have flowed into an overhead cost pool, these costs will be summarized at the end of the accounting period and charged to specific products based on any number of allocation methodologies. The allocation calculation will result in another transaction that shifts the overhead costs to product costs, which can occur both at the work-in-process and finished goods Wages Expense Wages Payable

XXX XXX

Record Wages Incurred

Overhead Cost Pool Wages Expense

WIP Inventory Wages Expense

XXX XXX

Charge Wages to Overhead Pool

XXX XXX

Charge Wages to Job

[Job-specific data stored in a subledger]

[Accumulate statistical data on job activity usage]

WIP Inventory Overhead Cost Pool

XXX

Finished Goods Inventory WIP Inventory

XXX

Charge Overhead Costs to Job

XXX XXX

Move Job to Finished Goods

Cost of Goods Sold XXX Finished Goods Inventory XXX Accounts Receivable Revenue

XXX XXX

Sell Finished Goods

E XHIBIT 5.2

J OB C OSTING T RANSACTIONS

FOR

L ABOR

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

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stages of production. Meanwhile, labor costs that have been charged directly to work-in-process inventory will then be shifted to finished goods inventory and later to the cost of goods sold in the same manner as for materials costs. As was the case for material costs, there are a large number of labor transactions that are required to track the flow of labor costs through the production process under the job costing methodology. There is a high risk that transactional errors will arise, just because of the large number of transactions, so control systems must be created that keep errors from occurring and verify that completed transactions are correct. The final job costing process under the job costing system is the allocation of costs to products. There are two ways to do this—either with the actual costs incurred during the production process, or else with standard costs that are later adjusted to match actual costing experience. The first of these approaches is called actual cost overhead allocation, while the later is called normal cost overhead allocation. We will address the actual cost overhead allocation first. Under actual costing, there are several sources of costs that will flow into an overhead cost pool. As shown in Exhibit 5.3, all production supplies that cannot be traced to a specific product will be debited to the overhead account and credited to accounts payable (the credit may also be charged to raw materials inventory or supplies expense, if supplies were first charged to either of these accounts). As already noted, some labor costs will also be charged to the overhead account. Also, and as previously noted under the materials costing flow, normal amounts of production scrap and spoilage will be charged to overhead. Indirect wages and other indirect costs will also flow into the overhead cost pool. At the end of the accounting period, the cost pool is charged out to various products based on a variety of possible allocation calculations, which are addressed in the activity-based costing section later in this chapter. Once overhead costs have been assigned to specific products, they follow the usual pattern of being moved to the finished goods inventory while their associated completed products are held in storage, and from there to the cost of goods sold upon sale of the product. The allocation of costs to specific jobs can be delayed for some time under the actual cost overhead allocation method, because some costs can be compiled only at the end of the month, or perhaps not until several weeks thereafter. This is a problem for those companies that want more immediate costing information. We use normal overhead cost allocations to resolve this problem. Normal costing means that a company charges out costs in the short-term using a historical average for its overhead costs, rather than actual costs. This process is shown in Exhibit 5.4. This allows costs to be charged to jobs at once. To ensure that the historical average being used for allocations does not stray too far from actual results, it is periodically compared to actual costs (which must still be accumulated), and adjusted as necessary. When actual and normal costs are compared, there should be a small variance, which can be disposed of in several ways. One approach is to charge off the entire variance to the cost of goods sold, though this can create an unusually high or low cost of goods sold. Another approach is to spread the variance among the cost of goods sold, work-in-process inventory, and finished goods inventory, based on the total balances remaining in each account at the end of the reporting period. A final approach is to retroactively charge the variance to every job. These three options require an increasing amount of work to accomplish, in the order described. For that reason, the first option is the most commonly used, while allocation to individual jobs is a rarity. The very large number of transactions required in a job costing system makes it a very inefficient costing methodology from the perspective of the accounting department, which must verify that all of the transactions entered are correct. It can also call for the purchase of large quantities of data collection equipment, such as automated time clocks and bar code scanners, which can be quite expensive. Furthermore, this system requires some participation by production personnel in the data collection process, which detracts from their primary mission of manufacturing products. However, given the need for job costing information, a company may find that there is no reasonable alternative to using this system. If so, the controller should carefully review the need for each type of data that can be potentially produced by the system, and collect only those that will result in valuable information — this will create a more efficient data collection environment that focuses only on the key cost elements.

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Overhead Cost Pool Accounts Payable

XXX XXX

Record Material Supplies Receipt

Overhead Cost Pool Wages Payable

Overhead Cost Pool Wages Payable

XXX XXX

Record Indirect Wages Incurred

Record Unassigned Direct Wages Incurred

[Job-specific data stored in a subledger]

[Accumulate statistical data on job activity usage]

WIP Inventory Overhead Cost Pool

XXX XXX

Record Indirect Expenses Incurred

Overhead Cost Pool WIP Inventory

XXX XXX

Overhead Cost Pool Accounts Payable

XXX XXX

Record Normal Spoilage and Scrap

XXX XXX

Charge Overhead Costs to Job

Finished Goods Inventory XXX XXX WIP Inventory

Move Job to Finished Goods

Cost of Goods Sold XXX Finished Goods Inventory XXX Accounts Receivable Revenue

XXX XXX

Sell Finished Goods

E XHIBIT 5.3

J OB C OSTING T RANSACTIONS

FOR

A CTUAL O VERHEAD A LLOCATIONS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

5.6 PROCESSING: PROCESS COSTING Process costing is used in those situations when it is impossible to clearly differentiate the cost of individual units of production. For example, it is a prime candidate for use in an oil refinery, where it is impossible to track the cost of an individual gallon of diesel fuel. The most common method for calculating process costs on a per-unit basis is to accumulate all production-related costs during the accounting period and calculate a weighted average per-unit cost based on these totals and the amount of production that was completed during the period, or which is currently still in process. An example of this calculation is shown in Exhibit 5.5.

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5.6 Processing: Process Costing

67

[Create Standard Allocation Rate for Jobs]

WIP Inventory Overhead Cost Pool

XXX XXX

Charge Standard Overhead Costs to Jobs

Overhead Cost Pool Accounts Payable

XXX XXX

Record Material Supplies Receipt

Overhead Cost Pool Wages Payable

Overhead Cost Pool Wages Payable

Record Indirect Wages Incurred

XXX

[Subtract Standard Allocations from Overhead Pool]

For Fin'l Statement Reporting

Small Variance

XXX

Write Off Variance to Cost of Goods Sold

E XHIBIT 5.4

XXX

XXX

Record Unassigned Direct Wages Incurred

Cost of Goods Sold Overhead Cost Pool

XXX

XXX

Finished Goods Inventory WIP Inventory Costs of Goods Sold Overhead Cost Pool Prorate Variance to Ending Account Balances

J OB C OSTING T RANSACTIONS

FOR

Overhead Cost Pool Accounts Payable

XXX XXX

Record Indirect Expenses Incurred

Overhead Cost Pool WIP Inventory

XXX XXX

Record Normal Spoilage and Scrap

For Highest Job Record Accuracy

XXX XXX XXX XXX

WIP Inventory Overhead Cost Pool

XXX XXX

Allocate Variance to All Jobs

N ORMAL O VERHEAD C OST A LLOCATIONS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

In the exhibit, there are three blocks of calculations, each one segregated by a horizontal line. The top block contains a conversion calculation, which converts the amount of completed and work-in-process units into units to which materials and other costs can be allocated. The first column of numbers contains the calculation for the allocation of direct materials costs, while the final column of numbers calculates the allocation of all other production costs. For the purposes of this calculation, we assume that there are two types of costs — direct materials, which are typically added at the beginning of the production process, and all other costs, which can be added at a multitude of other points during the manufacturing sequence.

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Units Summary

Completed Units Ending Units in Process Unit Totals Unit Cost Calculation

Beginning Work-in-Process Cost Current Period Costs Total Costs Unit Totals (see above) Cost per Unit Unit Cost Allocation

Cost of Completed Units Cost of Ending WIP Units Totals E XHIBIT 5.5

Direct Material Units

Conversion Factor

1,000 350 1,350

60%

Conversion Cost Units 1,000 210 1,210

Direct Materials $20,000 $28,000 $48,000 1,350 $35.556

Conversion Costs $15,000 $21,500 $36,500 1,210 $30.165

Direct Materials $35,556 $12,444 $48,000

Conversion Costs $30,165 $ 6,335 $36,500

Totals $35,000 $49,500 $84,500

Totals $65,721 $18,779 $84,500

W EIGHTED A VERAGE C OSTING C ALCULATION

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, John Wiley & Sons, 2001, Chapter 11.

Since materials costs are assumed to occur at the earliest stage of production, the calculation of equivalent units for direct material cost allocation is quite easy — just use the number of finished goods completed (1,000) and the number of units in work-in-process inventory (350). However, for the purposes of allocating all other production costs, we must reduce the amount of work-in-process inventory by an estimate of their aggregate level of completion, which in the example is 60 percent. This results in total converted units of production of 1,210. In the middle block of calculations, we accumulate the total cost of production and divide it by the equivalent number of units of production to determine the cost per unit. This calculation includes the costs that had been carried over in the work-in-process inventory from the preceding accounting reporting period, totaling $35,000. We add to this the current cost of production, which is $49,500, to yield a total cost of $84,500 that must be allocated to units of production. When divided by the slightly different units of production being used for direct material costs and all other production costs, we arrive at a direct material cost per unit of $35.556, and all other costs per unit of $30.165. The lowermost block of calculations requires us to multiply the cost per unit (as determined in the middle block) by the total number of units (as determined in the top block). The calculation is identified with arrows. The result is $48,000 in direct material costs, of which $35,556 are charged to completed units and the remainder to work-in-process units. Total other production costs are $36,500, of which $30,165 are charged to completed units and the remainder to work-in-process. As a cross-check, we can see that the total allocated is $84,500, which matches the total amount of funds that were to be allocated, as noted on the far right side of the middle block. This method is a simple one that requires very little data collection. However, some companies like to make the task even easier by avoiding the collection and interpretation of actual costs at the end of each accounting period. Instead, they prefer to use standard unit costs for their calculations, which allows them to calculate total costs more frequently and with no related data collection costs. This type of calculation is shown in Exhibit 5.6. In the exhibit, the first block of calculations does not change—we still assume that a conversion factor must be applied to the ending work-in-process inventory for the purposes of assigning other

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5.7 Processing: Standard Costing

Units Summary

Completed Units Ending Units in Process Unit Totals Unit Cost Calculation

Standard Unit Cost Unit Cost Allocation

Standard Cost of Completed Units Standard Cost of Ending WIP Units Standard Cost Totals

Direct Material Units

Conversion Factor

1,000 350 1,350

60%

69

Conversion Cost Units 1,000 210 1,210

Direct Materials $32,000

Conversion Costs $31,500

Direct Materials $32,000

Conversion Costs $31,500

Totals $63,500

$11,200 $43,200

$ 6,615 $38,115

$17,815 $81,315

$20,000 $28,000 $48,000 $43,200 $ 4,800

$15,000 $21,500 $36,500 $38,115 $(1,615)

$35,000 $49,500 $84,500 $81,315 $ 3,185

Period Variance

Beginning Standard Work-in-Process Cost Current Period Actual Costs Total Period Costs Standard Cost Totals Cost Variance E XHIBIT 5.6

W EIGHTED A VERAGE C OST A LLOCATION M ETHOD U SING S TANDARD C OSTS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 11.

production costs than direct materials. The difference arises in the second block, where we use only a standard cost per unit, rather than a summarization of actual costs. This cost is then carried forward into the third block of calculations, where we see that a total of $81,315 has been allocated to the ending finished goods and work-in-process inventory. However, this ending figure varies from the $84,500 that resulted from the preceding actual costing calculation in Exhibit 5.6. The difference of $3,185 was caused by a slight variance between the pre-set standard cost and the actual cost. The presence of this variance causes us to add a fourth block of calculations at the bottom of the exhibit, in which we compare the actual costs incurred during the period to the standard costs, which shows that more costs than expected were incurred in the direct materials column, while fewer costs were incurred under the other production costs column. The main issue for the controller is what to do with this variance. If negligible, it can be charged off to the cost of goods sold. If it is so large that expensing the difference will result in an appreciable impact on reported earnings, then a more accurate approach is to apportion the variance among the cost of goods sold, work-in-process inventory, and finished goods inventory. The data collection and calculations required for a process costing system are substantially simpler than what is required for a job costing system, and so is a favorite approach for those who wish to pare their data collection costs or who produce such large volumes of similar products that there is no point in attempting to track the costs of individual products.

5.7 PROCESSING: STANDARD COSTING The first step in the creation of a standard costing system is to create a set of standard costs in a variety of different areas. The industrial engineering staff is assigned the task of creating direct

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labor standard costs, while the purchasing staff is most typically assigned the chore of creating standard costs for purchased goods, and the controller is called on to coordinate the development of a set of standard overhead costs. If there are subproducts created during the production process that may be valued at the end of each accounting reporting period, then the industrial engineering staff will calculate these standards. It is also possible to reduce the areas in which standard costs are used, with actual costs being accumulated in other areas. This mix of costing types can arise when there is some concern that reasonably accurate standard costs cannot be constructed, or if existing actual costing systems already produce reasonably accurate results. Another issue to settle as soon in the standard cost development process as possible is the timing of changes to these standards. This can be done quite infrequently, perhaps once every few years, or as rapidly as once a month (which results in standard costs that are nearly indistinguishable from actual costs). The key determinant influencing the pace of change is the perceived pace at which actual costs are changing. If there are minimal changes to a manufacturing process, then there is certainly no reason to constantly review the process and set new standards. Conversely, a company that has installed an aggressive continuous improvement strategy will find that its standard costs are constantly falling behind changes in actual costs, which requires constant revisions to standards. The assumptions used to create standard costs must also be addressed. For example, an industrial engineer must make some assumptions about the speed of efficiency improvements being realized by the production staff (known as the learning curve) in order to determine the future standard cost that roughly matches these expected changes in efficiency. Similarly, a standard cost must be matched to the expected production equipment configuration to be used, since this has a considerable impact on the overhead costs that can be assigned to a product. Another key assumption is the volume of production, since a large assumed production run will spread its setup cost over many units, whereas a short production run will result in higher setup costs on a per-unit basis. Yet another factor is the assumed condition of the equipment to be used in the manufacturing process, since poorly maintained or old equipment will be in operation for fewer hours than would otherwise be the case. The production system being used, such as just-in-time or manufacturing resource planning, will also have a significant impact on standard costs, since different systems result in the incurrence of different types of costs in such areas as machine setup time, equipment depreciation, materials handling costs, and inventory investment costs. An issue that is particular to direct labor is the anticipated result of union negotiations, since these directly and immediately impact hourly wage rates. A final issue to consider is the presence and quality of work instructions for the production staff; the absence of detailed and accurate instructions can have a profound and deleterious impact on costs incurred. Given the large number of issues involved in the setting of accurate standard costs, it is no surprise that this task can require the ongoing services of an experienced group of professionals, the cost of which must be considered when making the decision to use a standard costing system. A final factor to consider when creating standard costs is the level of attainability of the costs. One option is to devise an attainable standard, which is a cost that does not depart very much from the existing actual cost. This results in reasonable cost targets that employees know they can probably meet. Another alternative is to use historical costs as the basis for a standard cost. This is generally not recommended, for the resulting costs are no different from a company’s existing actual cost structure, and so gives employees no incentive to attempt to reduce costs. The diametrically opposite approach is to create a set of theoretical standards, which are based on costs that can only be achieved if the manufacturing process runs absolutely perfectly. Since employees cannot possibly meet these cost goals for anything but very short periods of time, it tends to result in lower employee morale. Thus, of the potential range of standard costs that can be set, the best approach is to set moderate stretch goals that are achievable. Finally, we are ready to begin using standard costs. But for what purpose do we use them? One common usage is in budgeting. By creating detailed standard costs for all budgeting line items, company managers can be presented with financial statements that compare actual results to standard costs, so that they can see where actual results are falling behind expectations. However, this is a simple approach that requires little real attention to the setting of standards at the product level.

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71

Another reason for using standards is to create benchmarks for inclusion in a manufacturing resources planning (MRP II) production system. This commonly used system multiplies a production forecast by a detailed set of product labor, materials, and capacity requirements to determine how many direct labor personnel and specific materials and how much machine capacity will be needed. This system requires extremely detailed and accurate standards to be successful. The standards needed by MRP II are for units of labor, materials, and capacity, rather than their costs. In other words, a direct labor standard for an MRP II system may be 12 minutes of labor, rather than its cost for those 12 minutes of $4.58. Yet another use for standards is in product pricing. The company sales staff frequently asks the engineering staff to provide it with cost estimates for new product configurations, many of which are only slightly different from existing products. However, the engineering staff may take days or weeks to provide the sales personnel with this information — which may be too long to satisfy an impatient customer. By using standard costs, the sales staff can compile product costs very quickly with only a brief approval review from the engineering staff. Or, if the engineering staff is still in charge of creating new product cost estimates, then they can also use standard costs to more rapidly arrive at their estimates. In either case, customers will receive reliable price quotes much more rapidly than was previously the case. A very common use for standard costs is for the valuation of inventory. Many companies do not want to be bothered with the time-consuming accumulation of actual inventory costs at the end of each accounting period, and so they create standard costs for valuation purposes, which they occasionally compare to actual costs to ensure that the inventory valuation is accurate. It is not worth the effort to create standard costs for this purpose if a company’s inventory levels are extremely low, or if a just-in-time manufacturing system is in use, since the amount of time that will be saved in valuing inventory is small, given the minor quantities of stock that will be kept in the warehouse. However, manufacturers with large inventory balances will find that this is still an effective way to rapidly determine the value of inventory. Unfortunately, the use of standard costs for inventory valuation is also subject to control problems, for deliberate manipulation of standards can result in large changes in the value of inventory, which in turn impacts the reported level of company profits. For example, the standard cost for a finished goods item can include an assumption for the amount of production setup costs allocated to each item, which is heavily influenced by the assumed number of units produced in a manufacturing run. By shifting the assumed length of the production run downward, the amount of cost allocated to each unit goes up. This type of interference with standard costs can result in wildly inaccurate reported financial results. If standard costs are used for inventory valuation, the accounting staff will periodically compare standard to actual costs to ensure that there are not excessively large differences between the two. If a company is audited at year-end, then the auditors will require a comparison to actual costs, and a write-off of the difference to the cost of goods sold (if standard costs are higher than actual costs) or an increase in the inventory balance (if actual costs are higher than standard costs). Since a significant difference between the two types of costs can result in a startling change in the reported level of income during the period when this adjustment is made, it is wise to review some of the large-cost items on a regular basis in order to ensure that there will be no surprises at the time of reconciliation to actual costs. Consequently, we can see that there are still several areas in which standard costs can be used to create greater efficiencies in selected areas of activity. However, the number of viable applications has fallen with the advent of new computer systems and production methodologies, so one should carefully review the proposed applications for standard costs before conducting an implementation.

5.8 PROCESSING: DIRECT COSTING A direct cost is a cost that is directly associated with changes in production volume. This usually restricts the definition of direct costs to direct materials and direct labor (and a strong case can be made for not using direct labor, since this cost tends to be present even when production volumes

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vary). For example, the materials used to create a product are a direct cost, whereas the machine used to convert the materials into a finished product is not a direct cost, because it is still going to be sitting on the factory floor, irrespective of any changes in production volume. The use of direct costing results in a slightly different income statement, as shown in Exhibit 5.7. The only difference between the income statement shown in Exhibit 5.7 and a more traditional format is that all nondirect costs have been shifted below the gross margin line and into the production department’s costs. Though this seems like a subtle change, it focuses the attention of the management team on the incremental changes in the cost of goods sold that are usually masked by a large and relatively fixed amount of overhead costs. By focusing solely on the direct cost of a product or activity, a controller can provide valuable information to management regarding prospective changes in costs that will arise as a result of some management action. For example, if a change to a more efficient type of processing equipment is contemplated, then the direct cost of a product may be lowered if this will result in less material usage. This may also result in less direct labor cost if the machine takes over some tasks previously performed by employees — this will cut direct costs, but may increase overhead costs if the cost of the machine is higher than that of the machine it is replacing. Yet another example is when a customer wants the lowest possible price for a product, and the company has some free capacity available for producing what the customer needs; the use of direct costing will reveal the lowest possible cost that must be covered by the price charged to the customer in order to break even. Direct costing can also be used to determine which customers are the most profitable, by subtracting the direct cost of their purchases from the prices paid, which yields the amount they are contributing toward the company’s coverage of overhead costs and profit. Another very good use for direct costing is to include the concept in the budgeting system, where it is used to change budgeted variable costs to match the actual sales volumes achieved; this approach achieves a much closer match between the budgeted and actual cost of goods sold, because the budget now flexes with the actual volume level experienced. For all of these reasons, direct costing is a highly recommended costing system. However, there are a number of situations in which direct costing should not be used, and in which it will yield incorrect information. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today’s companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term profitability. For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company continues to use the $10.00 price for all product sales for well into the future, then the company will experience losses because overhead costs are not being covered by the

Revenue

$1,000,000

Cost of Goods Sold Direct Materials Direct Labor

$320,000 170,000

Total Direct Costs Gross Margin Operating Expenses Production Department General and Administrative

325,000 115,000

Total Operating Expenses

$ 440,000

Net Profit

$

E XHIBIT 5.7

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$ 490,000

I NCOME S TATEMENT F ORMATTED

FOR

50,000

D IRECT C OSTING

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price. The best way to address this problem is to build strict boundaries around the circumstances where incremental prices derived from a direct costing system are used. Another problem with direct costing is that it assumes a steady level of unit costs for the incremental costing and pricing decisions for which it is most often used. For example, a company receives an offer from a customer to buy 5,000 units of product X at a fixed price. The cost accounting staff may determine that the proposed price will indeed yield a profit, based on the direct cost per unit, and so recommends that the deal be approved. However, because the staff has focused only on direct costs, it has missed the fact that the company is operating at near full-capacity levels, and that to process the entire 5,000-unit order will require the addition of some costly machinery, the acquisition of which will make the proposed deal a very expensive one indeed. To avoid this problem, anyone using a direct costing system must have access to company capacity information, and should coordinate with the production scheduling staff to ensure that capacity levels will permit their incremental pricing and costing scenarios to be achieved. A subtle issue that many users of direct costing systems miss is that the types of costs that fall within the direct costing definition will increase as the volume of units in a direct costing decision goes up. For example, the only direct cost involved with a single unit of production is the direct materials used to build it, whereas a larger production volume will likely involve some change in the related number of manufacturing employees needed on the production line; these are wellaccepted concepts. However controllers frequently forget that additional direct costs will be included when the production volume rises to even higher levels. For example, if the direct costing decision involves an entire production line, then all of the equipment and supervisory costs that are tied to that production line are now also influenced by the decision to produce or not produce, and so should be included in the direct costing system. At an even larger level, the decision to use the production of an entire facility should include every cost needed to run that facility, which may include utilities, rent, and insurance—costs that are not normally included in smaller-volume production decisions. Consequently, direct costing analysis must be conducted within narrowly defined volume ranges, with careful attention to what costs are likely to vary with the volumes that are under review. Direct costing cannot be used for inventory valuation, because it is disallowed by GAAP. The reason for this is that, under a direct costing system, all costs besides direct costs are charged to the current period. There is no provision for capitalizing overhead costs and associating them with inventory that will be sold off in future periods. This results in an imbalance between the reported level of profitability in each period and the amount of production that occurred. For example, a manufacturer of Christmas ornaments with a direct costing system may sell all of its output in one month of the year, but be forced to recognize all of its nondirect production costs in every month of the year, which will result in reported losses for 11 months of the year. Under GAAP, these nondirect costs would be capitalized into inventory and recognized only when the inventory is sold, thereby more closely matching reported revenues and expenses. Given the wide disparity between the reported results, it is no surprise that GAAP bans the use of direct costing for inventory valuation.

5.9 PROCESSING: THROUGHPUT COSTING A costing methodology that focuses on capacity utilization is called throughput accounting. It assumes that there is always one bottleneck operation in a production process that commands the speed with which products or services can be completed. This operation becomes the defining issue in determining what products should be manufactured first, since this in turn results in differing levels of profitability. The basic calculation used for throughput accounting is shown in Exhibit 5.8. This format is a simplified version of the layout used by Thomas Corbett on page 44 of Throughput Accounting (North River Press, Great Barrington, MA: 1998), though all of the numbers contained within the example have been changed. The exhibit shows a series of electronic devices that a company can choose from for its nearterm production requirements. The second column describes the amount of throughput that each of

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Maximum Constraint Time: 62,200

Product 19
Color Television 100-Watt Stereo 5
LCD Television 50
HighDefinition TV

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

5.00

14

3,800/1,700

23,800

Throughput Total Operating Expense Total Profit Profit Percentage Investment Return on Investment E XHIBIT 5.8

Cumulative Throughput/ Product $ 81,100 168,000 37,260 119,000 $405,360 375,000 30,360 7.5% 500,000 6.1%

T HROUGHPUT A CCOUNTING M ODEL

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

the products generates per minute in the bottleneck operation; “throughput” is the amount of margin left after all direct material costs have been subtracted from revenue. For example, the 19
Color Television produces $81.10 of throughput, but requires ten minutes of processing time in the bottleneck operation, resulting in throughput per minute of $8.11. The various electronic devices are sorted in the exhibit from top to bottom in order of largest throughput per minute. This ordering tells the user how much of the most profitable products can be produced before the total amount of available time in the bottleneck (which is 62,200 minutes, as noted at the top of the exhibit) is used up. The calculation for bottleneck utilization is shown in the “Unit Demand /Actual Production” column. In that column, the 19
color Television has a current demand for 1,000 units, which requires 10,000 minutes of bottleneck time (as shown in the following column). This allocation of bottleneck time progresses downward through the various products until we come to the 50
HighDefinition TV at the bottom of the list, for which there is only enough bottleneck time left to manufacture 1,700 units. By multiplying the dollars of throughput per minute times the number of minutes of production time, we arrive at the cumulative throughput dollars resulting from the manufacture (and presumed sale) of each product, which yields a total throughput of $405,360. We then add up all other expenses, totaling $375,000, and subtract them from the total throughput, which gives us a profit of $30,360. These calculations comprise the basic throughput accounting analysis model. Now let’s reexamine the model based on a re-juggling of the priority of orders. If the cost accounting manager were to examine each of the products based on the addition of allocated overhead and direct labor costs to the direct materials that were used as the foundation for the throughput dollar calculations, she may arrive at the conclusion that, when fully burdened, the 50
HighDefinition TV is actually the most profitable, while the 19
Color Television is the least profitable. Accordingly, she recommends that the order of production be changed to reflect these “realities,” which gives us the new throughput report shown in Exhibit 5.9. The result is a significant loss, rather than the increase in profits that had been expected. Why the change? The trouble is that allocated overhead costs have no bearing on throughput, because allocated costs will not change in accordance with incremental production decisions, such as which product will be manufactured first. Instead, the overhead cost pool will exist, irrespective of any modest changes in activity levels. Consequently, it makes no sense to apply allocated costs to the production scheduling decision, when the only issue that matters is how much throughput per minute a product can generate.

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75

Maximum Constraint Time: 62,200

Product 50
HighDefinition TV 100-Watt Stereo 5
LCD Television 19
Color Television

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$5.00 7.50 6.21

14 8 12

3,800/3,800 2,800/1,125 500/0

53,200 9,000 0

8.11

10

1,000/0

0

Throughput Total Operating Expense Total Profit Profit Percentage Investment Return on Investment E XHIBIT 5.9

R EVISED T HROUGHPUT A NALYSIS B ASED

ON

Cumulative Throughput/ Product $266,000 67,500 0 0 $333,500 375,000 41,500 12.4% 500,000 8.3%

A LLOCATED C OSTS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

Capital budgeting is an area in which throughput costing analysis can be applied with excellent results. The trouble with most corporate capital budgeting systems is that they do not take into consideration the fact that the only valid investment is one that will have a positive impact on the amount of throughput that can be pushed through a bottleneck operation. Any other investment will result in greater production capacity in other areas of the company that still cannot produce any additional quantities, since the bottleneck operation controls the total amount of completed production. For example, the throughput model in Exhibit 5.10 shows the result of an investment of $28,500 in new equipment that is added later in the production process than the bottleneck operation. The result is an increase in the total investment, to $528,500, and absolutely no impact on profitability, which yields a reduced return on investment of 5.7 percent. Maximum Constraint Time: 62,200

Product 19
Color Television 100-Watt Stereo 5
LCD Television 50
HighDefinition TV

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

$ 81,100 168,000 37,260

5.00

14

3,800/1,700

23,800

119,000

Throughput Total Operating Expense Total Profit Profit Percentage Investment Return on Investment E XHIBIT 5.10

Cumulative Throughput/ Product

Throughput $/Minute of Constraint

R EVISED T HROUGHPUT A NALYSIS B ASED

ON

$405,360 375,000 30,360 7.5% 528,500 5.7%

A DDITIONAL I NVESTMENT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

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A more profitable solution would have been to invest in anything that would increase the productivity of the bottleneck operation, which could be either a direct investment in that operation, or an investment in an upstream operation that will reduce the amount of processing required for a product by the bottleneck operation. As another example, the cost accounting staff has conducted a lengthy activity-based costing analysis, which has determined that a much higher amount of overhead cost must be allocated to the high-definition television, which results in a loss on that product. Accordingly, the product is removed from the list of viable products, which reduces the number of products in the mix of production activity, as shown in Exhibit 5.11. The result is a reduction in profits. The reason is that the cost accounting staff has made the incorrect assumption that, by eliminating a product, all of the associated overhead cost will be eliminated, too. Though a small amount of overhead might be eliminated when the production of a single product is stopped, the bulk of it will still be incurred. Throughput accounting does a very good job of tightly focusing attention on the priority of production in situations where there is a choice of products that can be manufactured. It can also have an impact on a number of other decisions, such as whether to grant volume discounts, outsource manufacturing, stop the creation of a product, or invest in new capital items. Given this wide range of activities, it should find a place in the mix of costing methodologies at many companies. We now shift to a discussion of activity-based costing (ABC), whose emphasis is the complete reverse of throughput accounting—it focuses on the proper allocation of overhead.

5.10 PROCESSING: ACTIVITY-BASED COSTING An ABC system is designed to match overhead costs as closely as possible with company activities. By doing so, overhead costs can be reasonably associated with products, departments, customers, or other users of activities, which tells managers where overhead costs are being used within a company. This results in much better control over overhead costs. There are several ways to allocate overhead costs. Some overhead costs, such as utilities, are associated with specific machines. For example, a machine may require ten cents of electricity per minute. If so, this overhead cost can be charged out to those products that are run through the machine, based on the time spent being worked upon it. Other overhead costs are associated with a specific product line, and can reasonably be allocated to the activities performed within that product line. Maximum Constraint Time: 62,200

Product 19
Color Television 100-Watt Stereo 5
LCD Television

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

Throughput Total Operating Expense Total Profit Profit Percentage Investment Return on Investment E XHIBIT 5.11

R EVISED T HROUGHPUT A NALYSIS

WITH

Cumulative Throughput/ Product $ 81,100 168,000 37,260 $286,360 375,000 88,640 30.9% 500,000 17.7%

O NE L ESS P RODUCT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

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For example, there is typically a supervisor who is assigned to a single product line. If so, the fully burdened salary of this person can be charged to such related activities as production and maintenance scheduling. Still other overhead costs may be grouped by commodity used in the production process. For example, each member of the purchasing staff may be responsible for the procurement of a specific commodity. If so, this overhead cost can be distributed to individual products based on their usage of the commodity. Clearly, there are many valid ways to allocate overhead costs to various activities, and from there to users of those costs. An ABC system creates a structured approach to the accumulation, storage, and allocation of overhead costs using many of these activity measures. An ABC system is a difficult and complex one to create, because of the wide variety of costs that must be accumulated, tracked in relation to different types of activities, and charged off. Here are the primary steps involved in creating such a system: 1. Determine the scope of the system. A fully developed ABC system that encompasses all costs throughout a company is a massive undertaking that may not yield any results for several years. A better approach is to conduct a gradual rollout of the system that produces results more quickly. Accordingly, a key factor is limiting each incremental rollout of the system to a carefully defined segment of the business. The determination of scope should also include a review of the level of detailed analysis that the system is to produce, since an excessive focus on detail may result in a system that is too expensive in relation to the utility of the information produced. 2. Set aside direct costs. There will be several direct costs that can be clearly and indisputably traced to specific products. These costs should be identified early in the design phase, so that they will not be erroneously added to the ABC allocation system. 3. Locate costs in the general ledger. The next step is to identify each of the overhead costs in the general ledger that will be allocated by the ABC system. This can be a difficult undertaking, for the required costs may be lumped together in the ledger, and must be segregated through a new data collection system that involves the creation of a new general ledger account number. Alternatively, the split may be achieved less accurately by allocating a percentage of the cost in a single general ledger account to several overhead cost items that will then be allocated. 4. Store costs in cost pools. All of the costs that have been identified within the general ledger must now be stored in a series of cost pools. Each cost pool accumulates costs that are similar to each other. For example, a building cost pool will include the costs of insurance and maintenance for a building, whereas a product line cost pool may include the marketing and supervisory costs that can be traced to a specific product line. A third type of cost pool is one that is related to a specific production batch, and can include such costs as production control labor, tooling, materials handling, and quality control. The total number of cost pools used will have a direct impact on the maintenance costs of an ABC system, so the design team must balance the increased allocation accuracy associated with more cost pools with the extra labor needed to maintain them. 5. Determine activity drivers. Having summarized overhead costs into a set of cost pools, we must now allocate them, which we do with an activity driver—this is a variable that reasonably explains the consumption of costs from a cost pool. For example, some accounts payable costs are closely associated with the number of checks printed and mailed, while some engineering costs vary directly with the number of design changes added to a product. Examples of other activity drivers are the number of machine setups, the number of maintenance work orders, the number of purchase orders, and the number of customer orders processed. Whichever activity driver is chosen as the basis for cost pool allocation should be easy to calculate, require minimal data collection, and have a reasonably close cause-andeffect relationship with a cost pool.

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6. Spread costs from secondary to primary cost pools. Some of the cost pools include costs that are, in turn, distributed to other cost pools. These costs are usually for internal company services, such as management information systems services that are provided to other departments. These secondary cost pools must be allocated to primary cost pools. 7. Calculate the overhead cost per activity unit. We then divide the total number of occurrences of each activity driver into the total amount of costs in the primary cost pools for the accounting period, which results in a dollar figure per unit of activity. 8. Assign activity costs to cost objects. The final step is to calculate the usage of each activity driver by a cost object (which is anything that uses activities, such as products or customers). For example, if a product requires the creation of two purchase orders (which are activity drivers) and the ABC system has determined that each purchase order requires $32.15 to create, then the amount of overhead charged to the product will be $64.30. In brief, the ABC process involves taking costs out of the general ledger and assigning them to either secondary or primary cost pools, which are then distributed to cost objects through the use of activity drivers. The overall process is shown in Exhibit 5.12.

General Ledger

Secondary Cost Pool

Secondary Cost Pool

Direct Cost Pool

Batch Cost Pool

Product Line Cost Pool

Facility Cost Pool

Activity Driver

Activity Driver

Activity Driver

Cost Object

E XHIBIT 5.12

ABC P ROCESS F LOW

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 17.

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5.11 PROCESSING: TARGET COSTING Most of the costing methodologies described in this chapter are primarily concerned with the interpretation of costing data after it has already been incurred. Target costing differs from them in that it describes the costs that are expected to be incurred, and how this will impact product profitability levels. By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable profit on all new products. To use this methodology, the controller is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process. Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets. There are four basic steps involved in target costing. First, the design team conducts market research to determine the price points that a company is most likely to achieve if it creates a product with a certain set of features. The research should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes probably will do to the final price at which the product will be sold. The second step is to subtract from the prospective product price a gross margin that must be earned on the product; this can be a standard company-wide margin that must be earned on all new products, or perhaps a more specific one that management has imposed based on the perceived risk of the project. By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost. This total cost figure drives the next step. The design team then uses value engineering to drive down the cost of the product until it meets its overall cost target. Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on — in short, any activity that will lead to a reduced product cost. This process also requires the team to confirm costs with the suppliers of raw materials and outsourced parts, as well as the processing costs that will be incurred internally. The controller plays a key role at this stage, regularly summarizing costing information and relaying it not only to the team members, but to the managers who are reviewing the team’s progress. A standard procedure at this point is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after five months); if the team cannot meet increasingly tighter costing targets, then the project will be canceled. Once these design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which is follow-on activities that will reduce costs even further after the product has entered its production phase. This final step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition. The sources of these cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process (known as kaizen costing). The concepts of value engineering and kaizen costing can be used repeatedly to gradually reduce the cost of a product over time, as shown in Exhibit 5.13. In the exhibit, we see that the market price of a product follows a steady downward trend, which is caused by ongoing competitive pressure as the market for the product matures. To meet this pricing pressure with corresponding reductions in costs, the company initially creates product A, and uses value engineering to design a preset cost into the product. Once the design is released for production, kaizen costing is used to further reduce costs in multiple stages until there are few additional reductions left to squeeze out of the original design. At this point, the design team uses value engineering to create a replacement product B that incorporates additional cost savings (likely including the cost reduction experience gleaned from the kaizen costing stages used for product A) that result in an even lower initial cost. Kaizen costing is then used once again to further reduce the cost of product B, thereby keeping the cost reduction process moving in an everdownward direction. The entire target costing process, incorporating all of the preceding steps, is shown in Exhibit 5.14.

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Stages of Cost Reduction

Cost

Profit

Design Cost, Version A Kaizen Cost Reductions

Market Price

Design Cost, Version B

Kaizen Cost Reductions

Time

E XHIBIT 5.13

S TAGES

IN THE

C OST R EDUCTION P ROCESS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 18.

5.12 OUTPUTS: COST VARIANCES A costing methodology of any type is not of much use if there is no output from it that gives valuable information to the management team. One of the primary outputs that is expected is a listing of costing variances, which are actual costs that depart from expectations. There are a number of standard variance calculations that can be summarized into a report, and which we will cover in this section. Variances fall into three categories. The first is a price variance, and is the difference between the standard purchase cost of an item and the actual cost at which it was purchased, multiplied by the actual number of units purchased. It can be used to describe the variances in the general cost categories of purchased parts, direct labor, and overhead, and so is seen in three different places on cost variance reports. The second type of variance is the efficiency variance. This is the difference between the actual quantity of resources needed to manufacture something, less the standard quantity, multiplied by its standard cost. This variance can also be broken down into three subvariances: a direct labor efficiency variance, a yield variance that relates to materials usage, and a variable overhead efficiency variance. There is no efficiency variance related to fixed overhead costs, since they are not expected to change with volume, and so have no targeted level of efficiency against which to compare. The final variance is the volume variance. It applies to only one cost type, as opposed to the other variances; this is fixed overhead costs. Fixed overhead costs are charged to the cost of goods sold, or other parts of the income statement, as a fixed amount per accounting period, rather than as a percentage of the volume of production. Because of this difference in the method of cost allocation, a change in the actual production volume from the level that was expected when the allocation was set will result in a volume variance. It is calculated by multiplying the fixed overhead

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5.12 Outputs: Cost Variances

Conduct Customer Research

Conduct Competitor Research

81

Phase One: Conduct Market Research

Clarify Customer Requirements

Phase Two:

Determine Product Features

Determine Margin and Cost Feasibility

Determine Margin and Cost Feasibility

Finalize Value Engineering Results

Phase Three: Meet Margin Targets through Design Improvements

Finalize Design and Process Information

Phase Four: Initiate Product Production

E XHIBIT 5.14

Implement Continuous Improvement

Implement Continuous Improvement

T ARGET C OSTING P ROCESS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 18.

portion of the overhead rate by the number of units produced, and then subtracting this amount from the total fixed overhead cost pool. An example of these variances, and the calculations used to derive them, is shown in Exhibit 5.15. In the upper-left corner of the variance report, we see that there is a total variance of $61,725.

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Actual

Budget

Variance

Cost of Goods Sold 265,000

203,275

(61,725)

Material Price Variance: Total actual price/unit paid Total standard price/unit paid = Variance per unit  Number of units consumed = Material price variance 

Account Number 4000-020 4000-030 4000-040 4000-050

Account Name

Actual

Budget

Direct Materials Direct Labor Variable Overhead Fixed Overhead

102,500 34,000 50,000 78,500 265,000

76,500 29,450 36,550 60.775 203,275

Fixed Overhead Price Variance: 

= 

=

Total actual price/unit paid Total standard price/unit paid Variance per unit Number of units consumed Fixed overhead price variance



= 

=

Variance (26,000) (4,550) (13,450) (17,725) 61,725

Material Yield Variance: Total actual units consumed Total standard units consumed = Unit variance  Standard price per unit = Material yield variance 

10,000 8,500 1,500 9 13,500

Labor Price Variance: 7.85 7.15 0.70 10,000 7,000

Fixed Overhead Volume Variance: Standard overhead rate per unit Number of units consumed Total overhead charged to exp. Actual overhead cost pool Volume variance

10.25 9.00 1.25 10,000 12,500

Total actual price/hour paid Total standard price/hour paid = Variance per hour  Number of units consumed = Labor price variance 

8.00 7.75 0.25 4,250 1,063

Labor Efficiency Variance: 7.15 10,000 71,500 60,775 10,725

Total actual units consumed Total standard units consumed = Unit variance  Standard price per unit = Labor efficiency variance 

4,250 3,800 450 7.75 3,488

Variable O/H Price Variance: Total actual rate/unit paid Total standard rate/unit paid = Variance per unit  Number of units consumed = Variable O/H price variance 

5.00 4.30 0.70 10,000 7,000

Variable O/H Efficiency Variance: Total actual units consumed Total standard units consumed = Unit variance  Standard price per unit = Variable O/H efficiency variance 

E XHIBIT 5.15

10,000 8,500 1,500 4.3 6,450

C OST V ARIANCE R EPORT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 16.

The block of costs immediately below this shows the cost categories in which the variance arose, which sum to $61,725. Below and to the side of these variances are subsidiary variances that are linked back to the four major cost categories. For instance, the materials price variance in the upper-right corner reveals that the price paid for materials is $1.25 higher than expected, while the material yield variance located directly below it shows that 1,500 more units of materials were used for production than had been anticipated. The total variance from these two calculations is $26,000, which traces back to the total direct materials variance on the left side of the report. All of the variances trace back through the report in a similar manner. This is a good format for showing how variance calculations are derived, and how they flow through the accounting reporting system. A company may not choose to report on all of these variances, since the detailed investigation of each one can be extremely time consuming. Thus, the variance for the direct labor price may not

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be reported on the grounds that management has little control over it when pricing is ruled by a formal agreement with a labor union. Similarly, the fixed overhead volume variance may not be reported because it relates more to ongoing production volumes than to management’s ability to control the size of the overhead cost pool. Variances that are more commonly reported on are the material price variance and all types of efficiency variances; the material price variance is used to monitor the performance of the purchasing staff, while efficiency variances are used to oversee the entire manufacturing process. Some variances are not worthy of regular reporting, because they require an inordinate amount of data collection work in exchange for information that is not of much use to management. For example, a detailed scrap variance that itemizes every item that was thrown out during a reporting period, alongside the reasons for each one, calls for a very large amount of investigative effort. The resulting report will contain information that may result in some long-term savings, but probably not enough to justify the work required to create the report. Thus, report compilation work should be considered when reporting on variances. Once the cost variance report has been completed, the accounting staff either will be asked to conduct an investigation into the causes of specific variances, or should do so on its own. If so, it is useful to know in advance what types of problems are most likely to cause variances, so that investigative work can be first targeted at these items. The most common causes of each major variance are: • Fixed overhead spending variance
Suppliers have increased their prices for products and services that fall into this expense category. Review related supplier contracts for scheduled price increases.
The company has increased its usage of the products or services recorded in this category. If so, the costs may actually be variable, and should be shifted to a variable overhead account. • Labor price variance
The standard rate has not been altered to match changes in the union’s labor contract.
The standard does not include extra charges, such as shift premiums, bonuses, or overtime.
The people actually conducting work are at different pay rates than those that were assumed to be doing the work when the labor standards were created. • Material price variance
The actual price paid is based on a different purchasing volume than what was assumed when the price standard was originally set.
The standard price was erroneously copied from a similar product that has a significantly different price.
The purchasing staff is now buying replacement parts that have a different price than the parts that were the basis for the standard. • Selling price variance
Products were sold with different options than the products used to set selling price standards.
Customers have ordered in different unit volumes than those used to determine the standard price.
Customers have paid prices different from the invoiced prices (which will require investigation to resolve).
Customers were given promotional discounts on prices paid. • Variable overhead spending variance
The supplier has changed its per-unit pricing. Look for a contractually mandated change in the per-unit price.
The company is purchasing in different volumes, which alters the per-unit price paid.
There are misclassifications in costs between the variable overhead and other accounts.

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Though there are certainly other causes for variances, these are among the most common ones, and so should be investigated first. Also, the accounting staff will find that the same causes are likely to crop up over and over again, so it is useful to develop and continually update a list of variances caused from previous reporting periods. This becomes the accounting staff’s “short list” of variance causes that can be used to track down similar problems in the future.

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CHAPTER

6

RATIO AND TREND ANALYSIS 6.1 INTRODUCTION 85

(b) (c) (d) (e) (f)

Customer Service Measurements 99 Distribution Measurements 100 Engineering Measurements 101 Human Resources 103 Materials Management Measurements 105 (g) Production Measurements 106 (h) Sales and Marketing Measurements 108 (i) Cycle Time 110

6.2 HOW TO USE RATIOS AND TRENDS 85 6.3 A CAVEAT 86 6.4 MEASURES FOR PROFITABILITY 88 6.5 MEASURES FOR THE BALANCE SHEET 90 6.6 MEASURES FOR GROWTH 94 6.7 MEASURES FOR CASH FLOW 96

6.9 INTERRELATIONSHIP OF RATIOS 110

6.8 MEASURES FOR NONFINANCIAL PERFORMANCE 97

6.10 SETTING UP A SYSTEM OF RATIOS AND TREND ANALYSES 110

(a) Accounting 98

6.1 INTRODUCTION This chapter describes the analysis of a business by using ratios and trends. The most common accounting measurements are included here; these are good for analyzing the balance sheet, the income statement, and relationships between the two. In addition, there are a number of performance measurements in this chapter that do not directly relate to accounting, but rather to other functional areas, such as customer service, engineering, and materials management. These additional measures are necessary, because a controller cannot do an adequate job of maintaining systems, reporting on operating results, or recommending changes without a complete understanding of all company operations and how they interact. Consequently, the controller is well advised to develop a set of ratios and trend analyses for measurements that step beyond the usual accounting measurements to encompass the operating aspects of all departments. This chapter not only shows how to calculate each ratio, but also describes why each one is useful as well as any shortcomings it may have. The chapter concludes with a discussion of how ratios interrelate, as well as their limitations. The chapter is intended to give a controller enough information to set up a complete system of ratios and trends for the continuing analysis of all company operations.

6.2 HOW TO USE RATIOS AND TRENDS Ratios are very useful for determining the interrelationships between numbers. For example, without a ratio, a manager has no way of knowing if the amount of accounts receivable is an acceptable one or if there should be a major collection effort underway to bring in old accounts receivable. Similarly, only a comparison of inventory to the cost of goods sold will tell if there is an excess amount of inventory on hand. Finally, one must compare interest expense to earnings to see if there is a risk of not paying for at least the interest on debt, which could result in corporate liquidation. All of this information is critical, and ratios are the best possible tool for determining it. 85

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Ratios do not have to be used solely for analyzing financial information. For example, a ratio can reveal the extent to which a company has become top-heavy by comparing the number of indirect labor people to the number of direct labor employees. Another example is a comparison of sales to salespeople to see how many sales are being obtained, on average, by each salesperson. These measures are just as important as financial ones, but their components are not all found in the financial statements. Despite their uses, there is a problem with ratios—they give no historical perspective on a measurement. For example, a ratio may reveal the amount of inventory turnover, but this does not tell a controller how the ratio is changing over time. For this information, one must list a series of measurements on a trend line. This can be listed on a simple bar chart or a more complex three-dimensional one, or even on a primitive numeric table — the format is important only in that it must clearly show the reader any changes in the ratio. When using ratios and trend lines together, a controller has a powerful analytical tool. A trend line does not have to contain only ratios. They are commonly used to plot revenues or specific expense line items. This information is also useful, because management can see general trends that may require correction. The most common trend line uses only revenue data, because the sales and marketing manager wants to know the trend of sales for various divisions, product lines, and products. Once armed with this information, the sales and marketing staffs can take action to either continue hot sales growth or bolster flagging growth. Trend lines do not have to be plotted with only ratio information. An important consideration when using ratios or trend lines is that they must be used consistently. There is nothing more confusing to a management team than to receive an entirely different set of measurements every month. Some measures may be so difficult to understand that management does not have the time to interpret the newest batch of measurements, and so ignores them; this does not assist in management’s control of the business! Another problem is that inconsistent use of measurements eliminates one’s ability to create any trend lines; after all, a trend line requires a series of measurements, not just one. A trend line does not provide a sufficient degree of information if it contains less than a half-dozen data points, which will not happen without a consistent measurement program.

6.3 A CAVEAT The majority of this chapter covers the measurements that give a controller a better idea of the status of company operations. The key word is better, for one should not rely solely on these measurements to judge company operations. It is unfortunate that many controllers manage their departments strictly “by the numbers,” and make recommendations for changes elsewhere in the company based solely on that information. A good manager uses measurements only as part of the body of knowledge required to do a thorough job of effectively and efficiently running a business. Other items that a controller should know about in order to plot a strong management course in the sea of business uncertainty are: • Branding. Some companies, such as Coca-Cola, PepsiCo, or any automobile manufacturer, spend enormous amounts of money on marketing activities to build up the public’s image of their brands. This may seem like a waste of money to a typical cost-conscious controller, but it has been proven time and again that consumers will pay a significant premium for branded products. Consequently, a controller should have a sufficient knowledge of corporate branding activities before releasing a report to management that recommends deep cuts in marketing costs in order to save money. • Company organization. There may be quirks in how a company is organized that have a direct impact on the measurements that a controller sees. This is especially common for a large, multidivision company, where constant reorganizations result in reallocations of reporting relationships. For example, a controller may find that the sales department expenses for a division are rapidly surpassing the budget; a knowledge of the organizational structure might reveal that there is no one in that position due to a recent reorganization. This changes the con-

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troller’s action from a stinging memo to the general manager of the division regarding cost controls to a strong request to the human resources staff to hire a new sales manager. • Competitors. The actions of competitors have a profound impact on company operations. A competing product may be priced sharply lower than the company’s product, resulting in a matching price drop that is initiated by the marketing staff. Alternatively, a sudden drop in sales may simply be caused by the entrance of a new competitor, while a rapid sales increase may be caused by the demise of a competitor, sending all of its customers to the company. For example, a controller may strongly recommend a doubling of production capacity based on a sudden up-tick in revenues, though a knowledge of the industry would have revealed that a close competitor has gone out of business, and the up-tick should be expected to only roughly match the sales of that defunct business, which is not sufficient to warrant the expense of more production facilities. • Goals. If a company has established stretch goals that will be difficult to reach, a controller should expect strains on the organization that will appear in measurements. For example, an aggressive production plan will probably result in excessive levels of overtime and extra machine repair and maintenance; knowing about the goals would keep the controller in this example from spending too much time reviewing those measures that were clearly altered by the higher levels of production. • Labor relations. Several of the measurements in this chapter require close tracking of direct labor hours. However, a controller may find that labor relations are so tense that additional measurements might be seen as an excessive (and unacceptable) level of control. Also, poor labor relations may mean that employees are deliberately charging their hours to incorrect activities. The first problem voids the controllers’ ability to create measurements, while the second issue weakens their reliability even if they can be created. For example, a controller may see that measurements show a very low gross margin for a product line and launch a major cost investigation, only to find that the labor component is wildly incorrect. Previous knowledge of labor problems might have allowed the controller to restructure the components of the gross margin calculation, so that a trend line would have immediately shown that labor costs were the problem. • Management team. The character of the management team has a profound impact on measurements. If it is unethical, there may be problems with the period-end cutoff, because this is a prime area for manipulating the volume of sales. The problem may pervade the organization, creating difficulties due to loans to owners and managers, incorrect commission payments, or difficulties with missing assets. For example, a measurement may reveal that inventory turnover is much worse than the historical average; based only on that measurement, a controller might enter into all sorts of calculations and investigations to root out the problem, whereas the knowledge that the owners are trying to inflate inventory values to underreport the cost of goods sold will lead the controller straight to the warehouse for an in-depth audit of inventory quantities. • Marketplace. The market for a company’s products is rarely a completely stable one. It may be seasonal, resulting in wide revenue swings depending on the month, or it may be going through a period of rapid expansion or contraction. For example, a controller may be tracking a trend line of revenue levels and notice a sudden, sharp drop in revenues for a product line. A frantic call to the sales staff might not have been so frantic if the controller realized that the product line was lawn mowers, and that sales always drop by the middle of the summer. • Monopoly situations. It is not uncommon for a company to have a small number of products in its product portfolio that have no significant competition. This minority of products typically carry prices and correspondingly high margins, which may generate sufficient cash flow to make a significant difference to a company’s bottom line. A controller must know enough about a company’s competitive situation to know which products are in a monopoly situation, because these “breadwinner” products are critical. For example, a controller should carefully track price points, unit volume, and gross margins on all monopoly items in order to warn

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management of any price or margin erosion; controllers who do not know which products are breadwinners will probably not segregate them for measurement, possibly resulting in no one knowing about market changes that will have a major impact on company profits. • New market activities. Most companies attempt to enter new markets from time to time. This is a very expensive activity, because potential new customers must be educated about the company, research and development costs must be incurred to create new products for the market, a distribution system must be created, and a variety of policies and procedures realigned to better service the new markets. Many controllers take the conservative approach and protest these activities because of the large up-front cost. However, a more knowledgeable controller will realize that new markets drive company sales, and the expenses needed to enter those markets are the necessary costs of getting into them. • Policies and procedures. A company collects information in a more uniform manner if there are policies and procedures to cover all major transactions. If not, information may be accumulated into the wrong revenue and expense accounts, which plays havoc with a controller’s measurements. For example, telling employees to break out all entertainment expenses on their travel reports resulting in all these expenses being recorded as travel expenses. A controller who does not know about this problem may be led to believe that the high travel costs are caused by excessively high air fares, and recommend a clamp down on corporate travel. • Product pricing. A company may base its sales strategy on having the highest or lowest product price in the marketplace. This is not something that a controller typically measures, because the most common sales-related measures track only total revenues, not the component parts, which are prices and unit volumes. However, if the strategy is to maintain the highest or lowest price, then the controller must track this information and compare it to competing prices, so that management can maintain the appropriate price points. • Recruiting methods. A company that is situated in an industry in which there is only a small available pool of qualified applicants, such as an engineering or software design company, incurs tremendous recruiting costs. This may involve overseas trips to recruit foreign candidates, or perhaps paying exorbitant fees to outside recruiters to locate potential employees. In these industries, very high recruiting costs are simply a part of doing business. If a controller does not know this, the human resources staff may be on the receiving end of a series of complaints, accusing them of using the most expensive recruiting approaches, when in fact they may be doing a very cost-effective job of locating new employees. • Training. Poor employee training leads to poor transaction completion; because transactions are the basis for many measurements, this results in poor measurements. For example, poor training of the billing clerk may result in revenues being charged to an incorrect product line, which will skew both the revenues and cost of goods sold for the product line. If a controller knows where the training weaknesses lie in the organization, this makes it much easier to identify the problem and correct it, rather than assuming that the measurement is correct and that the gross margin for the product line is the real problem. The previous points illustrate why a controller must know an organization’s strengths and weaknesses, because they have a strong impact on measurements. This knowledge can be used in another way as well, for the measurement system can be altered to take advantage of corporate strengths, and bolstered to support the weakest areas. As discussed in Section 6.9, it is clear that the peculiarities ensconced in every company require a controller to change, add to, and delete from the existing set of measurements to arrive at a measurement system that properly tracks weaknesses while only exerting the lightest control over organizationally strong areas.

6.4 MEASURES FOR PROFITABILITY A controller needs to accurately judge the amount of profit extracted from a company’s operations, which means knowing the exact margin earned by division, product line, and product. A controller

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must also have a good knowledge of fixed costs and how they impact company profits at different sales levels, as well as a thorough understanding of the amount of overhead and how that relates to the cost of goods sold. This section provides the ratios and percentage calculations needed to extract this information from the income statement. The measurements are: • Break-even point. A crucial measurement for a controller to be aware of is a company’s break-even point. This is the sales level at which, given a predetermined gross margin rate, a company will make a profit of zero. This is important, because a company may have such a high fixed-cost structure or low gross margins that it is nearly impossible to turn a profit unless there are extraordinarily high sales. By spotting this problem, a controller can push for sales of higher-margin products or a reduction in fixed costs. To calculate break-even, simply divide operating expenses for the reporting period by the company’s historical average gross margin. For the gross margin figure, it is best to use a recent average, so that the measurement accurately reflects any recent changes. • Number of times interest is earned. This is an excellent measure of the risk a company undertakes when it adds debt. If the continuing amount of cash flow cannot cover interest payments on existing debt, then a company is in serious trouble and must take steps to reduce the level of debt immediately. The measure is also good for companies considering acquiring more debt; a poor ratio will tell them not to do so. To calculate the measurement, determine the amount of interest charged on debt for a typical period (perhaps an average of the interest payments for the last quarter). Then obtain the net income figure from the income statement and add back any noncash expenses, such as amortization and depreciation, which yields the actual cash flow. Then divide the average interest expense by the cash flow amount to determine the number of times that interest is earned. The figure can be skewed if there are interest balloon payments that are not factored into the average interest expense. • Operating margins by division, segment, product line. A company must have sufficient operating margins. Otherwise, all other management decisions become superfluous, since inadequate margins do not allow a company to throw off enough cash flow to stay in business. Consequently, the controller must calculate margins in a variety of ways—by division, segment, and product line—and pass this information along to management as frequently as possible. In particular, if the controller spots a rapid drop in margins, this information must go out to management immediately, rather than waiting until the next monthly financial reporting package. Information about operating margins is too time-critical to wait. The calculation for this measurement varies somewhat depending on the type of margin being measured, but is best calculated by creating a standard report for each variation using the accounting system’s report writer to extract data from the general ledger and recast it in an income statement format. This may require some changes to the chart of accounts to ensure that there is enough segmentation of information to ensure reporting accuracy. • Overhead rate. A primary area of competition is based on price, and the only way a company can succeed in that arena is to have extremely low costs. Costs are grouped into three areas, one of which is overhead. This can be a very large amount of money, especially for those organizations with bloated organizational structures. The amount of overhead is allocated to individual products, which has a major impact on the value of work-in-process and finished goods inventory. Allocation is based on an overhead rate that is calculated by compiling overhead costs for the period and dividing by the amount of direct labor expended during the period. The resulting overhead cost per direct labor hour is then allocated to inventory based on the amount of labor hours charged to the products. This method of charging costs to products can be highly inaccurate if the overhead rate per labor hour is extremely high, because a slight change in hours charged can result in a massive change in the overhead cost of the product. Also, because many products now require very few hours of work to produce, many companies are coming to the conclusion that direct labor is a poor basis for spreading overhead costs and are switching to more accurate allocation methodologies, such as activity-based costing (ABC).

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• Percentage return on net sales. This is the single most commonly reviewed measure in most companies. It is a good indicator of how well all aspects of the business are performing in order to arrive at a profit. It is best tracked on a trend line to see how the profit percentage compares to that of previous periods, and is especially useful when tracked by product line, where there should be a considerable amount of consistency in the percentage from period to period. To calculate the measurement, simply divide the profit into net sales for the same period. However, one must be aware that the profit percentage is subject to manipulation, because it is possible to modify accruals and noncash expenses (e.g., depreciation and amortization) to fit the profit number that management wants. • Ratio of sales returns and allowances to gross sales. This is an excellent way to determine the quality of goods sold or of the excess amount of inventory in the distribution pipeline. A company that finds customers sending back an inordinate amount of product, either has a faulty product that requires immediate corrective action, or has stuffed so much inventory into the distribution pipeline that retailers simply cannot sell it all. The latter calls for a different approach to selling the product. Tracking this information on a trend line is especially helpful, in order to see problems that may develop over several months. To calculate the measurement, divide the total sales returns by gross sales; both numbers should be aggregated separately in the general ledger. The ratio can be misleading, however, because sales returns invariably relate to sales from a previous period, not the current one against which the ratio is being measured. • Sales/profits per person. Some companies have very large staffs, and, because the payroll expense is large, they choose to use it as a major indicator of internal efficiency. When they see the sales or profits per person falling, their typical reaction is to cut staff to bring the numbers back into line with expectations. To calculate the measurement, simply accumulate the number of personnel from payroll records and divide it into either sales or profits, both of which can be obtained from the general ledger. However, the measure is easily skewed if a company uses a large number of part-time workers; if so, these people must be converted to full-time equivalents. Also, the number can be drastically changed if a company outsources its more labor-intensive functions, essentially negating the value of the measure. It is important to use all of the measures and not just a selection, for each one tracks different information that is critical to a complete understanding of a company’s costs, margins, and break-even points. The measures are summarized in Exhibit 6.1.

6.5 MEASURES FOR THE BALANCE SHEET One of the most heavily measured areas is the balance sheet. When used properly, the ratios and percentages noted in this section reveal a great deal of information about a company’s financial health, as well as its financial strengths and weaknesses. For example, several measures cover the size of a company’s debt holdings, as well as how this bears on the firm’s overall level of financial risk. Other ratios deal with the relative proportions of assets needed to create revenues and profits, which an astute controller can use to compare company performance to that of competitors as well as to that of “best practices” organizations that may lie outside the industry. Other measures can be used to determine a company’s short-term liquidity (which is of particular concern to lenders), as well as the age of assets. Finally, more advanced organizations are now trying to relate their assets to market valuations to determine their success in creating value in excess of the worth of their assets; there are several ratios here to assist in these calculations. The measurements are: • Debt/equity ratio. To a lender, one of the most important measures is the debt to equity ratio. This reveals the degree of leverage that management has imposed on the balance sheet by acquiring debt. If the amount of debt in relation to equity is excessively high, it may be difficult for a company to service the debt or to pay it off. When a lender sees this high ratio, it may be reluctant to issue additional debt without some other assurances from management, such as personal guarantees. To calculate the measurement, simply add up all long-term and

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Ratio

Derivation

Break-even point

Sales ----------------------------------------------------Average gross margin

Number of times interest earned

Average interest expense -----------------------------------------------------------Cash flow

Operating margin

Revenues -------------------------------------------Cost of goods sold

Overhead rate

Overhead expenses -----------------------------------------------Direct labor

Percent return on net sales

Net sales ----------------------Net profit

Ratio of sales returns and allowances to gross sales

Sales returns and allowances --------------------------------------------------------------------Gross sales

Sales/profits per person

Sales ---------------------------------------------------------------Total full-time equivalents or Net profits ---------------------------------------------------------------Total full-time equivalents

E XHIBIT 6.1

91

P ROFITABILITY M EASUREMENTS

short-term debt and divide it by total equity. However, management can play with the degree of leverage by moving some debt into operating leases, which are not recorded on the balance sheet. • Return on assets. This is an excellent measurement when a controller wants to know how well a company is utilizing its assets to generate revenue. If the amount of assets required in proportion to revenues is increasing, then there are inefficiencies, or at least unnecessary assets, in the organization that the controller should investigate. The components of the return on assets are shown graphically in Exhibit 6.2. Note in the exhibit the large number of components that a controller can investigate in this complicated measurement; problems can occur in such diverse areas as sales or accounts receivable that have a direct impact on the measurement. To calculate it, divide total sales by total assets, the major components of which are usually cash, accounts receivable, inventory, and fixed assets. However, this measure is not useful and can be downright misleading, when applied to a fixed asset-intensive business, such as an oil refinery, where there is a large investment that cannot be reduced, irrespective of the amount of sales generated. • Return on shareholder equity. This is one of the most important measurements for a shareholder. When a shareholder has a choice between investing funds in a company or doing so elsewhere, it makes sense to compare this measure to alternative investments, and to choose the higher of the two, while factoring in various risk issues. To calculate it, simply divide net income by shareholder’s equity, both of which can be found in the general ledger. The trouble with this measure is that it does not delineate changes in risk that may go hand-in-hand with changes in net income. For example, a company can increase its return on equity by incurring debt to buy back shares; however, the increased debt makes the investment more risky, so investors should also consider the debt/equity ratio alongside this one, in order to match changes in returns to changes in risk. • Current ratio. A common way to measure a company’s liquidity is to use the current ratio. This compares the amount of short-term assets to short-term liabilities. A good ratio is one that yields enough liquidity to pay off all current assets. If the ratio does not reveal this ability, it is possible that the company has a sufficient degree of liquidity difficulty that it is in

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Return on Assets

Multiplied by

Earnings Ratio

Turnover

Divided by Earnings

Divided by Sales

Sales

Minus Sales

E XHIBIT 6.2

Total Assets

Plus Cost of Sales and Expenses

Working Capital

Fixed Assets

Cash

Accounts Receivable

Inventory

C OMPONENTS

OF THE

R ETURN

ON

A SSETS

danger of going bankrupt. To calculate this measurement, divide all current assets by all current liabilities. It can be misleading if there is a disproportionately large amount of inventory in the current assets figure, because this measure is primarily designed to track liquidity, and inventory is not a very liquid asset. • Quick ratio. A controller who regularly uses a quick ratio instead of a current ratio probably has a problem with inventory. This is because the primary difference between the two ratios is inventory. The reason why inventory is dropped from the quick ratio is that it is not a very liquid asset, whereas the other components of the ratio are usually easily liquidated. This ratio gives one a good idea of how quickly a company can convert its current assets into cash to pay for current liabilities, which makes it an excellent measure of short-term liquidity. To calculate the measurement, add together all cash, accounts receivable, and temporary investments, and divide by current liabilities. • Ratio of sales to accounts receivable. A controller should keep a close watch over the proportion of sales to accounts receivable, since a change in the historical rate may be indicative of worsening collection problems. To calculate the measurement, divide the amount of credit sales by the accounts receivable balance for the reporting period (both numbers should be recorded in the general ledger). The ratio should be tracked on a trend line, so that problems are more easily revealed in comparison to previous periods. The measure can be inaccurate if there is a large dollar volume of cash sales included in the sales figure; also, if the accounts

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receivable balance is primarily composed of a few large invoices, having even one invoice moderately overdue will severely skew the measurement. • Accounts payable turnover. This ratio indicates the number of times that accounts payable were paid, or turned over, in a reporting period. It is an effective means for tracking the timeliness of payments. When tracked on a trend line, it is easy to spot when a company is entering financial difficulties, for the ratio will clearly worsen as the company delays payments. The ratio is also useful for predicting future accounts payable balances based on expected levels of purchasing. To compute the measurement, divide total purchases during the period by the ending accounts payable balance (though the average balance for the entire period is more accurate). This measure can be skewed if a company changes to or from taking early payment discounts, especially if this impacts a significant proportion of the accounts payable. • Ratio of repairs and maintenance expense to fixed assets. It is extremely useful to determine the condition of a company’s fixed assets, because one can thereby determine the need for expensive replacement equipment that may significantly cut into cash or borrowing reserves. The best way to do this without making a physical inspection of the equipment is to compare the size of the repairs and maintenance expense to the amount of fixed assets. When tracked on a trend line, one can easily spot any jumps in the ratio compared to previous time periods, which indicates an aging set of fixed assets. To calculate the measurement, obtain the repairs and maintenance expense from the general ledger, and divide it by the gross fixed asset cost (i.e., before depreciation). The ratio will be much more accurate if the accounting staff splits off unrelated repair and maintenance expenses, such as for grounds upkeep, and stores this information in a different general ledger account. • Ratio of depreciation to fixed assets. It is important to know the age of a company’s fixed assets, because an excessively old asset base may soon require replacement. One of the best ways is to simply compare the amount of accumulated depreciation to the amount of assets; a large amount of depreciation is a good indicator of old assets. To calculate the measurement, obtain the accumulated depreciation figure from the general ledger and divide it by the total fixed asset valuation (also obtained from the general ledger). The measure can be skewed if a company uses highly accelerated depreciation methods, such as double declining balance depreciation, because this appears to show an older asset base than is really the case. • Fixed-asset turnover. This measurement is most useful when plotted on a trend line. It shows how much of a fixed-asset investment is needed for management to achieve a specific level of sales. If the ratio increases, then the amount of assets required has gone up, which will probably also lead to a reduced return on assets (unless margins increase). To compute the measurement, divide sales by fixed assets. Both of these numbers are located in the general ledger. • Ratio of retained earnings to capital. A lender or investor uses this measurement to see how many earnings have been allowed to accumulate in the company. This is an especially important factor in a privately held company, where it is common for the owners to extract as much of the retained earnings as possible in the form of distributions, leaving few assets for continuing operations; this requires constant infusions of debt to keep the company afloat, and effectively shifts much of the risk from the owners to the lenders. To compute this measurement, divide retained earnings by total stockholder’s equity, both of which are found in the general ledger. • Economic value added (EVA). Many controllers do not track the returns on capital that their companies are achieving. If a company’s return is lower than its cost of capital, then it is making inefficient use of that capital. In fact, it may be better for investors to take their money out of such a company and invest it elsewhere. To calculate the measurement, multiply the amount of net investment (the amount of cash invested in the business, net of depreciation) in the company by the difference between the actual return on assets and the required minimum rate of return. Shrinking the amount of working capital or fixed assets, or increasing the rate of return on those assets will improve the EVA.

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• Market value added (MVA). From the perspective of a shareholder, a company is successful if its market value in terms of the value of its shares on the open market is in excess of the amount of capital invested in the business. If its market value is less than the amount of invested capital, then management has done a poor job of generating adequate returns. To calculate the measurement, multiply the number of shares outstanding by the share price, add in the market value of preferred stock and debt, and then subtract the total amount of invested capital. • Working capital productivity. It is becoming increasingly important for companies to operate their businesses on the leanest possible asset base. Not only does this improve the return on assets, but it also reduces the risk of losing assets by investing too much in a business. Much of a typical company’s investment goes into working capital, which is accounts receivable plus inventory, minus accounts payable. However, the amount of dollars in working capital is not a good way to judge it, because there is no way to compare it to some other measure of activity. This is where working capital productivity is useful. To calculate it, simply divide the amount of working capital into annual net sales. The resulting number is most useful when tracked over time and when compared to the similar number for competitors, for it tells the amount of working capital needed to support each incremental dollar of sales. These measurements are used to create an understanding of a company’s level of financial risk, liquidity, age of assets, and ability to leverage assets into revenues. It is very useful to track all of this information continuously and plot it on a trend line, so that management can spot any worrisome trends and act to correct them as soon as possible. The measures are noted again in summary form in Exhibit 6.3.

6.6 MEASURES FOR GROWTH Some companies find themselves on an extremely rapid growth path. When this happens, there are financial pressures on the corporation that require different measurements to discover. For example, there will be great strains on cash flow, so there must be a close watch over the percentage change in cash flow. Other issues include changes in sales and market share; these two measures can provide contraindications by moving in opposite directions, so it is helpful to track both measures side by side. Finally, investors want to know if all of the growth pains are worth it, so the controller should track changes in earnings per share. The measurements are: • Percentage change in cash flow. A change in cash flow is one of the first indicators of a variety of problems elsewhere in a company. For example, a decline in cash flow can be evidence of a decline in sales or gross margins, or it may be a sign of increased sales, general and administrative (SG&A) expenses, increased fixed asset expenditures, or even of a stock buyback. Whatever the reason, this is a good first indicator of trouble, and as such, the controller should rely upon it. There are two ways to calculate the measurement. The first and more accurate way is to add profits to all noncash and fixed asset expenditures. The “quick and dirty” alternative is to simply track the current cash balance. In either case, it is best to track the information on a trend line in order to spot any period-to-period problems. • Percentage change in earnings per share (EPS). A company may find that its sales, profits, and market share are continuing to improve, but that the EPS are not keeping pace. This can understandably cause concern by investors. The key factor causing this problem is the number of shares. An equity placement that adds to the number of outstanding shares can water down the EPS to the point where even enhanced profits will still result in a decrease in the EPS. The simplest way to calculate this trend is to divide net earnings by the number of outstanding shares and plot this on a trend line. • Percentage change in market share. The best absolute measure of a company’s performance is its market share. If the share increases, then the company is performing better than its competitors. To track it, use the market share results issued by industry trade organizations and plot the data points on a grid chart. However, a company may be gobbling up market share

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Ratio

95

Derivation

Debt/equity ration

Long-term debt  short-term debt ---------------------------------------------------------------------------------Total equity

Return on assets

Total sales ---------------------------Total assets

Return on shareholder equity

Net income ----------------------------Total equity

Current ratio

Current assets -----------------------------------------Current liabilities

Quick ratio

Cash  accounts receivable  investments ------------------------------------------------------------------------------------------------------Current liabilities

Ratio of sales to accounts receivable

Net sales ------------------------------------------------------------Total accounts receivable

Accounts payable turnover

Total purchases ------------------------------------------------------------------------------Ending accounts payable balance

Ratio of repairs and maintenance expense to fixed assets

Total repairs and maintenance expense --------------------------------------------------------------------------------------------Total fixed assets before depreciation

Ratio of depreciation to fixed assets

Accumulated depreciation --------------------------------------------------------------Total fixed assets

Fixed asset turnover

Net sales ----------------------------Fixed assets

Ratio of retained earnings to capital

Retained earnings --------------------------------------------------------------Total stockholder’s equity

Economic value added

(Net investment)  actual return on assets  required minimum rate of return)

Market value

(Number of shares outstanding  share price)  (market value of preferred stock and debt)  (invested capital)

Working capital productivity

Annual net sales --------------------------------------Working capital

E XHIBIT 6.3

B ALANCE S HEET M EASUREMENTS

and still be losing sales if the overall market is shrinking, so it helps to track the size of the market alongside the market share trend line. • Percentage change in sales. A controller should closely track the trend line for sales, not only for the company as a whole, but also for individual product lines. A continuing upward slant on a growth chart is obviously encouraging, but sometimes the most important trend to track is the rate of growth. Any decline in the rate of growth must not only be factored into future growth projections, but may also result in a discussion with the sales force to see if management should expect a sudden drop-off in sales volume — something that impacts lots of functional areas. To create the trend line, simply extract the periodic sales information from the computer system, usually with the use of a report writer to extract sales by product or product line, and then plot the data points on a grid chart. These measures are necessary for determining the amount of cash required to continue growth, the degree of growth occurring, and the extent to which investors are profiting from it. Because there are so many different factors to determine, it is necessary to track all of the measures noted in this section. The measures are summarized in Exhibit 6.4.

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Ratio

Derivation

Percentage change in cash flow

Incremental change in cash flow -----------------------------------------------------------------------------Cash flow from previous period

Percentage change in EPS

Incremental change in EPS ----------------------------------------------------------------EPS from previous period

Percentage change in market share

Incremental change in market share ------------------------------------------------------------------------------------Market shart from previous period

Percentage change in sales

Incremental change in sales -----------------------------------------------------------------Sales from previous period

E XHIBIT 6.4

G ROWTH M EASUREMENTS

6.7 MEASURES FOR CASH FLOW A company may look great on paper—sales spiraling upward, surging profits, and a vast backlog — and still go bankrupt. Cash flow measurements can see through all of the favorable indicators to ascertain the true health of the organization. The measurements in this section focus on stripping away extraordinary cash flow items to see how continuing operations are doing, as well as the ability of a corporation to cover continuing expenses for items not appearing on the income statement, such as debt repayments and fixed-asset purchases. The measurements are: • Cash flow adequacy. It is critical to know if the cash flow from operations is sufficient to meet all major payment commitments. These commitments do not include basic payments that are included in the income statement, such as payments for materials, utilities, or taxes; this is for non–income statement payments, such as debt payments. To calculate the measurement, divide cash flow from operations by all scheduled payments for long-term debt, asset purchases and dividends. However, this measure is not sufficient if management is in the habit of making unscheduled payments, such as for fixed assets that are not on the annual fixed-asset purchases schedule. • Cash flow return on assets. Though most companies just use the return on assets, this is a variation that may be worthwhile in some situations. Rather than dividing profits by total assets, just divide cash flow by total assets. Any difference in the two measures will be due to any noncash expenses. If there is a large amount of noncash expenses, then the cash flow return on assets can be substantially higher than the simpler return on assets. This can be used to explain company performance to investors when large depreciation or amortization charges are cutting into earnings. • Cash flow to sales. This is perhaps a better measure of profitability than a simple gross or net margin on sales. It reveals the total amount of cash flow attributable to each sales dollar. To compute it, divide cash flow from operations by revenues. Because the measurement strips out all noncash expenses, such as depreciation, it gives a good view of actual cash flows to be expected from operations. • Dividend payout ratio. An investor who relies on company dividends wants to know the likelihood of the company’s being able to continue paying out at the same rate. This measurement provides that information. By comparing the amount of cash flow to the dividend payout rate, one can easily track the proportion of cash that goes to dividends; if the ratio worsens over time, it is likely that the dividend will be cut. To calculate the measurement, divide the total amount of dividends by the total cash from operations. It is best to track this information on a trend line to spot changes over time. • Long-term debt repayment. A controller must be able to judge a company’s ability to repay debt, so that recommendations can be made to alter operations in favor of reducing debt, if the chief financial officer (CFO) decides that to be a prudent strategy. Many companies that

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are not fiscally sound can convince themselves otherwise, simply by continuing to pile on the debt. A controller can tell if a company is truly solvent by tracking debt levels over the course of a year to see if there are periods when short-term debt is completely paid off. If not, a company frequently rolls over short-term debt into long-term debt with a fixed repayment schedule; this too can be a sign of fiscal trouble if the controller finds that the excessive amount of debt is leading to an unfavorable debt/equity ratio or if the number of times interest is earned is dropping. If a controller just wants to see if a company is capable of paying off continuing long-term debt payments, which are composed of both interest and principal, divide the total amount of long-term debt payments by cash from operations. If the ratio is unfavorable, it is probably time to extend the terms of the debt, so that the periodic payments are smaller. • Operating cash flow. There are many factors that can impact cash flow, and many of them are extraneous ones that rarely repeat. Though one would think that these extraneous factors will eventually go away, there always seem to be a few that interfere with the determination of cash flow from basic operations. This measurement is based on only operating elements, excluding all other factors. This gives a controller the best information about the true status of cash flows. To compute the measurement, add noncash expenses to profits, and then adjust for changes in working capital (accounts receivable, accounts payable, and inventory). Just as important, the measure excludes any changes caused by investment income, fixed-asset sales, or extraordinary items such as income from legal or insurance settlements. Compiling cash flow measurements should be at or near the top of the controller’s “to do” list when the true health of a company needs to be obtained. If there is a problem, the controller can immediately get to work on fixing the underlying problems. If a controller does not regularly review this information, there is a risk that the company will find itself in a difficult cash position simply because the controller did not exercise enough foresight to accumulate the necessary information in advance. The measures are summarized in Exhibit 6.5.

6.8 MEASURES FOR NONFINANCIAL PERFORMANCE This section deals with measures that a controller is not so accustomed to measuring — nonfinancial performance. These measures can cover an extraordinarily wide range of activities, ranging from engineering to sales and marketing. Many companies are now realizing that nonfinancial performance in these other areas is just as important to corporate success as the purely financial measures that they are more accustomed to perusing. This section divides nonfinancial performance measurements into the traditional departmental functions. (e.g., accounting, production, etc.), and

Ratio

Derivation

Cash flow adequacy

Cash flow from operations All scheduled payments for long-term debt, asset purchases, and dividends

Cash flow return on assets

Cash flow ---------------------------Total assets

Cash flow to sales

Cash flow from operations ---------------------------------------------------------------Total revenue

Dividend payout ratio

Total dividend payments ---------------------------------------------------------------Cash flow from operations

Long-term debt repayment

Total long-term debt payments for the period -----------------------------------------------------------------------------------------------------------Cash flow from operations for the period

Operating cash flow

Profits  noncash expenses  changes in working capital

E XHIBIT 6.5

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describes a variety of measurements for each area that are extremely helpful for determining their efficiency, effectiveness, speed, and level of experience, all of which are direct contributors to corporate success. (a) ACCOUNTING. This section covers the performance measurements that a controller should use to manage the accounting department. The most heavily reviewed item is the average collection period for accounts receivable, because inattention to this area can lead to severe cash flow problems. It is also common to closely review the percentage of accounts payable discounts taken, so that the accounting department is not inadvertently responsible for extra expenses that could have been avoided. In addition, it is increasingly common to track the number of days required to release financial statements, with many companies even tying a controller’s bonus to this measure. Finally, an increasingly common set of measures is to track the efficiency of the accounting staff, much as the production staff has historically been tracked, by determining the number of errors committed and transactions completed per person. These are the primary measures used by a controller to manage the accounting department: • Average collection period. This is one of the best ways to determine the quality of accounts receivable. It shows the number of days that the average account receivable has gone unpaid. If the number of days resulting from the calculation is close to the number of days before which invoices are due (e.g., payable in 30 days), then it is unlikely that there are very many old accounts receivable, which highlights the ability of the accounting staff not only to issue error-free bills that are promptly paid, but also to rapidly collect overdue invoices. Conversely, an excessive number of collection days points to probable issues on the same topics. To calculate the measurement, divide average annualized receivables by average daily credit sales. • Percentage of accounts receivable. One of the primary measurements on which the controller is judged is the ability of the accounting staff to collect accounts receivable on time. If this does not happen, a company ends up with an excessive investment in accounts receivable, which is a poor use of funds. Also, older accounts receivable are at a greater risk of not being collected. To calculate this measure, print out an aged accounts receivable report, which should list at the bottom the total receivable amount in 30-day time buckets. Add up the summary totals for those time buckets that are considered to be overdue (e.g., everything over 60 days old), and divide it by the total of all accounts receivable. • Ratio of purchase discounts to total purchases. A company can save a fair amount of money by taking advantage of early payment discounts. Only a small percentage of suppliers offer early payment discount options, but if a company takes advantage of them all, the savings can add up to a tidy sum. The amount saved as a percentage of all purchases does not change much over time, so tracking the percentage of discounts taken is an easy way for the controller to discover if the accounts payable staff is missing out on some discounts. To calculate it, track the purchase discounts in a separate general ledger account, and divide this monthly figure by total purchases. Then track the resulting percentage on a trend line. • Time to produce financial statements. In today’s competitive environment, it is no longer acceptable to wait a month to receive the results of the previous month’s performance. Most managers need financial information as fast as possible, so that they can rapidly spot problems and correct them. The calculation is an easy one; just add up the days from the end of the month to the point when financial statements are issued. However, the measure is less meaningful if the accounting staff is already issuing interim reports before the financial statements that contain the most critical operating and financial information. • Transaction error rate. One of the most time-consuming activities in the accounting area is fixing errors. If something is wrong, the best person to find the error and fix it is a senior staff person or manager, and this type of person is usually already in short supply and certainly overworked. Consequently, there tends to be a long backlog of problems that the accounting department has in its queue, which may involve wait time by other departments, suppliers, or

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customers. Clearly, the controller must pay close attention to the transaction error rate, since it has such a major impact on workflows in the accounting area. This is not a measure that can be easily tracked by an automated system. Instead, the best approach is to review the transaction journals at the end of each month and add up the number of special debits and credits that were entered in the system — each one usually represents the correction of a previous problem. Then divide the number of errors by the total number of transactions, which also comes from the transaction logs. The main issue with this measure is that it only tracks items that have been corrected, not those that are still pending (which may be far larger than the number being corrected). • Transactions processed per person. Above all others, the accounting department is driven by the need to process large quantities of transactions, such as billings and payments to suppliers. Because of the large volume, this calls for extremely high levels of efficiency. By tracking the number of transactions processed per person, the controller can benchmark internal performance against that of other organizations to see if there are grounds for revamping processes to increase efficiency. The calculation varies somewhat by type of transaction, but it essentially requires that the controller accumulate data on the number of transactions processed during a specific time period, and the effort required to process them. It is easiest to do this with a periodic study, which may call for the services of a consultant. All controllers must be efficient in producing financial statements, collecting accounts receivable, taking purchase discounts, and processing transactions, and these measurements are the primary control point over those activities. The measures are summarized in Exhibit 6.6. (b) CUSTOMER SERVICE MEASUREMENTS. If there is a separate customer service department (or even if not), the measurements noted in this section are useful for determining the degree of customer satisfaction. Customer turnover shows the extent to which a company can retain its existing customer base, while two other measures note the types and quantities of complaints received, as well as the company’s speed in responding to them. The measurements are: • Customer turnover. A company expends a vast amount of resources to acquire new customers. It is much more inexpensive to simply retain the ones it already has than to find new ones, but this is sometimes lost on aggressive sales managers who celebrate acquiring new customers; the loss of an old one tends to pass unnoticed. The controller can point out this problem by reviewing the billing records to see which customers have not done business with the company for a long time. To calculate it, compare the billing database to the list of customers to whom the company has sold products or services in the past year and determine Ratio

Derivation

Average collection period

Average annualized accounts receivable -----------------------------------------------------------------------------------------------Average daily credit sales

Overdue accounts receivable

Total of overdue accounts receivable ---------------------------------------------------------------------------------------Total accounts receivable

Ratio of purchase discounts to total purchases

Total purchase discounts taken -------------------------------------------------------------------------Total purchases

Time to produce financial statements

(Financial statement issue date)  (First day of the month)

Transaction error rate

Number of errors --------------------------------------------------------------------Total number of transactions

Transactions processed per person

Number of transactions completed Number of full-time equivalents required to complete transactions

E XHIBIT 6.6

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how many have not been invoiced in the last quarter (or some other time period, as determined by management). Divide the number of noncurrent customers by the total number of customers to determine turnover. • Number of customer complaints. Any well-run company should know exactly how many customer complaints have been received, as well as the issues to which they pertain and how they were resolved. This information should be contained in a customer complaints database that is accessible to as many employees as possible. Only by tracking this information and taking corrective action as necessary can a company fix those problems that irritate customers enough to lead them to contact the company. To calculate the number of complaints, simply access the complaints database and summarize the number of complaints by time period. It is even more effective to summarize the complaints by type of complaint, which tells management what areas need the most corrective action. • Response time to customer complaints. If a customer complains and then does not receive a response within a reasonable time period, that customer is probably gone for good. By closely tracking the time it takes to respond to customer problems, management can alter the response system, which results in more satisfied customers who will continue to buy from the company. To calculate it, create a complaints database in which all contacts are logged; then subtract the response date from the initial contact date. An even better measure is to track the time it takes to completely resolve each complaint, rather than just the time to make an initial contact. These measures are summarized in Exhibit 6.7. (c) DISTRIBUTION MEASUREMENTS. Many companies seem to think that their jobs are complete once they have manufactured products; however, there is an art to delivering products to customers as quickly and with as little damage as possible. This section covers the primary measurements to use when evaluating this key function. The first measure covers the time needed to deliver products to customers, while the second explores the proportion of deliveries that meet expectations. The final measure is useful for discovering the amount of damage to products during transit. The measurements are: • Average delivery time. The distribution function is responsible for picking products, packaging them, and delivering them to the customer. If the customer is in a hurry to receive the product, the time needed to get the product into the mail is critical. To calculate this measurement, note in the company’s computer system the date and time when an order is sent to the shipping area, and compare this to the date and time when the order was listed in the shipping log as having been shipped. This is an easy calculation if the ordering and shipping functions are linked in the computer system, but otherwise very difficult. It rarely makes sense to track the time required to actually deliver the product to the customer, because the customer may specify a slow delivery method that will skew the measurement. • Percentage of on-time deliveries. It is very important that the company deliver products on the date requested by the customer. Many customers are now using just-in-time (JIT) manufacturing systems, and so they want deliveries on a specific date,. which means that they cannot Ratio

Derivation

Customer turnover

(Total customer list)  (Invoiced customers) ----------------------------------------------------------------------------------------------------------Total customer list

Number of customer complaints

Summarize complaints from complaints database for specified date range

Response time to customer complaints

(Response date)  (Initial contact date) or (Final resolution date)  (Initial contact date)

E XHIBIT 6.7

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be delivered early or late. To calculate this measurement, there must be a requested delivery date entered into the computer system for each customer purchase order; otherwise, it is impossible to determine when an order is supposed to ship. Next, there must be a shipment date recorded, against which the controller can match the required date. The computer system can then subtract the delivery date from the required date and summarize the difference for all deliveries. However, there must also be an adjustment to the calculation for the estimated shipment time to the customer. It is very useful to add a detailed listing of all “problem” shipments to this measurement, so that management can see where problems have occurred and correct them. • Percentage of products damaged in transit. Most companies do not deliver their own products to customers; a third-party carrier does it for them. The company must know if the carrier is damaging any of the delivered products, because this is not exactly good customer service, so that it can take steps to switch to a new carrier. This is a difficult measure to calculate unless customers tell the company about the damage; consequently, the best measurement point is customer complaints, which should be logged into a complaints database. The controller can then select only those complaints pertaining to damaged products, and divide this number by the total number of products shipped. If these measures are not tracked regularly, management will have no way of knowing the performance of its distribution function. The measures are summarized in Exhibit 6.8. (d) ENGINEERING MEASUREMENTS. The engineering department has a direct impact on product costs, as well as the efficiency of other departments, such as materials management and production. The measurements in this area are necessary to ensure that the key engineering functions are running properly, thereby improving the efficiency of other downstream operations. The bill of materials accuracy measurement is mandatory for ensuring that the correct quantities and types of parts are available for production. There are also several measurements, which can be used together or separately to determine the engineering department’s speed in completing new product designs as rapidly as possible, which is of considerable importance in an economy where market windows open and close very fast. A parts usage measure is crucial for determining the engineering staff’s ability to use existing parts in new products, greatly easing the work of the materials management staff, which must procure and store new parts. Finally, another measure determines the ability of the engineering staff to meet target costs; this skill is crucial for ensuring that a company prices its products at a price point that gives it a profitable share of the market. The measurements are: • Bill of material (BOM) accuracy. The engineering department has a major impact on the efficiency of the materials management department, in that it must specify in advance the materials needed to produce products. Without this information, the materials management personnel are reduced to guessing about the contents of new products, which commonly results in purchases of items that are never used, which contributes to an excessively large inventory. The materials list is commonly known as a bill of materials. To calculate its accuracy, review a bill of materials with the engineering, warehousing, and production staffs to ensure that all parts are actually needed. Each mistake, either in terms of quantities or item codes, is an error. Divide the number of accurate parts by the total list of parts needed to derive the accuracy percentage. Ratio

Derivation

Average delivery time

(Delivery date)  (Date order was sent to shipping area)

Percentage of on-time deliveries

(Required date)  (Actual delivery date)

Percentage of products damaged in transit

Damage-related complaints in complaints database -------------------------------------------------------------------------------------------------------------------------Total complaints in complaints database

E XHIBIT 6.8

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• Number of patent applications filed. Leading-edge research gives a company a good basis for building products that no one else can match. A good sign of this research is the number of patent applications filed during the period. It is easily tracked by the legal staff, which usually assists in creating and filing the necessary documents. However, filing a patent application and translating this into new products that generate sales requires lots of other activities, so patent activity is not a sure sign of future success. • Percentage of sales from new products. The previous measurement showing the number of new products is not as important as the percentage of sales being derived from them, since this is a more sure measure of corporate health. To calculate it, summarize the sales from new products (it is helpful to arrange the chart of accounts in advance to track this information) and divide by total sales. • Percentage of new parts used on products. The engineering staff should always strive to reduce the number of new parts in each product design to the absolute minimum, because not doing so entails buying from additional suppliers, as well as stocking extra parts in the warehouse, which requires an additional investment. To track it, compare the bill of materials for each new product to the existing list of parts in inventory to see which items are new. Then divide the number of new parts by the total number of parts used in the product. • Percentage of new products introduced in the period. A key measure of a company’s ability to thrive in the marketplace is the percentage of its products that are new. An old product line generally leads to declining sales, so the reverse is also true—constantly replenishing the product line leads to more revenues. To calculate the measurement, add up the number of new products introduced during the period and divide by the number of products available at the beginning of the period. This measure can be significantly skewed by how one defines a new product; if a minor product enhancement is defined as a new product, the company is only fooling itself into believing that it is creating new products. • Percentage of products reaching market before competition. It is not very useful to a company to release fabulous products to the market long after the competition when there is no one left to buy them. Instead, a company must tightly focus on bringing products to market as soon as possible, even if they are not quite as perfect as the designers would like. A good way to measure this is to manually track the product release date, and then keep abreast of release dates by competitors to see when they release similar or competing products. However, the measurement is quite judgmental, because it is sometimes difficult to determine if a competitor’s product is really similar to what a company has already released. • Percentage of released designs matching target costs. A new product will not be very profitable if the costs designed into it are so high that the company either cannot obtain a profit when selling at a competitive price, or must sell at an exorbitant price in order to obtain a profit. Instead, the controller should verify that product designs are being released that have costs matching expectations (the target cost). To calculate the measurement, simply summarize all actual costs for a product and divide them by the original target cost, which should be noted in the engineering documentation. It may also be useful to track the percentage by which released designs are missing their targets, so that management can work on gradually dropping costs down to target levels. • Time from design inception to production. The engineering staff must be able to produce new product designs as rapidly as possible in order to beat the speed with which competitors are introducing products. This is an ever-declining time period, so it is best to track the design time on a trend line, working toward extremely short design periods. To calculate it manually, note the design start and end dates and subtract the former from the later to derive the total number of design days. The design time will vary greatly by product, of course, since they may vary greatly in complexity, so it is best to track this information separately for each product line. Many companies treat their engineering departments as something of a “black hole”— they feed money into it, and new products come out from time to time, though no one knows their

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exact configurations, nor when they will be released. A better approach is to use the measurements in this section to determine the speed with which new products are being created, the efficient use of old parts in new products, and the level of detail that the department is providing the materials management personnel in terms of the parts needed to build each product. The measurements can also be used to determine the impact on sales of new product introductions. Finally, the department must be responsible for hitting prearranged target costs; there is a measurement here for determining that information. In short, this section provides the tools to attain a high level of control over the engineering department. The measures are summarized in Exhibit 6.9. (e) HUMAN RESOURCES. The human resources department fulfills a wide variety of tasks, some of which must be completed properly if a company is to avoid government fines, promptly fill new positions, and avoid excessive levels of overhead. The measure that is central to the needs of a growing firm that has an insatiable need for new employees is the time needed to fill requested positions. Other firms with lesser hiring needs may concentrate on fulfilling government requirements, such as the percentage of minorities on the payroll. There are several other measures covering the trend of fringe benefits or indirect labor to direct labor, which are useful for determining the trend of employee-related costs. For a more progressive company that wants to have a highly trained staff, there is also a measurement for tracking the percentage of employees with certifications. Some combination of these measurements will fulfill the requirements of most human resources departments. The measurements are: • Average time to fill requested positions. One of the human resources department’s most important tasks is to assist in finding good candidates for requested positions throughout the company. In an explosive growth company, where continued growth is almost entirely dependent on finding additional staff, this is the department’s most critical function. To calculate it, create a log book in which the date of all new position requests are received by the human resources staff, as well as the date on which offer letters are accepted by recruits; the difference between the two dates is the average time to fill requested positions. • Average yearly wage per employee. It is of moderate use to management to know the average annual pay of its employees, since this gives it some idea of the company’s pay levels as compared to the industry. For example, if the employee turnover rate is high and the average Ratio

Accuracy

BOM accuracy

Number of accurate parts per BOM ------------------------------------------------------------------------------------Total list of parts on BOM

Number of patent applications filed

Number of applications logged in as having been sent during the period

Percentage of new products introduced in the period

Number of new products introduced in the period Number of products available at the beginning of the period

Percentage of sales from new products

Revenues from new products ---------------------------------------------------------------------Total revenues

Percentage of new parts used on products

Number of new parts in BOM ---------------------------------------------------------------------------------Total number of products released

Percentage of products reaching market before competition

Number of products released before competition -------------------------------------------------------------------------------------------------------------------Total number of products released

Percentage of released designs matching target costs

Summary of actual product costs ------------------------------------------------------------------------------Summary of target costs

Time from design inception to production

(Completed design and signoff date)  (Design start date)

E XHIBIT 6.9

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pay rate is low, this may be an indication that the company must start offering higher pay rates in order to retain staff. To calculate it, use a report writer to create a standard report listing everyone’s pay rate; this usually requires two lists, one for the hourly staff and one for the paid staff. Then summarize each list. Multiply the total on the hourly employee list by the total number of standard hours worked in a year (usually 2,080), and multiply the total on the salaried employee list by the total number of pay periods. Then add the two lists together and divide by the total number of employees. This calculation may be slightly skewed if there are many part-time employees, since this will translate into a very low annual pay rate. • Employee turnover rate. By far the most important measurement in the human resources area is employee turnover. It is exceedingly expensive to recruit and train new employees, so management must tightly focus on retaining all current staff. To calculate it, add up the number of people who have left the company, and divide by the number of employees at the beginning of the measurement period. It may be useful to subdivide this measurement so that the most critical departments, such as engineering, are tracked separately. • Indirect to direct personnel ratio. Management may want to know if a company is becoming top-heavy with an excessive number of people in the overhead areas, such as administration, accounting, or engineering. Changes in this proportion are most clear when tracked over time (perhaps annually). To calculate it, summarize the number of personnel in overhead positions (the easiest way is to use the payroll system to list personnel by department) and divide that number by the total in direct labor positions (i.e., the production department). Another way to measure this is to use payroll dollars instead of headcount, which gives a more accurate picture of a company’s proportional investment in indirect labor. • Minorities percentage. Depending on the size of a company, there may be federal government reporting requirements for the percentages of various types of minorities in a company. If so, the best way to track this information is to record a minority code in the payroll or human resources computer systems for each person, so that a simple computer query can extract the information needed for various government reports. • Percentage of employees with certifications. A company with many certified employees is a company with a great knowledge base that will contribute toward constant system improvements. Certifications fall into nearly every functional area, from certified management accountants to certified engineers. This information can be recorded in the human resources database with a code, and can be extracted with a simple query. To calculate it, divide the total number of people with certifications by the total number of employees. This measurement can be subdivided into departments, so that management can determine the skill levels by functional area. • Ratio of fringe benefits to direct labor. The human resources staff is responsible for the cost (though not necessarily the types) of fringe benefits offered to the staff, which is principally comprised of medical insurance. Senior management sometimes looks at the ratio of fringe benefits to direct labor to see if too much is being spent on fringe benefits, and may cut back in this area if they perceive that to be the case. To calculate it, manually summarize the fringe benefit cost per person (or else accumulate the information through general ledger accounts) and divide it by the direct labor cost, which is usually obtained through the payroll system. • Trend of headcount. Some managers like to review the number of people in each department, preferably on a trend line, to spot unusual changes in headcount. This is most informative when tied to various activity measures (usually revenues), so that there is a direct relationship between an activity and headcount. Headcount is easily extracted from the payroll database, though one must be careful to translate any part-time staff to full-time equivalents to ensure comparability across time periods. There are many measurements available to track the performance of the human resources staff, or of the employees for whom they are responsible. Not all of these measurements should be used at one time, however. For example, a rapidly growing company will focus primarily on the department’s ability to rapidly recruit new people and will want to know about employee turnover, but a

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more staid organization may be more interested in obeying rules and regulations, and so will focus on minority percentages. For this area, the controller must fit the measurements to the circumstances. The measures are summarized in Exhibit 6.10. (f) MATERIALS MANAGEMENT MEASUREMENTS. Recent developments in the materials management area can make this one of the most streamlined operations in a company. Measurements are needed to verify the extent of the department’s efficiency. For example, inventory accuracy is needed to ensure that a material requirements planning (MRP) system operates properly. Also, an inventory turnover measurement is needed to verify the outcome of MRP and JIT systems. In addition, there are several measures for determining the department’s success in shrinking the number of suppliers, as well as of switching to more efficient electronic commerce systems. It is also important to track the percentage of on-time parts delivery, since this impacts the ability of the production department to complete new products on time. The measurements are: • Inventory accuracy. The inventory database must accurately reflect the quantities, part numbers, and locations of all inventory in stock. If not, the materials management staff cannot be sure about what materials are in stock, and will probably purchase extra materials to cover this level of uncertainty, which increases the inventory investment as well as the potential level of obsolescence. To measure it, print out a listing of the inventory and its locations and audit a significant sample from the listing. Divide the number of test items with correct information by the total number sampled to obtain the accuracy percentage. • Inventory turnover. An extremely important measure is inventory turnover. This tells management the proportion of inventory in stock (as raw materials, work-in-process, and finished goods) as compared to the cost of goods sold. A high proportion of inventory indicates that there is an excessive investment in working capital that is a good target for reduction. To calculate it, add up the cost of all inventory and divide by the annualized cost of goods sold. This calculation can be skewed if there is a large amount of finished goods on hand (which can fluctuate widely if sales are highly seasonal). Ratio

Derivation

Average time to fill requested positions

(Date offer letter is accepted by recruit)  (Date of receipt of position request)

Average yearly wage per employee

(Summary of all hourly wages  number of annual working hours)  (Summary of all salaries) Number of employees

Employee turnover rate

Number of employee departures -----------------------------------------------------------------------------------------------------------Number of employees at beginning of period

Indirect to direct personnel ratio

Number of personnel in overhead positions ------------------------------------------------------------------------------------------------------------Number of personnel in direct labor positions or Total payroll of overhead positions ----------------------------------------------------------------------------------------Total payroll of direct labor positions

Minorities percentage

Summarize by minority code in payroll or human resources systems

Percentage of employees with certifications

Number of employees with certifications -------------------------------------------------------------------------------------------------Total number of employees

Ratio of fringe benefits to direct labor

Total fringe benefit expense ------------------------------------------------------------------Total direct labor expense

Trend of headcount

(Total full-time employees)  (Total full-time equivalents for part-time employees)

E XHIBIT 6.10

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• Number of suppliers used by commodity code. The materials management staff can become overwhelmed if it is managing too many suppliers. It is better to utilize the services of a smaller number of suppliers, so that a company has enough time to implement supplier rating systems, electronic data transfers, and mutual product designs with a limited group of business partners. An excessive number of suppliers in each commodity code is a clear indicator that some shrinkage of the supplier base is in order. To calculate it, use the accounts payable database to create a list of all suppliers from whom the company has made purchases in the last year, and sort the list by commodity code. • Obsolete inventory percentage. An excessive amount of obsolete inventory is an indicator of too much inventory on hand (since not all of it is being used), an inadequate materials management system (since it is not using up in-house parts), or of the unwillingness of management to dispose of old parts. In any of these cases, a controller needs to emphasize that eliminating the root causes of obsolescence are a primary method for reducing materials costs. To calculate it, use the materials management system to extract all inventory records for which there has been no inventory movement for a long time (which can vary from a few months to years, depending on the industry); when the costs of these inventory items are divided by the total inventory cost, this yields a rough measure of total obsolescence. The measure can be skewed by items that are old, but which can be sold—a review by management will easily uncover these items. • Percentage of on-time part deliveries. The most important function for the materials management staff is to ensure that materials arrive on time, so that the production process is not held up. This requires tight control over the arrival of needed materials. To calculate this measurement, create a report in the computer system that compares the requested arrival date on all company purchase orders to the dates on which parts were actually received (which should be entered by the receiving staff). If these portions of a company’s systems are not run with computers, the measurement is nearly impossible to calculate. • Percentage of suppliers using electronic data interchange (EDI). The materials management staff can operate more efficiently if it conducts electronic purchasing and other transactions with suppliers. By doing so, it reduces the time required to transfer information, and, depending on the interfaces used, can even lead to the near-automation of most transactions. To measure it, manually summarize the number of suppliers with whom the company has EDI links, and divide by the total number of suppliers with whom the company did business in the past year (which is obtained from accounts payable records). • Total number of components. Many companies are overwhelmed with an excessive number of parts, many of which have not been used in a very long time, but which the materials management staff must still track. If there is an excessive amount, the best management action is to undertake a detailed review of parts usage to see what can be eliminated from stock. To calculate this measurement, simply run an inventory listing for all items currently in stock, and add up all the line items. It is also helpful to compare the number of parts to sales, since the number of parts will probably increase with revenues. It is also useful to create a “where used” report that shows the products for which each part is used; if a part is in stock but is not used on any current products, then it is a prime candidate for elimination. Today’s competitive pressures almost always result in some changes in the materials management area, either to electronically link to suppliers and customers, or to increase the speed or efficiency with which materials are procured and sent to the shop floor. The amalgam of measurements in this section will serve the controller in determining departmental performance for almost any performance improvement project. The measures are summarized in Exhibit 6.11. (g) PRODUCTION MEASUREMENTS. The production department has been greatly impacted by JIT production methods, and to a large extent the measurements in this section are needed to identify its success. A key JIT concept is reducing equipment setup times, so there is a measurement for that. Also, there is a measure for tracking the proportion of successfully completed products;

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Ratio

107

Derivation

Inventory accuracy

Number of accurate test items -----------------------------------------------------------------------Number of items sampled

Number of suppliers used by commodity code

Sort accounts payable list of suppliers by commodity code

Obsolete inventory percentage

Cost of inventory items with no recent usage ----------------------------------------------------------------------------------------------------------Total inventory cost

Percentage of on-time part delivery

(Actual arrival date)  (Requested arrival date)

Percentage of suppliers using EDI

Number of suppliers with EDI linkages ---------------------------------------------------------------------------------------------Total number of suppliers

Total number of components

Summary of all inventory line items

E XHIBIT 6.11

M ATERIALS M ANAGEMENT M EASUREMENTS

under JIT, this should be very nearly 100%. The turnover of work-in-process inventory should also increase under a JIT system, so there is a supporting measurement here for that. There are also more traditional measures that are not used in JIT, such as the percentage of scrap, and labor productivity. The measurements are: • Average equipment setup time. In a just-in-time manufacturing environment, it is critical to only produce what is immediately needed. However, most companies still make long production runs, even though this generates more products than are needed. They do this because the production equipment takes so long to set up that it is only cost-effective to make long production runs. The solution, then, is to reduce the length of the equipment setup times. This is tracked separately for each piece of equipment, and is usually done by either the production or process engineering staffs. The calculation is simply the time (in hours, minutes, or seconds) required to switch a machine over from one type of production to another. • Percentage of acceptable products completed. Management should know what proportion of every production run results in good products that are acceptable for sale. This is absolutely critical in an industry such as chip wafer manufacturing, where yield rates may be as low as 20 percent. To calculate the measurement, create a system for collecting and counting all unacceptable products from a production run, and then divide this amount by the total of all products created in the run (either acceptable or not). It may only be necessary to aggregate this information for a single monthly measurement, but it is more common to run the measurement by product line, since yield may vary dramatically by type of product. • Percentage of scrap. A good way to determine if the production department is making efficient use of materials is to track the amount of scrap falling out of the manufacturing process. An excessive scrap amount is an indicator of a variety of items, such as improper machine setup (which requires extra material to test it), employee theft of materials, and faulty products that are detected during the production process and thrown away. Due to the large number of underlying problems, this measure should be considered only a symptom of the real problem, with much additional work required to discover the underlying issues. There are several ways to calculate the measurement. The most inaccurate is to throw all scrap into scrap bins, and then periodically weigh the bins to estimate the cost of what is inside. A more accurate approach is to use an MRP system to determine the material cost that should be required for scheduled production, and then compare this to the actual cost to determine the difference. It can be especially difficult to determine the cost of products that were scrapped after some amount of labor and overhead had already been applied to them. • Unit output per employee hour. A company that operates along traditional lines, using long production runs, wants to know about the ability of its employees to churn out products at the highest possible speed. This measurement is no longer used in a JIT environment, where the

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emphasis is on only producing what is needed, rather than producing at the fastest possible rate. Also, focusing on this measure tends to increase the production error rate, since employees will complete products irrespective of problems, because they are being judged on their speed, not their accuracy. Nonetheless, if a controller still wants to calculate this measurement, the best approach is to aggregate all personnel in an assembly line or on a specific job, add up the hours worked from payroll records, and divide this amount by the number of products completed during the same time period. This number will be inaccurate if the payroll hours include a holiday for which employees are being paid. The number will also be incorrect if the output is based on direct labor dollars (instead of hours), because the dollar amount can be considerably increased by overtime or shift differentials. • Work-in-process (WIP) turnover. A company that is focusing on improving its JIT manufacturing systems uses the WIP turnover rate as one of its primary measures of success. This is because a properly functioning JIT system requires very little inventory in the manufacturing process, so the WIP turnover rate should be very high. To calculate the measurement, take the period-end work-in-process figure from the general ledger and divide it by the cost of goods sold for the year. This measure should be tracked on a trend line, since anyone involved in a JIT system will want to track it as direct evidence of the success of the system. Traditional production systems focus on improving the speed of output, while newer systems tend to focus on product error rates and the amount of work-in-process. This section has the measurements a controller needs to track the performance of either type of system. The measures are summarized in Exhibit 6.12. (h) SALES AND MARKETING MEASUREMENTS. The sales department represents the controller’s leading edge of information about conditions in the marketplace. Measurements for this area must be constructed that yield as much market information as possible. One is market share, which reveals a company’s share of the market “pie.” Another key factor is a company’s ability to convince customers to sole source their purchases through it. Also, several other departments depend on the sales staff to keep a steady flow of orders coming into the company; a backlog measurement is a prime advance indicator of potential trouble. Finally, there are several sales trend lines to watch that indicate problems with the rate of sales growth (or decline) that are of use when planning for new products or upgrades to existing products. These measurements follow: • Market share. Sometimes an upward trend in sales volume disguises a decline in market share. For example, upward sales growth in the computer industry means little, when everyone’s sales are growing; only growth that exceeds the growth of competitors matters, because this allows a company to exercise economies of scale, thereby lowering costs and reaping greater profits than competitors. Market share is a difficult item to measure; the best calculation is to fund an industry trade group that releases an annual or quarterly market share surRatio

Derivation

Average equipment setup time

(Start time for new production run)  (Stop time for last production run)

Percentage of acceptable products completed

Number of rejected products ------------------------------------------------------------------------------------------Number of products in production run

Percentage of scrap

(Actual cost of goods sold)  ( Standard cost of goods sold ) -----------------------------------------------------------------------------------------------------------------------------------------------Standard cost of goods sold

Unit output per employee hour

Aggregate output per production area -------------------------------------------------------------------------------------------Total hours worked in production area

WIP turnover

Total work-in-process -------------------------------------------------------------Annual cost of goods sold

E XHIBIT 6.12

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vey. If there is no trade group, the marketing staff must conduct its own research, which will probably be moderately inaccurate; nonetheless, either method will reveal changes in market share over time that management should act on as necessary. • Number of major accounts for which the company is the preferred supplier. The ultimate goal of any sales department is to make the company the sole supplier to the best customers. This allows it to incrementally raise prices enough to reap good margins, while at the same time avoiding an excessive number of sales contacts, which merely increase overhead costs. To calculate it, the sales staff must contact suppliers to determine company sourcing status; the total number of these customers must then be divided by the list of active major customers. This is a difficult measurement to construct, for there may be some debate regarding what constitutes a major account; the best approach is to set a hard limit on sales volume from each customer during the previous year—if a customer exceeds that level, it is designated a major account. • Ratio of backlog to sales. The sales department must support the production department in having enough sales on hand to avoid a significant slippage in the flow of production, which may result in major layoffs in the production area. It helps to maintain a consistent pattern of sales, too. A good control point is to constantly compare the dollar volume of backlog to a short-term record of sales to see if there are sudden changes in the backlog that require immediate action by the sales force. To calculate it, summarize the dollar value of all orders not yet in production (which is usually available on the production backlog report), and divide it into a rolling average of the last three months’ sales. • Sales trend by product line. The sales and engineering staffs need to know when the trend of product sales is beginning to slow or decline, so that they can either run promotions to increase sales (a function of the sales and marketing staffs) or renew sales with replacement products. To do this, there should be a trend line, preferably in graphic form, for each product line. To calculate it, accumulate product sales under different sales codes or general ledger accounts, and transfer the monthly sales information to a graphical display. It is dangerous to report this information on an excessively summarized level, since it may hide a multitude of sales variations for separate products or product lines that are being grouped into a single trend line. A controller should track all of the measurements in this section, because each one shows a different aspect of the sales and marketing functions, and all of them are important. One must track market share, as well as the trend of sales by product line, while it is always prudent to determine the size of the backlog. Finally, the sales staff should always strive to achieve sole-source status with suppliers, and the controller should remind them of this responsibility by tracking that information and reporting it back to them. All of these measures are key to controlling the sales and marketing department. The measures are summarized in Exhibit 6.13. Ratio

Derivation

Market share

Dollar volume of company shipments -----------------------------------------------------------------------------------------Dollar volume of industry shipments

Number of major accounts for which the company is the preferred supplier

Number of major sole-source customers -----------------------------------------------------------------------------------------------Number of major customers

Ratio of backlog to sales

Dollar volume of all orders not yet in production --------------------------------------------------------------------------------------------------------------------Average of sales for last three months

Sales trend by product line

Summary of sales by product code or (Summary of current period sales by product code)  (Summary of previous period sales by product code) Summary of previous period sales by product code)

E XHIBIT 6.13

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(i) CYCLE TIME. There is one measurement that cuts across all departmental boundaries. That is cycle time, which is used to determine the time taken to complete a transaction. Because many transactions cut across departmental boundaries, the measurement is placed here, rather than under the previous department headings. This is also done to emphasize the importance of the measurement. Poor cycle time leads to very slow customer service, which is bad for customer retention and therefore revenues. This is a very important item for a controller to track. Major processes, such as order fulfillment, run through multiple departments, and so are not actively tracked by individual departments (they just blame problems on the other departments that are also involved in the process). However, these are frequently the cause of major inefficiencies in a company, and so the controller should periodically review the time required to process transactions through them, so that management has a clear understanding of the time interval (or “cycle time”) needed. The calculation will vary depending on the process, but the basic method is to create a set of standard transactions and run them through a process, taking note of the beginning and ending dates (or times). The average transaction length becomes the official cycle time for the process. It is very important to not only know the time needed to process transactions, but also to constantly strive for better performance. Thus, a controller should continually track cycle times to enhance a company’s level of performance and competitiveness. The measure for cycle times is summarized in Exhibit 6.14. Ratio Cycle time E XHIBIT 6.14

Derivation (Process end time)  (Process start time) C YCLE T IME M EASUREMENT

6.9 INTERRELATIONSHIP OF RATIOS Focusing on a problem ratio and resolving the underlying issues can create problems with other related ratios. For example, a company’s debt covenant may specify a current ratio of 2:1. If the ratio is 1.5:1, the controller can borrow money and retain the cash to improve the current ratio. However, the controller’s action also worsened the company’s ratio of long-term debt to shareholder’s equity. The controller must be aware of changes to other ratios that may result from fixing seemingly unrelated measurements. A number of impacts on related ratios are noted in Exhibit 6.15.

6.10 SETTING UP A SYSTEM OF RATIOS AND TREND ANALYSES There are enough measurements in this chapter to keep even the most analytical controller happy. However, there are so many that issuing all of them will drown the management team in a flood of data that it has no time to read. The controller must select only a portion of all measures for perusal by management. The controller must know how to pick the correct measures and how to present them in a clear and understandable format. The first step is to match the measurement system to company objectives. Some management teams are driven by strong revenue growth, because they have a tight focus on grabbing as much market share as possible; this is common in a new industry. For this situation, there should be a preponderance of measures that closely track all changes in revenue streams. Other companies are in slow-growth industries where the focus is on gaining a slight edge in profitability over the competition. In this case, the bulk of the measures should track gross and net margins and the key components thereof. Another common occurrence, especially in high technology industries, is for corporate success to be largely driven by the organization’s ability to acquire and retain the best employees. In this case, the most important measurements may not even be financial — they are human resources related, such as employee turnover percentages and the time needed to fill open positions. Consequently, company objectives play a strong role in a controller’s choice of measures to report.

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A Change in This Ratio

111

Impacts These Ratios

Current ratio

Management improves the ratio by borrowing money and retaining the cash: the ratio of long-term debt to sharedholder’s equity worsens because debt has increased.

Ratio of long-term debt to shareholder’s equity

Management improves the ratio by liquidating short-term investments to pay down the long-term debt; the current ratio worsens because investments have been reduced.

Ratio of net sales to receivables

Management improves the ratio by factoring receivables: the ratio of net profits to net sales worsens because there is a service charge associated with factoring the receivables.

Turnover of inventories

Management improves the ratio by selling off inventories; the ratio of gross profit to net sales worsens because management must pay premium prices to buy raw materials on short notice and ship it to the company by express freight.

Ratio of net sales to working capital

Management improves the ratio by extending payables; the ratio of gross profit to net sales worsens because suppliers will not ship additional raw materials, so management must pay premium prices to buy raw materials on short notice and ship it to the company by express freight.

Ratio of repairs and maintenance to fixed assets

Management improves the ratio by cutting the amount of maintenance work on equipment; the ratio of net income to net sales worsens because production capacity drops when equipment breaks down.

Number of times fixed charges are earned

Management improves the ratio by using cash on hand to pay down debt; the current ratio worsens because the cash is used.

Ratio of gross profit to net sales

Management improves the ratio by increasing prices; the ratio of net income to net sales worsens because fewer people buy the product at the higher price.

Ratio of operating expenses to net sales

Management improves the ratio by reducing the accounting department’s payroll; the ratio of gross profit to net sales worsens because there is no cost accountant to review increased product costs.

Ratio of net income to net sales

Management improves the ratio by selling manufacturing equipment and recording a gain on the sale; the ratio of gross profit to net sales worsens because production capacity is reduced, and production must be given to subcontractors at a higher cost.

E XHIBIT 6.15

I MPACT

ON

R ELATED R ATIOS

Another important consideration for creating a measurement system is the strengths and weaknesses of a company’s controls. For example, if there are many divisions, all of which handle a large amount of cash, it is reasonable for a controller to create many cash-related measurements that track cash receipts and disbursements, as well as the company’s ability to collect the cash from all divisions and properly invest it. Another example is inventory systems; if there is a strong JIT manufacturing system in place, then there is little need to expend an excessive amount of company resources on measuring the small amount of inventory needed to maintain it. However, a befuddled manufacturing system may call for a considerable amount of inventory measuring — perhaps weekly or even daily — as well as constant tracking of obsolete inventories. If there are strong controls already in place, such as a billing system that creates perfect customer billings, then there is little need to measure it. However, strong controls frequently become strong because employees know that they are being measured; completely removing the measurement tells employees that

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the control is no longer important, so they do not expend the same effort to keep the control strong. Consequently, it is less necessary to measure strong control points than weak ones, but these measurements should not be completely eliminated; instead, they should be conducted less frequently. A key consideration that is all too frequently ignored is the time needed to collect information that forms the basis for a measurement. If the data collection systems needed to calculate a measurement are not in place, a controller should seriously consider abandoning the measurement unless it is absolutely critical or it is only needed for a single measurement, not to be repeated. For example, if a controller receives a request for sales broken down by product but finds that the accounting system will not easily divulge this information, the only option in the short term may be to go through all invoices issued for the month and manually summarize the information. Clearly, this is not a viable option for the long term. If the controller cannot find a more automated approach to collecting the information, it is time to discuss the cost of collecting the data with the person requesting the information to see if it is really needed. Too often, a controller simply goes on wasting time month after month, issuing measurements that require vast amounts of manual labor, when the information was only needed once. Continual communications with management is the key to keeping away from using labor-intensive measurements. Another approach is for a controller to track all possible measurements, but to only report those results to management that do not meet expectations. For example, the accounting staff can track every conceivable measurement related to the engineering department, but only reveal those measurement results that show problems. Though this approach will tightly focus management attention on problem areas, there are several reasons for not using it. One is that, even though only high-variance measures are being reported, some of these measures may be in areas so unimportant that management is simply being distracted from more important tasks. For example, high employee turnover among the distribution personnel may not be an issue if the company is a newspaper, where high turnover among the newspaper delivery people is an expected part of the business. Another reason is that this approach puts a large burden on the accounting staff. Many measures must be manually calculated, and doing this for a very large number of measures is not a good use of staff time. Finally, management can become confused when it is presented with a different set of measurements every reporting period; some measures may be unfamiliar, so the controller must retrain management to understand the new measures. This not only wastes the controller’s time, but it also interferes with the orderly conduct of management work. Consequently, tracking all measures and reporting by exception is probably too labor intensive and complicated to be an effective measurement presentation approach for most companies. An example of how to determine what ratios to track follows: Leforto Electronics designs circuits for other manufacturing companies. It has no inventories, and most of the staff is in the engineering department. The company is growing at a very rapid rate through increasing sales to a small number of key accounts. In this case, the controller can safely avoid measurements for inventory. Because engineers are generally hard to come by, there should be a measurement to track employee turnover, as well as one to track the time needed to acquire new recruits. Given the small number of customers, a customer turnover statistic may be of some importance. Also, since the company does nothing but design circuits, it is reasonable that profitability is closely tied to the speed with which the engineers complete their design work, so a measurement should track the percentage of design jobs completed on time. Finally, given the small number of customers, it is possible that there are a few large invoices to customers, which makes cash receipts very “lumpy.” Given this issue, there is a strong need to monitor the age of accounts receivable, as well as short-term cash forecasts. This is a simple example, but it is evident that the measurement systems needed for Leforto Electronics will vary considerably from companies in other industries, where the underlying operating conditions might make all of Leforto’s measurements useless, while calling for a completely different set of measures. A good example of a company that must use an entirely different set of measurements is a manufacturing company. This one we shall call Manfred Manufacturing. This company builds a large number of products, which requires a large number of component parts. It sells them to a large number of distributors, most of whom buy in small quantities; some are old friends of the owners. The industry is a mature one, so profit margins are low. The direct labor content of most products

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is high. In this case, there is no need to track engineering variances at all. Instead, there must be a strong emphasis on inventory tracking as well as obsolescence, since this probably constitutes a large part of the balance sheet. In addition, there must be careful margin tracking for all products and product lines in order to find and correct the prices of products with low margins. Also, because some customers are friends of the owners, it seems likely that their credit standing is being ignored, so close tracking of overdue accounts receivable is critical. Finally, because of the large labor component in product costs, the controller should adopt measurements for tracking labor efficiency as well as hours charged to specific jobs. In comparing these two examples, it is evident that a controller must take into account such disparate items as a company’s industry, number of customers, preponderance of certain departments, and even owner friendships when devising a good set of performance measurements.

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CHAPTER

7

INTERNAL CONTROL SYSTEMS 7.1 INTRODUCTION 115 7.2 OBJECTIVES 115 7.3 RESPONSIBILITY FOR INTERNAL CONTROLS 116 7.4 EXAMPLES OF INTERNAL CONTROLS 117 7.5 WHEN TO ELIMINATE CONTROLS 119

7.6 TYPES OF FRAUD 121 7.7 PREVENTING FRAUD 122 7.8 HOW TO DEAL WITH A FRAUD SITUATION 125 7.9 FOREIGN CORRUPT PRACTICES ACT 126

7.1 INTRODUCTION Historically, the reason a company places emphasis on its internal control systems is to keep fraud from occurring. Although reducing fraud losses is still a valid concern, more companies are now emphasizing internal controls because they monitor the consistency with which transactions are completed. This change in emphasis has been brought about by the realization that a company can generate a significant competitive advantage by improving the quality and speed of delivery of its products by tightly monitoring its systems. Thus, internal controls are used not only to combat fraud but also to monitor the consistency and completion speed of transactions. Besides objectives, this chapter also notes how responsibility is assigned for various controls. This is not a simple issue, because controls spread across many departments, making it difficult to pin down the reason for a control failure. In addition, the chapter contains an elementary set of control points that are useful for controlling the most basic company functions. Though by no means complete, they give the reader a rough overview of the types of controls that a controller should consider installing. In addition, controls may eventually outlive their usefulness due to changes in the business. Accordingly, guidelines are provided on how to spot and eliminate these controls. Fraud is then discussed: the types of fraud one encounters, how to detect it, and how to prevent it. Most controllers will encounter a case of fraud at some time in their careers, though it may be as minor as petty cash pilferage, so these sections serve as a good reference point for how to identify, prevent, and deal with such problems. Finally, the chapter notes the main points of the Foreign Corrupt Practices Act, which is a federal law that directly impacts a company’s internal control systems. In short, this chapter provides an overview of controls—why they are used, how to create them, and when to eliminate them.

7.2 OBJECTIVES It is not sufficient to scatter a large number of controls throughout a company’s transaction processing systems, because this random approach may result in an insufficient number of controls over key risk factors, while adding an excessive number of controls in areas where there are few risks. The upshot of a control system that is poorly planned is a high-risk transaction environment that is nonetheless burdened with an excessive number of controls. This section discusses the primary 115

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control objectives that a controller should consider in order to implement only those controls that are most important for a specific set of transactions. The main control objectives are: • Authorization. Was the transaction authorized by management? This could be evidenced in a general way by establishing related policies, contract authorization limits, investment limits, and standard price lists; or specific authorization may be needed in a given situation. • Reconciliation. Periodic reconciliations of physical assets to records, or control accounts, should be made. This can include bank reconciliations, securities inventories, physical inventories of raw materials, and comparison of work-in-process and finished goods to control accounts. • Recording. Transactions should be recorded, not only in the proper account, but also at the proper time (i.e., proper cutoff ) and with the proper description. No fictitious transactions should be recorded, and erroneous material and incomplete descriptions should be avoided. • Safeguarding. Physical assets should not be under the physical custody of those responsible for related recordkeeping functions. Access to the assets should be restricted to designated individuals. • Valuation. Provision should be made for assurances that assets are properly valued in accordance with generally accepted accounting principles (GAAP) and that the adjustments are valid. These five control objectives relate to the prevention of errors and the detection of any errors or irregularities in transactions. They must be considered when the evaluation of an internal control system is made.

7.3 RESPONSIBILITY FOR INTERNAL CONTROLS Although the controller has a major involvement in the design and maintenance of internal controls, he or she is not the only one responsible for internal controls. This is an especially important factor to consider because of the Foreign Corrupt Practices Act (see Section 7.9), which can entail jail terms for senior company management if there are inadequate control systems. In addition to this factor, there are many control systems that extend beyond the reach of a typical controller’s jurisdiction; therefore, other people within a company must take a hand in creating and maintaining those systems. This section discusses the various positions within a company that are responsible for internal controls, as well as the extent of that responsibility. They are noted as follows, in descending order by position: 1. Board of Directors. This group is ultimately responsible for a company’s control systems, as it is responsible for total company performance. Unfortunately, it operates at such a high level that it cannot adequately monitor, or even have a knowledge of, all key control systems. It can alleviate this problem by forming an audit committee to which the internal audit department reports; this allows the Board to closely monitor all reviews of the control system, which allows it to mandate changes that are deemed necessary by the internal audit staff. 2. Senior management. Although the Board of Directors is theoretically responsible for the adequacy of controls, it is senior management that actually has this responsibility from a practical perspective. This is because senior management is “closer to the action,” with a much more detailed knowledge of operating conditions. Accordingly, the senior management team must ensure that there is an efficient and effective system of internal controls that results in accurate financial information, as well as the safeguarding of assets. Senior management must: • Assume responsibility to shareholders for the accuracy of financial reporting. • Create and maintain a properly documented internal control system. • Create and maintain the proper environment to enforce the necessary controls. This may require the use of policies, procedures, and statements of ethical standards to enforce.

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• Identify the risks inherent in the business and the potential for errors and irregularities in various parts of the transaction processing systems. 3. Financial management. Though other members of management have responsibility for the adequacy of controls, this burden falls heaviest on the members of the financial management team, for they are presumed to have the highest degree of training and experience in this area. Also, the majority of control points are typically installed in areas that are under the direct control of the financial managers. Consequently, from a practical perspective, these employees have the bulk of the real responsibility for controls. The financial management team must: • Know the technical requirements of a sound financial control system and how to create such a system based on the nuances of the existing business. • Verify that a sufficient number of controls are installed and that they operate in a satisfactory manner. • Enforce conformance to all controls, as noted in policies and procedures. • Assume direct responsibility for the accuracy of the information contained in periodic financial statements and accompanying notes. 4. Internal audit staff. This group has a major impact on the presence of adequate control systems. It is responsible for reviewing the existence and effectiveness of control systems in a variety of areas, and reports to management on the adequacy of those controls, as well as any deficiencies. However, the audit program followed by this group is usually approved by the internal audit committee, which is a subset of the Board of Directors. If this program is inadequate, the internal audit staff will not conduct a sufficient number of reviews to ensure the adequacy of internal control systems. Also, this group is not empowered to change any control systems; instead, it only reports on problems. This limits the effectiveness of the internal audit staff in forcing necessary changes to control systems. 5. Independent auditor. This position is listed as the lowest of the management positions, although in reality it is located here simply because it is the only position in the list that falls outside of the corporate hierarchy. As part of an outside auditor’s audit of a company’s financial statements, it is customary to determine the strength of the underlying control systems that support those statements. If weaknesses in the control systems are discovered, the auditor is in a unique position to report this information to senior management as well as the Board of Directors as part of a management report that frequently accompanies the audited financial statements. The reported weaknesses can also be accompanied by recommendations to improve the situation. If management wants additional assistance from the auditors, they can be called on to provide educational materials or training to the company, as well as a more complete review of the control systems. However, a controls review is considered only to be part of the audit work for a full audit, and not for a review or compilation; these two lesser forms of financial review are increasingly common for many companies, so in these cases, the external auditor has minimal impact on or responsibility for the state of a company’s control systems. Responsibility for the adequacy of a control system is spread throughout a company, with theoretical responsibility residing in the Board of Directors and practical responsibility sitting squarely on the shoulders of the financial and senior managers. This group is assisted by the internal and external auditors, who can recommend changes to existing controls but do not have the authority to make any changes.

7.4 EXAMPLES OF INTERNAL CONTROLS This section provides a “laundry list” of controls that are commonly used. Controllers can pick from this list when creating control systems for their companies. However, do not be misled into

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believing that the only crucial controls are noted below. On the contrary, there are many controls that are industry-specific that will not be found anywhere in this book. To gather information about these special controls, it is useful to consult with an external auditing firm that has experience in a specific industry, or obtain advice from an industrial trade group with similar expertise. Conversely, it is not necessary to implement every control listed in this section, because this would introduce a great deal of inefficient control redundancy. The best use of this section is as a reference for carefully selecting controls that can be shaped and altered to fit a company’s specific needs. The controls are grouped by balance sheet and income statement category. They are: • Cash
Compare check register to actual check number sequence.
Control check stock.
Control signature plates.
Perform bank reconciliations.
Review uncashed checks. • Investments
Impose investment limits.
Require authorizations to shift funds among accounts.
Verify that investments do not exceed federally insured limits. • Accounts receivable
Require approval of bad debt expenses.
Require approval of credits.
Require constant review of old accounts receivable. • Inventory
Conduct inventory audits.
Require approval to sign out inventory beyond amounts on pick list.
Restrict warehouse access to designated personnel. • Employee advances
Continually review all outstanding advances.
Require approval of all advance payments to employees. • Fixed assets
Ensure that fixed-asset purchases have appropriate prior authorization.
Verify that correct depreciation calculations are being made.
Verify that fixed-asset disposal are properly authorized.
Verify that fixed assets are being utilized. • Accounts payable
Compare payments made to the receiving log. • Notes payable
Require approval of the terms of all new borrowing agreements.
Require supervisory approval of all borrowings and repayments. • Revenues
Compare all billings to the shipping log. • Cost of goods sold
Compare the cost of all completed jobs to budgeted costs.
Pick from stock based on bills of material.

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Purchase based on blanket purchase orders and related releases.
Reject all purchases that are not preapproved.
Require approval of all overtime expenditures.

• Travel and entertainment expenses
Audit expense reports at random.
Issue strict policies concerning allowable expenses.
Require supervisory approval of all expense reports. • Payroll expenses
Require approval of all overtime hours worked by hourly personnel.
Require approval of all pay changes. • Occupancy expenses
Compare the cost of employee furnishings to company policy.
Compare the square footage per person to company policy. • General
Audit credit card statements.
Impose a total monthly dollar limit on credit card purchases.
Impose single transaction limits on credit card purchases.
Impose supplier exclusions on credit card purchases.
Require supervisory approval of credit card statements. • Other: Contracts
Require monitoring of changes in contract costs.
Require monitoring of when contracts are due for renewal.
Require specific authorizations for various levels of monetary commitment. The controls noted in this section are among the most common ones used, irrespective of the type of industry. Although a controller may select the majority of his or her controls from this list, it is important to consider special controls that are indigenous to specific industries and do not appear on this list.

7.5 WHEN TO ELIMINATE CONTROLS Most controllers are good at imposing new controls, but few give any thought to eliminating them. This is an extremely useful exercise, because fewer controls translate into less work by the staff and (sometimes) quicker transaction processing times. This section discusses how to set up an orderly system for reviewing controls at regular intervals and eliminating those that are no longer necessary. In order to review the need for controls, one must first know what they are. Many controllers have no idea of the types of controls a company uses, because they have inherited an informal mass (or mess) of controls from the previous controller, and never trouble themselves to understand the system. Accordingly, the first step is to conduct a broad-ranging series of interviews with employees to understand the flow of transactions throughout the company, and then convert this information into a set of easily understandable flowcharts. A quarterly control review can be scheduled in which the controller scans the existing controls to see if any controls have become unnecessary; this happens when changes in business conditions, such as new operating procedures, outsourcing, or reengineering, render existing controls obsolete. Any additions to or deletions from a company’s control systems must be reflected in the flowcharts, so they must be updated regularly, even if the formal control review takes place only quarterly. Using flowcharts and a scheduled control review allows a controller to eliminate unnecessary controls.

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Although flowcharts are an excellent method for tracking control points, a controller can take the concept too far. It can take an enormous amount of time to convert every conceivable process into a flowchart, and more time to ensure that it stays correct. To avoid too large a time investment, those systems that have no significant financial impact, such as the scheduling for janitorial services, should be ignored and concentration should be on key transactions, such as order fulfillment. Once key controls have been documented, the controller should determine how much it costs to have them in place. This step is very important, for a controller is responsible for installing controls that are cost effective, not ones that require so much effort that company operations are severely burdened by them. To determine control costs, a controller should observe controls in action to see how much labor and material costs are required to maintain them. This is a very inexact science, and a controller may be forced to rely on nothing more than the opinions of the employees who use the controls. Still, even estimates of costs are better than no information at all. A controller should also categorize each control as being a major or secondary control. Most control systems have multiple controls that focus on solving a control problem, with a few controls being extremely important and others being relatively unimportant. For example, a primary control over inventory is installing a fence around the warehouse to eliminate pilferage, while a secondary control is bonding the warehouse staff so that a company can obtain reimbursement if an employee is caught stealing inventory. By categorizing controls in this manner, a controller can see which controls are necessary and which can be deleted. The final step in determining which controls can be eliminated is to add control costs (as previously determined) to the chart that categorizes controls as being major or secondary. This allows a controller to quickly skim through the list of controls and see whether there are any secondary control points that are very expensive. If so, these are prime candidates for elimination. Before deleting these controls, however, a controller should first make a determination of the risk of not having them. Even an expensive secondary control point may have some value if it provides control over a potential asset loss that is so large that the control is still worth having. Risks that fall into this category include loss of investment accounts due to embezzlement or the loss of entire facilities due to fire damage. For these situations, which are admittedly few in number, it may still be worthwhile to retain controls that would otherwise be eliminated. A simpler, though less effective, way to review controls is to constantly review the need for control reports. All companies rely on a large number of reports that list transactions; when regularly reviewed, these reports act as controls over a large number of activities. A controller can determine whether these reports are needed by tracing them to report recipients and quizzing them regarding the need for the reports. This can result in a major reduction in the number of reports used, which is a major time savings if the reports are being manually prepared. A more common method of reducing the number of controls is to conduct an intensive review of controls whenever there are significant changes to the business, such as reengineering projects, outsourcing of major functions, or downsizing. When these events occur, the controller should be heavily involved in examining proposed system changes, which will likely result in the elimination of large numbers of controls. It is common to enroll the internal audit staff in these reviews, because it is largely concerned with the adequacy of existing controls. However, although there will almost certainly be some reduction in the number of controls as a result of these changes, there may be a need for an entirely new set of controls that are just as, if not more, expensive than the controls being eliminated. When a controller decides to eliminate a control, it is best to review the decision with anyone who may be using the control for other reasons. This is a major concern when the control point is a report that contains valuable information. For example, a control report that lists all fixed assets may also be used by an accounts payable person to determine the value of assets to be reported to the government for the calculation of property taxes. When these types of controls are eliminated, there may be so much extra work required by other parts of the company to “fill the gap” of the information that is no longer available that the cost of stopping the control may exceed the cost of leaving it in place. Thus, checking with potential users is key prior to stopping a control point. Finally, it is common to order the elimination of a control point, only to find that the controller’s order is ignored by the staff. This happens when employees are so overwhelmed with work

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that there is a strong predilection toward keeping systems the way they are, rather than working through the details of system changes. It is also common when control changes are not properly thought out; the staff frequently realizes that there are unresolved issues and balk at making changes until these issues have been resolved. In the first case, the controller should request the assistance of the internal audit staff, which can conduct periodic reviews of processes to see if changes have actually been implemented. In the second case, the controller is well advised to listen to staff objections and work through changes with them, which usually results in altered systems that are more clearly understood and which have greater staff acceptance. Proper follow-up and attention to staff objections are critical to ensuring that control system changes are completely implemented. In short, a controller can eliminate unnecessary controls by conducting a periodic review of existing controls, itemizing why they are used, and including the cost of each one as well as the changes in risks if they are eliminated. A detailed review of this information will usually reveal a number of control points that are too expensive for the level of incremental control they provide. It is important to review proposed control eliminations with other employees to ensure that there are no undocumented uses for the controls that may justify their continued existence; this review may also uncover objections to changing the system, which the controller should deal with prior to making alterations. By following these steps, a controller can keep the number of controls to a minimum, while still ensuring that a company’s major control objectives are met.

7.6 TYPES OF FRAUD All controllers must be aware of the primary types of fraud. By knowing them, a controller can design effective control systems for their prevention. This knowledge is also useful for those controllers who are interested in increasing transactional efficiency by reducing some control points—only by knowing how employees can take advantage of a reduced set of controls to commit fraud can a controller judge which controls can be safely eliminated. All types of fraud involve the theft of company assets. However, within the broad category of “assets” lie a large number of subcategories, such as fixed assets, employee advances, and cash. The type of fraudulent activity needed to take each of these subcategories of assets away from a company differs for each category, and is described in the following list by subcategory: • Expense account abuse. Employees run extra expenses through their expense reports that are not allowed by company policy, or use false receipts to charge extra expenses that did not actually occur. Employees may also charge expenses that are higher than allowed by company policy. For example, employees may take first-class plane trips, charge through exorbitant meals, and expect reimbursement for nonbusiness expenses, such as gifts or clothes. • Nonpayment of employee advances. Employees who have requested an advance payment of their paychecks or an advance to cover trip expenses will not pay back the company for these expenses. This tends to be a passive activity, for they do not actively try to bilk money from the company—they just do nothing to pay back what they have already been paid. • Purchases for personal use. Employees can take advantage of the authorization systems built into the purchasing system to order items for their personal use. This is most common when a company has high approval limits, so that employees can order items with no fear of review by their supervisors. This is also common when companies exercise little control over company credit cards, so that employees can charge through purchases that are not in any way related to company business. • Supplier kickbacks. Employees in the purchasing function can arrange with suppliers to buy their products and services at inflated costs in exchange for direct payments back to the employees. Depending on the quantities purchased, the amount of these kickbacks can be enormous. • Theft of cash and investments. The primary target of many employees who commit fraud is cash. This can be done in a variety of ways. One is to steal a blank check and make it out to

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the employee. Another is to gain control of bank account authorization codes and wire large amounts of funds to an employee-controlled bank account. Yet another approach is to steal cash. However, from a practical perspective, this tends to be the most difficult area in which to steal a large amount, for most companies tend to focus their controls on this asset area. • Theft of fixed assets. Fixed assets that are not bolted down, are small in size, and have a high resale value are subject to theft. This is especially true if the assets are rarely used or stored in out-of-the-way locations, so that no one will notice a theft for some time. This type of fraud is especially common in companies in which there is minimal tracking of assets. Conversely, large and heavy equipment that requires immense effort to move is practically immune to theft. • Theft of inventory or supplies. Employees can remove supplies and inventory from the company, either for personal use or for resale. Supplies are especially easy to remove, because they are not tracked as carefully as inventory items and are not normally stored in a restricted area. This is an especially large problem if inventory items have a high street value, are small enough to be easily concealed, and are not rigorously tracked. Large and inexpensive inventory items are much less likely to be stolen. These asset areas correspond roughly to the asset section of the balance sheet. The most commonly recognized fraud areas involve cash and investments, but it is actually much easier for an employee to steal assets in other areas, such as inventory, because the greatest concentration of controls cover the cash area, with much weaker controls elsewhere.

7.7 PREVENTING FRAUD According to the Association of Certified Fraud Examiners, the cost of fraud is now $400 billion per year. For some firms, the amount is so crippling that at a minimum it takes a large bite out of profits, and in some cases takes down the entire company. Even if the amount being stolen is small, most controllers feel as though fraudulent activities are a personal affront, for it means that someone has found a way to circumvent the control systems that were personally installed by the controllers. Accordingly, this section is designed to give a controller a list of warning signs for how to spot fraudulent activities, and what to do about it. There are two sets of fraud indicators. The first is at a high level: How management acts and its way of running the company are either direct indicators of fraud by management or indicate a general pattern of behavior that, if duplicated lower down in the company, will create an environment in which fraud will flourish unchecked. The high-level indicators are frequently missed, because the controller is so wrapped up in managing at this level that the signs are too close to see. It is best to ask the company auditors for their opinions regarding fraud indicators at this level, for they can provide a more balanced, outside view of the situation. The high-level fraud indicators are: • Management creates an overly complex organizational structure. If there are so many interlocked organizations that it is difficult to track transactions through the myriad of entities, it is possible that senior management has purposely created this level of complexity in order to hide fraudulent transactions. • Management has an excessive emphasis on meeting profit goals. If the management team cares for nothing but meeting profit goals, this channels everyone’s activities in that direction. This may seem innocuous, but if the goals are extremely hard to reach, there is a considerable temptation for employees to fabricate profits by any number of means in order to meet their goals. This is particularly a problem when large bonuses are awarded when profit goals are met. • Management has an aggressive attitude toward financial reporting. The management team may use the loosest possible interpretations of the accounting rules in order to recognize revenue and income. When this is present, it is possible that management is also engaged in other activities that are beyond the accounting rules. Surprisingly, controllers do not always see this, because they may have been in the accounting department so long that they accept the loose accounting interpretations as normal.

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• Management is unwilling to pay for good controls. A management team with an undue focus on profits may not want to pay for the more expensive control points that will prevent large-scale fraud. Employees will eventually determine where there are no controls or weak ones, and some will be tempted to exploit the situation. • Management is dominated by one person. If there is a strong owner or chief executive officer (CEO) running the company who brooks no discussion of decisions made, there is a strong risk of fraud, probably by that person. The risk is especially high in this situation, because the CEO has absolute authority to do anything—no controls will be effective in this situation. • Management prefers excessive decentralization. The management team may have a preference for minimal control from the headquarters facility; instead, it favors a “hands off ” approach for all subsidiaries. This is a laudable approach in many situations, but there should be a sufficient level of oversight to at least ensure that adequate control systems are in place at all subsidiaries. • Management turnover is high. When there is a large amount of churning among the management ranks, it may indicate that there are ongoing activities that are questionable, and that the departing people have chosen to leave rather than be associated with the company. • Customers or suppliers are suing the company. There may be lawsuits pending related to not paying suppliers or not providing complete services to customers, and which may be caused by fraud on the part of senior management. These lawsuits frequently escape the attention of the controller, because they are handled through the legal department. • Management is forcing a rapid pace of growth. If a company is going through a period of explosive growth, it is extremely difficult to maintain control systems. Also, because so many people are being hired during this period, it is difficult to conduct an adequate level of screening of incoming employees, so there is a greater likelihood of hiring someone who has committed fraud in the past. • Management is acquiring a large number of companies. When management acquires a series of companies at high speed, it is possible that it will buy into a company where fraud is present. This is because a newly acquired company may have poor control systems that allow this to happen. The real problem is that, because of the pace of acquisition, the controller may not have sufficient time to create and monitor controls at each newly acquired company, which means that there is an environment in which fraud can continue to flourish. There are a number of warning signals to look for at an employee level that may be indicators of fraud. These indicators require no special control system; a controller simply needs to be aware of them in order to identify situations in which there is a stronger likelihood of a possibly fraudulent situation. If a number of the following factors are present, a controller is justified in conducting an especially careful audit to determine whether there are fraudulent activities occurring. The warning signs are: • 401k withdrawals. An employee is more likely to commit fraud if short on cash. One sign of this is repeated withdrawals from a 401k plan or reductions in the amount of paycheck withdrawals that go to the plan. Another sign of this is a long history of asking for advances on paychecks. • Bad debt write-offs. There appears to be a large proportion of bad debt write-offs occurring. There may not be any increasing trend line indicating this, since fraudulent write-offs may have been going on for a long time, so an alternative way to tell is to compare the rate to industry standards. • Inventory discrepancies. If there are constant discrepancies between expected inventory records and actual counts, this is a sign of possible inventory theft; this also applies to manufacturing tools, which are especially easy to sell. Continuing losses of small quantities of easily salable items are a major indicator of theft. • Invoicing discrepancies. A common type of fraud is to intercept incoming checks and hide the theft by constantly modifying customer invoices with adjustments of various kinds to

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make them match a smaller amount of customer payment. A large number of invoice adjustments is a sign of this problem. • Lack of supervision. Some employees, for whatever reason, have not been subjected to close management for a long time, which gives them an opportunity to devise fraudulent activities in the absence of any oversight. • Large personal expenditures. Some employees spend their fraudulently acquired funds in a very public manner; seeing an employee arrive in a new and expensive car is an indicator of this, especially when combined with a change of home address (which they usually give to the payroll person so that paychecks are mailed to the correct location), which may indicate the purchase of a more expensive home. • No competitive bidding. A number of contracts are being awarded without any competitive bidding, which indicates that suppliers may be paying purchasing personnel to do this. However, this is increasingly difficult to prove, because just-in-time manufacturing principles dictate that sole sourcing is a better purchasing technique than using competitive bidding. • No payment from the sale of assets. When a controller notices that there are fewer assets, either from sale documents or a fixed asset audit, it is useful to see if cash was received as part of the transaction. If there does not appear to be any compensation for transferring the asset to the recipient, the controller should suspect that funds were pocketed and investigate further. • No vacations. Key staff people somehow never manage to take any vacation time for years on end, which may indicate that they are afraid of having their activities detected in their absence. • Supplier addresses match employee addresses. A virtually certain indicator of fraud is when an employee sends in invoices from a fictitious company and has the payments sent to his or her home address. Though it can be difficult to compare the list of employee addresses to the same information for suppliers, it may be worth the effort if a controller suspects that there are problems with supplier payments. Though these indicators of fraudulent activities are legitimate, a controller must realize that there are also real reasons for many of the same activities, so it is easy to receive a false impression that someone is committing fraud. For example, an employee may not have taken vacation during the past year, but this may be due to a workload that was so severe that there really was no way to take it. To avoid false indicators, it is better to rely on a combination of factors. For example, if a billing clerk suddenly arrives in a new sports car, and this is coincident with a number of billing irregularities, then there are excellent grounds for conducting an investigation. While noting that several indicators in combination represent a reasonable warning of the presence of fraud, it is even more likely that the vast majority of fraud cases leave no warning signs at all. Many perpetrators conduct their activities on such a low level, taking assets worth very small amounts, that it is very nearly impossible for anyone to spot them. In these cases, the controls that would be necessary to prevent or find fraud would be so onerous that the cost of the controls would very likely exceed the cost of the fraud. For example, employees may be using the company postage machine to send out personal mail. The control over this might require installing a lock on the machine as well as direct supervision when it is in use. Doing this may be more expensive than the cost of any lost postage. In short, many fraud cases involve losses on such a small scale that it is not worth the effort of installing controls to ensure that it does not happen. Other fraud cases do involve potentially large losses. A controller must act to prevent these situations from occurring, since they can have a large impact on company cash flow and profits. The best way to determine the extent of potential fraud is to review all areas of the company and estimate the largest amount of fraud that can possibly occur in each function. To use the previous example, the upper limit on losses through a postage machine is the amount of postage stored in it, which rarely exceeds $1,000 and is usually considerably less. However, the potential for inventory theft in a large warehouse area may run into millions of dollars. Another example is sending wire transfers; if a person can send one for all available company funds to a numbered Swiss bank account, this can bankrupt a company. Of the three examples, it is clear which areas require a

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broader range of controls. Accordingly, a controller should first evaluate all functional areas to determine the degree of potential loss and hone in on those areas in which the company can lose large sums. When a controller reviews a business to locate potentially high-risk fraud situations, there is a great likelihood that the review will miss some potential situations if the controller does not have a strong knowledge of the business. For example, if a manufacturing company hires a controller from one of the service industries, that controller will not have a good knowledge of internal controls over manufactured goods, and of how materials can be removed from the system without detection. In this situation, a controller can flowchart the main processes of the company, which also yields an excellent knowledge of operations. However, many controllers, especially new ones, do not have time for such an in-depth review. In these cases, the controller can bring in the company auditors, who have presumably audited many similar companies, and who have a great store of knowledge of control systems. The auditors can conduct the review and make a large number of recommended system changes in a very short period of time. In short, assessing the existing control environment requires a good knowledge of systems, which may call for outside assistance in conducting the review. Aside from the use of control systems to combat fraud, there are other ways to detect it, such as notification by fellow employees. In many cases, other employees are well aware of fraud situations and make the (false) assumption that management knows about it too and has chosen to take no action. The best way to clear up this level of employee uncertainty as well as to be on the receiving end of information about fraud problems is simple accessibility. It is very helpful if a controller or someone on the controller’s staff is a gregarious type who mixes constantly with other people in the company. By making themselves available, the accounting staff puts itself in a better position to be trusted by other employees, which results in information about improprieties. Notification by employees is an important second source of information about fraud. There are many warning signs that indicate the presence of fraud. A controller is well advised to review this information from time to time to determine whether there are conditions at a company that make it easy for fraud to occur. In addition, there should be a continual review of control systems to monitor the risk and amount of loss at various points in the company. If there have been changes in these factors since the last review, a controller should consider altering the controls. Finally, it is almost as important to keep lines of communication open between the accounting staff and the rest of the company, for hints from employees run a close second as a good method for spotting fraud cases. By using general indicators and good control points, and by being receptive to employees, a controller will have a much better chance of finding fraud in the company.

7.8 HOW TO DEAL WITH A FRAUD SITUATION A controller faces difficult choices when confronted with a fraud situation—should the company go public and push for criminal charges against the perpetrator, or is it better to reach a private resolution? Some companies even accept payment back from the problem employee and then retain that person! This section discusses the factors in favor of and against each option. The following list notes the primary options available to a company when resolving a fraud situation. The first point is the most drastic resolution, with succeeding options declining in severity. For each item, there is a discussion of the likely results of each action, as well as any moral considerations. • Bring criminal charges. This option sends the clearest message to employees—that the company will not tolerate fraud under any circumstances. Therefore, it tends to have a positive impact on reducing subsequent fraud. Also, from a moral standpoint, it is the correct action to take, because there is now a public record that a person has committed an illegal act, which gives adequate notice to other companies that may hire the individual. However, publicly held companies tend not to take this route, because a public display of corporate incompetence that originally allowed the fraud to take place does not give the company a positive public image, and may even lead to the firing of top management by the Board of Directors. Consequently, and unfortunately, many companies tend to shy away from this option.

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• Demand restitution and fire the employee. This option is the most common one. A company is certainly justified in demanding restitution, and should always fire anyone committing fraud, as this avoids the chance of any recurrence of the situation. Also, because there are no legal proceedings, stockholders will not find out about the fraud situation, which upholds the reputation of the company as well as senior management. However, this does not create a public record that the wrongdoer has committed fraud, so other companies that hire this person will have no way of knowing that they are hiring a “bad apple.” Thus, this option is not as morally acceptable as the first option. • Dismiss employee for cause. Many companies take this approach if there is no reasonable chance of recovering missing funds or other assets. This approach also avoids any legal controversy that may result in adverse publicity. However, it creates no public record of wrongdoing, so the perpetrator is free to commit fraud again elsewhere. • Permit employee to resign. This approach is sometimes allowed for employees who have committed fraud but who occupy such high-profile positions that their firings would excite comment by the business community. The same option may be extended to employees who have worked for a company for such a long time that management feels it has some obligation to allow a quiet departure. However, from a moral perspective, this is one of the worst options; another company will have no reason to suspect that there was a criminal situation at a previous company, because there is no record of a firing. By selecting this option, a company allows a perpetrator to continue fraudulent acts at other organizations. • Demand restitution and permit the employee to stay. Though this option allows a company to recoup its losses, it runs the substantial risk of having the perpetrator commit fraud yet again. Also, other employees will see that there was no drastic action taken, so they will either be encouraged to commit fraud themselves, or will at least have a minimal incentive for reporting future cases of fraud to management. Despite these drawbacks, companies continue to select this option for two reasons — either the person committing fraud is a member of the family that owns the company, or management feels that it has a better chance of getting its money back by having direct control over the payroll deductions that will gradually return the cash. • Do nothing. Companies pick this option primarily because the person committing fraud is a co-owner of the business, which makes it difficult to take any action. This has a demoralizing effect on other employees who see illegal activities taking place without any fear of retribution, and frequently leads to excessive levels of employee turnover, as people find other companies with more upright moral standards. The range of actions that management can take to combat fraud is very broad. The best approach is to take a stern stand against all cases of fraud, which has the multiple benefits of setting a good example for other employees to see, giving a company some chance of reacquiring lost assets, and of leaving a public record of criminal activity, which gives other companies due notice of a prospective employee’s character. The other options for dealing with fraud will result in increasing levels of difficulty, such as no return of lost assets, reduced employee morale, possible increases in employee turnover, and additional fraud cases at other companies as employees emigrate to new companies and commit crimes again. In short, management should react strongly to any cases of fraud, including prosecution to the fullest extent of the law.

7.9 FOREIGN CORRUPT PRACTICES ACT Congress enacted the Foreign Corrupt Practices Act in 1977. This Act was passed because of disclosures by the Office of the Watergate Special Prosecutor and the Securities and Exchange Commission (SEC) of the use of U.S. corporate funds for domestic political contributions and for the bribery of foreign government officials. Some of these payments were clearly illegal and others questionable, while some payments appeared to have been made by avoiding internal control systems. To prevent these problems from occurring in the future, the Act requires a publicly traded

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company (it does not apply to privately held companies) to keep in reasonable detail “books, records and accounts” that accurately and fairly reflect its transactions and disposition of assets, and maintain an adequate system of internal controls. The control system must have the following attributes: • Transactions must occur under the authorization of management. • Transactions must be properly recorded. • There must be reasonable controls over access to assets. • There must be periodic reconciliations of recorded to actual assets, with an investigation of any differences. This Act is particularly applicable to multinational organizations, so the controllers of these organizations must be aware of it and its ramifications for enhanced control systems. To be in compliance with the Act, a controller should be particularly mindful of the adequacy of company control systems, as well as of subtle changes in financial results that may indicate the presence of control problems.

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CHAPTER

8

INTERNAL AUDIT FUNCTION 8.1 INTRODUCTION 129

8.5 INTERNAL AUDIT OBJECTIVES 132

8.2 REPORTING RELATIONSHIPS 129

8.6 INTERNAL AUDIT ACTIVITIES 134

8.3 COMPOSITION OF THE AUDIT COMMITTEE 130

8.7 MANAGING THE INTERNAL AUDIT FUNCTION 136

8.4 ROLE OF THE AUDIT COMMITTEE 131

8.1 INTRODUCTION A key factor in the internal audit function is the manager to whom the function reports, since an incorrect reporting relationship can lead to skewed audit programs that avoid the areas supervised by that manager. Another issue is the objectives that the internal audit function should follow; too narrow a set of objectives may avoid reviews of key areas that are in serious need of help, while an excessively broad range of objectives will water down the department's ability to complete a reasonable set of target programs in a timely manner. A wide range of suggested activities for the internal audit staff are listed in this chapter, which are of use when determining a set of audit programs for the upcoming period. Finally, key factors are noted to consider when creating and maintaining a management system that provides an effective degree of control over the internal auditing staff. This chapter consists of an overview of the internal audit function, why it exists, what it does, and how to manage it.

8.2 REPORTING RELATIONSHIPS Many companies adopt a reporting relationship between the accounting and internal auditing functions that leads to strained relations between the two functions. This section analyzes the problem and suggests a solution. Many companies have the head of the internal audit department report to either the controller or (more commonly) the chief financial officer (CFO). They do so on the grounds that the bulk of the work performed by the internal audit staff addresses accounting and finance issues, so it makes sense to cluster the departments together. In addition, the internal audit staff is usually trained in accounting and is probably looking toward a promotion into the accounting and finance staffs once they have completed a tour of duty in the internal audit area. By keeping the two departments “under one roof,” the accounting and finance staffs get a close look at the internal audit staff and can use this knowledge to promote them into the most appropriate positions. There are valid reasons for having the internal audit staff report to the manager of the accounting or finance functions. Unfortunately, this relationship does not work very well. The reason is that the job of the internal audit staff is largely to review and report on the operations of the accounting and finance staffs. Because these reports tend to focus on problems, they do not cast the management of the accounting and finance departments in an overly favorable light. Consequently, if the internal audit staff reports to this area, it is common for the controller or CFO to design audit programs that focus on relatively innocuous areas, or else to focus on other parts of the company, while ignoring the 129

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accounting and finance areas. An alternative result is for the internal audit reports to be buried, so that senior management does not review any information that is critical of the way in which the accounting and finance areas are being managed. All of these outcomes tend to focus minimal internal audit attention on key accounting and finance processes, which is the precise area in which the auditors should be spending most of their time. The reporting relationship has a direct bearing on the review work performed by the internal audit staff. If the internal audit staff is to conduct unencumbered reviews of the accounting and finance areas, it is necessary to shift the reporting relationship away from them. This allows the internal audit staff to avoid any problems caused by managers who do not want to have deleterious results shown to senior management. However, moving management of the function to a different area of the company raises similar problems, for anyone to whom the function reports will also not want the group to conduct any internal audits on areas that may reflect poorly on the manager. Consequently, the internal audit function should only report to positions at the top of the organization, where the manager is responsible for the entire company, and thus has no reason to avoid poor results in specific areas. This position can be the chief executive officer (CEO), but if this person is engaged in questionable activities, he or she may try to quash all internal audit activities. The best alternative is the board of directors, which is responsible for no company functions, and who is only concerned with maintaining the most efficient and effective operations, as well as appropriate levels of control over assets. The board can direct the internal audit staff by forming an audit committee. This committee can approve suggested audit programs, besides its usual function of selecting and overseeing the activities of the external auditors. This solution gives unfiltered information to the board, while also allowing it to target those areas of the company that it feels may be in most need of a review. Since this section has recommended that the internal audit staff not report to the controller, one might ask why this chapter is even included in this book—after all, if it is not managed by the controller, why discuss it? The reason is that the controller can still have a considerable amount of control over the annual list of audits that the department conducts. This happens for two reasons. First, the controller is the senior accounting officer in the company, and as such is in the best position to spot problem areas and request audits that will highlight any problems. Second, whether there is a direct reporting relationship or not, the manager of the internal audit staff will recognize that the controller is more senior in the corporate hierarchy, and so it is a good idea to at least listen to any recommendations for future audits. For these reasons, the controller still has a considerable amount of influence over the activities of the internal audit staff, no matter who is the manager of the function. In short, it is inappropriate for the internal audit staff to report directly to the controller or CFO, because they can skew audit programs or hide results to show the accounting and finance areas in the best possible light. It is better to assign the audit staff to the audit committee of the board of directors, which is a much more impartial management group.

8.3 COMPOSITION OF THE AUDIT COMMITTEE The audit committee should be a standing committee of the Board of Directors, and should be comprised primarily of non-officer directors. These directors should not be involved in the management of the company, nor have previously been its officers. These restrictions are intended to create the most independent overview environment possible for the committee. The committee is generally comprised of between three and five members, not all of whom must have an accounting, auditing, or finance background. It can be more useful to have some directors with a solid operational knowledge of the industry in which the company operates; these people can spot potential control weaknesses, based on their knowledge of how transactions flow in an industry-specific environment. Nonetheless, at least one committee member should have considerable training or experience in the accounting and finance arena. The committee should be expected to meet on at least a quarterly basis. The CFO is rarely a member of this committee. Instead, sometimes she will be asked to attend its meetings in order to advise committee members on specific issues, or to answer questions about

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problems that the committee has uncovered through its review activities. The CFO should certainly maintain a strong line of communication with committee members, in order to inform them of possible accounting rule changes or prospective policy changes that may impact the reporting of financial information. The CFO should also educate committee members about key financial topics, such as corporate lines of business, accounting policies, legal obligations, regulatory filings, and industry accounting practices. The director of the internal audit function usually reports to the CFO, but can report instead to the audit committee. The most common reporting relationship is for the internal audit director to be supervised by the CFO, but to have unimpeded access to the audit committee at any time; this reporting system is designed to give committee members direct access to the results of internal audits, while at the same time giving the internal audit director the ability to go around the CFO if that person appears to be obstructing the dissemination of internal audit results. In short, the audit committee’s structure is intended to be as independent of the management team as possible, while still giving it direct access to key accounting and audit personnel within the management team.

8.4 ROLE OF THE AUDIT COMMITTEE The goal of the audit committee is to assist the Board of Directors by providing oversight of the financial reporting process and related controls. The committee is not empowered to make any decisions—rather, it recommends actions to the full Board, which may then vote on its recommendations. The exact range of tasks granted to the audit committee will vary, but are generally confined to the following issues: • Tasks related to company management:
Review expenses incurred by the management team. Used to spot any excessive use of corporate funds by managers.
Review business transactions between the company and the management team. Used to ensure that managers are not enriching themselves at the expense of the company, as well as not holding their personal interests above those of the company. • Tasks related to external auditors:
Recommend the hiring of external auditors. Used to ensure that a truly independent auditor is used, rather than one having connections with the company in some way that may influence its review of the company’s financial statements. The audit committee should also base this recommendation on the auditor’s expertise in the industry, the quality of its services, the extent to which it performs other services for the company, and the amount of its quoted fees for the audit.
Review auditor recommendations. Used to ensure that control issues spotted by the auditors are properly dealt with by the management team, resulting in a stronger control environment.
Review disputes between the external auditors and management. Used to determine if the management team is attempting to force the auditors to agree with an alternative accounting treatment for transactions.
Review the use of external auditors for other services. Used to determine if the external auditor has obtained such a significant amount of extra business with the company that it may be less inclined to issue an unfavorable audit opinion, due to the risk of losing the additional business. • Tasks related to internal audits:
Review the replacement of the internal audit director. Used to verify that the internal auditor director is being replaced for reasonable cause, rather than because the CFO wants to install a more malleable director.
Review the internal audit staff ’s objectives, work plans, training, and reports. Used to verify that the internal audit staff is appropriately targeted at those areas of the company

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that are at greatest risk of control problems, and that the audit staff is appropriately trained to handle the audits. A detailed review of the annual work plan will reveal if the internal audit director has allocated a sufficient amount of time to each audit, or has sufficient staff available to complete all goals.
Review the cooperation received by the internal auditors. Used to spot possible areas of fraudulent activities, since minimal cooperation is a signal that an auditee may be hiding information from audit teams.
Review disaster recovery plans. Used to ensure that adequate recovery plans have been created and tested for the most likely disaster scenarios. • Tasks related to financial systems:
Investigate fraud and other forms of financial misconduct. Used as the grounds for a direct investigation of any situation possibly involving deliberately inaccurate financial reporting or the misuse of company assets.
Review corporate policies for compliance with laws and ethics. Used to ensure that all corporate policies, irrespective of their relationship to financial systems, are constructed in accordance with local regulations, and meet the restrictions of the corporate statement of ethical activities.
Verify that financial reports address all information requirements of lenders. Used to ensure that lender-required financial information is reported to them at the appropriate times and in the correct formats, so there is minimal risk of losing vital credit lines as a result of missing information.
Review all reports to shareholders, including special reports, for consistency of information. Used to verify that all reports present a consistent picture of corporate financial health to investors. This is of particular concern for special reports, which tend to include different types of measures (such as EBITDA instead of the net income figure found on financial statements) and bullish statements by management that do not always match the tenor of information presented in the standard set of financial reports. Of special interest is the audit committee’s emphasis on the review of a wide range of financial activities—with the exception of one item: The audit committee is empowered to investigate fraud and other forms of financial misconduct, rather than review the results of such an investigation by someone else. The reason for this direct action is that employees are probably involved in the fraudulent activities, which may possibly involve members of management, so the audit committee can obtain an unbiased review of the situation only by doing so itself. Thus, in all cases besides the investigation of financial misconduct, the audit committee’s role is to examine the results of a variety of audits and other investigations to ensure that the company’s system of financial reporting fairly represents actual operating results.

8.5 INTERNAL AUDIT OBJECTIVES It is extremely important to determine the correct set of objectives for the internal audit staff. These objectives are used as the framework for constructing audit programs, as well as for determining the most appropriate skill set for the staff, plus the number of people needed to staff the department. Devising the correct set of objectives has a direct bearing on both the structure and work of the department. This section describes a typical set of objectives, as well as some changes to the list that are appropriate under certain circumstances. There is a broad range of internal audit objectives that a company can adopt. The exact number and type of objective can vary greatly, depending on the anticipated size and skill of the audit staff, as well as the perceived need for audit reviews (which is frequently based on the past history of the company) by the management team that creates or approves the list of objectives. For example, a company may have had a great deal of trouble convincing its staff to follow a specific set of procedures, and so it will place great emphasis on an objective that hones in on the consistent use of

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policies and procedures. Another company may have had trouble with fraud or harrassment in the past, and so one of its key objectives will be to ensure that the company's code of ethics is being followed. Yet another company may have been burned by inconsistent financial reporting, which calls for an objective that tracks this issue. The most common minimum objectives for the internal audit department will address the need to safeguard assets and create accurate financial statements. These objectives are strictly financial in nature, and can be handled by an audit staff with a traditional financial background and a minimum training in company procedures. These are also useful objectives when the audit staff is so small that there is no room to pursue a wider-ranging set of objectives. These objectives are: • That control systems will adequately safeguard company assets • That company financial statements follow generally accepted accounting principles (GAAP) and are accurate These objectives can be widened to include reviews of operating policies and procedures. This is a very common objective if there are perceived problems in this area. Also, problems in operations tend to have an impact on the accuracy of the financial statements, so many companies take the view that this objective goes “hand in hand” with the earlier objective for financial statements and therefore must be included. However, this requires a broader range of skills and a much larger work plan, so this objective tends to result in a larger and more experienced audit staff. This objective is: • That the company is following operating policies and procedures Given the prevalence of computer systems and the degree to which they are now integrated into a company’s most crucial operations, it is also common to specify an objective that addresses this area. By doing so, a company must add a highly skilled group of computer system auditors to the internal audit staff. Any review work involving computer systems requires a considerable degree of knowledge, primarily of systems design and testing. Some more detailed reviews may even require a knowledge of programming languages, though it is customary to contract out this more specialized audit work, since it is difficult to find and retain personnel with such unique skill sets. It is sometimes necessary to contract out virtually all computer-related audit work, given the difficulty of finding qualified staff people to conduct the work. This objective is: • That computer systems are accurately processing data It is common for companies to also require reviews of ethical standards by the internal audit group. This requirement is frequently a result of a highly public scandal that has damaged the company’s reputation or of a large lawsuit settlement that could have been avoided if there had been higher ethical standards (e.g., kickbacks, sexual harassment, etc.). Since this type of audit tends to fall outside of the experience of a typical internal auditor, it is customary to bring in a consultant to advise on how to construct and follow through on ethics audits (with the primary focus being on audits of scheduled ethics training of employees). This objective is: • That the company is following an approved set of ethical guidelines There should be an objective that requires the internal audit staff to support the activities of the external auditors. This objective is necessary because the fees charged by the outside auditors can be reduced by supplementing their work with that of the internal auditors. There is a limit to how much work the inside auditors can perform, because an excessive degree of assistance by them would interfere with the independence and objectivity of the external auditor’s work. Nonetheless, the outside auditors may rely on them for a significant volume of work. This objective is: • That the department adequately supports the activities of external auditors The previous objectives have addressed key areas of a company that must be reviewed. In addition, there should be an objective that requires the internal audit manager to prepare an annual internal audit plan for reviewing the previous objectives. This is important, because it forces the manager to address such issues as the importance of various audits, the degree to which some

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objectives are being addressed at the expense of others, and the adequacy of the department's staffing and expense budget. This objective is: • That it creates an annual audit plan that addresses all of these objectives The final objective relates to the output from the work of the internal audit department. While the previous objectives have established a direction for the audits to be conducted or the management of that work, there is no provision for what the department is supposed to do with the results of all this work. Accordingly, the final objective requires the department to create reports that detail all findings and make recommendations to resolve problems. In addition, the objective should require that the reports be distributed to those levels of management that can use the information to resolve the problems. This final objective closes the loop on all activities required of the internal audit department. This objective is • That it provides written reports of its findings to those levels of management needing the information in order to correct faulty systems The bulk of these objectives relate to the types of audit work to be conducted by the department, with the key areas including the safeguarding of assets, accuracy of financial statements, and reviews of operations and computer systems. Many of these objectives are discussed again in the next section, where we derive internal audit activities based on each of the objectives.

8.6 INTERNAL AUDIT ACTIVITIES This section is based on the objectives that were described in the previous section. Though there are a few activities noted here, the reader should not rely on this list to create a comprehensive set of activities for an internal audit department. The reason is that there will certainly be additional activities that are unique to each company; also, there may be a number of activities that are specific to particular industries. A manager who is compiling activities for this department should talk to consultants, external auditors, and trade associations that have considerable experience in specific industries to obtain input on additional activities for the department. This will yield a more comprehensive set of tasks for the internal audit department. The eight internal audit objectives noted below are all followed by a variety of related audit activities. 1. Objective: That control systems will adequately safeguard company assets
Cash: Verify that there are adequate controls over petty cash.
Fixed assets: Verify that there is a sufficient degree of control over borrowed assets. Verify that there is a sufficient degree of control over the acquisition and disposal of assets.
Inventory: Verify that there are sufficient safeguards against the loss of inventory. Verify that there is a sufficient degree of control over consigned inventory.
Supplies: Verify that there is a sufficient degree of control over the purchase, storage, and use of supplies. 2. Objective: That company financial statements follow GAAP and are accurate
Cost of goods sold: Verify that product bills of material are accurate. Verify that the cost of goods sold is correctly computed. Verify that there is a proper cutoff of receipts and shipments at the end of the reporting period.
Expenses: Verify that all expense accruals are correctly calculated. Verify that all prepaid expenses are expensed in the correct periods. Verify that expenses are incurred only up to budgeted levels. Verify that paychecks are only calculated and paid for current employees. Verify that payroll amounts are correctly calculated. Verify that the assumed resale values of fixed assets are reasonable, based on a current review of asset values. Verify that the authorization for incurring expenses is appropriate. Verify that the time period over which depreciation is taken is reasonable, based on industry standards and historical usage.

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Revenue: Verify that billings are only made for services and product sales that are actually

completed. Verify that invoices are recorded in the correct periods and amounts. 3. Objective: That the company is following operating policies and procedures
Determine labor productivity.
Investigate and determine the cause of transactional errors.
Review the appropriateness of expenses for new construction.
Review the fixed asset purchasing goals after-the-fact to see if goals were met.
Review the obsolescence of existing equipment.
Verify the appropriateness of pay levels based on experience and education.
Verify from a sample of expense reports that only those approved types of travel expenses are being reimbursed.
Verify that bank reconciliations are regularly performed and reviewed.
Verify that financial statements are published within specified due dates.
Verify that machine run rates are within expected levels.
Verify that product quality levels match minimum standards.
Verify that production scrap rates are within expected levels.
Verify that shipments are made on scheduled ship dates.
Verify the accuracy and timeliness of all key transactions. 4. Objective: That computer systems are accurately processing data
Verify from a sample of transactions that the computer system is correctly calculating accounting transactions.
Verify that data from an acquired company is accurately entered into the existing computer system.
Verify that new systems under development are designed with an appropriate number of control points to ensure proper processing of transactions.
Verify that there are a sufficient number of safeguards built into the system to ensure a rapid recovery from catastrophic computer damage.
Verify that there is sufficient testing of systems and data during a conversion of computer systems to a replacement system. 5. Objective: That the company is following an approved set of ethical guidelines
Follow up on reported ethics cases and determine the extent to which formal ethics training programs would have avoided the situations.
Verify from training records that each employee has received at least the minimum number of ethics training hours per year.
Verify that the training materials used to teach ethics to employees contain information that matches and supports the principles described in the company's official ethics policy. 6. Objective: That the department adequately supports the activities of external auditors
Verify that the internal audit staff completed the tasks assigned to it by the external auditors.
Verify that the tasks assigned to the internal audit staff to support the external auditors were completed to the satisfaction of the external auditors.
Review the entire external audit program and make recommendations to increase the share of work completed by the internal audit staff, in order to reduce fees charged by the external auditors. 7. Objective: That the department creates an annual audit plan that addresses all of these objectives
Verify that a broad range of managers are consulted regarding the contents of the annual audit plan.

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Verify that the annual audit plan contains some reviews for all of the previous audit objec-

tives related to control over assets, ethics, operations, financial accuracy, and operations.
Verify that the key control problems pointed out by the external auditors are being addressed

by the annual audit plan. 8. Objective: That the department provides written reports of its findings to those levels of management needing the information in order to correct faulty systems
Verify that feedback is solicited from auditees regarding the findings and recommendations made in audit reports.
Verify the degree to which recommendations have been implemented, subsequent to the release of audit reports. This section presented a wide-ranging list of internal audit activities that are closely tied to the audit objectives described in the last section. However, this is not a comprehensive list, so other industry-specific sources should be consulted in order to compile a more complete listing of activities.

8.7 MANAGING THE INTERNAL AUDIT FUNCTION The internal audit department is not a line function, so there are no regular outputs to examine, nor are there any direct cost savings or added revenues attributable to it. This lack of clear results makes it somewhat more difficult to manage the function. This section describes the main steps that a manager should complete in order to create a management system for the internal audit function, as well as a means for determining the status of activities, and controlling it based on that information. The first step in managing the department is to create and disseminate a clear set of responsibilities for the internal audit staff. This gives the department definitive guidelines to follow, as well as direction in its daily activities. A typical responsibility statement should include: • That control systems will adequately safeguard company assets • That company financial statements follow GAAP and are accurate • That the company is following operating policies and procedures • That the company is following an approved set of ethical guidelines • That computer systems are accurately processing data • That the department adequately supports the activities of external auditors • That it creates an annual audit plan that addresses all of these objectives • That it provides written reports of its findings to those levels of management needing the information in order to correct faulty systems Once these objectives are in place, the manager can focus on the primary output — the annual audit plan—as the easiest means for managing the department. The annual plan is usually a brief document that lists every audit to be completed during the year, as well as a brief description of the objectives of each audit. For example, it might include the following audit: Review the method for recording additions, changes, and deletions of fixed assets to and from the accounting records for the Andersonville facility. The audit will verify that the correct capitalization limit is being observed, that there are documented and justified reasons for making alterations to the fixed asset records subsequent to additions, that deletions are recorded properly, and that the sale amounts of assets are reasonable.

Though this audit description gives one a good idea of what will happen during an audit, it does not yield a sufficient degree of additional information, such as the number of hours budgeted for the work, who will be assigned to the project, or when it will take place, for a manager to achieve tight control over the department. This requires a more detailed audit budget for the year, such as the one shown in Exhibit 8.1. The primary information contained in this budget are the budgeted hours scheduled for each job, and the estimated range of dates during which work will be completed.

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Division

Project

Hours

Start Date

End Date

Personnel

Denver Denver Boston Chicago Chicago Atlanta Atlanta

Fixed assets Billings Fixed assets Fixed assets Billings Fixed assets Billings

240 280 240 240 280 240 280

01/01/XX 01/01/XX 02/16/XX 04/01/XX 02/22/XX 05/16/XX 03/08/XX

02/15/XX 02/21/XX 03/31/XX 05/15/XX 03/07/XX 06/30/XX 04/21/XX

Smith/Jones Barnaby/Granger Smith/Jones Smith/Jones Barnaby/Granger Smith/Jones Barnaby/Granger

E XHIBIT 8.1

S AMPLE I NTERNAL A UDIT B UDGET

Once armed with the internal audit budget, a manager can exercise a much greater degree of control over the internal audit department. The budget information allows a manager to use the following controls: • Compare budget to actual hours worked. • Compare budget to actual project start dates. • Compare budget to actual project completion dates. • Compare budget to actual staffing requirements. In addition to these quantitative control points, there are a variety of other controls that a manager can use. These extra controls tend to supplement the quantitative controls, and can be “mixed and matched” to derive a set of controls that are best suited for specific situations. The extra controls are: • Compare the written objectives of the department to its actual activities. • Ensure that the internal audit staff coordinates its work to support that of the external auditors. • Ensure that there is an up-to-date policies and procedures manual that clearly shows how audit work is to be conducted. • Review audit reports for activities conducted, findings noted, and recommendations given. • Review comments from departments that were the subject of audits. • Review the mix of scheduled reviews to see if there is a lack of attention to specific areas, such as reviews of accounting, computer, or operational controls. • Review work papers to ensure that audits were completed in as thorough a manner as possible. • Verify that audit recommendations are being acted on. • Verify that auditors have a sufficient educational background to conduct specific types of audits (some audits are so specialized that outside expertise must be brought in). • Verify that the audit committee is satisfied with departmental performance, and follow up on any shortcomings. • Verify that the department is reviewing the controls being built into new computer system projects. • Verify that the department is sufficiently large to accomplish all planned goals. • Verify that there are scheduled reviews of the company's ethical standards. • Verify that there have been no restrictions of departmental activities due to intransigence by auditees, and bring up exceptions with the audit committee for action. It is important to have prior knowledge of the activities of and conditions in the internal audit department before selecting from the previous list of management controls, because this information has a direct bearing on which controls are selected. How does one gather this information? There are a variety of information sources that can be consulted, including: • The depth and accuracy of audit planning. An internal audit is a project, and as such must be adequately planned and then managed against that plan to ensure that audits are completed on time.

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• The image of the department. The department manager and any staff members who are in direct contact with other departments must present a positive and professional image, especially when conducting reviews, discussing recommendations, or presenting findings. • The opinion of the outside auditors. The external auditors are accustomed to working with the internal audit staff from time to time, and can usually provide an opinion regarding the quality of the department's work. • The quality of personnel practices. The members of the internal audit staff should have a high level of training, possess adequate knowledge of the areas being audited, have clear career paths that are well documented, and be conversant in the use of any new technologies that assist them in conducting their jobs. • The reaction of departments that have been reviewed. Any auditees should have a positive view of the internal audit department (unless it discovered massive problems!), since auditors should conduct their reviews in a professional manner and keep auditees well informed of their progress and recommendations. • The reaction of senior management and the board of directors. These managers should feel that the internal audit group has provided meaningful insights on company operations, as well as made solid improvement recommendations. • The types of recommendations in previous audit reports. If there is a large proportion of less important recommendations, this is a sign that the internal audit staff is either not well acquainted with the systems it is reviewing, or that the quality of work conducted is so low that no significant recommendations are likely to be found. Only by reviewing this information can a manager determine the particular strengths and weaknesses of an internal audit department, which can then be used to select the specific control methods necessary to manage the department. In general, a successful internal audit manager should utilize all of the quantitative measures noted in this section, and supplement them with a selection of qualitative controls (also noted in this section) that are tailored to the specific circumstances of the department. Only by doing so can a manager create a management system that is both efficient and effective, which will result in a high-performance internal audit department without an excessively burdensome management system.

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CHAPTER

9

GLOBALIZATION: COMPLEXITIES AND OPPORTUNITIES 9.1 INTRODUCTION: PERVASIVE NATURE OF GLOBALIZATION 139 9.2 CHANGING NATURE OF INTERNATIONAL TRADE 140 9.3 IMPACT OF GLOBAL TRADE ON SEGMENTS OF THE U.S. ECONOMY 140 9.4 DETERMINING AND IMPLEMENTING SUCCESSFUL GLOBAL STRATEGIES 142 9.5 ORGANIZATION STRUCTURE IN A GLOBAL ENTERPRISE 143 9.6 VIRTUAL CORPORATION 145

9.7 TECHNICAL ASPECTS OF THE CONTROLLERSHIP FUNCTION UNDER GLOBALIZATION 146 (a) Open Communications 147 (b) Uniform Data Requirements 147 (c) International Accounting Requirements 148 (d) Measuring Foreign Operations. 149 (e) Evaluating Capital Expenditures 152 (f) Transfer Pricing 154 (g) Taxation 155 (h) Import/Export Regulations 157 (i) Managing Currency Risk 157 (j) Foreign Corrupt Practices Act 158

9.1 INTRODUCTION: PERVASIVE NATURE OF GLOBALIZATION Those active in business know that change is constant. It seems some subjects are emphasized, then deemphasized and later emphasized again, for example, benchmarking, reengineering, empowered workteams, leveraged buyouts, mergers and acquisitions, explosion of new technologies, the changing nature of capital markets. And now we have globalization. In the 1970s and 1980s, international trade, in the eyes of many, focused on North America, Europe, and Japan — the most developed markets. Now vast new markets have opened for Western goods in Asia, South America, and Eastern Europe. It is these still developing areas, which include the Pacific Rim, India, Latin America, China, and Africa, that need attention. This is where the largest growth will be. With the greatly expanded global horizon, the financial executive should be aware of these aspects: • The expanded markets for U.S. goods and services, and the related impact on specific industries, required changes in packaging and product design, and distributions to meet local tastes. • Potential changes in sources for raw materials and supplies. • Widened financial investment opportunities, with differing rates of return and diversification possibilities in foreign stocks (including ADRs — American Depositary Receipts), bonds, and global mutual funds specific to a particular county or region. • Possible impact on organization structure, including top management structure and related local management chain of command and financial management structure. 139

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While the subject of globalization is currently popular, it bears mentioning that though many managements may attempt to do business globally, a very large number do not. Converting a local business to a global basis is difficult. The differences in style of management required, in control and lack thereof, and in business practices, causes some management to shy away from globalization. (see Section 9.7.) But the rewards, if successful, are great — shared resources, shared management talent, broadened markets, lessened impact of a local economy downtrend. Globalization under the proper conditions can open up a world of opportunity. • Possible changes in corporate or entity relationships, including the virtual corporation. • Changes in policies and procedures relating to planning and control responsibilities or other activities required by U.S., foreign national, or local laws and regulations—as well as transfer pricing guidelines.

9.2 CHANGING NATURE OF INTERNATIONAL TRADE U.S. companies have engaged in international trade for many years by exporting U.S. produced goods or services, importing selected foreign products, and utilizing factories in foreign countries to assemble products for sale in the United States. With the emergence of huge trading blocks in North America (including the implementation of the North American Free Trade Agreement [NAFTA], Europe [the European Union], and East Asia [the Pacific Rim]) and the growth in other areas, major changes are taking place as to the manner in which global or multinational organizations are doing business. Cross-border trade and investments are both rising dramatically. These specific developments illustrate the trend: • Many U.S. companies are increasing their foreign capital investments in plant and equipment. • U.S. investors are putting record funds into foreign investment — ADRs, some stocks, bonds, and mutual funds. • Some U.S. corporations are engaging in sophisticated or advanced research and development (R&D) in foreign laboratories instead of the United States. • U.S. owned companies are beginning to employ large numbers of foreign workers relative to the number of U.S. employees. • Many U.S. owned corporations are exporting foreign produced goods to the United States. Conversely, some foreign-owned companies are establishing manufacturing plants and distribution facilities in the United States for the sale of their U.S. produced goods. • Many non-U.S. companies with facilities in the United States are exporting a significant value of U.S. produced goods to foreign markets. For many years, U.S. global companies regarded foreign plants as appendages for the manufacture and sale of products designed or engineered in the United States. Given competitive pressures, the superior knowledge that foreign nationals have about local practices or customs in their country, and perhaps a less dominant position of some U.S. products and services, there is now more of a cross flow of technology, capital, and talents in many directions. In reality, the nationality of a company is not as clear as it once was; and the chain of command may include many U.S. citizens as well as foreign nationals. All these developments add to the complexities of doing business on a global basis.

9.3 IMPACT OF GLOBAL TRADE ON SEGMENTS OF THE U.S. ECONOMY It should be of general interest to know how global trade affects different segments of the U.S. economy. How does it impact a particular industry or company? Because U.S. government statistics do not provide much assistance, Business Week made its own review after dividing the U.S.

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economy into three segments: (1) exporting trade, (2) import-competing trade, and (3) domestic trade.1 The makeup of the sectors and the general conclusions are: 1. Exporting trade. The exporting sector consists of industries that are competing effectively in markets at home and abroad. To be included, the industry group must export at least 10% of its output. The exporting sector includes industries such as: Financial services Higher education Instruments International communications and transportation Lumber and paper products Moviemaking and other entertainment

Aircraft Business services (e.g., consulting and accounting Chemicals Computers Drugs Electronic equipment and components

The Business Week report indicates that workers in the exporting sector are winners in the trend toward a global economy. Exporters have expanded output and sales, and they also have boosted productivity by reducing jobs and substituting capital for labor. Although employment was flat, average real wages increased by 5.2% since 1980. As one economist stated, “Export success means rising wages.” 2. Import-competing trade. Industries in the import-competing category import no more than 10% of foreign goods into the U.S. market. This sector includes the following categories of industry: Automobiles and motorcycles Cement Clothing Consumer electronics Furniture Machine tools Mining

Most industrial machinery Screws, nuts, and other small hardware Shoes and luggage Steel, aluminum, and other metals Tires Toys

Employees in this segment have been hurt by the direct and indirect effects of foreign competition. Jobs have become scarce, and wages, once good, have fallen. 3. Domestic. This category includes industries that do little importing or exporting. Most are service industries, although some manufacturing is included (e.g., concrete blocks) when local tastes, standards, or economics limit international trade. The domestic sector includes these industries: Business services Commercial printing Concrete products Construction Domestic transportation and communications Education (primary and secondary) Financial services, real estate, and insurance

Food processing Health services Personal services (e.g., hair dressing and automobile repair) Publishing Rubber and plastic products Wholesale and retail trade

Global competition has pushed down wages in the domestic sector. While it may be relatively easy to find work, pay has decreased and is getting lower. Moreover, as imports or increasing productivity reduce the number of jobs in other categories, many employees have migrated to the service sector, making competition a more important factor. Global trade can affect just about everyone in every sector of the economy. 1. Michael J. Mandel, and Aaron Bernstein, “Dispelling the Myths That Are Holding Us Back,” Business Week, Dec. 17, 1990, p. 67.

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9.4 DETERMINING AND IMPLEMENTING SUCCESSFUL GLOBAL STRATEGIES A great many factors influence whether a particular entity will be successful in the global marketplace. Perhaps no factor is more important than the selection of the proper strategies; and this includes determining the strategy decided upon in the proper manner. It is a reflection of the “NIH” syndrome—not invented here. A key player in carrying out global strategies is the subsidiary top manager. Some research into the viewpoints of these managers revealed these conclusions as to the process by which strategies should be determined.2 • It is important that the head office executives become familiar with local conditions. Only where the subsidiary managers believe the head office executives understand how the local market operates do they respect the decisions reached, and make a greater effort to follow them. • Two-way communication is essential. Subsidiary top managers value the ability to voice their opinions and exchange ideas with the home office in reaching a strategic decision. • Subsidiary managers must regard the decision-making practices as consistent. In other words, strategic decision making is a political process as well as any economic and competitive process. Subsidiary managers must not conclude that those on the “inside track” will be heard, but that all others will be overlooked. • Subsidiary managers must believe they have the ability to reflect or openly challenge the head office decision. In such an environment, the subsidiary managers think the head office may better recognize that strategic decisions will be of a higher quality, and will be made in the overall economic interest — not primarily a political interest. • Subsidiary top managers think it is only fair that the head office explain the reasons for the final global strategic decisions. When such a procedure is followed, many subsidiary managers tend to believe that the head office at least considered the subsidiary position, and that they thereby acted in a fair and impartial manner. The existence of a fair process of establishing global strategies is key to making the strategy successful. It tends to cause subsidiary managers to pursue voluntary execution—doing more than is required — rather than compulsory execution—meeting minimum requirements. The traditional mechanism for strategy enforcement—incentive compensation, auditing or monitoring systems, heavy-handed disciplining by the head office, and other rewards or punishments — are of some worth. But these mechanisms are of declining value by reason of such trends or factors as these, among others: • Increasing size of subsidiary units • A growth in unique or distinctive skills in the subsidiaries • Growing and extensive communication between the subsidiaries in comparing ideas (and excluding the home office) • Growing importance of subcultures • Increasing difficulty in monitoring efforts in enforcing the prescribed strategy—due to an inability to distinguish the cause of failure — whether the result of factors beyond the control of the manager, or poor implementation that he or she can control • Growing loss of control by the central office The growing complexities in the global marketplace make a participative management approach, perceived as fair and equitable, increasingly important. Aside from the psychological environment, the most important factor is the actual strategy adopted. The predominant philosophy or type of

2. W. Chan Kim, and Renee A. Mauborgne, “Making Global Strategies Work,” Sloan Management Review, Spring 1993, pp. 11– 26.

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strategy will depend, among other things, upon the product, the industry, the specific market, and the nature of the competition. A study of styles of competition in the semiconductor business made by a Fordham University Graduate School of Business professor concluded that, in this instance, U.S. firms tended to develop a unique strategy while the effective Japanese competitors tended to win by implementing in a superior manner a not-so-unique strategy.3 A comparative summary of different competitive actions in this specific market are shown in Exhibit 9.1. Dominant Competitive Style Action

U.S. Company

Securing unique product-market advantage Role of process technology (which transfers a product design into marketable products)

Sources of process technology know-how

Withdrawal from the market

Status of vertical integration

E XHIBIT 9.1

Attempts to develop unique advantage for each product line Great variance from company to company. Large firms may attempt to stay in the forefront of process technology, whereas firms that rely most heavily on product-market differentiation may consider process technology less important Often depends on external sources — e.g., by engaging in collaborative research, by outright purchase, or by seeking assistance from equipment manufacturers Tends to withdraw from product-market segment when clear advantage cannot be gained, often after competitive pressures make segment unprofitable Generally values such integration only when related products contribute uniqueness

Japanese Company Does not seek unique productmarket advantage; relies on low cost and high quality Emphasizes staying at the forefront of technology—both for product development and for capital improvement

Tending to favor internal development

Seldom withdraws from market; tends to remain in product segment and to strive for profitability through efficiency

Highly values vertical integration as part of drive to self-sufficiency

C OMPARATIVE C OMPETITIVE S TYLES

As might be expected, the dominant competitive style influences any industry structure, which in turn influences the industry’s member firms, their suppliers, and their customers. Exhibit 9.2 compares the impact of the two competitive styles on some important industry factors and characteristics. Note that the impact could be either an advantage or a disadvantage for any given particular firm.

9.5 ORGANIZATION STRUCTURE IN A GLOBAL ENTERPRISE The removal of trade barriers and the trend toward a global economy is changing the manner in which companies do business and, as a consequence, often also causes a change in some organizational arrangements. As entities become global, new threats appear in the home market as well as

3. See William G. Egelhoff, “Great Strategy or Great Strategy Implementation — Two Ways of Competing in Global Markets,” Sloan Management Review, Winter 1993, pp. 37– 50.

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Competing Style

Distinguishing Characteristics Impact on Factor Strategic variety

Industry concentration Industry survival pattern Industry Characteristics Product life cycle

Risk of technological or environmental change Profit margins E XHIBIT 9.2

“Superior” Strategy

More Effective Implementation

Greater variety of strategies results in greater range of products as well as greater segmentation of markets

Fewer strategies, resulting in more direct competition between products and product substitutes, with emphasis on quality and cost Only a few successful competitors and high industry concentration Efficient competitors survive and dominate industry, with lower turnover among leaders

Many successful competitors and low industry concentration Innovative competitors survive and dominate industry, with high turnover among leaders

Strategy is most effective in early stage of product life cycle, when technological and/or environmental change is rapid and a variety of feasible product designs exist Entity risks losing competitive advantage when there are fewer such changes and when imitators enter market Less direct competition, resulting in higher profit margins

Strategy works best in later stages of product life cycle, when technological and/or environmental change is slow and the basic designs have evolved Entity risks losing competitive advantage when technological and/or environmental change dominates market More direct competition, resulting in lower profit margins

“S UPERIOR S TRATEGY ” VS . M ORE E FFECTIVE I MPLEMENTATION N ONUNIQUE S TRATEGY

OF A

the foreign market. New products enter the marketplace, and competition increases for existing as well as new customers. These competitive forces are causing these changes: • Increased customer demands. Customers tend to require faster deliveries, improved quality, and more numerous other related services. • Quicker responses. It becomes increasingly necessary to react quickly to competitive actions, as well as changing market conditions, and to shorten the time for development of new products and services. • Improved outsourcing or subcontracting. Another frequent requirement is the developing of closer relations with key suppliers so as to facilitate just-in-time delivery of materials or parts or other fast response needs. • Strengthening core competencies. With the need to assemble and strengthen core competencies, some entities are forming flexible partnerships — as discussed in Section 10.7. These business adaptations, coupled with the changes in information technology and the inflexibility of traditional, cumbersome, and bureaucratic structures, excessive management layers, and onerous procedures, are resulting in some new organization structures. Some may be recognized in a realigned organization, and others are reflected in “new organizations” that are not usually a part of the typical organization chart. A few of these new relationships are reflected in the phenomena listed next. • High-performance teams. This is a group of individuals with differing skills brought together to function as a team and to completely reengineer a process—such as filling customer orders or a manufacturing sequence. The team works as a group using shared information and groupware— especially designed software to support collaborative effort.

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• Integrated organization. In reality this is a change in the access and flow of information. Instead of, for example, three separate resource areas (a) financial, (b) physical assets, and (c) human resources, a new integrated information system lets executives directly access the required data. This new information system removes layers of management and modifying influences. • The extended business. With the help of industry standards, computer systems are extending outward and linking with both customers and suppliers. In a sense, a change is taking place from a vertical organization to a horizontal entity. Again, some of this change is seen in the virtual corporation. We see the impetus of international competition forcing the elimination of layers of management, and effective working groups built around key processes instead of single functions or departments. Moreover, knowledge of local markets and important customers argues for a great deal of decentralization. In the context of organization structure, two other changes are occurring: 1. Unit headquarters. In this increasingly global economy, many U.S. companies are transferring abroad the world headquarters of important business units. Astute managements are recognizing that they must operate near key customers and closer to competitors — not in a far-away location. Many large business are finding that a company cannot be run from a single location; several different headquarters may be required for different product lines or competitive postures. With such changes, some loss of control may result. Hence, the controller must be sensitive to these developments. 2. The finance organization. Just as the principle of decentralization applies to the marketing function, it could be advantageous in the finance organization. The chief financial planning and control office of the subsidiary unit should report administratively to the local unit manager. This structure tends to make the financial executive a member of the local management, and not be perceived as the eyes and ears of the corporate office. Also, it should make the local financial manager more responsive to the needs of local management. The corporate controller could then provide functional guidance, such as the financial procedures to be used, internal control procedures, and report requirements for the home office. The staff relationship of the unit controllers to the corporate controller is illustrated in Exhibit 9.3.

9.6 VIRTUAL CORPORATION In the context of meeting global competition, a new form of organization—the virtual corporation— is emerging to more quickly take advantage of new economic opportunities. This development in organization structure warrants discussion in a separate section. While often used in connection with outsourcing, the concept may spread to other functions. Webster’s Ninth New Collegiate Dictionary defines “virtual” as “being such in essence or effect though not formally recognized or admitted.” By this definition, a virtual corporation is an entity that, although not formally recognized or admitted as a corporation, is such in effect. As typically described, it is a temporary, flexible network of independent organizations linked by information technology for the purpose of sharing skills, costs, and access to one another’s markets. It is a means of quickly meeting competitive pressures. The principal characteristics of this form of organization are: • Excellence. Each participant in the organization commits its “core competence” to the joint effort — with the result that each function or process can be world class in a faster time than other methods. A single corporation only rarely can achieve world class status in most of its functions. • Opportunistic and temporary. The association is less likely to be either permanent or formal than other arrangements. The entities band together to meet a particular need or to take advantage

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E XHIBIT 9.3

G LOBAL O RGANIZATION S TRUCTURE ( WITH E MPHASIS ON THE F INANCIAL O RGANIZATION )

of a particular opportunity. When the need no longer exists, or the benefits have been realized, then the organizations disband. But benefits have accrued for each member. • Existence of indeterminate borders. With the many contacts among suppliers, customers, and perhaps competitors, the corporate boundaries often become blurred. • Technology dependent. The new information technology enables the widely dispersed entities to communicate and work cooperatively. The electronics interchange reduces greatly the time required for legal decisions, or link-ups, or making changes. • Codependence. The nature of the new relationship makes each participant quite dependent on the other members of the group. • Loss of control. The various characteristics listed above results in some loss of control over some operations, with possible related difficulties. This form of organization should be considered by some global entities.

9.7 TECHNICAL ASPECTS OF THE CONTROLLERSHIP FUNCTION UNDER GLOBALIZATION The bulk of the preceding discussion in this chapter has related to those general aspects of globalization or international trade of which the controller should be aware. Additionally, in properly carrying out the duties of a controller in a situation involving multicountry operations, as contrasted with single country activities, these subjects are germane and specific to the task — and they are all interrelated: • Open communications • Need for uniformity in data definition • Complying with international accounting requirements

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• Measuring foreign operations • Translating financial statements • Evaluating foreign investments —capital expenditures, R&D projects, operating programs (such as designing and constructing an aircraft), and so on • Transfer pricing • Taxation • Import/export regulations • Managing currency risk • The Foreign Corrupt Practices Act (FCPA) (a) OPEN COMMUNICATIONS. Two factors contribute to communication problems in an international operation. They are language and distance. It is important for a controller to address these problems and develop a satisfactory solution. The most obvious way to handle the language problem is to ensure that someone with good bilingual skills is representing the controller in the overseas operation. This individual must be able to deal effectively with the local country officials and employees and then communicate important and necessary information back to the parent. The communication can be in person, by phone, by letter, and by data transmission. In larger operations, private communications systems will allow easy teleprocessing and telecommunications. In smaller organizations, careful planning of when calls and data are transmitted will result in good communications. However, even after placing a qualified representative in the foreign operation, the controller must remain aware of the importance of clear information exchange. The need becomes even greater as the company expands into more countries and as the foreign operations become a bigger part of the business. One technique that has proved effective is to issue written instructions on important matters such as: • Planning assumptions • Accounting and reporting requirements • Control assessments • Disbursement practices The instructions should be formal notification to the subsidiaries as to what is required of them. The letters or instructions should be controlled (e.g., a sequential number assigned to each one so that all recipients are aware of all communiques). It is helpful to the subsidiaries if the parent periodically issues a summary of all such instructions that are still in force. A second, and probably invaluable, communication technique is the one-on-one meeting. It is here that all the nuances of operation are really covered. These meetings of key people (controller to controller) should take place at least once a year and probably more often if there are difficult issues to be resolved. Another effective communication vehicle is the use of group meetings, seminars, and classes wherein the controller sponsors a meeting of international people perhaps from several countries at which specific items of mutual interest are discussed. This also allows people with the same problems to come together and informally talk about problems. There has proved to be a continuing benefit in this approach in that the people stay in touch with one another to discuss ongoing and future problems and share solutions. New developments in groupware to provide meeting support can assist in keeping the communication lines open. (b) UNIFORM DATA REQUIREMENTS. When operating internationally it is essential that there be worldwide uniformity in data definitions for three reasons: 1. It simplifies consolidation of financial statements and reports.

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2. It allows for comparability of results. 3. It permits timely release of reports. The use of a standard schedule of accounts, developed and maintained centrally but responsive to country needs, is the most obvious way to achieve uniformity or reporting. It becomes simple then to define the aggregation of data in order to achieve usable reports. This results in one scorecard that is then used by all parts of the organizations within the company. To be effective, use of a standard reporting chart of accounts requires that headquarters have a knowledge of the out-of-country business and how it is to be recorded and summarized. It also requires an interpretation of U.S. accounting standards, which must be articulated and promulgated to all subsidiaries so that financial reports have a uniformity of structure and content. To sum up, a world-class accounting operation would be organized to: • Keep responsibility for recording at the country level. • Provide clear instructions to the countries as to how transactions would be summarized and reported. • Have each country prepare statements in the parent-company currency using U.S. generally accepted accounting principles (GAAP). This structure will result in uniform accounting reports to allow comparison between units. It will also permit tighter closing schedules and the resultant earlier release of information both within the company and externally. (c) INTERNATIONAL ACCOUNTING REQUIREMENTS. accounting operation the controller must address:

In putting together a world-class

• Records of a subsidiary must be kept in the local currency and language and must meet local fiscal, professional, and tax requirements. • The records must then (a) be adjusted to “generally accepted accounting principles” of the parent, and (b) be translated into the currency of the parent. (Less commonly, a second ledger may be maintained in the currency of the parent and in accordance with GAAP of the parent.) The record keeping of the subsidiary is generally done locally. The day-to-day transactions covering payment of salaries, purchasing of goods and services, billings to customers, and collecting cash, as well as maintaining and controlling assets and liabilities all take place locally and in local currency. The accounting for these transactions is most effectively done where and when they transpire. The accounting records must be constructed so as to provide adequate information to prepare tax returns and produce local financial statements for regulators, creditors, unions, and other interested parties, and to facilitate reporting to the parent company. The accounting standards to be followed must be those of the host country so the record keeping must be done using those standards or easily convertible to them. This conversion is necessary if the accounting standards used are not local standards but rather are those of the parent company’s country. It should be noted that the accounting standards required by the authorities vary from country to country. The International Accounting Standards Committee (IASC) is attempting to minimize alternatives by issuing international standards, but all such standards must then be adopted by the appropriate authorities in each of the countries before they become official. This could be a long and tedious process. In the meantime a broad knowledge of each country’s generally accepted accounting policies must be developed and maintained by the controller of a multinational company. A listing of International Accounting Standards as issued by the IASC is available, but the acceptance by each country must be determined individually. The translation and remeasurement of local results can be done by either the local country or the parent. If done in-house by local personnel, there will be a need for each country controller to understand U.S. GAAP. This can be accomplished in several ways: through a program of individual education, through in-house seminars and workshops, and through centrally developed and

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issued accounting instructions, all of which must be directed by the corporate controller. The latter provides the best opportunity for uniformity in recording and reporting and probably will be necessary even if local finance people become knowledgeable about parent-company GAAP. If the translation and adjustments are done at the parent-company headquarters, there are several areas of concern. First, country management will not have an opportunity to review the dollar results before they are put into the consolidation process, and valuable insight into cause and effects of current operations will be missing. Second, higher management at the parent headquarters will be viewing reports that have not yet been seen at the operating level. Communications could easily become confused and important decisions delayed. Having the translation and remeasurement work done at the country level is the more effective approach. (d) MEASURING FOREIGN OPERATIONS. measurement techniques are:

In most organizations, the primary control and

• Define key objectives. • Prepare a financial plan, compare actual results to it, and take corrective action. • Compare actual results to a prior period. The multinational company generally uses these techniques to measure the translated results of its foreign subsidiaries. The technique is effective if the variable of currency fluctuation is recognized and adjusted for. As mentioned elsewhere in this chapter, translated results can present a very different picture of operations and financial condition than local currency results reflect. The controller should be familiar with both sets of data and the analysis supporting them. However, it is the parent-company currency that is used for external reporting; therefore, the use and understanding of translated financial statements will remain a key part of the controller’s work. As an overall summary of this task of measuring the financial performance of a global unit manager, the reports should reflect these three objectives: 1. To reflect the financial plan for all activities under the control or responsibility of the local manager. 2. To measure actual results against plan for those matters under the control of the local manager. 3. To reflect the planned results translated into the parent company currency; and to identify planned vs. actual results segregated between (a) those reflecting the entity manager’s performance and (b) those which are due to the impact of currency fluctuations. (i) Comparisons with Budget or Plan. The biggest unique planning and control problem facing the controller of an international business is that of fluctuations in the currency exchange rate. When plans or budgets are established an estimated exchange rate must be used to express in the parent’s currency the budget amounts developed in local currency. The “actuals” from the accounting records are translated at the current rate, which is usually different from the rate used for the plan, for example: Currency Exchange Rates 4 local currency (L/C)  $1 5 local currency (L/C)  $1

Plan assumptions Actual

Statement of Operations

Sales (L/C) Rate Sales ($)

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Actual

Budget

Variance (Unfavorable)

1,000,000 5:1 200,000

1,000,000 4:1 250,000

-0(50,000)

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In this example the parent-company currency, the U.S. dollar, has strengthened, and it now takes more local currency units to equal one dollar than was planned. The effect is that, when viewed from a local perspective, sales are on plan, but when viewed from a parent-company perspective (i.e., the dollar), the subsidiary is under plan and substantially so, requiring analysis and explanation. One way to give a better view of what is happening is to add two more columns to the report, showing the effect of currency. The report now tells the reader that the unfavorable variance is all due to a currency exchange movement. Statement of Operations Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

Currency Translation

Business Performance

200,000

250,000

(50,000)

(50,000)

-0-

If the example was changed to include a modest overbudget situation in local currency, it would be reported as follows:

Sales (L/C) Exchange rate Sales ($)

Actual

Budget

Variance (Unfavorable)

1,100,000 5:1 220,000

1,000,000 4:1 250,000

100,000 (30,000)

In this example the results shown in dollars portray a misleading result, but when the currency effect is shown separately, a much clearer picture emerges. Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

Currency Translation

Business Performance

220,000

250,000

(30,000)

(55,000)

25,000

The amount of variance due to business is calculated by either: (1) taking the variance in local currency and translating it at the current rate, or (2) more commonly since local currency results are not usually transmitted early, having the countries calculate the actual results translated at the plan rates. In the examples, both budget and actual would be translated into dollars using the plan rate of 4 L/C  $1. The analyst would keep the budget amount constant at a 4:1 translation rate and prepare an “actual” using the same translation rate to produce the following result:

Sales (L/C) Exchange rate Sales ($)

Actual

Budget

Variance (Unfavorable)

1,100,000 4:1 275,000

1,000,000 4:1 250,000

100,000 25,000

The above variance is attributed to sales being higher than planned and is therefore the variance due to business operations. The difference between the total variance in translated amounts and the business variance determined above is attributed to the effect of currency changes.

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(ii) Comparisons with Prior Year. A similar problem in plan/actual comparisons occurs when current actual results are compared to the actual results of prior periods. If the exchange rates used for the two periods are different, then the results are clouded by the change. For example, if

Sales (L/C) Exchange rate Sales ($)

Current Year

Prior Year

Increase/(Decrease)

1,000,000 5:1 220,000

900,000 4:1 225,000

200,000 (5,000)

However, if the exchange rates are normalized by translating the current period using the same exchange as the period being compared to, the following picture results: Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

220,000

225,000

(5,000)

Currency Translation

Business Performance

(55,000)

50,000

As in the plan/actual analysis, the “actual” results in both periods would be translated at the same exchange rate to produce the following result:

Sales (L/C) Exchange rate Sales ($)

Current Year

Prior Year

Increase/(Decrease)

1,100,000 4:1 275,000

900,000 4:1 225,000

200,000 50,000

By isolating the currency exchange effect, we can see that there was a growth in the business of $50,000 or 22%, rather than a 2% decline. We can also see that the currency effect was to reduce sales, in dollars, by 25%, wiping out the operating growth and resulting in a decline in reported sales compared to the prior year. (iii) Inflation. In a multinational company, the impact of inflation on the business results is not different from a national company; usually it is just more volatile. The same analyses and actions taken in regard to home-country inflation generally apply to translated results. However, there are many less developed nations that experience hyperinflation (i.e., annual inflation in the hundreds or thousands of percent). For these situations, some special analysis of local currency results must be made to normalize for inflation. Establishing a base year for currency value and then adjusting subsequent years results to that value presents a more accurate picture of growth or decline. For example, hyperinflationary country A experiences a 100% inflation rate in the current year. Its sales results for this year and last year are: Current year Prior year Increase Percentage

L/C L/C L/C

1,000,000 750,000 250,000 33%

However, using the prior years’ currency value as 1, the current year value is 0.5 after adjusting for 100% inflation (1 /100% 1). The current year sales value when compared to last year is L/C 500,000 (1,000,000  0.5). So instead of a 33% gain in sales, there has been a 33% decrease—a

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very different result and one requiring further analysis and action. This is called constant currency and the results are: Current year Prior year Decrease Percentage

L/C L/C L/C

500,000) 750,000) (250,000) 33%

As indicated above, this inflation move is reflected in currency translation rates and translated results therefore have only the parent-company inflation rate included. (e) EVALUATING CAPITAL EXPENDITURES. When the question “Should we invest overseas?” is raised, all the analyses used in making capital investment decisions in the home country will have to be made. Additionally the new risks of exchange rate fluctuations and political uncertainty must be considered. Unless there are unusual circumstances (e.g., a need to maintain special know-how available in a specific location), the key consideration in the investment discussion is the return on assets or return on equity that relates to “cash flow to the parent.” (i) Exchange Rate Fluctuations. The impact of currency movements on financial statements and the analysis of them is discussed in detail in the section of this chapter titled “Measuring Foreign Operations.” Exchange rate fluctuations will also have a significant effect on the cash flow to the parent of an investment in a foreign country and so must be recognized in the planning and assessment of investment alternatives. It should be noted that the analysis of investment returns when calculated in the currency of the country where the investment will be made results in a different answer than when it is done in the currency of the parent. For example, using a “net present value” analysis to determine the return in both currencies shows the comparison illustrated in Exhibit 9.4. A rule of thumb is that if this investment does not yield a positive cash flow in the parent’s currency then it should not be made. If the return is positive then the required internal rate of return and/or the hurdle rate of return must be met. Another good rule of thumb is that the rate of return should at least exceed the expected interest rate of government securities in that country. Subsidiary Currency

Parent Currency

Net profit before depreciation

After-tax value of dividends, interest and royalties remitted by the subsidiary

Plus Present value of terminal value (liquidation value)

After-tax recoverable amount

After-tax amount remitted to parent

Equals Total present value of cash inflows

Estimated amount

Translated value of remitted amounts

Minus Original investment (plant and working capital)

Translated amount

Established amount in parent currency

Present value of cash inflows over the life of the project

Equals Net present value E XHIBIT 9.4

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C ALCULATION

OF

N ET P RESENT V ALUE

IN

T WO C URRENCIES

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In estimating the value in the parents’ currency of future cash flows, it is necessary to forecast for each of the years included in the analysis: • Exchange rates • Withholding taxes • Currency restrictions • Political risks This is a difficult but doable effort. (ii) Exchange Rates. In considering the economic exposure to future foreign exchange risk, both the cash flows in foreign currency and the value of dividends in the parent currency must be considered. For example, a devaluation of the foreign currency will result in a decrease in the value of foreign currency dividends in the parent currency. But, it may also lead to an increase in foreign currency profit as a result of increased sales volume or sales price on exports. The net impact on the cash flow to the parent is the sum of both effects. The analysis should begin with an assessment of the most likely exchange rates anticipated by year. Then simulate what would happen to cash flows under a variety of “what-if ” scenarios. For example, if it is decided that the most likely case is a 5% devaluation of the foreign currency each year, a cash flow plan using that premise should be prepared. It can then be varied by asking “what if ” it is less or more than 5% and the same plan and assessment done at 3% and 4%, or 6%, 7%, 10%, etc. Another scenario that should be performed is “what if ” there is appreciation rather than devaluation and the plan is assembled using 2% or 5%, etc. The relevant range of possible changes depends upon the foreign currency under consideration. Brazil can be safely expected to have its currency continually devalue, and only devalue. The range, however, is very wide and volatile, perhaps 100% to 200% per year. The Netherlands on the other hand could have its currency move in either direction but probably no more than 10% each way. After the economic analysis is finished then a probability-of-occurrence analysis should be performed and a weighting given to the results. For example, if there are two probable scenarios — a 5% devaluation and an 8% devaluation—and the probability is judged to be 80% for the 5% case and 20% for the 8% case then the following cost estimate can be made and incorporated into the estimated results: 5% devaluation  NPV  0.80  A 8% devaluation  NPV  0.20  B Expected value of exchange movement  A  B (iii) Political Risks. It is necessary to estimate the costs associated with the political risk of investing in a particular country. This risk can be defined as the risk that the foreign government intervenes in some unexpected way that affects cash flow to the parent. There are several exposures in this area: • Unexpected change in repatriation restrictions. In order to force reinvestment in its country, a government may forbid any funds from leaving the country or it might severely limit the amount or percent. For example, in India the amount “repatriable” is negotiable but must be approved by the authorities. • An unexpected change in withholding taxes on remittances • An unexpected change in import duties • An unexpected change in labor and wage laws • Devaluation of currency • Expropriation of assets

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In this latter extreme situation there are two effects on the cash flow to the parent: 1. The assets are not paid for by the expropriating government, or the payment is less than fair market value. 2. Future cash flows from operations are lost. Insurance against expropriation can be purchased in the United States through the Overseas Private Investment Corporation (OPIC), but there is a premium to be paid that represents immediate cash outflow that must be weighed against the present value of the possible future loss. There are sources of information on each of the political risks. For example, in the United States there is Frost and Sullivan’s World Political Risk Forecasts. This publication summarizes the expert opinions of individuals knowledgeable about each country relative to three kinds of investments: 1. Financial — loans to the country 2. Investment — direct investment in the country 3. Exporting — exports to the country It assesses the political stability of the country, government restrictions (duties, tariffs, control of natural resources), and economic policies that affect inflation and exchange fluctuations. This information and data like it make it possible to establish ranges of probability in estimating factors over many future years that will affect cash flows of foreign subsidiaries. It is the controller’s responsibility to ensure that this analysis is done as best it can be and not ignored because it is too difficult or includes too much “soft” data. (f) TRANSFER PRICING. An international transfer price is the value given to goods or services produced or performed in one country for the benefit or use by a related company in another country. For example, the ABC Company, an American company, has subsidiaries in Germany and France. It has a manufacturing plant in Germany that supplies products to both France and the United States. It has a computer center in France that services France and Germany. Its headquarters and research and development facilities are in the United States. Transfer prices have to be developed for: • Products shipped from Germany to France and to the United States • Information services performed by France for Germany • A share of R&D expense to be paid by France and Germany • A management fee assessed by the U.S. parent on its subsidiaries We will now examine how each transfer price could be determined. (i) Development of the Transfer Price. It is usually the responsibility of the corporate controller to develop the transfer prices that will be used in dealings between subsidiaries or between parent and subsidiaries. The price used will result in a profit or loss for the exporting country and will directly influence the profit or loss ultimately realized in the importing country. Such a situation has led some multinationals to develop transfer prices that are very subjective and result in the lowest profit (or even losses) being reported in the highest tax rate countries and conversely the highest profit being realized in the lowest tax rate countries. While this approach seems logical and defensible at first glance, it is unfair and has resulted in more laws and restrictions by the countries that believe they are being taken advantage of. Furthermore, in recent years the Internal Revenue Service (IRS) has taken a more aggressive stance in its search for transfer pricing abuses. The use of subjectively developed transfer prices also complicates the measurement system and frustrates local management because it cannot control or influence a significant item of cost. A more businesslike approach is for the controller to establish a uniform, objective system of transfer pricing that is: • Simple and inexpensive to administer • Understandable to the users

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• Fair in its effect on measurements An arm’s-length, objective system can take two forms: 1. Cost based 2. Market based (ii) Cost-Based System. A cost-based system, the one usually favored by American companies, uses the output of the company’s cost accounting systems and adds a markup for profit to it. This profit factor is usually established for the long term and not changed unless it becomes unrealistic. One approach to establishing the profit factor for a country that manufactures a product is to use a long-term (e.g., ten-year) average of the consolidated company’s net-income-before-taxes margin. Other objective and fair methods can be identified by each company. Once established, the estimated transfer price should be published and used in the preparation of financial plans by the various units. The markup on the transfer of services performed by one unit for another is more subjective and a flat percentage is usually established and not changed. For example, computer services could be marked up 10%, treasury services 5%, and so on. The important factor is that after a reasonable decision is made as to amount, then it should not be changed and it should be applied uniformly in all countries. If products are marked up 15% and services 10%, there should be no exceptions made based on unique facts and circumstances. To allow deviations introduces complexity and confusion into the internal system and causes consternation and distrust on the part of country regulators and tax authorities. (iii) Market-Based System. A market-based system, the one usually favored by many European countries, starts with the expected selling price in the importing countries and reduces it by estimated locally incurred cost, expenses, and profit, to arrive at a transfer price that is affordable to the importer. This price is then used by the exporter in billing the related company and should recover the actual costs incurred in the production of the goods and services along with a reasonable profit. In order to make a market-based transfer-pricing system effective, the transfer price must be accurately developed and then published and used until it is revised. (iv) Royalties. Whether a cost-based transfer price system or a market-based transfer price system is used by a multinational company it will probably also employ a “royalty” system in addition. The transfer price system is used to move goods and services between related companies. A royalty system is used to recover, from the subsidiaries, compensation for “know-how,” the use of brand names, company logos, and the like. The two most common royalties charged to subsidiaries are for: • Research and development • Parent-company management The royalty for R&D is traditionally a percentage of sales. It can be based on the ratio of R&D expense of the consolidated company to total sales of the consolidated company applied to the total sales of the subsidiary company. The resultant amount, less any locally incurred R&D, would be the R&D royalty due to the parent company. A parent-company management royalty is usually not based on a ratio but is rather an apportionment of the total parent-company staff and general expense based on a relationship of the subsidiaries. One method is the percent each subsidiary contributes to gross income applied to the total parent-headquarters expense pool. Another is a negotiated fee based on number of employees, profit margin, growth, and so on, but which recovers all parent-headquarters expenses. In applying these approaches to the example given at the beginning of this section, the transfer prices shown in Exhibits 9.5 through 9.8 would be developed. (g) TAXATION. Tax laws in each country are extensive, complex, and changeable. Since the impact of the laws is to share a significant percentage of the company’s profit (on average, 30% to

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a. Product manufactured in Germany at a cost of 1,000 DM

a. Computer center work done in France at a cost of 100 FF

b. ABC Company NEBT margin  12% (for last 15 years)

b. Uniform markup for all nonproduct goods and services  10%

c. Transfer price  1,000  12% (12%  1,000) 120

c. Transfer price  100  10% (10%  100) 10

Total  1,120 DM E XHIBIT 9.5

Total  110 FF

D EVELOPMENT OF T RANSFER P RICE FOR P RODUCTS

E XHIBIT 9.6

DEVELOPMENT OF TRANSFER PRICE FOR N ONPRODUCT S ERVICES

a. R&D expense for consolidated ABC Company  $10,000 (average 10 years)

a. The parent-company corporate expense for current year  $20,000

b. Total gross income for Consolidated ABC Company  $200,000 (average 10 years)

b. Gross income by unit

c. Royalty for R&D R&D Expense  Gross Income  5% of Gross Income d. Germany current year gross income Royalty at Total at 2 DM  $1  France current year gross income Royalty at Total at 4 FF  $1  E XHIBIT 9.7

U.S. France Germany Total

$ 10,000 $200,000

Management fee $20,000  % U.S. 63 France 12 Germany 25 Total 100%

80,000 DM 5% 4,000 DM $ 2,000 100,000 FF 5% 5,000 FF $ 1,000

$ 100,000 20,000 40,000 $160,000

E XHIBIT 9.8

% 63 12 25 100% $ 12,600 2,400 5,000 $20,000

D EVELOPMENT OF R OYALTY FOR P ARENT -C OMPANY M ANAGEMENT

D EVELOPMENT OF R OYALTY FOR R ESEARCH AND D EVELOPMENT

60%) with the various governments of the countries in which the firm does business, it is essential that local tax experts be available to the company. These local tax professionals have the responsibility to understand local tax law, interpret the law as it applies to the company business, advise local management how to minimize taxes, and handle the filing and reporting of local tax returns. The local tax expert should also be aware of possible tax changes and assess the effect of such changes on the local business. He would then keep the parent’s tax executive (e.g., controller) informed of important matters. While it is essential to have local tax experts it is also important to have a coordinated tax operation. This will require an expertise that is broader but perhaps not as deep as the local requirements. It is this centralized organization that develops tax planning and strategies and thereby contributes to the overall financial plan of the company. The senior tax executive has the responsibility of: • Estimating taxes to be paid by period • Negotiating disputes with authorities • Providing advice and counsel to local experts He should also have the authority to resolve disputes and disagreements. Aside from the complications of foreign taxes, the controller must be sensitive to the U.S. tax laws and regulations. The IRS carefully checks transfer prices. New tax laws are being enacted to eliminate loopholes. In 1993, a law was passed to eliminate “earnings stripping” by foreign

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companies. This occurs when a foreign entity uses large loans instead of direct equity investment to fund its U.S. activities. The interest payments on the loans become a tax deduction, thus “stripping” away U.S. tax exposure. The controller and tax executives minimize taxes in all legal ways; therefore, they must be continually aware of any relevant changes in U.S. tax laws. (h) IMPORT/EXPORT REGULATIONS. At one time, up until the early part of this century, the primary source of income for the various governments was from tariffs on imports. The regulations covering the tariffs are lengthy and complex. They represent an accumulation of many years of continual tinkering with the rules and laws. It is therefore of real importance that the controller have an understanding of these regulations so that he can organize and operate in the most effective manner and in the best interest of the company. Very often the import/export department does not report to the controller, but the controller must be knowledgeable about the operation and be involved in negotiations, procedural controls, and so on. Duties are usually assessed on imports not on exports. However, it is the exporter who must prepare documentation in accordance with the regulations of the country of import so that the goods delivered into the country are clearly labeled and identified. This facilitates customs clearance and should result in earlier delivery of products or services to customers and earlier receipt of payment by the exporter. There are many import/export brokers who are invaluable in helping firms find their way through this most complex operation, worldwide. Their services should be utilized. The parent company working with subsidiary company management should identify and engage the broker best qualified to handle the kind of business in which the company is engaged. (i) MANAGING CURRENCY RISK. A controller can take some steps to lessen the impact of wildly fluctuating currency on the operation of the business, insofar as imports and exports are concerned. If, for example, the parent currency is stable and strong, then billing and requiring payment in the parent’s currency will eliminate losses due to the decline in value of a foreign currency. Assume the following wherein the foreign currency has an inflation rate of 10% with a corresponding loss in value of its currency.

U.S. dollar  Foreign currency

May 1

June 1

1 1

1.0 0.9

The U.S. company sells 1,000 units at $1.00 each on May 1 and bills the customer $1,000 to be paid in 30 days. On June 1, $1,000 is received from the customer and deposited in the bank. There is no gain or loss on the transaction. However, what happens if the U.S. company sells 1,000 units at 1 foreign currency each on May 1 and bills the customer 1,000 foreign currency. On June 1, 1,000 foreign currency is received from the customer but when converted into dollars at the bank only $900 is deposited. There is a $100 loss due to changes in exchange rates (inflation). What can the U.S. company do to protect itself against such a loss? There are several actions available. • Do business only in the parent company’s currency. • Require cash payment on delivery if business is done in foreign currency. • Buy a forward exchange contract if business is done in foreign currency and credit terms are offered. (i) Currency Hedging. The first two items need little elaboration. If the transaction is made in the seller’s currency then all risk of loss is transferred to the buyer. If cash is paid on delivery there is no risk of exchange loss.

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However, in many instances, those two options are not available and the seller must do business in foreign currency and offer credit terms. In these instances, in order to mitigate the exchange loss the seller can buy a contract from a bank to sell foreign currency 30 days after the transaction. In the example, the contract would be bought on May 1 to deliver 1,000 foreign currency on June 1. The price is established by the bank (which is also entering contracts to deliver foreign currency to other customers) and might be for $950 for each 1,000 foreign currency delivered. The amount of loss is therefore known at the time the contract is entered into. This is called hedging and while it takes uncertainty out of the transaction, it will still produce some loss to the company, since the bank will charge a fee for handling the exchange contract in addition to reflecting an estimate in the movement of the currency. If the company is purchasing from a foreign business, similar dynamics are at work. If you buy in foreign currency you stand the risk of inflation impacts. If the foreign currency declines faster than the buyer’s currency there will be a gain; if slower, there will be a loss. The loss can be hedged by buying a contract to purchase foreign currency at a set price at some time in the future. Again, this will not usually eliminate the exchange loss, but it will eliminate uncertainty as to how much it will be. Hedging can be used in connection with the payment of dividends, interest, and royalties, and can also be extended further into the future to cover probable purchases (e.g., where there is a single foreign supplier) and sales in an ongoing operation. (j) FOREIGN CORRUPT PRACTICES ACT. No discussion of the controller’s role in international operations would be complete without addressing the FCPA. In the 1960s and 1970s, some multinationals had been involved in bribing foreign officials in order to get or keep business in their countries. It was a serious problem that had to be resolved. In December 1977, the U.S. Congress passed an act making it illegal for an issuer of securities in the United States to make certain payments to foreign officials. It also required such issuers to maintain accurate records. Following is a summary of the Act’s key requirements: 1. Payments to officials. The act made it unlawful for American companies to offer money or gifts to any foreign official, political party, or political candidate in order to influence that person in his official capacity. Influence meant having the person fail to perform his official duties or having the person use his influence with others in order for the company to obtain or retain business in the foreign country. The penalties for violation of this act are fines of up to $1,000,000 for any concern convicted of the violation. In addition, individuals involved in such illegal payoffs are subject personally to fines up to $10,000 and prison for up to five years. 2. Accounting and control requirements. The act also requires that issuers of securities make and keep books, records and accounts in reasonable detail, that accurately and fairly reflect the transactions and dispositions of assets. Devise and maintain a system of internal accounting controls that is sufficient to provide reasonable assurances that: (a) The transactions are executed in accordance with management’s general or specific authorization. (b) Transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. (c) Transactions are recorded to maintain accountability for assets. (d) Access to assets is permitted only in accordance with management’s authorization. (e) Asset records are verified with physical assets periodically and appropriate action taken with respect to any differences. The controller has a basic responsibility to comply with the requirements of the FCPA and any related legislation and amendments which pertain to maintaining an adequate system of internal control. (See Chapter 8.)

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CHAPTER

10

RECRUITING, TRAINING, AND SUPERVISION 10.1

INTRODUCTION 159

10.5

IMPORTANCE OF REDUCED TURNOVER 164

10.2

RECRUITING SOURCES 159

10.6

10.3

FACTORS TO CONSIDER WHEN RECRUITING 162

IMPORTANCE OF DEVELOPING CAREER PLANS FOR EMPLOYEES 167

10.7

10.4

FACTORS TO CONSIDER WHEN PROMOTING 163

IMPORTANCE OF COMMUNICATIONS WITH EMPLOYEES 169

10.8

HOW TO MOTIVATE EMPLOYEES 171

10.1 INTRODUCTION A prospective controller is well advised to peruse this chapter several times, for it contains information that is vital to the controller’s career. If the accounting staff is carefully selected, properly trained, and motivated, the controller will enjoy a huge productivity advantage over a controller who does not pay attention to these factors. The inevitable results of not doing so are slipshod work, high employee turnover, and massive inefficiency due to the time needed to constantly recruit and train new employees. Consequently, the recruiting, training, and supervision functions are crucial to the success of a controller. It is unfortunate, but business schools rarely give any formal training in this most important area, so controllers must pick up the requisite knowledge through either hands-on experience, a mentor, or additional training. This chapter is also a valuable source of information on the topic, but should be used as an overview. More detailed information can be obtained from books that deal entirely with business management.

10.2 RECRUITING SOURCES This section describes a number of sources a controller should consider when searching for candidates for accounting positions. There are three key factors involved in selecting a recruiting source, and these factors are discussed for each of the possible recruiting sources: 1. Recruiting cost. The cost of recruiting an accounting person can range from $100 for an advertisement in the local newspaper to one third of the hired person’s salary, which is a typical charge if the person is hired through a search firm. The recruiting cost tends to have a low level of importance if the recruiting task must be completed at once and a higher one if there is a long time line involved. Also, the lower-cost approaches tend to involve extra time by the controller to screen recruits, whereas more expensive approaches, such as using a search firm, tend to require less screening time, because this task is completed by the 159

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intermediary. In short, a cheap recruiting method takes longer and requires more effort than an expensive approach. 2. Recruiting quality. The quality of the person hired tends to go up if there is a long time interval for the recruiting process. This is because a controller can take the time to obtain a large pool of candidates, interview them at his or her leisure, and spend the extra time needed to review their references. The reverse is generally true if there is a time crunch involved. However, these assumptions are generalizations, for it is also possible to run into a perfect candidate on the first day of a search. 3. Recruiting time. As noted in the first two factors, the time allowed to conduct a recruiting campaign will usually result in higher costs if there is little time available, because a controller must resort to expensive sources. Also, there is a chance that the quality of candidate recruited will be lower if the recruiting period is short, because there is only enough time to meet with and evaluate a limited pool of candidates. Once a controller has determined which of these three factors (or a combination thereof) are paramount in the search for a specific candidate, it then becomes an easier matter to select the correct recruiting source. For example, if a controller needs a new payroll clerk immediately, even if there is a high cost involved, it is best to go straight to a search firm, which will charge an inordinately high price but will present a set of qualified candidates in as little as a day. However, if there is no rush to fill a position, the search firm may be the last source consulted. The recruiting sources are: • Audit and consulting firms. It is common for a controller to hire from the ranks of the auditing and consulting firms that work for the company. This approach is very inexpensive, because the controller probably already knows the best performers within these firms and just calls them to see if they are interested in a position. This can also result in a fast hire, so there is a very short time line involved. The quality of the person hired also tends to be high, because the audit or consulting firms have already done the prescreening when they hired these people. In short, this is an excellent way to bring in top-notch personnel quickly and at low cost. • Authors. A rarely used recruiting technique is to hire the authors of published accounting works. This approach ensures specific knowledge by the candidate of the subject matter for specific jobs. However, there is no assurance that this knowledge equates to good job performance. Also, there are very few published authors within the geographic range of most companies, so the volume of candidates acquired through this approach is slim. The cost and time needed to hire through this approach are minimal, because the controller already knows the name of the person to hire —it is simply a matter of making contact and arranging an interview. • Campus recruiting. A good recruiting source for lower-level positions is the college campus. However, it is difficult to determine the quality of the people hired, because they have never worked before. Also, this tends to require a very long lead time, since candidates must be recruited months in advance; thus, this approach is useful only for filling positions that are constantly needed and for which accurate hiring projections can be made. It is also expensive to send personnel to colleges for recruiting and costly to bring in candidates for additional interviews. • Employees. One of the best sources of recruits is current employees. This approach works best when a company offers recruiting bonuses to employees. This incentive turns the entire employee group into an enthusiastic horde of recruiters. They have the additional advantage of recruiting their own friends, which typically results in a great deal of prescreening by the employees, resulting in a high quality of recruit. This also tends to be a fast way to gain recruits. The only problem is that the recruiting bonuses paid to employees can be rather large, usually exceeding $1,000 and sometimes going higher than $5,000 for each person hired. • Former employees. A controller should go to great lengths to maintain contact with quality employees who have left the company. Sometimes, the reasons why they left (higher pay, better positions, etc.) are not good enough, and they may be willing to return to the company.

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This approach is not only quick and inexpensive, but best of all, it results in highly qualified candidates who require minimal interviewing before being hired back. This is one of the best recruiting methods, though it typically results in only a very small proportion of the people hired into the accounting department. • Internet postings and advertisements. A new recruiting method is to use the Internet. This can involve either posting a job or reviewing posted resumes. Either alternative is inexpensive but requires screening an inordinate number of potential recruits. It is a quick recruiting method that even beats the speed of newspapers, because one can access an Internet site and immediately review resumes or post a job opening, with no transactional delay. However, this approach is similar to newspapers (see below) in that the quality of recruit tends to be low. • Newspaper advertisements. This approach involves placing ads in newspapers to attract candidates. This is the most common recruiting method, but it has a major problem: It typically results in a vast number of applications, which requires a great deal of screening to arrive at a small group of qualified candidates (or none at all!). However, advertisements are inexpensive and can be placed in newspapers on very short notice. For the more senior accounting positions, this approach tends not to result in a very large pool of qualified candidates. The biggest reason for the low quality is that only those people who are actively looking for work are reviewing the advertisements; this ignores the most qualified people, who are currently working elsewhere. • Professional organizations. This approach involves meeting qualified candidates through the meetings of professional organizations. It requires a great deal of “face time” by a controller or other members of the accounting staff, who must attend many organizational functions to meet with potential recruits. Though there is a minimal direct cost, the amount of labor by the accounting staff can be excessive. Also, it takes many months of attending meetings to build up a lengthy list of potential recruits. However, this can result in high-quality candidates who have been prescreened through the organizational meetings. Due to the time involved, this tends to be a little-used recruiting method. • Professional publications. This involves advertising in a professional publication to which an accounting person subscribes, such as the Journal of Accountancy. The advantage of this approach is that only a select group of trained accountants will see the advertisement, which thereby reduces the pool of recruits to a select group, thereby increasing the quality of applicant. This tends to be a slow recruiting method, due to the lead time needed to advertise, so it works best if there are many accounting positions that must be continuously filled. • Search firms. This is the most expensive recruiting approach, for search firms typically charge between one quarter and one third of a hired person’s first year’s salary as their fee. However, there are good reasons for using this method. One is that the search firms conduct their own screening of candidates, which results in a higher quality of applicant. Also, most search firms maintain a lengthy backlog of resumes, and so can bring in many candidates on short notice. Thus, the quality of recruits and the speed with which they can be brought to the controller may offset the high cost of this alternative. • Unsolicited applications. The lowest-cost recruiting method is to receive an unsolicited application, because there is no advertising cost at all. Also, if a company stores these applications, there is no wait time needed to collect resumes, since they are all kept on file. However, despite these favorable points, unsolicited applications tend to result in the lowest possible quality of candidate. This is because there is no screening mechanism built into the process, which results in lots of interviews by the controller to separate the chaff from the wheat. On the whole, the extremely low quality of candidates results in very few companies relying on this recruiting approach. There are a variety of ways to recruit qualified accounting candidates, based on the key factors of time, cost, and quality of recruit. A controller can pick a selection of recruiting methods from

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this list to create a mix of methods that will greatly enhance the chance of bringing in the right recruits within the required time frame and at the right cost.

10.3 FACTORS TO CONSIDER WHEN RECRUITING There are a number of applicant attributes to consider when recruiting. An applicant should possess as many of them as possible to a high degree, for any lack may lead to an excessive degree of turnover, poor job performance, or complaints by other people who work with the recruit. The key attributes fall into the categories of technical ability, communication skill, and stability. In more detail, they are: • Integrity. The accounting department has some control or influence over the disposition of assets, the reporting of financial information, and the use of controls. If a person lacks integrity, a controller may find that assets go astray, financial information is incorrectly reported, or controls are not enforced. The resulting havoc occurs because accounting personnel were not concerned about doing the right thing. Instead, accounting employees must care about their reputation for honesty and objectivity, which causes them to point out unethical considerations or actions to higher management even if such things are not illegal but perhaps only misleading or unfair. Due to the extreme importance of this factor, any hint of minimal integrity on the part of a candidate should immediately disqualify that person from receiving a job offer. • Process knowledge. The accounting function is similar to manufacturing in that it involves highly predictable process flows that must be carefully organized in order to reach peak levels of efficiency. Clearly, it is of great use if new employees already have these skills, so it is useful to include process flow questions in an interview. To determine whether an applicant has these skills, interview questions should cover an applicant’s knowledge of and experience in implementing and using accounting best practices. Applicants with this kind of background are most likely to create an efficient and effective accounting department. • Certification review. If an applicant holds one of the major accounting certifications (e.g., certified public accountant, certified management accountant, or certified internal auditor), the company should contact these certifying organizations. There are two reasons for doing so. First, the company should verify that the applicant actually has earned the certification and that it has not lapsed. Second, the company should ask if there have been any warnings (of which there are various levels, such as license suspensions or revocations) issued by the certifying organization to the applicant for misconduct in the past. Any such occurrences should be grounds for considerable additional investigation prior to issuing a job offer. Usually, given the level of trust required in an accounting position, it is not a good risk to hire someone to whom a warning has been issued. • Communication skills. An invaluable attribute is excellent communication skills. In order to succeed, a candidate should be able to actively participate in meetings with other employees, clearly summarize and present information, and create understandable written reports. It ultimately means having others understand what you want to tell them. This can be difficult when financial people communicate with nonfinancial people, because the complexity and jargon of the profession must be replaced with simple business language. • Drive. Though a candidate may have an overwhelming impressive set of credentials, strong interpersonal skills, great integrity, and fine background experience, none of these factors will be of much use if the person lacks the drive to complete work in a timely manner and take the initiative in undertaking new projects. This is the key underlying factor impacting a person’s ability to be promoted into new and more difficult positions. It is also one of the most difficult issues to fully understand when interviewing a candidate. To do so, a considerable portion of the interviewing time should cover a candidate’s underlying goals and objectives — a strong goal orientation is a sure sign of a strong drive to succeed.

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• Technical capability. An accounting recruit must have the basic accounting knowledge that can be imparted only through a regular course of training, which can include a bachelor’s or MBA degree. Possessing such a degree from an accredited university should form the basis of a minimal technical qualification. If the person does not have such a degree, then further evaluation is necessary to ensure that the person can adequately complete any assigned work. Bringing an untrained person into a professional job, no matter how good the other qualifications, will probably result in that person’s becoming dissatisfied and discouraged and eventually leaving the company or requiring unusual amounts of management attention. • Teamwork skills. An applicant must be able to function with the rest of the group. It is easier to identify characteristics that will inhibit integration rather than those that will guarantee it. If a candidate, who should be on his or her best behavior, comes across as abrasive, it is reasonable to expect that this person will have a negative influence on the work group. This behavior will likely turn off fellow workers and require an excessive proportion of the controller’s management attention. Both results will detract from the quality of performance of the work group as a whole. For evidence of teamwork skills, the interviewer can question the candidate about leadership roles. This can be leadership in school activities if the person is coming from college, or civic or work-related activities if the person has some experience outside of college. • Turnover likelihood. Because it is a time-consuming and expensive process to hire a professional, it follows that the people who are hired should have a high probability of staying with the company. There are many considerations in trying to assess a candidate’s staying potential. From the candidate’s perspective, some of the considerations are the likelihood of being satisfied with his or her professional responsibilities, prospects for advancement, and degree of comfort with the culture of the organization. From the company’s perspective, some of the considerations are the person’s ability to handle changing environments, acceptance of retraining, and ability to relocate as necessary. Evaluating these considerations may be the most difficult assessment of all for a recruiter to make. Each of the above subjects should be discussed in depth and the candidate’s views and preferences carefully considered. There are a variety of factors to consider when evaluating a potential job candidate. It is useful for a controller to review this list of factors prior to extending a job offer.

10.4 FACTORS TO CONSIDER WHEN PROMOTING A controller can do a wonderful job of recruiting the best possible staff and still experience high staff turnover due to a poor promotion policy. This section discusses two kinds of promotion, as well as the reasons for engaging in one type versus the other. The most common kind of promotion is one that shifts a staff person sideways through the hierarchy of the accounting department. This type of promotion is intended to expand a person’s skill base. For example, a person who is fully experienced in the billing area can be shifted to accounts payable in order to gain experience in how that functional area operates. The same approach can be used to add to the experience of the staff in other areas, such as collections, fixed assets, taxes, or producing the financial statements. This type of promotion can be given to the entire accounting staff, which rotates among the various functional areas. Generally, it reduces turnover, because the controller is giving all employees a chance to acquire new skills. However, the reverse can also happen if a staff person does not want to shift to a new skill area, and may even quit if the change is effected. A controller must watch out for this problem by carefully interviewing the staff about prospective switches to new areas. If it is clear that a person has “maxed out” and no longer desires to learn new tasks, then it is best to leave that employee alone in order to avoid any turnover. A less common type of promotion is of the vertical variety, in which someone is shifted upward in the corporate hierarchy. This will always be less common, for there are far fewer positions available at the management level than at the clerical level. Promotion to a management position is

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based on the presence of an entirely different set of skills than are used as the basis for a sideways promotion. A controller must be extremely careful in evaluating employees for promotion to a management spot, for any missing skills may not only result in the departure of the person being promoted (who was probably an excellent performer at the lower, clerical level), but also of the staff reporting to that person, and will likely result in a great increase in the time required by the controller to handle the situation. What are the key skills needed by someone being promoted to management? Certainly, it is necessary to have a reasonable knowledge of accounting theory and practice, but the primary emphasis is no longer in these areas, especially as a person is promoted to higher levels of the organization. Instead, the main focus is on people skills: communication, team building, reviews, and interviews, as well as planning and control. The mindset of anyone in this position is to effectively coordinate the activities of the underlying personnel, not to continue doing the work that took place prior to promotion. This is an extremely difficult transition for many people in the accounting profession, for it is filled with a large proportion of people who are introverted and process oriented, which results in a good clerk but a poor manager. The best approach for a controller who has just promoted someone to management is to realize the most likely traps into which the former clerk can fall, and to provide constant monitoring and advice. This should be intensive during the first few days of the promotion, thereby giving the promotee the best possible chance of succeeding in the new position.

10.5 IMPORTANCE OF REDUCED TURNOVER The bane of many accounting departments is the turnover of the accounting staff. It results in staff turmoil, inefficient transaction processing, and lots of wasted time on the part of the controller. This section describes the impact of turnover, and how to prevent it from happening. Some company departments assume that high employee turnover is a common fact of life, and that they must continually deal with bringing in a high percentage of new employees every year. This is true for many low-skill areas, such as assembly, where the entire workforce can turn over in one year. Alternatively, a highly skilled profession with lots of stress, the consulting industry, also has very high turnover, typically in the range of 25 percent to 33 percent per year. However, the accounting area should not be an excessively high-stress area, so it should not have the turnover rates common in consulting. It also requires a significant level of skill, so its turnover rates should not match those of an assembly operation. Instead, a controller should target a turnover rate well below 20 percent, and preferably only half that amount. This means that the average accountant should stay in the controller’s department a minimum of five years, and preferably ten. By keeping the staff turnover rate as low as possible, a controller can avoid many problems that result in gross inefficiencies, poor customer service, high error rates, and increased costs. These problems are: • Add poorer methods. A new recruit may have his or her own ways of dealing with transactions, which may not be as efficient as the ones developed during the tenure of the person being replaced. When this happens, the efficiency level of the position drops for some time, until the new person has reviewed and evaluated how work is completed and improved operations based on that experience. • Increased costs. Not only must a controller pay for recruiting costs to replace someone (e.g., newspaper advertisements, search firm fees, and travel expenses), but there are the added and less clearly defined costs of training new employees and correcting the inevitable mistakes that they will make as they learn their jobs. In addition, the controller must pay for replacement staff to fill in during the period when the old employee has already left the company and the new one has not yet started. • Increased inefficiency. The typical new hire, unless vastly experienced, will not reach the efficiency levels of the person being replaced for at least six months. This inefficiency will appear in several ways: the extra time required to complete tasks, the extra temporary help

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needed to support the person, and the time of other staff people needed for training. For some recruits, performance never reaches the level attained by the previous employee, in which case the controller may be forced to move the new hire to another position, or else let the person go and then spend even more time looking for another replacement. • Increased time by the controller. The recruiting process is a very time-consuming one, and the time a controller puts into it takes away from other tasks, such as preparing and evaluating financial statements, undertaking new cost-reduction projects, or analyzing various accounting-related proposals from around the company. In short, recruiting reduces the time available for completing other aspects of the job. • Loss of specialized knowledge. Every company has a unique set of processes. When a company loses an employee, it also loses that person’s knowledge of the processes. When a new person arrives to replace the outgoing person, some of that specialized knowledge may be lost, or at least take many months before it is assimilated from the other members of the accounting department. If turnover is extremely high, there may so few “old timers” left in the department that this specialized knowledge is permanently lost. • Risk of an inappropriate hire. Bringing in a new person carries with it the risk of hiring someone who is hiding a past of improper behavior, who may attempt to take company assets once in a position to exercise control over assets (a common enough position in the accounting department). Another risk is that a controller may find that the person hired is so inappropriate for the position that termination is the only answer, and then find that the new employee has sued the company for wrongful termination. No matter how correct the controller’s actions may be in getting rid of the employee, the company must still expend a large amount of money to defend itself against litigation. Obviously, there are many reasons to avoid turnover. However, in today’s environment of highly mobile employees who can find work elsewhere in little time, and who feel little association with a single company, how is it possible to drive turnover down to such low levels that a controller no longer has to deal with its effects? The answer is to meet the needs of employees. They may not feel any closer association with the company (a difficult proposition), but they will react well to an enlightened style of management that is revealed by the factors noted in the following list, such as flex hours, slightly higher rates of pay, and recognition programs. A controller will find that these factors will vastly reduce turnover by giving employees no possible reason to leave the company. The ways to reduce turnover are: • Clarify jobs and related procedures. There is nothing more irritating for a new employee than to be unceremoniously dumped into a new job without any clue regarding what the job entails or how to perform tasks. This lack of information causes a great deal of stress for a new employee, who must essentially build a job description from scratch, probably making mistakes along the way. It is also difficult to get a good performance review if there is no baseline job description against which to be measured. A controller can avoid this degree of uncertainty by supplying each new employee with an accurate job description that is supplemented by detailed procedures that clearly describe how each required job element can be completed. An example of such a job description is shown in Exhibit 10.1. • Improve communications. Employees want to know what is going on. For example, a controller can sit down with the accounting staff every month, after financial statements are published, and go over the company’s results with them. This gives the staff a good feel for how the company is doing, what they can do to improve the situation, and (above all) it tells the staff that the controller is not trying to hide anything from them. This sets the tone for an open and constructive dialogue between the controller and the staff; if the controller is willing to impart information to them, they will be more comfortable with bringing information to the controller.

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Position:Assistant Controller Report To: Controller Review Dates: 1. 01/20 2. 04/20 3. 07/20 4. 10/20

Quarterly Review Quarterly Review Quarterly Review Annual Review

Pay Change Criteria: 1. If issue financial statements within 5 days of month-end. • OK performance: ____% if reach 5 day close by end of 20XX. • Good performance: ____% if reach 5 day close by September 20XX. • Great performance: ____% if reach 5 day close by July 20XX. 2. If achieve accounts receivable turns of 9.0. • OK performance: ____% if reach 9 turns by end of 20XX. • Good performance: ____% if reach 9 turns by the end of September 20XX. • Great performance: ____% if reach 9 turns by the end of July 20XX. Overview of Tasks: Timing

Description

Daily Daily Daily Daily Daily Daily Daily Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Yearly Yearly

Collect accounts receivable Maintain general ledger accounts Receive and apply cash receipts Run batch jobs and backups Clear checks for accounts payable and accounts receivable Reconcile invoices with customers Take deposits to bank Calculate monthly quality bonus Complete bank reconciliations Conduct internal audit tasks Create variance report Prepare borrowing base reports Prepare financial statements Prepare tax returns Prepare workers’ compensation insurance reports Track fixed assets Track mold shop expenses Create documents for annual audit Update archives

Development Areas: 1. Financial statement preparation 2. Activity-based costing 3. Report writer training E XHIBIT 10.1

S AMPLE J OB D ESCRIPTION

• Increase pay. Many companies have a policy of paying employees the median pay rate for their job classifications. Though this ensures that a company is not paying too much for its staff, this policy does not take into account the total cost of employment. If a company loses employees to competitors who are willing to pay somewhat more than the median pay rate, it must then incur substantial additional costs to recruit and train a replacement. When this

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recruitment cost is added to an employee’s median pay rate, it becomes apparent that a company should actually pay somewhat more than the median rate in order to avoid the costs of turnover. • Look for a history of job longevity. A controller can avoid turnover up front by hiring only recruits with a history of staying with their previous companies for long periods. This avoids potential employees who are more likely to walk out for minor reasons over which a controller may have little control. • Meet special employee needs. Employees may have special needs, such as flex time, so that they can handle various aspects of their personal lives that might otherwise interfere with company business. A controller should consider these needs and modify employee work routines (within reason) so that employees can continue to work for the company. It is important not to allow too many exemptions to specific employees, because this may engender ill will among other employees who do not appreciate the special favors being extended to a minority of them. • Recognize employee efforts. Some employees make exceptional efforts on behalf of the companies where they work, yet receive no recognition for these efforts. After going to extra lengths to help the company, an employee should receive some special recognition, which makes that person want to stay with the company—not because they are making more money or have a fancy title, but because they feel appreciated. This type of recognition can take a variety of forms, such as tickets to sports events, plaques, public recognition, or an employee- of-the-month parking spot. • Review employees frequently. Employees want to know where they stand in terms of performance, potential advancement, and the impression given to coworkers. It is difficult for an employee to make meaningful changes to work habits in a timely manner if this information is communicated only once a year, during the annual review. Instead, a controller should schedule informal quarterly reviews to supplement the annual review, plus more frequent feedback if there are issues that require immediate corrective action. By giving frequent reviews, a controller not only ensures improved behavior by employees, but also a better sense by staff of how they are doing, which reduces their level of uncertainty. There are a number of techniques for avoiding turnover, which tend to emphasize clear job descriptions for employees, frequent communications, and paying attention to special employee needs. By taking these steps, a controller can greatly reduce the costs of turnover and increase the productivity of the accounting department.

10.6 IMPORTANCE OF DEVELOPING CAREER PLANS FOR EMPLOYEES Even though accountants are known to be a thoroughgoing and detail-oriented group, most do not engage in a sufficient degree of career planning. This results in a considerable amount of movement between jobs, as they go in search of perceived incremental improvements to their positions, presumably resulting in better titles, greater responsibilities, and more pay. This behavior also results in a great deal of turnover, which, as noted throughout this chapter, is anathema to any controller. This section describes how to lock in employees for long periods of time by assisting them in developing career plans. For the typical accountant, there is no specific career plan, and for only the rare few is it even committed to paper. A more common career plan is to acquire some sort of certification or college degree early in the career and then use these credentials to gradually work up through the ranks at a corporation until reaching the pinnacle of success, the chief financial officer (CFO) position. Because only a small proportion of accountants can reach this position (after all, there are not many CFO positions available), every accountant needs a great deal of preplanning to assist in achieving this goal, or to aim for goals culminating in different positions. The controller can assist

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with this difficulty by meeting each staff person and comparing the aspirations to the existing set of experience and skills, and determining where there must be improvements for that person to reach whatever the goal may be. This plan should clearly define required skills, a time line for achieving them, and specific action steps by the staff person as well as the controller to ensure that those steps are reached. For example, an accounts payable staff person may have no experience with payroll. To acquire it, the controller can commit to assigning the staff person as a backup to the regular payroll person for the next year. In exchange, the payroll person will become the backup for the accounts payable person for the same period. This ensures that both employees acquire more knowledge and experience. Why would a controller go to some lengths to ensure that the entire accounting staff will eventually be in a position to replace the controller? There are several reasons. First, putting every staff person on a solid career path will lock them into working for the company for a long time. For example, encouraging employees to take reimbursed college courses will keep them with the company until a degree is acquired, which can easily take six years. Also, rotating a staff person through all possible accounting areas takes a number of years, especially if the company is a large one. In both cases, a controller can effectively reduce (if not eliminate) turnover by keeping the entire staff busy with various kinds of training programs. The second reason is that very few accounting employees really have the wherewithal to become a CFO; instead, they will be promoted to the point where the job responsibilities match their abilities, and they will stop. By using career planning and reviewing progress, it will become obvious to both the staff person and the controller when this point is reached, and the controller can then shift the motivational focus to retaining that person in the same position for as long as possible. Third, a mature controller will realize that an accountant who has the ability to eventually become a controller or CFO should be allowed to do so. Rather than getting mad at an employee who has been thoroughly trained by the controller, it is best to throw a farewell party for the person and maintain relations when the person moves on to other organizations. This not only maintains goodwill between the controller and the former staff person, but also makes it easy for the person to return someday, or to refer other people to the controller for various positions. Finally, a controller can use career planning to determine the timing of changes in the department. For example, if it is obvious that a qualified subordinate should go outside the company to take a controller position elsewhere, the controller can use the career plan to make a rough estimate of when this might occur (or even discuss the issue with the subordinate), and then make plans to promote other people in an orderly fashion to fill in the post that is about to be vacated. In short, career planning reduces turnover while promoting employees to the maximum level and allowing the controller to plan for employee advancement in an orderly manner. Some controllers include career planning in an employee’s annual review. This is a mistake, because the annual review is supposed to cover issues that the employee is required to do, whereas a career planning session discusses items that are optional — an employee may take additional steps to advance his or her career, but those steps can be taken at the discretion of the employee. For example, a goal that might be discussed during an annual review is the ability of an employee to issue financial statements within a specified time period and to determine a course of remedial action if that goal has not been met. A career planning session discusses any steps an employee has taken along his or her career path, and what assistance the controller can give in furthering that person’s aspirations. In short, a controller adopts the role of a supervisor when using an annual review to cover immediate performance issues, but must switch roles to be a mentor and coach when covering career planning issues. Due to the different roles of the controller and the differing types of discussions, these two meetings should not be merged. A key part of career planning is sharing the salary ranges of targeted positions with the accounting staff. There is a considerable motivation in knowing that there is a large increase in pay associated with gaining a higher-level accounting position. Telling employees about market rates for desired positions can also keep them from making a mistake in pursuing a position that does not yield a significant pay increase in proportion to the amount of work required to attain the position. One may think that there is some risk in appearing to promise specific pay rates to employees well in advance of their being placed in those positions, so it is important to tell employees up front that prospective pay rates fall within fairly wide pay ranges, and that they can expect to begin

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at the lowest levels of the pay rates and gradually gain additional compensation as they gain experience and skill. Informing employees of the pay rates for future positions is a key part of the career planning process. A controller should encourage the accounting staff to earn certifications. There are many accounting certifications, all of which require a considerable amount of training before one can pass the required examinations. By taking the training, an employee can improve his or her skill set, which directly benefits a company by bringing more expertise to its accounting operations. To encourage the acquisition of certifications, a controller should actively pursue the purchase and distribution of study materials, as well as pay employees for the time off needed to take the tests. To really encourage acquiring certifications, a controller can even offer one-time bonuses or pay raises to those who have successfully completed their examinations. The most common certifications for an accounting person to earn are: • Certified Public Accountant (CPA). The examination is standardized, but additional certification requirements vary by state. Contact your state’s Department of Regulatory Agencies (or such similar organization) for more details. The examination requires three days of testing. • Certified Management Accountant (CMA). The examination is standardized and requires 90 hours of CPE every three years to renew. The examination requires three days of testing.
Address: Institute of Certified Management Accountants, 10 Paragon Drive, Montvale, NJ 07645. Phone: 201-573-6300 • Certified Internal Auditor. The examination is standardized and requires 100 hours of CPE every three years to renew. The examination requires two days of testing.
Address: Institute of Internal Auditors, 249 Maitland Avenue, Altamonte Springs, FL 32701. Phone: 407-830-7600 • Certified Production and Inventory Manager. The examination is standardized and requires no continuing education. There is no required renewal. The examination requires the completion of six tests, which can be completed at different times.
Address: American Production and Inventory Control Society, 500 West Annandale Road, Falls Church, VA 22046. Phone: 800-444-2742 • Certified Production Manager. The examination is standardized and requires 120 hours of CPE every five years to renew. The examination requires one day of testing.
Address: National Association of Purchasing Management, P.O. Box 22160, Tempe, AZ 85285. Phone: 602-752-6276 Some of the certifications listed do not directly cover accounting topics. Instead, they address such areas as production, logistics, and purchasing. It is useful for an accounting person to acquire these extra certifications, because there is great value in having a broad knowledge of how a wide array of processes function throughout a company.

10.7 IMPORTANCE OF COMMUNICATIONS WITH EMPLOYEES The title of this chapter includes the words “training” and “supervision.” Communicating with employees comprises a key element of both activities. A controller should include a variety of modes of communication with the accounting staff, which can vary in frequency based on the type of communication. This section notes the different types of communication, as well as the offsetting risks of losing some confidential information to competitors. There are several distinct types of communications that a controller should use. One consists of operational information. This type of information describes company performance, and that of the accounting area in particular. It can include such performance information as the number of days to issue financial statements, accounts receivable turnover, and the dollar amount of accounts payable discounts that were not taken. It is crucial to impart this information regularly, because the accounting staff needs it to determine its own performance, as well as to form a basis

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for requesting additional improvements in the future. The information is best presented in a historical context, so that there are a string of performance figures that clearly show a trend line of performance; this is best presented in a chart or white board, so that the information is presented visually, not verbally. Another type of communication consists of financial information. Since one of the primary functions of the accounting staff is to generate information that is summarized in the financial statements, it makes sense to show them the result of all that work — the financial statements. Many company managers shy away from the prospect of revealing company performance to employees, especially if performance is poor, but one of the best ways to motivate employees is to give them this information; then they are more likely to pitch in and suggest ways to improve performance. The only type of financial information that one can legitimately withhold from employees is salary data, because this is considered confidential by most managers, not to mention most employees. Financial information can also include the budget, which can be shared with the staff without divulging payroll information. The financial statements and accompanying budget yield much greater employee understanding of a company’s overall situation. An additional type of communication is of personal performance information. This is a form of communication that many controllers do not perform well. The worst case is when controllers essentially ignore the accounting staff, never giving them any feedback on their performance. This tells the staff nothing about how they are doing, and in the absence of information, they tend to assume the worst. The next worst form of communication is going over performance only during an annual review. Though many controllers consider this to be a sufficient interval for giving feedback, it is actually far too infrequent. There may be a problem with performance early in the review period, which a controller notes for the annual review but does not mention to the employee until the actual review. This means that the staff person is performing improperly for nearly a year before getting any feedback! Many controllers delay in giving feedback because they do not relish the charged emotional atmosphere that frequently results. However, by waiting until the review and churning out a long list of faults, this tends to exacerbate the situation and results in a difficult review. By far the best way to issue personal performance information is by wandering through the accounting area on a daily basis and giving feedback in small doses to everyone. This gets the staff used to continual feedback and results in a vastly more relaxed working environment. In short, the frequency of feedback is very important when relaying personal performance information. A final type of communication is of general information. This can be directives issued by senior management (such as news about a company merger), notes about the work schedule (such as when the company will observe holidays), or similar information. Though the most minor forms of general information can be communicated by such media as voice mail, e-mail, or the venerable memo, more important information, for which employees may have questions, is best communicated in person. The timing of the information may also have a bearing on the form of communication used. For example, a notice regarding when an official holiday will be taken is easily communicated by memo if done a month in advance, but may require an in-person discussion if it is being communicated one day in advance, because this may interrupt work schedules and require some negotiation with the staff regarding taking alternate holiday time. Thus, the form of communication used to impart general information depends on the lead time used, as well as the likelihood of answering questions from the staff. This section has focused on feeding as much information as possible to the accounting staff, on the assumption that a well-informed staff is a satisfied one. However, the response of senior management to this approach is frequently that of the risk to the company — what if a dissatisfied employee takes the information to a competitor or issues it to the press? Of course this can happen, but usually only when relations with the staff are so bad (perhaps due to a lack of information) that employees are actively looking for a way to harm the company. In this case, the controller is well advised to look for employment elsewhere, since the working environment is exceptionally difficult. When staff relations are good, the risk of disseminating information outside the company is much lower. To provide additional coverage to the company, all financial information can be marked as classified, which gives the company some recourse to legal action if it finds that infor-

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mation has left the company. Usually, it is much more beneficial to issue information to the staff than to worry about the much smaller risk that the information will get out to the general public or to competing firms. The recurring recommendations in this section have been to give lots of information to the accounting staff, and to do so as frequently as possible. This is very important for maintaining good staff morale and usually results in better performance. Many old-time controllers who were brought up in an environment of “closed books” will have a hard time with this approach, especially if it requires lots of face time with employees. Nonetheless, the controller who invests time in his or her staff will reap considerable rewards in terms of a happy, well-informed, and productive department.

10.8 HOW TO MOTIVATE EMPLOYEES Motivating employees clearly improves employee morale as well as department performance, but motivation should be based on a multilayered motivation scheme that covers the long, medium, and short term. By using this multilayered approach, employees are presented with a richer environment in which to work, which is more satisfying for them, and gives them many good reasons for staying with the company. This section discusses multilayered motivational systems. A long-term motivational system is based on the career plan. As noted earlier, in the “Developing Career Plans” section, the controller should discuss career options with all accounting employees, and devise a progression of steps that will last for a number of years, culminating in greatly increased levels of experience and expertise for them. This is an excellent long-term motivator, but does not grab the attention of the typical employee on a day-to-day basis, because it is typically comprised of course work that happens only after working hours or involves occasional seminars or job switches. Something more is required that will make motivation a more immediate issue. A midrange motivational system is the annual performance goal. Many controllers set up goals for each employee to reach, which are used in determining pay raises or bonuses at the end of the year. Examples of these goals are increasing accounts receivable turnover through greater attention to collections, taking all purchase discounts, and issuing financial statements by a specified date. These can even be tied to a specific pay raise. For example, accounts receivable turnover of 8.0 can be awarded with a 2 percent raise, while a turnover rate of 10.0 will result in a 3 percent raise. This type of motivational system is an excellent way to focus the attention of the staff on key improvement goals, while rewarding them as well. Though this is a good motivator, especially when used in concert with the longer-range career plans, it still does not focus day-to-day attention on the tasks at hand. That requires a short-range motivation system. A short-range motivation system is one that grabs and holds the attention of the accounting staff every day. This system is much more difficult to arrange than the long-term and midrange motivational systems, and also requires much more work by the controller to keep it operational and meaningful. The reason for the excessive level of attention is that the motivational targets must be changed from time to time to avoid boredom, while the types of awards must also be changed for the same reason. When constructing short-term goals, a controller can devise an enormous array of potential targets, such as the cleanest desk or the fastest response to an e-mail. However, it is best to create group goals so that the entire team wins, rather than just one person. The targets are not necessarily intended to cause any long-term change. Instead, they should be fun and make employees feel better about coming to work. For example, a clean desk week may leave no lasting impression or enhance company performance, but it will give the staff something to focus their attention on in the very short term. Also, the rewards for reaching such goals should involve the group, such as a free team lunch or a block of tickets to a sporting event. The reward should always act to bring the group together by treating them as a unit, not split them apart by giving different awards to different people. A short-range motivational system is targeted at employee morale, not at reaching any quantifiable goals. In summary, employees can be motivated with three types of motivation systems. The first is the long-range career plan, which requires minimal attention by the controller to maintain. The

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second is annual performance goals; this is the most common motivational system employed by controllers and also requires minimal work to maintain. Finally, there should also be brief, team-based contests or targets in the very short term (e.g., weekly) to grab the attention of the accounting staff and add some spice to the work experience. This short-term system requires the most work by the controller but also greatly contributes to a more pleasant work environment, which is a prime factor in motivating employees.

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CHAPTER

11

CONTROLLER’S ROLE IN INVESTOR RELATIONS 11.1

INTRODUCTION 173

11.7

11.2

OBJECTIVES OF THE INVESTOR RELATIONS FUNCTION 174

INFORMATION NEEDS OF OTHER GROUPS 178

11.8

DISCLOSURE POLICY 178

11.3

EVOLVING NATURE OF THE FUNCTION 174

11.9

ORGANIZATION STRUCTURE FOR INVESTOR RELATIONS 179

11.4

COMMUNICATION VEHICLES FOR INVESTOR RELATIONS 174

11.10 ROLE OF THE CONTROLLER AND OTHER PRINCIPALS 180

11.5

INVESTOR RELATIONS MESSAGE RECIPIENTS 175

11.6

INFORMATION NEEDS OF THE FINANCIAL ANALYST 176

11.11 CHANGES IN THE CAPITAL MARKETS 182 (a) Some Suggested Financial Market Objectives 182 (b) Some Suggested Methods 183

11.1 INTRODUCTION Very little has been written about the controller’s role in investor relations (IR). This is partially because many controllers, by all outward signs, are not actively engaged in this function—at least as far as the public is concerned. In Chapter 2 of this text, investor relations activities of the controller are included in the category of “Additional Controller Functions.” To many outsiders with an interest in investments, the controller is variously regarded as the “inside man,” the number cruncher, the figure man, or the introverted accountant. To be sure, many of these same representatives do not have a real understanding of what the controller should do or can do. In contrast to this view of the controller, in discussions with security analysts, they have expressed opinions to the authors concerning a preference for talking about financial matters with the controller because “he has the facts” (while many of the nonaccounting-trained public relations persons do not). Certainly, if the chief accounting officer wishes to climb the financial ladder or aspire to a broader executive career, experience in the IR arena may be very useful. In reaching some conclusion concerning those duties the controller might perform in this interesting IR function, a review of the following facets may help in ferreting out those activities for which the controller might be suited, and which he or she might enjoy: • The objectives or purpose of the IR function • The nature of the function • The principal vehicles used to convey financial information • The nature of the “customer” • What type of information is desired and limits on its disclosure • Some brief observations about organization structure in this field 173

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11.2 OBJECTIVES OF THE INVESTOR RELATIONS FUNCTION In a general sense, it may be said that the principal purpose of the IR function, regardless of who performs it, is the enhancement of shareholder value. Isn’t this a familiar term? The stated purpose by the perpetrators of some hostile takeovers is “to enhance shareholder value”; the defense against such actions, as voiced by some chief financial officers (CFOs) of the targets, is an effort “to enhance shareholder values by increasing the price of the common stock.” As a matter of fact, one of the purposes of sound financial policy is to enable the company to raise funds, on an acceptable basis, to meet its needs, so as to enhance the long-term interests of the shareholder; and a related corollary is to cause the entity to be so well regarded in the financial marketplace that its stock will command an acceptable price/earnings ratio. Some chief executive officers (CEOs) might still regard the IR function as a simple financial reporting activity, with no intent to affect the stock price. But many CFOs will bluntly state that the objective is to maximize the market price so as to minimize the cost of equity capital. Executives of brokerage houses will acknowledge that a continuing IR program helps prepare the market for a public offering, and influences the credit ratings of fixed-income securities. Certainly, the importance of the stock price is not lost on those CEOs engaged in sell-offs, acquisitions, or other restructuring. In the view of the authors, these enumerated purposes, however described, translate into an objective of enhancing shareholder value. In today’s environment, companies must compete for investment capital—whether in the bond market or the equity market. But to secure recognition, the story of the enterprise must be told. Just as the advantages and uses of a company’s service or product must be described and marketed, so also information about the value of an entity’s securities and its financial prospects must be disseminated, understood, and accepted.

11.3 EVOLVING NATURE OF THE FUNCTION Investor relations has been, and probably still is, an evolving activity. About 30 years ago, it often was a part of the public relations department, perhaps viewed as a somewhat specialized communication function. In the 1950s through the 1960s and into the early 1970s, with the rapid growth of employee retirement funds, many blue-chip companies, including General Electric, used skilled communicators to “educate” portfolio managers and brokerage intermediaries about the investment merits of the company’s stock. By the mid-1970s, when many individual investors abandoned thestock market, when the market was dominated by large institutions, when many less-than-blue- chip companies felt they were neglected by the brokers and investing institutions, and when the need for more capital intensified, many managements became more aggressive, and began directly contacting potential investors, both institutional and individual, who were willing to take more risks and were often receptive to growth situations and better-than-average returns. The individuals representing these companies were variously communication specialists and security analysts. In this time frame, with the growth of dividend reinvestment plans, self registration, and an increased recognition of the need to plan and sell new security issues, the IR function became more marketing oriented. These changes also induced changes in the nature of the IR specialist. While communicators (public relations) and security analysts had predominated, gradually more and more individuals well acquainted with finance assumed a greater role. The customers became far more sophisticated about what they needed. So the IR function evolved into a combination of two disciplines—communications and finance. Accordingly, in this century, the IR function must not only communicate effectively about past performance, but it must more closely align itself with the strategic plans of management and tell its customers more about corporate goals and the entity’s strengths and weaknesses.

11.4 COMMUNICATION VEHICLES FOR INVESTOR RELATIONS At this point, perhaps a recap of the several vehicles now commonly used to communicate with “investor relations customers” may be helpful. Each is directed to a somewhat different audience,

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and each typically conveys a disparate or varied message—but always with an investor-related aspect. They are distinct in words and tone from the typical product or service advertising originating with the advertising or marketing department. The methods used to communicate investor-related messages, in no special order, include: • Annual report to shareholders • Quarterly reports to shareholders (and the financial community) • Annual meeting with shareholders • Reports to the Securities and Exchange Commission (SEC)
Annual Report Form 10-K
Quarterly Report Form 10-Q
Current Report Form 8-K • Regular or special meetings with security analysts, institutional investors, brokers, and large individual investors — often arranged in cooperation with one of the several associations or societies for analysts • Institutional advertising in newspapers or periodicals (financial or general interest) • Dividend stuffers • Corporate announcements of special interest to investors or potential investors:
New products or services
Management changes
Acquisitions and/or divestments
Reorganization attempts, etc.: restructuring, unfriendly takeovers • Videocassettes dealing with financial matters • Use of toll-free telephone numbers • Individual meetings with government representatives and the stock exchanges concerned with financial matters (Internal Revenue Service, SEC, etc.)

11.5 INVESTOR RELATIONS MESSAGE RECIPIENTS Broadly and technically speaking, the IR function must service an unusually complex and diverse audience. For example, here is a typical listing (with some overlapping) of the vast potential “customers”: • Investors and potential stock investors (small) • Large institutional stock investors and potential investors • Security analysts • Credit-rating agencies • Financial advisory services • Brokerage firms • Bond-rating agencies • Bank loan officers • Bondholders • Financial press • Portfolio managers • European/Japanese investors • Acquisition candidates • Government agencies dealing with financial matters (federal, state, and local) • Employees

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Having said this, it should be realized that three broad groups with which the IR activity is primarily and continuously directed are (1) security analysts, (2) stockbrokers, and (3) large institutional investors. Practically speaking, and as discussed later, some of these information-seeking persons would deal directly with the CFO — that is, the bank loan officer handling most of the company’s current bank borrowings, the bond-rating agency, or credit-rating agency—in some kind of one-on-one desired meeting that is heavily and technically financial in nature. Many of the members of the three principal groups mentioned — security analysts, stockbrokers, or institutional or other large investors (or their representatives) — are quite sophisticated financially. Each of the three groups may, and usually does, have different information needs; and each may be motivated, for different reasons, to discuss the financial affairs of the entity.

11.6 INFORMATION NEEDS OF THE FINANCIAL ANALYST The management of a company usually desires that it be perceived in its most favorable light— hopefully without exaggeration, and as objectively determined. While communication with all segments of the IR audience on this matter is important, perhaps the key person is the financial analyst, also called the security analyst. He is in a position to influence a large cross-section of investors. It therefore especially behooves the IR executives to know what information the analyst needs and how he will probably use it. It is imperative that the financial executive involved (CFO or controller) properly interpret the information for this analyst and not merely infer certain conclusions. In most instances, the analyst desires information so that he can reasonably predict earnings (and hence market price, potential of the stock dividend rate, etc.). A most important source of information for the security analyst is management presentations generally made to large institutional investors, and brokers, or investment bankers, as well as the analysts themselves. The information gained from such meetings, plus that distilled from annual and quarterly reports, or Form 10-Ks and the like, together with discussions among other analysts, and other articles about the company and the industry, enable the analyst to reach certain conclusions about the entity and aid in helping him predict financial performance. These analyst meetings present an unusual opportunity for the company to portray itself in its best light. They not only permit the company to make factual presentations, but also to subjectively influence the analyst about the depth of management and long-term objectives of the company. Moreover, they enable management to directly answer the questions of the group and fully explain troublesome events, such as complicated footnotes to the annual report and so forth. Each industry and each company has certain factors that are important to its well-being and growth. For example, in the aerospace business, the order backlog is of significance, as well as the status of various contracts or programs. In other companies, product development might be of major interest. Facts and opinions should be divulged within the limits of prudent disclosure. Such meetings with analysts are not just public relations events. Solid and specific information is needed. While each entity has its own requirements, here is an outline of suggestions about presentation content to analysts for a well-established, reputable company. 1. To give a sense of an experienced, in-depth, and well-qualified management: (a) The CEO should be present and give the principal talk—about prospects, style of management, management development programs, market position, etc. (b) The key executives should be introduced, and usually should make some short comments about their areas of responsibility. (c) Perhaps the organizational structure and incentive system and the like should be discussed. 2. To provide an insight into the long-term prospects of the entity, the following subjects might be covered by a knowledgeable executive (CEO, executive vice-president, senior vice president of finance or controller): (a) The system or method of strategic planning (b) The short-term or annual plan process, and the related control system

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(c) Some examples of long-range objectives that have been achieved (and perhaps some that were not) (d) The long-range outlook for the industry or selected products or markets (e) The status of market penetration or dominance for some key products (f) Important research and development programs underway (Whether specific quantified projections or plans should be divulged may depend on the individual circumstances.) 3. To provide a broad financial picture, including the financial strength of the company, perhaps a slide presentation (graphs and charts) could be given that would identify: (a) (b) (c) (d)

Status of orders on hand Trend of sales, by product line Margins by product line, or organizational units, and trends thereof Financial position through comments about a condensed balance sheet, with emphasis on key ratios or relationships (e) The trend of long-term indebtedness, times debt service is covered, debt capacity, and so on (f) The trend of cash flow by important segments: from operations, investing activities, and financing activities, and perhaps cash flow per share from operations (g) Trends on equity and earnings:
Growth in equity
Equity relationships (ROE)
Earnings per share
Return on assets

(h) By simple explanation and illustration, any aspect of the financial statements that often causes confusion (inventory, valuation method, tax accruals, reserves, etc.) (i) Perhaps some comparative ratios with industry or selected competitors (j) Company posture regarding acquisitions or diversification 4. The chief marketing executive probably should make a presentation that would describe and illustrate major new products, or major revenue procedures, and the sales prospects for the next year or two 5. Other executives, as appropriate, might discuss any timely topics, such as: (a) Employee relations (b) Cost reduction programs (c) Process improvements, including use of computers (d) Information resource management (e) Quality control changes (f) Any major troublesome contracts or publicity items and the like The objective should include a demonstration of financial conservatism, stability, and ability to raise capital when needed. Interpretation of what the figures mean should be given; it should not be left to the unaided judgment of the analyst. In fact, the executives deeply involved in the process should know their audiences and determine what they need to know, so that the analysts (and others) may make a proper evaluation of the entity. These are some key points that should be covered. Experience at meetings with analysts, including their questions, will provide guidance as to other subjects of interest. The data presented to the analysts might serve as a point of departure for responding to the information needs of other groups. Above all, the presentations by management, and the responses to questions raised by the analysts, must be open, frank, and responsive to the information needs. Any sense that management is

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not forthright and will not truthfully answer reasonable questions will cause analysts to choose not to follow the company’s progress.

11.7 INFORMATION NEEDS OF OTHER GROUPS The financial analysts and large investors of all groups, as might be expected, do the most probing. Their approach is highly analytical. Usually, when a company can adequately communicate with this group, it can deal effectively with most others. These other players have varying interests, some of which involve answers to the items raised in the preceding sections. Perhaps the typical individual shareholder is most concerned with the general progress of the company and the prospect of continued and increasing dividend payments. A highly skilled financial background is not required to meet her inquiries. At the other extreme, a bank loan officer will be interested in the prospects of repaying the loan on time; and it might be proper to make available to him the annual plan or budget for the next year or two, and perhaps the long-range financial plan. His relationship is more confidential than the general public, and he is entitled to such knowledge. Bond-rating agencies may be exposed to past and prospective debt service coverage and related matters. Credit agencies, who have the published annual report available, may direct their questions to the content of the balance sheet items, and prospective earnings. Many other investors may be interested in the significance of certain litigation, or product development. The required financial knowledge of the IR interface person will depend on the types of questions and the inquisitor’s knowledge and interest.

11.8 DISCLOSURE POLICY In providing information to or communicating with analysts, brokers, investors, or others, a matter to be resolved is: What constitutes proper and adequate disclosure? Typically, management is concerned about excessive disclosure that may harm the company. On the other side of the question, there should be sufficient disclosure to enable the analysts and others to discern shareholder value. Hence, the problem is one of weighing the benefits versus the costs. On the one hand, the dangers of excessive disclosure include: • Loss of competitive advantage through early disclosure of new products or marketing strategy or other strategic information • Exposing the entity to litigation by reason of allegedly providing insider information, or attempting to foreclose competition or otherwise violate antitrust laws • Generating earlier competitive reaction, or even new competitors, than would otherwise be the case • Revealing strengths or weaknesses that might invite an unfriendly takeover attempt Most analysts would prefer to get information first, or early, but normally there is no benefit to them in causing long-term share decline. And most appreciate the need to protect competitive information. While there is a danger in excessive disclosure, there are sometimes unrecognized costs of insufficient disclosure. Some of these are the following, resulting in a share price lower than normally might be the case: • Failure to provide adequate data may encourage analysts and others to avoid the company and fail to follow its progress. • Lack of information may cause unpleasant or unexpected surprises—something the financial community abhors. • If the management does not maintain good relations with analysts and investors, it usually takes much longer for positive developments to become known and reflected in the stock price.

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• Most importantly, lack of firsthand knowledge, such as that secured through personal contact, prevents analysts and other interested parties from “kicking the tires”— from assessing the depth and quality of management, the adequacy of the company’s controls, its ability to cope with change, as well as the quality of the product and services. The IR group and management must thoroughly weigh what constitutes a proper balance in its disclosure policy.

11.9 ORGANIZATION STRUCTURE FOR INVESTOR RELATIONS A successful IR program must, as previously mentioned, permit the exercise of two skills by company executives: the ability to (1) communicate effectively and (2) ferret out and comprehend the financial significance of operating trends and relationships, together with the composition of the various elements in the financial statements and their significance or impact. Company representatives must clearly, and often in sophisticated or knowledgeable financial terms, discuss highly technical financial issues with a great many types of investors or potential investors. What organizational structure best fills or facilitates this execution? Several structures may be observed in operation, but one truth is paramount: There must be a coordinated approach; the company must speak with one voice. Thus, confusion is created if the vice president of sales discusses the potential financial impact of a new product to a group of distributors as having certain results, and the financial vice president describes a quite different financial impact with a group of financial analysts. Assuming adequate and effective coordination among the company’s spokespersons, as to the presentation of financial data, what organizational structure is desirable? One answer is, “The one that is effective.” The external or investing public of a company is viewed by many top executives as consisting of several parts of the whole. The result is a dichotomy of views about proper organization: • In some companies there is no single executive who is responsible for the external investor relations (as distinguished from employee relations). Basically, each major executive meets with his audience, e.g., a research audience, a marketing audience, a manufacturing group, a financial group. However, whenever financial content is involved, it would be cleared with the proper financial executive. • In other entities, a single executive is held accountable for the IR function. Under this latter scenario, the IR activities might be a segment of the public relations department (renamed an investor relations department). Also, under such a plan the finance department, including the controller, would be considered an internal function — a resource to be made available to those responsible for the IR activities. • Some other organizational structures divide the responsibility into two segments: (1) The activity relating to preparation of the annual and quarterly reports to shareholders, institutional or financial advertisement, small shareholder inquiries, and the like, is handled by the public relations department (and coordinated with finance)—the so-called mass media facet; (2) the unit relating principally to contacts with security analysts, large institutional or individual investors, investment bankers, rating agencies, and so forth — that audience assumed to possess considerable financial know-how—is handled by an investor relations unit reporting to the CFO or a financial officer. Presumably the members of this unit have a financial background (CPAs, accounting, investment banking) but have also been trained in communication skills. The type of “customer” determines the unit most likely assigned the task. There must be coordination with the public relations segment or unit. Finally, one other factor should be mentioned as a possible participant in the IR activity, and that is a professional IR agency. While such a firm often may be used by small companies, sometimes they can also be helpful consultants to medium-sized and larger entities in properly organizing the

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IR function. The authors should point out, however, that most investor/analyst types prefer to deal with a member of management, and not an outsider, in seeking financial information about a company. The proper organizational structure for a specific company will depend, again, on the interests, ability, and personality (and perhaps financial interest) of the officers and executives who are actual or potential participants—consistent with management philosophy, style of management, available time, and so forth.

11.10 ROLE OF THE CONTROLLER AND OTHER PRINCIPALS Having provided only a very general background on the sources of financial information about the company, the type of inquirers, and suggestions about management presentations to the security analysts in particular, the basic question is, “What should be the role of the controller?” As is often true, what functions an officer performs depends on several factors, including his or her ability, personality, and interests, along with the interest and capabilities of the other officers, as well as the size of the company, management organization structure, management style, and so forth. If there is a CFO as well as a controller, the duties will be shared. And in those instances where the CEO feels he himself should play a major role in IR, that will further divide the effort. If the controller is a good financial analyst, certain activities will tend to be assigned to this position; and if the chief accounting officer is, in addition, a good presenter or communicator, then still other duties are likely to fall in this direction. For the typical medium-sized to large company, where the CEO is somewhat active in IR, and where the CFO tends to spend some time with IR activities, a likely split of functions might be listed as: Controller 1. An information resource or source for any financial data, for those officers and executives who need it for IR purposes including: (a) Financial statements reflecting actual results and/or condition of the entity and/or any segments, such as (i) Statement of income and expense (ii) Statement of cash flows (iii) Statement of financial condition (b) Relevant financial analyses of actual data and trends of these statements, as required for IR purposes, such as (i) (ii) (iii) (iv) (v) (vi)

Inventories Accounts receivable Long-term debt, by category of debt Plant and equipment, by location Relevant ratios, including comparisons with industry and competitors Detail and type of revenue and expenses by appropriate segment

(c) Financial statements and related analyses representing planned or forecasted results or condition, both the annual plan and long-range plan, for the consolidated entity and any segment. (This data should be available, but often should not be disclosed to the analyst groups, etc.) (d) Relevant graphs and tabulations, showing financial trends and relationships, actual and projected. Basically, all financial data (whether to be presented to outsiders, or simply used as background or a reference source) should be prepared under the supervision of, or by, the controller, subject to appropriate suggestions or constraints by the CFO or CEO.

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2. As required, an interpreter of the financial data, when asked to do so by other major officers or executives present, to the appropriate IR audience (groups, individuals [analysts, investors], financial information sources such as Dun & Bradstreet, TRW, bank loan officers, etc.) 3. A communicator of financial information to individuals and groups entitled to receive it, under the applicable working rules. This would include presentations to groups or individual analysts, investors, or brokers, and so forth, as well as the answering of their questions. It might be that the controller would (1) make presentations in the absence of the CFO, and (2) give talks to small groups regularly, with the CFO (or even the CEO) handling the larger or more important meetings. Certainly, if the controller is a good communicator he or she should be trained to be the alter ego of the CFO. 4. Either prepares, or reviews for accuracy and completeness, any financial commentary in such financial documents as the annual report to shareholders, quarterly report to shareholders, Form 10-K, or 10-Q, etc. 5. A reviewer for content and accuracy all news releases, special announcements, and publications of the investor relations activity (and those of other executives) dealing with financial/ accounting matters. As applicable, the controller would make his or her recommendations or comments to the CFO, unless she is authorized to make the final decision in the event of disagreement or needed major changes. When the controller is de facto the CFO, he or she would exercise the duties listed previously, plus those of the CFO enumerated next. Chief Financial Officer 1. Should be the principal communicator of financial policy, and the reasons therefor, financial status and operating trends and relationships to major groups, including the leading security analysts of the industry, major brokerage houses, and large investors — actual or potential — whether institutional or individual. 2. Should be the principal spokesman or negotiator, subject to approval of the CEO and/or board of directors, as may be applicable, in connection with the actual and imminent raising of capital—whether equity or indebtedness. Thus, he or she would be the principal contact with investment bankers, large commercial bankers, lessors, and institutions, using such advice and assistance deemed necessary. 3. Should delegate to the controller any of the above duties, and any lesser ones, relative to investor relations when deemed to be in the interest of the company, and assuming the controller is experienced and capable. 4. Should review all major published financial documents (annual report to shareholders, quarterly reports, financial news releases), and receive comments from controller, for accuracy, completeness, adequate disclosure, and the like. 5. If the IR department is a part of the financial organization, should direct its activities, establish appropriate disclosure policies, and develop a competent and professional IR staff to handle those functions not assigned to the CEO or the controller or himself. If the IR activities are under the cognizance of the CEO or the public relations officer, the CFO should make appropriate recommendations on suggested improvements. Chief Executive Officer 1. Preside over major meetings with security analysts, large investors, and the like and present the background and related information on such important matters as: (a) (b) (c) (d)

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2. 3. 4.

5.

6.

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(e) Any forthcoming major events that can be announced (management changes, acquisitions, divestments, etc.) Additionally, he should answer the questions of the audience on major public matters and the like. By bearing and knowledge he should demonstrate that he is, indeed, the CEO. Meet, on a one-to-one basis or with a few individuals only, any major investor, opinion maker, banker, and so on, who wishes to see him. Discuss major points as in 1 above. As appropriate in IR meetings, refer financial questions to the vice president of finance or controller, and certain operating questions to the operating executive present. As to important financing matters, meet with other major players, as deemed proper: commercial bankers, investment bankers, rating agencies, institutional investors, etc. He should lend support to the proposed transactions, provide relevant background about the company, and answer questions directed to him. Ascertain that the messages in any important public statements (e.g., the annual report, quarterly financial reports, financial-type news releases) are as he thinks they should be, or understand why not. Address important company matters and the annual meeting of shareholders.

11.11 CHANGES IN THE CAPITAL MARKETS Among other objectives, a purpose of the IR function is to enable the company to raise funds to meet its needs, on an acceptable economic basis, so as to enhance the long-term interests of the shareholders. But the financial environment changes, among other things, as the business cycle changes, or the perceived relative status of the company or industry changes, or, indeed, as the moods of the investor vacillates. Some recent developments include demands by some pension funds that they have a greater voice in certain company policy decisions; increased agitation by unhappy shareholders about exorbitant levels of executive compensation or perquisites; pressures by some institutional investors to make the board of directors more independent of the CEO; proposals by company management for the “protection of shareholders” in the event of an unsolicited bid for the corporation; and vastly increased volatility in the stock market. While circumstances will differ company by company, there will be instances wherein the CFO, probably assisted by the controller, will find it necessary to become more aggressive in cultivating the financial market, and take these actions: (1) Establish specific financial market related objectives, which will be in the shareholders’ interest; and (2) develop some methods of helping to reach these (new) objectives. All of this is to say that the IR function is not merely a passive communication caper. (a) SOME SUGGESTED FINANCIAL MARKET OBJECTIVES. The objectives of the company, with respect to financial markets will depend on what condition appears to need improvement or change. In the experience of the authors, here are some typical objectives, one or more of which might apply to a particular entity: • Increase the P/E ratio to X, or to the Standard and Poor’s (S&P) 500 level, or to the best in the industry. • Lengthen the average stock holding period by attracting more long-term investors. • Reacquire 25% of the present outstanding shares through stock repurchase programs. • Increase the average daily share sales volume — to, say, 100,000 (so that institutions can buy or sell in a given day without significantly moving the stock price). • Reduce volatility by expanding the shareholder base. • Build shareholder demand (by diversifying the shareholder base). • Create a greater demand for company bonds or other debt securities. • Reduce the proportion of shares held by institutional investors. While consistent earnings growth, based on good products and capable marketing, and a sound financial position, are fundamental in attaining and maintaining many of these objectives, another

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aid is to target particular markets and properly communicate relevant financial information. Which targets need to be reached will require an analysis of the present shareholder types, and so forth. A few comments on this phase follow. (b) SOME SUGGESTED METHODS. A successful IR program involves providing reliable, consistent, timely, and truthful information about the company on such matters as depth of management, developments as to products and markets, probable trend of sales and earnings, and some guidance on company financial objectives—not only to the usual array of stock brokers, security analysts, and individuals, but more especially to carefully selected institutions that probably would be a desirable type of shareholder—who could aid in meeting the objectives set out in the investor relations agenda. Some suggestions include: 1. Maintain a current, well-documented background book which is available to all key executives, and for all key contacts with the investing groups. Such an information source would provide these benefits:

2.

3.

4.

5.

(a) The reader will have a better idea of what subjects are matters of concern to an investor or potential investor. (b) The executives will have a consistent and uniform response to the queries. (c) The reader will be updated on the current developments in his company which should be communicated to the investing public. In terms of content, aside from the financially relevant information on the company itself, the data book might contain information about potential investor contacts: location, position, investment patterns, availability for conference calls, and so on. Be certain that all key internal officers are current on new and important developments and that the investor significance is understood. With such a background, the likelihood is reduced of making offhand comments which can be misinterpreted. Establish close one-on-one relationships with selected institutional investors where particular investor relations objectives can be furthered. It already has been mentioned that increasing the investor base by the addition of long-term investors will lengthen the average holding period. Creating closer relations with institutional investors also may reduce volatility. Volatility occurs or increases because large segments of the shareholder population decide to take the same action at the same time, for example, sell the shares. If large shareholders are kept informed about the company, this may decrease the tendency to follow the actions of other investors. These long-term investors may buy more shares while the short-horizon investors may be selling—thus creating a balance in the marketplace, and maintaining the price. The program for contacting large institutional investors or potential investors can include periodically scheduled visits (once or twice a year) to the financial centers (New York, Boston, Chicago, San Francisco, etc.) to meet particular institutional investors and security analysts. Consider the possibility of conference calls to selected investors or security analysts. This has the advantages of (a) making one call instead of numerous ones, (b) releasing the data to many sources at the same time, and (c) tends to keep the message more consistent. A disadvantage arises of making it more difficult to answer all the questions of every analyst, and so on. In some circumstances, increase the contacts with noninstitutional investors. Some corporate financial executives have felt their company might be vulnerable to extend pressures when too large a portion—say 75 percent to 80 pe rc e nt—of the shares were in the hands of institutional investors. For example, the entity might become a target for a hostile takeover. Hence, there could be merit in expanding the ownership base through appropriate and frequent contacts with buy-side security analysts, brokers, and so on. So there is much to be said for considering certain specific investor relations objectives and developing a specific program to meet them.

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PART

THE PLANNING FUNCTION OF CONTROLLERSHIP

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CHAPTER

12

BUSINESS PLANS AND PLANNING: INTERRELATIONSHIP OF PLANS, STRATEGIC PLANNING 12.1

INTRODUCTION 187

12.2

BUSINESS PLANNING DEFINED 188

12.3

FRAMEWORK FOR BUSINESS PLANNING 188

12.4

TIME AS RELATED TO PLANNING 188

12.5

PLANNING PERIOD: HOW LONG IS “LONG RANGE”? 189

12.6

SYSTEM OF PLANS 190

12.7

STRATEGIC PLAN: AN OVERVIEW 190

12.8

CORPORATE DEVELOPMENT PLAN 191

12.9

OPERATIONS PLAN 191

12.10 BASIC ELEMENTS IN ANY PLAN 191 12.11 PLANNING PROCESS 192 12.12 PLAN FREQUENCY 194 12.13 PLAN GUIDELINES 194 12.14 WHO SHOULD DO THE PLANNING? 195 12.15 SUPPLEMENTAL PLANNING: ALTERNATIVE SCENARIOS 196

12.16 PLANNING TIMETABLE OR SCHEDULE 196 12.17 STRATEGIC PLANNING: AN IN-DEPTH REVIEW 196 12.18 ENVIRONMENTAL ANALYSIS 198 12.19 CRITICAL SUCCESS FACTORS 199 12.20 BUSINESS MISSION OR PURPOSE 200 12.21 LONG-RANGE BUSINESS PLANNING OBJECTIVES 202 (a) Illustrative Long-Range Objectives 203 (b) Linking Objectives 203 (c) Setting The Long-Range Objectives 203 12.22 DEVELOPING STRATEGIES 205 (a) Appraising Alternative Strategies 207 (b) Some Illustrative Strategies 207 12.23 STRATEGIES AND THE PLANNING PERIOD 208 12.24 ROLE OF THE CONTROLLER 208 12.25 IMPROVING THE STRATEGIC PLANNING PROCESS 210

12.1 INTRODUCTION Business planning, when properly done, is a complicated but fascinating procedure, intertwined with all the functions or departments of the entity. This chapter discusses how the various elements of the strategic plan are interrelated and provides an overview of the planning process. It seeks to review some of the basic questions raised in the planning process and to consider in some detail the elements of strategic planning. Chapter 13 further shows how the elements of the strategic plan are combined into an integrated plan, expressed in financial terms, covering a span of several years — a task of particular importance to the chief financial executive and the controller. Chapter 14 then provides an overview of the short-term planning process and how the parts are combined into the annual business plan. 187

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12.2 BUSINESS PLANNING DEFINED The concept of business planning is not new. Many companies have utilized formal or organized plans for years. What is different, however, is the emergence of comprehensive planning systems and a new sense of urgency about the need to plan—whether it be because of the disastrous inflation of the early 1980s, the heightened foreign competition of the 1990s, the instability of international currencies in the late 1990s, or the speed of technological changes. Be that as it may, the financial aspects of planning are important to business survival and growth; and the financial officers of the corporation should be aware of the interrelationship of plans, methods of planning, problem areas, and the concomitant financial implications of each. Given the need for sound planning, what, then, is a plan? It is a predetermined course of action. The process of thinking ahead and making a judgment on a course of action, giving consideration to the many feasible alternatives available is the planning process. A plan, accordingly, must recognize three factors: 1. It must involve the future. 2. It must involve action. 3. It should give recognition to the organizational structure of responsibility, authority, and accountability by which action takes place in a given business. A plan assumes a predetermination to take action, which distinguishes it from forecasting. Forecasting may involve predicting the future to some degree, but it does not necessarily involve future action by the planner or his company. It often involves future action by someone else. Hence, forecasting may be used to predict future conditions or action by other forces, such as governments, competitors, and environment. The planner determines a course of action to reach an objective. Business planning may be done only in the mind of the chief executive or may involve a well-organized effort by many individuals. The problems of what, why, and how will be discussed.

12.3 FRAMEWORK FOR BUSINESS PLANNING Perhaps the best way to understand what constitutes good business planning is to recognize three separate and related elements: 1. The system of plans that should comprise the whole—for all activities of the business and for all planning periods—and their relationship to each other. 2. The orderly process by which each plan is formulated. 3. The basic elements that should be inherent in any sound plan of action. But before the planning system and process is discussed, it may be desirable to review the “time factor.”

12.4 TIME AS RELATED TO PLANNING In a sense, planning may be described as an opportunity to consider and experiment with the valuable assets (including both employees and materials) of a company before committing them to risk. The future period for which different industries must commit these resources varies greatly as, for example, from the season-oriented apparel business to the decade-oriented orchard or ranch operations. It is obvious in the planting of citrus groves or the building of a butadiene plant that a period beyond the immediate future must be considered. This properly should involve “long-range planning.” This difference in period for which planning must be undertaken can be better viewed in the light of “generations” of product and market. A company has existing products that are being sold in present-day markets and may be described as current generation products and markets. But at an unknown time in the future these existing products and markets will be superseded and replaced by new products and/or new markets, and so on ad infinitum.

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The same business judgment that recognizes the inevitability of the change or evolution of things also understands the need for a complete planning process. This continual change in business environment as related to the potential of the company is best illustrated in Exhibit 12.1. The profile of projected earnings indicates a downward trend in earnings from existing products or situations. Development projects now underway will slow the deterioration. However, it may be inferred from the exhibit that this company must attain at least the growth rate of the industry — through new developments, including a reevaluation of the existing business and present research and development projects, to avoid the “gap” of lost opportunity. And this process, if carried out properly, will involve all phases of business planning.

12.5 PLANNING PERIOD: HOW LONG IS “LONG RANGE”? Strategic planning sometimes is referred to as “long-range planning.” Just how far ahead should a company plan? What are some of the factors to be considered in selecting the proper period for which to plan? Each business has characteristics that need to be identified in determining the time period of planning. A company should plan ahead only so far as it is useful. Surveys on this subject indicate that among companies that do long-range planning, the most common period is five years, although the trend is toward a greater distance into the future. Some of the factors that serve as a guide in selecting the proper planning time span are: • Lead time for product development. This includes the length of time from the idea of a new product until the design, manufacture, and distribution are completed. One company may take three months, whereas another may require several years. • Length of life of the product. The probable period before a product is considered obsolete clearly will be a factor. • Market development time. This period can vary tremendously—from several years for a complicated industrial product to perhaps only several weeks for women's fashions. • Development time for raw materials and components. Some extractive industries such as iron ore mining or oil drilling may require a decade of advance planning. Wood products companies may consider a period beyond the life expectancy of their present management.

E XHIBIT 12.1

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S OURCE OF T HE “G AP ”

A

C OMPANY ’ S N ET I NCOME —

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• Time for construction of physical facilities. For many plants a minimum of two years for design and construction of a plant and its equipment is needed. • Payout period for capital investment. Obviously, the period over which the investment in capital equipment will be recovered must be weighed. Payoff may vary from several months in a highly speculative and profitable field such as certain chemicals to perhaps more than a decade for some utilities. Thought must be given to conditions that will prevail during this payout period to focus on the probability of recovering the investment and earning an adequate return on it. Consideration of these factors, plus any other pertinent ones, will give some indication of the minimum period for strategic planning.

12.6 SYSTEM OF PLANS There are three major components in an integrated planning structure: 1. At the summit or vertex is the strategic plan. It seeks to outline in general terms the characteristics and objectives of the firm. 2. Stemming from the strategic plan is the corporate development plan that concerns itself with the development of “new” products and markets. 3. Also deriving from the strategic plan is the operations plan that focuses largely on the existing generation of products and existing markets. Each is discussed subsequently.

12.7 STRATEGIC PLAN: AN OVERVIEW Strategic planning begins with the present and extends to the most remote period selected as useful for planning purposes and therefore should be included in the planning cycle. The purpose of strategic planning is to set the guidelines and policies of the company that serve as the basis for the next echelon of plans—the development plan and the operations plan. The strategic plan focuses attention on the needs, dangers, and opportunities facing the company. It identifies the key decisions that must be made and usually sets guidelines and deadlines for making them. The process guides the company in decisions about the current generation of products as well as the next and succeeding generations of products and markets. Through this thinking and communicating process it helps assure that the plans and decisions of the various units are moving the company to the same agreed-on objectives. A strategic plan generally involves the following components: • A clear and understandable statement of the company’s basic purpose. Examples of such statements are: to maintain the existing share of market; to maintain financial performance at not less than current levels; and to develop new business capabilities that will enable the company to have a faster rate of growth than the industry. • A carefully thought-out strategy or means to accomplish this basic purpose. This should include certain specific actions, such as: eliminate Division E and market area R, accelerate advertising program in Territory B, build Research and Development competence in X product line, and diversify by acquisition into S product line. • A statement of specific goals to be achieved under the strategy and means of measuring progress toward each. Examples include financially expressed goals, such as: By the Year a. Sales 1. Dollars 2. Percent of present product total

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200X

200Y

$160MM 75%

$350MM 55%

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191

By the Year b. Rate of return on investment 1. On assets employed 2. On common shareholder equity 3. On net sales c. Per share earnings

200X

200Y

12% 17% 5% $2.50

15% 23% 7% $3.40

• A statement of the assumptions or conditions used or needed to achieve the goals. These may include: continued guarantees of foreign investments, favorable decisions by the U.S. Department of Justice on pending cases, increase in the gross national product (GNP) by at least 3.5% annually, availability of suitable financing at a cost of less than 11% per annum, establishment of a computer center for scientific applications, and inflation rates: 2000 – 2005, 7%; 2006–2010, 6%.

12.8 CORPORATE DEVELOPMENT PLAN Auxiliary to the strategic plan is the corporate development plan. It may be said to relate principally to the new product and market activities, to the actions or methods by which the new generations of products and/or markets will join existing ones. This product- and market-oriented development activity will concern itself largely with: • The establishment of those conditions or business climates that foster and encourage the creation or discovery of new products and markets • The gathering together of pertinent data to identify those fields with the highest potential return on the corporate resources. A corollary to this effort, of course, is the establishment of the necessary procedures to identify areas of less desirable growth (including existing products, etc.). • The determination of resource requirements and the scheduling needed to implement the program as it passes into normal operations The corporate development plan has three segments: 1. The Divestment Plan, which relates to the sale or merger or shutting down of major parts or divisions of the business; 2. The Diversification Plan, which relates to the development of new products for new markets and also considers whether entry into the markets should be by acquisition or merger on the one hand or by internal development of these new products on the other; 3. The Research and Development Plan, which involves the many aspects of research and development (R&D).

12.9 OPERATIONS PLAN The remaining indicated second echelon of planning is what is termed the “operations plan,” since it is concerned principally with current business actions. Essentially, it covers the near-term activities and extends to every function of the firm. It deals with and influences the functions directly and indirectly involved in distributing the present generation of products to existing markets. Basically, it relates to the development of the plan of operations for the next year or two. It is essentially detailed in nature and specifies plans by individual function, the whole of which becomes the “annual plan” or some such designation.

12.10 BASIC ELEMENTS IN ANY PLAN The strategic plan is broad and general in nature. Conversely, the annual operations plan is quite detailed and specific—and becomes the budget or control tool for the near term.

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Plans may differ in the time period covered or in subject matter. But mature consideration will indicate that each sound plan must contain these basic qualities, some of which have been implied in the preceding discussion: • Statement of purpose. Identifying the purpose of the plan gives the reader the reason for the action required. It answers the “why” part of the question. It sets forth the objective. The purpose of the strategic plan may be broad and general. As the plans become more detailed, so also must the reasons for proposed action become more specific, more refined, and more detailed. • Identification of action to be taken. Obviously, the purpose of formulating a plan is to take action, and the plan must stipulate what kind of action need be taken. Again, the more detailed the purpose, the more specific or concrete must be the action—from broad general terms in the strategic plan to minute details in a segment of an operating plan. • Specification of the resources to be used. The basic task of management is to use all resources wisely. A firm’s resources include not only funds but also people, plant and equipment, technical know-how, and other proprietary knowledge. Plans must indicate which resources are needed—and whether they are on hand or must be acquired—to avoid a conflicting assignment of their sources or a less than optimal use. • Identification of goals. The goals define the level of accomplishment expected from the action taken. Stated otherwise, goals answer the question of what is to result from the activity. • Establishment of definite time schedules and adherence thereto. Progress toward the goals must be measured not only in degree of achievement but also in time. • Identification of conditions to be met or assumptions made. Generally, the important underlying conditions on which the plan depends must be made known to those who must approve the recommendations. If these conditions do not come to pass, then the responsible executive must be made aware of this situation at definite checkpoints so that corrective action, including changes in plans if necessary, may be made.

12.11 PLANNING PROCESS With the various segments or elements in a strategic plan identified, it is probably easier to focus now on the planning process itself. Assume a decentralized management-type company, wherein each division management must consider the environment in which it operates, and reach conclusions about its product lines, and so on. The planning cycle at the division may be as illustrated in Exhibit 12.2— an iterative process. A brief description of the 12 steps is: 1. The management sets certain tentative goals and objectives, based in part on guidelines developed by the corporate office. 2. An analysis is made of the expected internal and external environment in which it expects to operate for the planning period. 3.- 4. Basic assumptions are made about this environment and the division's current posture. 5. A market analysis is made to determine or confirm the most effective marketing method. 6. A marketing plan is devised (taking into account the new products and markets, and status of existing markets and products) for each year of the planning cycle. 7. The market support plan by years is made (sales strategy, required staff, advertising and sales promotion, etc.). 8. Using the factors determined from steps 6 and 7, the sales estimate by years, by product, by territory, and by salesperson is developed. 9. Based on the sales estimate, the related organization and manpower needs throughout the rest of the division (production, research, services, etc.) are completed and costed on a time-phased basis. 10. Fixed asset (facilities) plans are developed by year of need and amount of expenditure.

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12.11 Planning Process

E XHIBIT 12.2

193

D IVISION S TRATEGIC P LAN C YCLE

11. The financial plan (cash, cash generation, income and financial condition, time-phased) is developed. 12. Conclusions are reached as to whether or not the plan is satisfactory. If not, the iterative process may begin again until an acceptable plan is developed. This plan, with assumptions and recommendations, is presented to the corporate management and, if approved, is incorporated into the total company plan. Meanwhile, at the corporate office, comparable analyses and studies have been taking place, giving consideration to the thinking of the chief executive officer (CEO) and other corporate executives. These reviews are intended to facilitate an independent judgment on suitable corporate objectives, as well as to provide guidance, where appropriate, to the divisions and subsidiaries. The planning cycle, including the relationship of the strategic plan to the annual operating plan of the corporate office, is illustrated in Exhibit 12.3. There are five basic steps: 1. Selected strategic studies are made, perhaps covering a period of 30 years, and on some phases, as appropriate, in cooperation with the division having fundamental knowledge of products and markets. 2. An environmental analysis (discussed in Section 12.18) is made and tentative conclusions reached regarding the internal and external environment in which the company operates. 3. Based on the studies in steps 1 and 2, strategic guidelines are developed for the divisions, as well as the corporate functions. Company objectives and goals (tentative) are established. 4. With the corporate input as well as the division/subsidiary data, the strategic plan (for 10 years) is developed. If it is not satisfactory, adjustments are made, through an iterative process, until it is deemed acceptable. 5. When the strategic plan is approved, the appropriate sections serve as the basis for developing a detailed annual plan for the first one or two years. The approved annual plan becomes a commitment and a budget — perhaps monthly for major programs and at least quarterly for the total company/division performance. Corrective action is taken as warranted.

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E XHIBIT 12.3

A EROSPACE C OMPANY O VERALL P LANNING

AND

R EVIEW S YSTEM

12.12 PLAN FREQUENCY A question might be asked, “How often should the business plan be updated or revised?” In general, it might be stated that planning is a “continuous” process and that as significant developments occur, such should be inputted to the master strategic plan. Given computer technology, this task is made somewhat easier through the automated centralization and automation of information. In regard to the frequency of formal updating or revision, many companies find it practical to update the strategic plan on an annual basis. In effect, one year is dropped, and a new one is added. Each year, as new perceptions of the business or new opportunities or threats emerge, these, in effect, are studied and incorporated into the planning process and resultant plan. The short-term business plan, of course, should be prepared each year. However, since the annual plan is not only a plan but also a control tool, it would seem prudent to review it if major events change. Thus, if a major contract is canceled, or a war occurs, or any important plant is destroyed, a new plan would be needed. However, changes in conditions per se should not be the excuse for revision of the plan because the operating group is not achieving the goals. The impact of the deviation, and expected year-end (or other period) result, can be identified without changing the plan, but by quantifying the indicated final results for the year, and the departure from the business budget (plan).

12.13 PLAN GUIDELINES The heart of sound planning is thinking and communicating, whether for the strategic plan or the short-range plan. The expectations and instructions from top management are necessary, among other reasons, to communicate concepts vital to effective planning to all participants. The attempt should be to motivate thinking and not merely provide instruction on completing a form. Furthermore, especially from the financial viewpoint and in decentralized operations, a somewhat structured system of reporting the plans is required. Without it, consolidation at the corporate level is difficult or almost impossible. What should be included in the instructions for both division and corporate must be developed by each company. To assist division managers in communicating with top management, and top management with the board of directors, some idea of subjects covered may be gleaned from instructions in a manufacturing company regarding the content in the executive summary to be presented in the division

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195

strategic plan—with further details provided in supporting schedules and related information in the short-term plan. The contents of the executive summary should include: • Comparison to the prior year plan • The major planning assumptions (external and internal) • Growth strategy • Business goals • Perceived strengths, weaknesses, opportunities, problems, and threats • Optimization of profit plans for the existing business • Programs and strategy for new business development • Financial summaries of major factors, trends, and return on assets

12.14 WHO SHOULD DO THE PLANNING? Having defined plans—and discussed the types of plans, the time covered by plans, and the planning process — a logical question arises about who does the planning. This subject can best be discussed by differentiating between the strategic plan, discussed in Section 12.16, and the short-range plan, discussed in Chapter 14. There is little doubt that the CEO is responsible to the board of directors for the strategic plans of the company — the direction in which the company intends to go. Some would say the CEO is the chief long-range planner. Certainly, the CEO’s style of management will have a direct impact on the planning process. Ultimately, long-range planning must involve most elements of management. Accordingly, who does the planning will depend on circumstances. The planning could involve: • Only the CEO • The chief executive and staff • A committee, perhaps part time, composed of representatives of each major discipline, or each major operating group • A separate permanent planning department that would provide leadership and coordination in the process — with adequate support from the chief line and staff executives Which of these structures it will be hinges on several factors, including: • Stage of evolution of planning in the company. If the planning is informal and sporadic, the chances are that, in fact, the chief executive will be the chief planner— with limited assistance from others. • Attitude of the CEO. This may determine the extent or depth of the planning activity. Support from this source is a “must” for effective planning. • Size of the company. Generally, the larger the company the more likely it is to make formal long-range plans. • Nature of the company’s markets. Military suppliers, for example, often do more planning than the consumer goods manufacturers. Without getting into a prolonged discussion of organization, there are some general observations that may be helpful if a company is staffing a corporate-level planning group. A balanced group containing several disciplines is desirable. Several functions must be included: marketing, engineering, finance, human resources, and research. Regardless of background, prime requisites of the individual are flexibility and creativity. Excessive formalization in planning, especially strategic planning, can destroy what it is all about — the surfacing of creativity and intuition. In developing strategies, specific procedures and analysis are required. But the real benefits of strategic thinking are the invention of new ideas, and not just the rearrangement of old ones.

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12.15 SUPPLEMENTAL PLANNING: ALTERNATIVE SCENARIOS Planning is usually done with the most likely set of events being the assumptions. Accordingly, it may be called the most probable scenario or case. Yet a company must be prepared if these events do not take place. Hence, alternative plans also are necessary. Management must be made aware of financial results should certain possible but improbable occurrences happen. Financial management must have some sense of the maximum financing needs should events proceed far better than expected. Some managements prepare supplemental financial plans to give a sense of a reasonable range of possibilities. A typical one-year summary is shown in Exhibit 12.4. Although the emphasis may be on the most probable case, sufficient analysis should be done on the alternate scenarios so that the full financial implications are understood.

Optimistic case Most Probable case Pessimistic case E XHIBIT 12.4

Net Sales ($000)

Net Income ($000)

Earnings per Share

$ $ $

$ $ $

$ $ $

A LTERNATIVE S CENARIO F INANCIAL P LAN

12.16 PLANNING TIMETABLE OR SCHEDULE To achieve a sound strategic or short-term plan on a timely basis, it is desirable to prepare a calendar of events. With respect to the strategic plan, the calendar may be issued at the time of the chief executive's announcement of the annual strategic planning effort. A short, simple calendar of events used by an aerospace company is outlined in Exhibit 12.5. Issuance of general guidelines (environment, etc.) by the CEO to division heads and other interested parties Receipt of division plans by chief officer Completion of review and analysis of division plans by corporate staff Preparation of consolidated and corporate position Review with top management and board of directors E XHIBIT 12.5

S AMPLE C ALENDAR

OF

April 30 July 31 September 30 October 31 November 30

E VENTS

In this instance, the cycle for the strategic plan is separated from the short-range planning cycle, among other reasons, to distribute more evenly the time spent in the planning effort. Although the dates cited indicate the latest acceptable time for completion of the activity, in fact there is a continuous interface between the corporate and division planners, and often the financial officer will perform alternate scenarios that are needed for the long-term financial plans.

12.17 STRATEGIC PLANNING: AN IN-DEPTH REVIEW Various names have been attached to the business planning function that encompasses a period of time beyond the next year or two: total planning, comprehensive integrated planning, top management planning, comprehensive corporate planning, long-range planning, and strategic planning — to name a few. A practical definition is that used by George A. Steiner:1 “Strategic planning is the systematic and more or less formalized effort of a company to establish basic company purposes, objectives, policies, and strategies and to develop detailed plans to implement policies and strategies to achieve objectives and basic company purposes.”

1. George A. Steiner, Strategic Planning. What Every Manager Must Know (New York: The Free Press, 1979), p. 15.

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The strategic planning cycle, an iterative process, is depicted graphically in Exhibit 12.6. Most strategic planning processes encompass these seven steps: 1. Analysis of the industry and business environment and status 2. Determining the corporate mission or purpose (In some instances the sequence of these first two activities, both closely related, may be reversed.) 3. Selecting the company’s long-term objectives 4. Developing appropriate strategies 5. Preparing the long-range plan, including the financial plan 6. Measuring actual performance (of the milestones to be attained each year) against the plan 7. Analyzing the reasons for departure from the plan, and taking any appropriate action It is to be observed (in Exhibit 12.6) that the cycle has been separated into two phases: (1) the strategic planning segment where much conceptual thinking usually takes place, with emphasis on

E XHIBIT 12.6

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T HE S TRATEGIC P LANNING C YCLE

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product and marketing considerations, and (2) the long-range planning phase. This second phase often is more financially oriented in terms of considering funding sources and timing, and financial structure, and so forth, for the several years — a function in which the controller must play a more important role, perhaps, than in the first phase.

12.18 ENVIRONMENTAL ANALYSIS Logically, in determining the steps a company should take to ensure its survival and long-term growth, it is important to understand the environment in which it probably will be operating. This has two aspects: 1. The external environment—those influences outside the company that are or will be dominant factors in its activities 2. The internal environment—those forces inside the entity that will be significant forces in how it will function The external influences may be grouped for discussion purposes into these four categories, perhaps in order of importance, for most companies: 1. 2. 3. 4.

Economic Technical Legal or political Social

In deciding on certain actions, such as expanding into a new territory, or introducing a new product, or selling a segment of the business, these economic factors should be weighed: • Level or stage of the business cycle • Level of general business activity • Entrance of competitors • Industry cycle • Foreign exchange rates For other decisions, other economic factors might have to be considered. A partial list of technical factors, which may be more important in some industries than in others, relate to: • New products of the same general type • New products of a different kind that can serve the same need • New processes • New capital equipment (which can greatly impact unit manufacturing costs) Legal or political considerations that may influence company behavior include: • Legislation affecting the product or activity — local, national, foreign, or domestic • Court decisions relating to interpretation of the laws • Administrative actions — local or national, that affect the enforcement of the law Some legal developments may aid the proposed actions; some may be discriminatory. Finally, the social acceptance of the product or service sold, or the manufacturing process may be an influence. Social mores do change; and what is acceptable in one community or country may be unacceptable in another. Each of these external factors must be considered in terms of impact on the company. An equally key environmental factor is a proper evaluation of the business status — an introspective look. The management must try to objectively view itself. In looking at “what makes the company tick,” these are some matters to be considered:

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• Company strengths and weaknesses. This involves knowing the functions and areas in which the company performs well, understanding how its strengths compare with competitors’, and reaching conclusions on whether or not its strong points may be improved and its weaknesses overcome. Among the many indicators to be examined are:
Product acceptability
Share of market
Marketing posture
Proprietary product status
Manufacturing costs
Quality control
Product deliverability (availability and speed)
Patent status
R&D success
Raw material sources
Foreign market status
Plant capacity
Financial strength
Judgment and skill of the management
Flexibility and capacity to change • “Critical success” factors. This refers to knowing what particular attributes are responsible for the company’s success. It may be such characteristics as good quality control, quick response time to sales orders, personality of the representatives, or sound engineering, etc. (see Section 12.19). • Status of each product in each market segment. Included in this grouping might be:
Understanding the life cycle stage of each product—embryonic, growth, mature, declin-

ing (see Exhibit 12.9).
Understanding each business segment as to market share and growth rate, according to the

Boston Consulting Group matrix2 as either:

A star—high market share, high growth rate A cash cow— high market share, low growth rate, significant generator of cash A wild cat—low market share, high growth rate; probably a cash user until the product and market are more developed A dog — low market share, low growth; a candidate for divestment Those who know the market and the product must be able to reach objective decisions about each. Knowledge of the preceding factors in all three categories is important in deciding on the corporate mission and the strategy to reach the corporate objectives.

12.19 CRITICAL SUCCESS FACTORS The “success” factors are also called key success factors, or perhaps more popular now, in planning jargon, the critical success factors (CSFs). These normally would be identified in the environmental analysis. The characteristics that surround or identify the CSFs are: • Vital or essential to achievement of the overall corporate objectives • Expressed as actions that must be taken, either continuously or when threats appear, or as conditions develop that must be overcome

2. William Lalli (ed.), Handbook of Budgeting, 5th ed. (Hoboken: Wiley, 2003), Chap. 2.

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• Somewhat limited in number, that is, not everything that can be done is critical • Controllable by the entity to which they apply, or capable of being offset by other actions of the entity • Hierarchical by nature, that is, they may apply to the business as a whole, or for each division, or for each major function, such as marketing, manufacturing, finance, or R&D • Applicable to each entity that has the same objective in the industry While the CEO and other long-time major executives probably will have in mind some or all of the critical success factors, some logical spots to search or examine in the environmental analysis are: • Product or service areas where the greatest growth is expected • Product areas that are generating, or are expected to generate, a major portion of the sales and /or operating income • Functional or product/service areas where the greatest technological advances are expected Critical success factors may be deduced from the strategies selected by particular companies or by the major problems the management thinks it must solve. Some examples are: • For a food products manufacturer:
Need to improve quality control
Necessity of making packaging more attractive
Need to introduce competitive product within three months of the leader • For a retail food chain:
Need to increase gross margins on meats, fruits, and vegetables
Necessity of expanding in more affluent suburbs
Desirability of adding a delicatessen • For an aircraft manufacturer:
Desirability of adding a manufacturing and repair facility in country X to better service customers in that growing market
Need to introduce just-in-time (JIT) inventory controls
Need to penetrate foreign markets of Asia to offset declining U.S. business

12.20 BUSINESS MISSION OR PURPOSE Environmental analysis is intended to provide the background for the early step of determining the corporate mission or purpose. Of course, management may decide to tentatively establish the business purpose or mission and then see if the environmental analysis seems to indicate that conditions will reasonably permit its achievement. One of the principal tasks of top management is to formulate the basic purposes and missions of the company. As Peter Drucker has said, management must decide, “What is our business and what should it be? ”3 This requires a great deal of conceptual thinking as to what the business is all about. It is this mission statement that serves as the guideline for strategic planning. How should the mission statement be formulated? In smaller companies it tends to depend largely on the thinking and values of the CEO. But in larger companies it is done more effectively by consultation and exchange of ideas among the management—although the CEO has an important voice. An offsite planning meeting of the key management team is one way to address the issue. A questionnaire is provided to each participant before the meeting and answers are prepared. 3. Peter Drucker, Management: Tasks, Responsibilities, Practices (New York: Harper & Row, 1974), p. 75.

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Such answers may be tabulated and discussed separately. Item by item, there is a thorough review and a consensus is reached. Good conceptual thinking, based on experience and knowledge of the business, is essential. There is no uniform content of mission statement. They vary from lofty statements of principle, representing the values of the CEO, to very detailed and concrete guidelines. Excess detail may be counterproductive, and vague general statements may not be useful in formulating objectives and strategies. Perhaps a middle ground may best serve the purpose. In the words of George A. Steiner, “Carefully prepared missions have been the source of success of companies. Revised missions have turned companies around. On the other hand, poorly formulated missions have brought disaster to some companies.” 4 The list of questions may be helpful in probing subjects that are to be contained in a mission statement, and that give recognition to the unique business. For example, if the marketing channel of a pharmaceutical company is through doctors of medicine to the ultimate patient, then some statement concerning the doctors may be germane. So what factors are important to the survival and growth of the entity — in the eyes of management? Perhaps these subjects, which can be identified and/or refined by the planning meetings, should be a part of the mission statement. Some suggested items for inclusion are: • Product or product line • Market and market share • Profitability on sales, assets, and/or shareholders’ equity • Growth in (select some): sales, market share, specific product lines, earnings, earnings per share, jobs, and/or markets served • R&D • Productivity or efficiency • Flexibility in manufacturing process, R&D methods and technology, meeting customer delivery needs, responding to competitive actions, and meeting changing societal needs • Company image • Observing code of conduct • Developing managerial pool The preceding items may be in response to these basic subject categories: • Survival or continuance • Profitability • Growth • Flexibility Having covered some possible subjects, what are some illustrative examples of company statements of purpose? Some concise mission statements from company policy manuals are: • To be the predominant supplier of electronics countermeasures to the U.S. Air Force • The primary mission of the [XYZ corporation] is to assist our clients in achieving cost-effective employee benefit plans through the effective marketing of innovative and especially designed concepts intended to reflect the strengths of the client company. • The mission of the [Custom Engineering Corporation] is to maintain a viable growing business by designing, developing, manufacturing, and marketing custom engineered products and services to meet the needs of selected utility and construction companies.

4. George A. Steiner, Strategic Planning: What Every Planner Must Know (New York: The Free Press, 1979), p. 162.

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Some practical observations about mission statements are: • The principal application of a mission statement is to serve as a guide to policy decisions, to provide direction. Accordingly, it should be quite specific, and not a lofty statement of admirable purpose. • As to products or product lines, careful designation may be important—whether the product/ service is defined in broad terms or more narrowly described. The wording can be significant. Thus, a statement that company Y is in the communication business might have quite a different impact than to specify narrower business lines, such as newspapers, television, and/or radio. • The mission generally should include the scope of operations. While the mission will identify the line of business, the scope will delineate the market, for example, United States rather than worldwide. • A realistic statement of purpose probably will be influenced by these three factors: 1. The basic competence and characteristics of the entity itself, e.g., skill of the management, capital resources, operational capabilities, physical assets, geographical location, availability of skilled personnel, raw materials sources, etc. 2. The expectations of the stakeholders — those who have something at stake within the firm: the management, shareholders, creditors, employees, suppliers, customers. The relative weight of each faction's influence will help shape the relative importance of different elements of the mission. 3. The nature of the expected future external environment, for example, regulation, social trends, inflation rates, the stage of the business cycle.

12.21 LONG-RANGE BUSINESS PLANNING OBJECTIVES Some managements use the terms purpose, objective, and goal interchangeably. For our discussion, the term objective shall refer to a desired result or condition to be achieved by a stated time. By some definitions, a quantified objective is a goal. As shown in Exhibit 12.7, once the business purposes or missions have been determined, then the long-term objectives may be established. It should be realized, of course, that the establishment of objectives is an iterative process, closely coupled with the determination of strategies. One influences the other. In any event, the criteria for satisfactory long-term objectives include these characteristics: • Suitable. Logically, an objective should support the basic purposes and missions of the entity. Achieving the objective should move the enterprise in the direction of meeting its purpose. Achieve by Year Objective

2004

2010

Aggregate sales volume (millions) Percent of non-U.S. sales Percent of new products Operating profit (% of sales) Rate of return: On total assets On net worth Earnings per share Price/earnings ratio Labor content in products Minorities as % of workforce

$560 20% 15% 17%

$1,200 25% 30% 22%

10% 19% $2.50 11% 25% 15%

12% 25% $4.25 15% 22% 20%

E XHIBIT 12.7

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• Feasible. Objectives should be achievable. It serves no useful purpose to set an unrealistic objective or goal. Any objective should be established giving recognition to the expected environment: competitive actions, technical achievements, political feasibility, social acquiescence, and so on. • Compatible. Each objective should be compatible with the other objectives. For example, the objective for Product A or strategic business unit X (SBU) should be in harmony with, or certainly not in conflict with, the objectives for the overall entity. • Measurable. Actual results should be measurable against planned results over a specified time span. Thus, if the objective is “To attain a sales level of $100 million by the year 1999,” then attainment is readily identifiable. Objectives may be quantified in any one of several ways: monetary units, unit quantity, cost, rate, percentage. Only when the objective is stated in concrete terms and for specified periods of time can their attainment be measured reasonably objectively. • Flexible. Objectives should not be easily changed; nor should they be immovable. When major unforeseen contingencies occur, they should be changeable to be more realistic. • Motivating. Another important characteristic of a proper objective is its motivating power. An objective should not be so easily achieved that it is certain of attainment. Nor should it be too difficult to accomplish. It should be at such an effort level that those to be judged by it generally agree it can be reached. This implies that those who are to meet an objective should have a voice in setting it. The management members involved should regard it as a commitment to be met with adequate effort. (a) ILLUSTRATIVE LONG-RANGE OBJECTIVES. In practice, most enterprises have only a few long-term planning objectives. In theory, however, goals or objectives could be set for every function and every department in the business. Typically, many of the objectives are financially expressed and relate to sales volume, profitability, and market share. But measures may be developed for any number of factors that need change: labor content, share of minorities in the workforce, skill diversification in the engineering or research staff, labor turnover rates, productivity, R&D expenditures, share of sales from nearly developed products (over a five-year span), and ad infinitum. Planning objectives should be set for those critical factors essential to the success of the enterprise. (See Exhibit 12.7.) (b) LINKING OBJECTIVES. Those involved in setting overall company objectives, or, indeed, objectives for each SBU, should realize that major objectives are closely related to subobjectives. Thus, the return on shareholders' equity must be supported by a proper gross margin objective (translated to a percent of net income to sales objective) and asset turnover objective, and a satisfactory leverage factor (see Chapter 7). The margin objective in turn could relate to a product mix objective, a sales volume objective, and, perhaps, a productivity increase goal. Some sense of this interrelationship or linking of objectives and subobjectives may be gleaned from the tree shown in Exhibit 12.8. (c) SETTING THE LONG-RANGE OBJECTIVES. When a decision is to be made about the major long-range objectives, two questions may come to mind: (1) Who should set the objectives? (2) How should the objectives be established? (i) Who Should Set the Objectives? On the matter of who should set the objectives, several factors will be at play. These include the size of the company; the style of management; the organization structure; the personality and interests of the CEO; the capabilities of, knowledge of the business by, and interests of, the top management. Recognizing these elements, the following comments are made: • The CEO might establish the major long-range planning objectives—provided the CEO is knowledgeable and has a good sense of the business.

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Long-Range Objective

Subobjectives (to be Specified by Year)

Subobjectives (Most to Be Achieved by 2007)

Attain a net sales volume of $990 million by 2007

Increase market share per year for these products: X—12% Y—5% Z —9% Introduce new products that will provide 25% of sales volume by 2006 Acquire K company of equivalent in S product area

Earn a net profit to sales ratio of 10% by 2007 Earn 25% on average shareholders’ equity by 2007 (Specify objective for each year) Achieve a capital structure by 2006 of: Debt 30% Equity 70%

E XHIBIT 12.8

Reduce material costs by: 25% in 2005 10% in 2006 Increase high margin product share by 40% by 2007 Reduce overhead content by 20% by 2007 Purchase common stock aggregating $250 million by 2006 Issue senior debt of $800 million (assuming proper market environment) by 2006

Attain a productivity increase of 5% per year

Change to process N in Los Angeles Robotize 10% of operations Introduce team concept in four plants by 2006

Double manufacturing capacity by 2007

Lease space in Pacific Southwest Expand training programs in Arizona and New Mexico

L INKING O BJECTIVES

AND

S UBOBJECTIVES

While this procedure may be satisfactory in a small company, as the company gets larger this is less than desirable because (a) the typical subsidiary president usually resents being given a goal without any voice in setting it; and (b) the CEO often does not have the requisite product and market knowledge. • Top management might dictate the objectives. Although such a base is broader than the CEO alone, it can suffer the same deficiencies as mentioned previously. • In those instances in which the business is larger, and is basically on a decentralized style of organization, the objectives may be negotiated between the head of the SBU and the top management. Usually it is not satisfactory for the unit heads to establish the objectives because few top managements are willing to have targets set without their review and approval. • Finally, in the larger companies, where the SBU has its planners and the central management has its corporate planner or planning coordinator, through the iterative process of discussing alternative strategies, objectives, and the corporate mission—agreement often can be reached on what constitutes an acceptable objective. Such a base, of course, is much broader than merely the top management and the head of the SBU. (ii) Methods of Setting the Long-Term Objectives. Setting realistic long-term objectives is not quite as simple as just having one executive, the CEO, or a group, dictate a figure or goal. To be

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sure, the process might commence with suggestions from those sources; but it is infinitely more satisfactory to have some identifiable points of reference recognizable by those who must meet the objective. What are these? How can they be determined? Some of the methods employed in business, depending on circumstances, are: • Past performance—with some type of trend extrapolation. In some instances, to use last year's performance and to adjust for experienced improvement or some arbitrary factor is not using the available tools, and it may be downright naive, by letting poor performance continue. • Past performance adjusted for the estimated impact of expected forces. Recognition is given to the result of expected changes, both internal and external, such as: product obsolescence, government regulations, new product developments, competitive actions, industry sales forecasts, and so on. • Competitive analysis. With the availability of the 10-K reports of competitors, analyses could be made of competitive performance. Return on assets, gross margin percentage, sales volume trends, funds spent on R&D, selling expenses, individual competitor data or group data can be used as a basis for calculating desired performance on some item. • Environmental analysis, situation analysis, or strategic analysis. In the analytical study of the operations, certain comparative relationships will become evident—some good and some poor. The impact of expanding the more productive or effective ones can be judged or calculated on such matters as sales volume (impact of advertising, or using a certain channel of distribution, changing prices, or using a given source of raw material, etc.). The best methods used in one area might be applied to other areas, etc. In turn, these actions could impact the objective. • Strategy iteration. This is similar in principle to the preceding situation analysis. New strategies may be developed and the impact could be estimated as to certain objectives. There are several bases and supporting statistical analyses of various types that can aid in the selection of suitable long-term planning objectives.

12.22 DEVELOPING STRATEGIES The final function mentioned in Exhibit 12.6 as requiring a great deal of conceptual thinking is that of developing the appropriate strategies to achieve the business objectives. After the basic mission or purpose and long-range planning objectives have been determined, then the next step is to search out those strategies best able to achieve the objectives. As used herein, strategy means the way, path, or program by which the entity deploys its human and financial resources and its physical assets to achieve the business purpose. A great deal has been written about identifying and evaluating strategies. Yet, the fact remains that the process is largely an art and developing a successful strategy often involves a great deal of luck. In strategic planning, the emphasis usually is on products, market, and marketing. In developing successful strategies, it is probably desirable that the company's creative talents be energized into suggesting the most ingenious and comprehensive methods or paths possible. This development task may be assigned to gifted individuals or groups in marketing, planning, or other departments who have a reasonable knowledge of the operations — with the evaluation and selection assigned possibly to other groups. Sources that might provide clues for potential alternative strategies include: • Review of company reports and records • Observation and discussion of the operations, including the known or alleged strengths and weaknesses • Review of competitive or somewhat comparable activities • Discussion of the situation and alternatives with persons familiar with the industry and the company, including consultants, educators, board of director members, think tanks, and so forth

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In any event, when the list of alternative strategies has been developed, they should be screened by knowledgeable people (perhaps the CEO and other top management) to eliminate the impractical. Then, the remaining strategies should be evaluated on both a qualitative and quantitative basis. Qualitative factors might involve the impact on other product lines or organizational units, on the corporate image, etc. Quantitative measures could include contribution margin, cost effectiveness, return on assets, market share, and operating profit. In connection with evaluating alternative strategies, George A. Steiner has said, “. . . The most effective universal approach to decision making is to ask the right question at the right time.” 5 To identify and evaluate strategies, he has devised a list of 38 questions that help ensure a correct decision if asked at the right time and given proper weight.6 This art of strategy determination involves a good insight into the company's strengths and weaknesses, the problem, combined with good judgment and intuition, and a willingness to examine some new ideas. A summary of the facets of strategy development includes: • Comprehending the current status of the business and where continuance of the same policies and strategies will take it. This involves identifying such factors as:
Major products
Major markets
Important strengths and weaknesses of the entity as compared to competition
Present major strategies in the several fields
Knowing the economic contribution (cash flow, operating profit, asset usage) of the vari-

ous segments (product, market, profit center, etc.) • Understanding the company objectives and how they differ from results of continuing the present activity — the gap. (See Exhibit 12.1.) • Recognizing some of the strategies that may or could be involved in the strategic planning, and selecting the practical ones for study
Product strategies. Product design, new product development, adding new products by

purchase or acquisition, product obsolescence, life cycle of products—that will influence strategy (See Exhibit 12.9.)

E XHIBIT 12.9

P RODUCT L IFE C YCLE —A N I NFLUENCE

5. Ibid., p. 192. 6. Ibid., p. 194 –195.

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Market strategies. Adding or dropping markets; changing distribution channels, methods

of sale, prices, terms of sale, delivery methods, advertising media, promotional methods
Manufacturing strategies. Plant locations, subcontracting, foreign sources, manufacturing

techniques, material content, quality control
R&D strategies. University affiliations, joint ventures, licensing, purchase of rights
Financial strategies. Inventory financing, credit terms, debt structure, ESOPs, stock issues,

control systems, planning system, inflation hedging, foreign exchange practices, leasing instead of purchasing fixed assets, and so on
Human resource strategies. Organization structure, style of management, decentralization, downsizing, recruitment programs, training programs, wage and salary levels, executive replacement • Evaluating the proposed individual strategies and judging how they will assist in meeting the business objective (a) APPRAISING ALTERNATIVE STRATEGIES. As the strategic planning cycle illustration in Exhibit 12.6 reflects, the last step before preparing the long-range plan is to develop the principal strategies by which the company objectives and basic purposes will be achieved. But as also stated, the process of selecting the proper strategies involves a great deal of art as well as science. Presumably, after much discussion between the principal functional officers and the CEO, the most appropriate strategies will be tentatively selected. If the process is done properly, the chosen means will be evaluated both qualitatively and quantitatively. It is in the realm of quantitative analysis that the controller can bring to bear expertise in marshalling the financial facts in order to present the financial effect on the company of the strategy. Depending on the subject matter, the strategy may impact on: • Net revenues • Manufacturing costs • Selling expense and distribution costs • R&D • General and administrative expense • Assets or investment required • Liabilities assumed • Return on assets and equity • Earnings per share Evaluating the one strategy may not be enough. Business decisions usually involve the selection of alternatives. Therefore, a good financial job would include evaluating one or two practical alternatives. And the most favorable, after full review by the management, would be that included in the formal strategic plan. In presenting the formal strategic plan to top management, or the board of directors, it may be desirable to advise the audience of the impact of the other feasible, practical, or considered likely, scenarios. The impact on earnings per share of the alternative strategies is shown in Exhibit 13.11. Should some of those more drastic, but unlikely, events be appraised, even if not formally incorporated in the plan presentation? For example, should the impact of war, or a major earthquake, or loss of a major customer (if the strategy fails) be evaluated? The answer is “yes,” within reason. By such appraisals, management will gain insight as to the effect (both cost and duration) of major unlikely events. This type of information would be restricted to the top management of the entity. (b) SOME ILLUSTRATIVE STRATEGIES. From the listing of the basic types of strategies, some alternative strategies may be deduced. However, listed below are a few specific illustrations of strategies undertaken. What strategies must be employed or changed obviously depends on the

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problems to be overcome. The strategies have been grouped into typical groupings of product strategies, market strategies, and operating efficiency: • Products
Change the style of packaging to appeal to the middle-aged group.
Change packaging to smaller quantities to attract the elderly singles.
Add a related product that would use the same distribution channel and methods as the other

products.
Drop line Y, which provides no contribution margin.
Modify product so it will serve a function not now recognized.
Consider private brands in the Southeast. • Markets and Marketing
Enter growing European market through a joint venture.
Change prices to meet competition of “R” chain.
Increase local advertising to cover TV in markets W, X, and Y.
Change from sales representatives to agents in the Northwest territory.
Reduce promotional effort on product “ T” in marketplace because of its declining stage in

the life cycle. • Operating Efficiency
Switch to “just-in-time” inventory control method in Los Angeles and San Francisco.
Establish warehouse in Denver.
Enforce terms of sales so as to increase receivables turnover.
Dispose of Kansas City subsidiary in view of losses and lack of growth prospects.
Sell Chicago office building, in present inflated market, reduce space requirements, and

move to less expensive location.

12.23 STRATEGIES AND THE PLANNING PERIOD In discussing strategic planning, one more important subject relates to timing. When should a particular strategy start? Different strategies often must start at different time periods. In the context of strategic planning, it is important that the proper plan — the annual plan or the strategic plan — provide for implementation of the strategy. This is best illustrated in Exhibit 12.10. Some strategies must commence during the short-term or annual plan to be fully effective at a stipulated time in the strategic plan. Thus, strategies 1, 2, and 4 start in the indicated quarter of the annual plan. The others begin in another planning period. The annual plan, discussed in Chapter 14, must provide for those strategies which need to start in that time frame to be fully effective by a specified date in the strategic plan.

12.24 ROLE OF THE CONTROLLER It may be taken for granted that when the selected strategies and plans are combined and consolidated into financial terms for the planning period (discussed in the next chapter), the controller will be heavily involved. What is the role in those earlier phases of strategic planning that require a great deal of conceptual thinking, such as: • Determining the corporate mission • Selecting company long-range objectives • Developing strategies

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E XHIBIT 12.10

R ELATIONSHIP

OF

S TRATEGIES

TO THE

209

P LANNING P ERIODS

It is precisely these areas that call for an extensive knowledge of the products, markets, and external environment, as well as the internal influences. It is also an area where a great deal of subjective judgment takes place in an unstructured setting. Many of the factors are not subject to measurement; and much guessing takes place. According to a survey of controllers,7 a great number of controllers desired to participate more fully in the entire strategic planning process. In a 17 percent response rate to a similar questionnaire to CEOs, the chief executives were stated as not being enthusiastic about expanding the controllers’ participation in the three phases. Obviously, the degree to which a controller should be involved depends in part on the ability to contribute something of value to the process. This, in turn, may depend on the controller's knowledge of the business — especially the markets and products — as compared to the other functional executives. Moreover, technically speaking, involvement could mean either giving informal advice, providing data or analyses, or actually making decisions, e.g., choosing alternatives. In the typical enterprise, with a highly competent managerial staff, the following are possible roles the controller can have in the planning process: • General. In those areas susceptible to financial or economic analyses, whether based on internal and/or external data, where the controller is knowledgeable, the controller should prepare the analysis and present recommendations. This can be done based on a request or at the controller's own instigation. Additionally, if the controller has significant information, is reasonably knowledgeable, and believes conclusions reached are based on erroneous assumptions or information, the observations should be made known (at the controller’s own risk if the correct facts are not shown or the controller doesn’t really comprehend the picture). 7. Richard H. Fern, and Manuel A. Tipgos, “Controllers as Business Strategists: A Progress Report,” Management Accounting, March 1988, pp. 25 – 29.

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• Company mission. The company mission or purpose will be determined based on a thorough knowledge of the entity’s strengths and weaknesses and a host of subjective opinions. If the controller is aware of erroneous financial or economic assumptions used (which should be disclosed) in reaching the decisions, then the controller can and should provide alternative suggestions. Otherwise, this area should be left to the decisions of the other officers. • Long-range objectives. As to those long-range objectives that involve conclusions based on financial facts or calculations (such as return on shareholders’ equity), the controller should make or assist in making the necessary analysis. If the conclusions reached are erroneous or not realistic, there is an obligation to bring this to the attention of the appropriate executive and to demonstrate in what way the objective is unrealistic (or too easy of attainment) and what might be more appropriate. It would seem that there are a great many areas relating to long-range planning objectives where the expertise of the controller should be useful — but not all. • Developing strategies. In this phase, also, financial analysis probably could be applied to some of the strategies. Suggestions would be those relative to profit impact of alternative choices, relative to cost/effectiveness, unrealistic earnings estimates of proposed acquisitions, unduly optimistic economic assumptions, too high an inflation rate, or cost estimates that are too low. Of course, the controller has the task of selling to top management or the planning group, the usefulness of his capabilities in financial analysis; and if the controller desires to work in the unstructured environment and more subjective arena, the benefits must be demonstrated.

12.25 IMPROVING THE STRATEGIC PLANNING PROCESS We have attempted to explain the desired procedures to make strategic planning a success, but weaknesses do creep into procedures. A summary of comments which express the thoughts of many experienced strategic planners follows: • In too many companies, strategic planning has become overly bureaucratic, absurdly quantitative, and largely irrelevant (because of the changing environment). • Companies must think and act strategically every day — not just in the annual planning (once a year) cycle. • Key words are focus and flexibility. Focus refers to the need to figure out what the company does best, and build on it. It means developing the “core competence” to meet customer needs. Flexibility means sketching rough scenarios of the future—the “bands of possibilities”—and being ready to use them when the opportunities arise. • The basic function of the “corporate planner” is to coordinate and advise the line managers. It is the latter who have prime responsibility for formulating and implementing the planning. • Because many companies reward short-term results, such as increasing sales or reducing costs, it is difficult to encourage truly long-term, far-sighted planning. • Strategic planning still largely involves unquantifiable factors such as experience, instinct, guesswork, and just pure luck.

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CHAPTER

13

FINANCIAL IMPACT OF THE STRATEGIC PLAN: LONG-RANGE FINANCIAL PLAN 13.1 13.2 13.3

13.4 13.5 13.6

INTRODUCTION 211 KEY ELEMENTS OF A STRATEGIC PLAN 211 CONTRAST OF STRATEGIC PLAN (FINANCIAL ASPECTS) WITH THE ANNUAL PLAN 212 CAPITAL INVESTMENTS 213 RISK ANALYSIS 214 KEY RELATIONSHIPS 215

13.7

OBJECTIVES OF THE LONG-RANGE FINANCIAL PLAN 215

13.8

CONSOLIDATION AND TESTING PROCESS 216

13.9

REPRESENTATIVE FINANCIAL CONTENT OF A LONG-RANGE PLAN 216

13.10 ILLUSTRATIVE FINANCIAL EXHIBITS IN THE PLAN PRESENTATION 217 13.11 ROLE OF THE CONTROLLER 230

13.1 INTRODUCTION Chapter 12 dealt with the system of business plans, the essential components of each, and the general relationship of the strategic plan to the short-term annual plan. It also discussed the development of appropriate strategies for each function of the business: marketing, manufacturing, research and development (R&D) human resources, and financial. The concepts were introduced without attaching numbers. This chapter addresses the communication of the business plans to top management and the board of directors. It identifies the key elements of the strategic plan that should be discussed between the board of directors and top operating management as well as between corporate management and the heads of the strategic business unit (where applicable). Most important, the strategic plan is quantified in the format of the long-range financial plan. This chapter also defines the objectives of the long-range financial plan presentation. To further clarify the strategic planning process, the strategic plan is contrasted with the annual plan, business risks are discussed, and the concept of capital investment is introduced. The content of the long-range financial plan presentation is illustrated with a complete sequence of financial exhibits.

13.2 KEY ELEMENTS OF A STRATEGIC PLAN This discussion assumes a decentralized organization with several strategic business units. It is necessary to present the relevant data on each. If a business is not decentralized or is composed of basically one area, the same key elements discussed herein should be presented for the business as a whole. In the review of a strategic business plan, very often emphasis is first on the basic issues without an excessive amount of quantified data. The purpose is to provide insight about the operating 211

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center, or strategic business unit (SBU). While the specific content will depend on the individual circumstances, the following eight elements probably should be included in the plan presentation: 1. A basic statement by the division general manager or subsidiary president about:
The mission of the center or SBU
The key issues and opportunities critical to its future
The long-range objectives
The basic strategies

2. The long-range plan for each business area, including:
A definition of the products and services to be provided
Principal markets served and the primary customers
Principal competitors in each market, their primary characteristics, strengths, weaknesses,

and anticipated strategies, as well as how the operating center expects to compete with them
Key issues of each business area, including the threats and opportunities
Objectives for the business area
Strategies to be pursued
Milestones for each business area that will describe the key steps to be reached, on a

scheduled basis, as an indication of progress toward carrying out the strategy and reaching the objective
The most vulnerable or weakest strategies or objectives in the strategic plan, and reasons

for this judgment 3. Summarized financial schedules for the SBU or business area and operating center (discussed in Section 13.10) 4. Human resources overview of the operating center—a summary of the plans for growth, retention, productivity improvement, upgrading quality of management, or other key factors, external or internal, relating to this subject 5. Perhaps an information resource management overview of the data processing function for the operating center, including major systems to be acquired, renovated, or developed 6. A facilities overview of the operating center, including the impact of any changing technology, or major subcontract plans, and other significant factors that would impact such matters as sales per square foot of covered area or square foot of covered area per employee 7. An overview of productivity improvement plan for the operating center 8. An overview of any other functional area, such as R&D activity, that is crucial to the success of the SBU or operating center. Such narrative would relate to programs, strategies, and objectives, each time-phased. These elements provide some sense of the scope of the strategic plan review, above and beyond the financial aspects.

13.3 CONTRAST OF STRATEGIC PLAN (FINANCIAL ASPECTS) WITH THE ANNUAL PLAN The business strategic plan is discussed in Chapter 12 and this chapter; and the annual business plan is discussed in Chapter 14. As explained in Section 13.5, the strategic plan relates to many years and is concerned with basic strategies and the mission of the business entity. The annual plan deals with a much shorter time period—only a year or two—and is concerned primarily with current operations; it includes much more detail. It is the supporting or supplementing phase of the first year of the strategic plan. Exhibit 13.1 differentiates between the financial accumulations or groupings of the two plans. The strategic plan emphasizes the corporate mission, strategies, and key relationships; it does not

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13.4 Capital Investments

Accounting Focus Details costs by individual account (type of cost, e.g., labor) Includes departmental budgets (purchasing, receiving, etc.) Used for monthly comparison of planned with actual results Includes cash budget Includes income and expense plans Includes plan for financial condition E XHIBIT 13.1

L ONG -R ANGE

VERSUS

Long-Range Financial Plan

Annual Plan

No

Yes

No

Yes

No Yes Yes Yes

Yes Yes Yes Yes

213

A NNUAL P LAN

deal with the very detailed expenses of each department. The strategic plan may involve substantial analyses of alternative scenarios.

13.4 CAPITAL INVESTMENTS Both long- and short-term financial plans identify the planned investment in assets, both working capital and plant and equipment, required during the planning period, in order to achieve the planned profit objectives. For plant and equipment planned expenditures, the annual plan usually includes a section on the capital budget — as explained in Chapter 31. The required facilities and purpose are described in some detail and a specific cost or expenditure for each identified. The board of directors is advised of the required cost for each significant item, as well as the expected rate of return on the investment. In some instances, the board will grant specific authorization at the time the annual plan is approved. In other cases, when the time for making the commitment is near, the board may require a further detailed review, and then approve an acceptable appropriation. As a contrast, in the long-range planning cycle, each strategic plan usually contains only a highly condensed summary of expected plant and equipment expenditures. A plan may identify the estimated expenditure in one of these ways, depending on the relative amount of financial resources needed, and the extent of the analysis or study undertaken to quantify the planned cost: • By a single one-figure item for each year of the strategic plan (see Exhibit 13.3.) • By identifying by plan year the amount of the planned expenditure as to purpose, such as:
Expansion (higher sales volume)
Diversification (new products)
Increased efficiency (e.g., reducing manufacturing costs)
Replacement (e.g., worn out or obsolete equipment)

• By identifying the expenditures by product line or business unit, such as electronics, telecommunications, or aircraft assemblies, for each of the plan years Use of any such highly condensed presentation or disclosure in the strategic plan approval process by the board of directors or top management is usually only an approval “in principle.” It does not constitute authority to make commitments for the expenditures. Approval of a specific appropriation for the specific asset or group project is still generally required. As to the capital requirements for current assets for both the strategic plan and the annual plan, these are determined based on experienced or planned turnover rates, the expected sales volume, the expected inflation rate, and other factors affecting the asset investment. In the strategic or long-range plan, the estimate is general and usually is related to total product sales. In contrast, in

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

the more detailed annual plan, the receivable investment may be calculated based on expected specific product sales to specific large-volume buyers or groups, the terms of sales, and the expected turnover rates. Planned inventory investment in the strategic plan is based on general turnover rates. In contrast, the annual plan investment in inventories may be based on specific monthly production plans by product, by plant, and so on. With the growing trend to a reduced investment in receivables and inventories, through the use of computer technology, just-in-time techniques, and new group manufacturing methods, lower receivable and inventory levels should be planned. The rate of return on assets employed in the business is one test of the competence of management. (see Section 13.6 on key relationships.) Hence, the level of capital investment is critical.

13.5 RISK ANALYSIS Engaging in business involves the assumption of risks. The proper assessment of risks that may occur and their probability is important in both plans, but it is especially significant in strategic planning. To the extent that it is practical, the possible impact of major risks should be incorporated in the financial statements and alternate scenarios suggested. Some of the risks that might need consideration include: • Competitive response. Competitors will have a response to any new product introduction or expansion into a new geographic area. The response may be price cuts, lawsuits, lobbying for government regulation, or other possibilities. • Capital cost overruns. Construction projects have been known to exceed budgets. A worst-case scenario could help management anticipate funding requirements. • Nationalization of facilities. Some countries have a history of nationalizing certain industries with little or no compensation to the previous owners of expropriated facilities. If management becomes aware of such a problem, then it may wish to relocate its new facilities. • Ecological costs. Some companies (e.g., Manville Corporation, the tobacco industry, and pharmaceutical companies) have been targets of lawsuits due to products that were later found to be unsafe. In addition, any product or process that has significant chemical waste by-products should be brought to the attention of management, because resulting lawsuits or government fines could destroy any profits from sale of the product. • Sales fluctuations. Sales projections are sometimes inaccurate. Management should be aware of the worst and best case scenarios. The worst case may result in significant losses to the company, and the best case (as recently experienced by several personal computer manufacturers) may require construction of additional production facilities. • Raw material scarcity. Some raw materials are in short supply (computer chips) or are tightly controlled by the producer (oil by the Organization of Petroleum Exporting Countries [OPEC] in the 1970s). If so, sales projections may fall short due to the inability of the company to produce enough of the product to meet demand. • Deterioration of margins. Competing products may come onto the market that will force margins to deteriorate due to price cuts. The company should make some attempt to identify this risk from both national and international competitors and derive a likely range of margin percentage reductions to factor into the long-range plan. • Technological advances. Advances in technology may make a product obsolete (e.g., calculators versus slide rules). Though these advances may be hard to predict, some rudimentary technology can be found in trade literature that will allow the company to forecast a decline in its market. For example, the movie video rental market is projected to decline as on-demand movie rentals become available through cable television companies. Proper risk assessment is essential in business planning. Consideration of such exposures can help in building a plan that keeps such risks within an acceptable level.

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215

13.6 KEY RELATIONSHIPS Key relationships are important guides in any business planning, and they are particularly valuable in constructing the long-range financial plan. Ratio analysis is discussed in Chapter 6, and the importance of selected ratios is reviewed in the relevant chapters of this book. Some especially significant ratios to consider in long-range planning are: • Percentage return on assets (see Exhibit 13.16) • Percentage return on shareholders’ equity (see Exhibit 13.17) • Turnover of assets • Operating margin as a percentage of sales • Net income as a percentage of sales (see Exhibit 13.3) • Earnings per share (see Exhibit 13.11) • Book value per share (see Exhibit 13.3) • Ratios of long-term debt to net worth (see Exhibit 13.18) • Current ratio (see Exhibit 13.19) • Times fixed charges are earned The importance of each of these relationships or ratios is explained in Chapter 7.

13.7 OBJECTIVES OF THE LONG-RANGE FINANCIAL PLAN Having briefly reviewed the subjects that the line officer of the SBU and/or the company planning officer would discuss in a top-side review of the strategic plan, the remainder of this chapter will dwell on the long-range financial plan. Chapter 12 deals largely with establishing the mission or purpose of the entity, then deciding what steps must be taken (objectives), and how they will be carried out (strategies) to reach the planned mission. In a sense, these constitute a series of actions for which the individual costs and results (income) must be determined. It is somewhat akin to locating a piece of a puzzle. These pieces or segments then must be fitted together, and it must be determined that the resulting total picture is what was expected or desired. The chief financial officer (CFO), usually working through the controller and staff, must analyze each new segment or action in terms of costs and revenue, add it to the other continuing planned functions of the business, provide additional financial input where appropriate, consider the financial policy implications of each, and summarize or consolidate the various segments, on a time-phased basis, to the end that the chief executive officer (CEO), the other top executives, and the board of directors will: • Comprehend the results of the strategic planning, in financial terms, as to all important factors, including:
Income and expense
Cash sources and uses
Capital (fixed assets) commitments and expenditures
Financial position • Be aware of the significant financial risks or exposures, if any. • Be assured that all reasonable financial resources probably will be available as needed, on an acceptable basis, to meet the needs of the company. • Recognize that the planned financial position or health of the entity must be continuously maintained in an acceptable manner so as to command respect from investors of all types (shareholders, institutional investors, commercial bankers, and others) over the longer term.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

• Have confidence that the terms of any existing or potential credit agreements — bond indentures, commercial bank lending agreements, long-term loan contracts—can be met without endangering the company. • Understand that shareholders’ value probably will increase. • Expect that the various approved financial goals can be met, for example, increasing the return on shareholders’ equity, the return on assets, increasing earnings per share, and so forth.

13.8 CONSOLIDATION AND TESTING PROCESS In many companies, the focus of management, as far as the strategic plan is concerned, often is on the income statement and perhaps the statement of cash flows. An astute management, and especially the CFO, knows that attention must be given to the financial position as well as to operating results. The entity must maintain adequate financial health to attract capital when needed, to pay dividends on a competitive basis, and otherwise enhance shareholder value. So how can the accounting process of summarizing the long-range financial plan be described? In principle, the process of preparing the financial statements for the strategic plan will be substantially the same as preparing the statements of actual results for each monthly closing, with these differences: • Essentially the same type of entries will be prepared for the planned figures as is done for the actual figures; that is, there will be an entry to charge accounts receivable and credit sales for the planned sales; another to charge inventory, with a credit to the various liability accounts for the cost of material, labor, and manufacturing overhead for the manufacturing activity. The entries for the long-range plan will parallel those for the regular monthly closing. However, in most instances, the entries will be made on an annual basis so that annual financial statements can be prepared. (Thus, if it is expected that events during a given year will cause a failure to meet credit agreement standards, then—and only then—need interim statements be generated.) • Detail costs by each department and/or cost center probably need not be determined for the annual data, but only for the total function. Manufacturing costs in total should be known in order to arrive at the inventory valuation and the like. • The year-end financial position should be checked at each year end to see that it meets acceptable financial standards. Thus, if cash is inadequate at year end, then borrowings must be assumed or planned so that adequate cash is available, and plans for its repayment must be incorporated in other future years. If receivables appear too low, the cash collections and/or terms of sales need to be reviewed; or, if dividends on common stock appear low in relation to earnings, the assumption about payout should be checked and so forth. • Naturally, the cost or financial impact of any proposed or planned strategy must be reflected in the annual accounting entries (e.g., the added expense of new salespersons or a new sales promotion program—just as in the short-term plan). The impact on income and expense, cash, and balance sheet of any planned acquisition; the result of any assumed new stock issue; and so forth must be reflected in the statements. Computer programs are available to assist in translating plans to financial terms. Most of the above comments are precautionary because some financial staff in the past have prepared financial statements with excessive or unnecessary detail — which often clouds the issues. In other instances, the financial plan entries have not been checked to ascertain that the cost/revenues impact of a proposed strategy has not been overlooked and so forth.

13.9 REPRESENTATIVE FINANCIAL CONTENT OF A LONG-RANGE PLAN What information should be included in the financial commentary and related exhibits of the long-range plan, expressed in financial terms? The intent is to communicate the important points

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217

or facts of the plan. Accordingly, it should be tailored to fit the audience (executive management and the board of directors), and excessive detail should be avoided. Some relevant comments on a suitable financial plan presentation are: • The subjects addressed should be:
Those that the CEO and the CFO think are essential to a full disclosure of any significant

financial aspects of the strategic plan and to the direction in which the company is moving
Those that are essential to convey a full appreciation of the financial risks to be taken and the potential rewards
Those in which the board (or executive management) has shown particular interest—as judged by past comments or questions in previous board meetings
Finally, if not contained in the above, the underlying financial or economic assumptions— even though the CEO and/or the CFO might regard them as implied or understood • The method of presentation should invite attention and be easy to understand. It could be a written report, but an oral presentation with visual aids might be more effective. This latter technique usually permits the immediate answering of any questions that might arise. While the usual rules for effective presentations apply, here are some reminders:
Keep it simple and not in financial jargon (if the board is not composed of experienced






financial people). Use a largely graphic presentation in color. New computer software facilitates this. Have only a relatively few lines or figures on each chart. Show relationships, not just absolute data. Keep the monetary units large—thousands or millions, not individual units. Present the data in a logical order so that each financial statement can be followed and the relationship to other financials can be comprehended.

13.10 ILLUSTRATIVE FINANCIAL EXHIBITS IN THE PLAN PRESENTATION The actual exhibits to be presented to the executives will vary from industry to industry and from company to company, depending on, among other things, the critical success factors, past problem areas, and those facets of particular interest to the audience. Some of the exhibits of an actual strategic plan presentation for an electronics company have been used (all figures are fictitious), as being representative of a decentralized management, with several SBUs, and a history of excessive debt load when viewed against a probable cyclical downturn and the management’s conservative standards. See the following financial exhibits and their brief commentaries: • Exhibit 13.2: Basic Financial/Economic Assumptions. In any plan, the assumptions often are critical, and management should be advised of the important ones. • Exhibit 13.3: Financial Highlights. The exhibit shows the trend of those factors that management (and the industry) regard as key to progress. The format is highly condensed as each item later will be discussed in detail by the use of a supporting slide. • Exhibit 13.4: Statement of Consolidated Earnings. The exhibit presents a traditional income and expense statement showing net sales and the related major functional costs and can indicate the percentage of sales operating margin and net income ratios. • Exhibit 13.6: Consolidated Net Sales. The trend of planned sales for five years, compared with the actual company sales of the past year and estimated sales for the current year is illustrated.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION B ASIC F INANCIAL /E CONOMIC A SSUMPTIONS 2004–2008 S TRATEGIC P LAN Inflation rate (average) Interest rates (average) Prime rate Long-term (30 years) Capital expenditures Research and development expenditures Major acquisitions No change in income tax rates or base No recession Defense expenditures drastically reducing E XHIBIT 13.2

5% 10%–13% 9%–12% $670 million $320 million Not in planning period

B ASIC F INANCIAL /E CONOMIC A SSUMPTIONS

• Exhibit 13.5: Net Sales by Strategic Business Unit. In addition to consolidated sales, the sales by strategic business unit are shown. Presumably, each SBU has been discussed by the general manager. This exhibit relates the individual sales to each other and to the whole. • Exhibit 13.7: Percentage of Net Sales to U.S. Department of Defense. The management does not wish to remain highly dependent on sales to the Department of Defense and carefully monitors the trend in the volume of such business. • Exhibit 13.8: Consolidated Sales Backlog—By Strategic Business Unit. In the high-technology area, the orders on hand, the sales backlog, is an important gauge of the business trend. This exhibit reveals how much firm business has already been contracted for several years in the future, and the relative share of each SBU. • Exhibit 13.9 and Exhibit 13.10: Consolidated Net Earnings and Income (in total and by SBU). These exhibits reflect the trend of consolidated net income, together with the net income of each SBU. They are supported by a condensed traditional statement of income and expense for each SBU, showing the percentage operating profit and percentage net income to sales — important signals in the business — as well as the absolute figures. • Exhibit 13.11: Earnings per Share. The board of directors and the management, as expected, are interested in the earnings per share and the growth rate. Incentive compensation depends on (1) achieving plan, and (2) the percentage increase from the preceding year. This chart is supplemented by one showing the growth rate imputed to each SBU. • Exhibit 13.12: Earnings per Share—Three Scenarios. Because plan achievement is never certain, the impact of selected other strategies is quantified. The reason for selecting the particular strategies in the plan was discussed at the operating center level and is repeated in condensed terms at the top management/board level. Comparable charts are prepared for cash flow, return on assets, return on shareholders’ equity, and so on. • Exhibit 13.13: Statement of Consolidated Cash Flows. The sources and uses of cash are identified in this highly condensed statement—with no detail by working capital items. Supporting this statement is a similar one for each SBU. • Exhibit 13.14, and Exhibit 13.15: Consolidated Financial Position. A condensed statement of planned financial position is presented, and points of compliance (or noncompliance) with the bond indenture requirements, important contracts, or management standards are identified. Additionally, the aging of accounts receivable, composition of inventory, makeup of accounts payable and accruals, and paydown of senior debt (before due date) may be discussed.

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Per share

E XHIBIT 13.3

F INANCIAL H IGHLIGHTS

Common shares outstanding (thousands) at year end

Return on average equity (%)

Book value per share (year end)

Research and development expense

31,050

7.45%

$ 43.03

50

115

3.09

Percentage of sales

Capital expenditures

96 1.9%

Amount

Net earnings

5,052

Net sales (consolidated)

31,110

12.59%

46.93

55

115

5.66

3.2%

176

5,500

3,750

3,600

$ 3,800 5,650

Past Year

Sales backlog (year end)

New orders

Item

This Year (Indicated Final)

Actual

13.10

31,220

9.74%

55.38

57

100

5.22

2.9%

163

5,700

3,020

8,470

2005

31,290

17.11%

63.57

64

50

10.16

5.0%

318

6,400

3,020

6,400

2006

Plan Year

31,300

20.39%

75.91

69

50

14.22

6.4%

445

7,000

3,520

7,500

2007

2008

219

31,350

23.59%

$ 93.78

70

50

20.00

7.8%

627

8,000

3,720

$ 8,200

Illustrative Financial Exhibits in the Plan Presentation 13.10

31,210

13.78%

51.87

60

420

6.79

3.5%

212

6,000

250

2,500

2004

T HE H I -T ECH C ORPORATION F INANCIAL H IGHLIGHTS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS E XCEPT PER S HARE )

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C ONSOLIDATED E ARNINGS

$ 181 111 $ 292 $ 168 72 $ 96

OF

223 15 238 312 136 176

$4,461 40 50 41 $4,592 $ 460

S TATEMENT

4,815 41 55 39 4,950 550

$5,052

Net Sales Operating costs Manufacturing Marketing Research and development General and administrative Total Operating margin Other expenses Interest expense Other (net) Total Earnings before income taxes Income taxes Net earnings

E XHIBIT 13.4

5,500

Past Year

Item

This Year (Indicated Final)

Actual

200 15 215 385 173 212

5,204 39 120 37 5,400 600

6,000

2004

T HE H I -T ECH C ORPORATION S TATEMENT OF C ONSOLIDATED E ARNINGS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

190) (10) 180) 333) 170) 163)

4,995) 40) 114) 38) 5,187) 513)

5,700)

2005

7,000 5,791 46 140 43 6,020 980 100 10 110 870 425 445

5,420 42 128 42 5,632 768 180 10 190 578 260 318

2007

6,400

2006

Plan Year

50 10 $ 60 $1,140 513 $ 627

$

$6,544 52 160 44 $6,800 $1,200

$8,000

2008

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13.10 Illustrative Financial Exhibits in the Plan Presentation

221

T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET S ALES 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.5

C ONSOLIDATED N ET S ALES

T HE H I -T ECH C ORPORATION N ET S ALES BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.6

N ET S ALES

BY

S TRATEGIC B USINESS U NIT

Exhibit 13.16: Return on Average Assets. Return on assets is an important measure of the management’s use of assets, particularly at the SBU level. The trend in total is discussed, and performance by each SBU is reviewed, showing the analysis by the two relevant factors: turnover and percentage return on sales.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION N ET S ALES —P ERCENTAGE TO U.S. D EPARTMENT 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.7

N ET S ALES —P ERCENTAGE

TO

OF

U.S. D EPARTMENT

D EFENSE

OF

D EFENSE

T HE H I -T ECH C ORPORATION S ALES B ACKLOG BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.8

S ALES B ACKLOG

BY

S TRATEGIC B USINESS U NIT

• Exhibit 13.17: Percent Return on Average Shareholders’ Equity. A key measure of this management is return on shareholders’ equity — the trend as well as the entity’s performance versus competitors.

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223

T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET E ARNINGS 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.9

C ONSOLIDATED N ET E ARNINGS T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET I NCOME BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.10

C ONSOLIDATED N ET I NCOME — BY S TRATEGIC B USINESS U NIT

• Exhibit 13.18 on page 229 and Exhibit 13.19 on page 229: Ratio of Long-Term Debt to Net Worth, and Current Ratio. Given the preoccupation with debt, and the covenants of the indenture, the long-term debt to net worth ratio especially is reviewed, as is the current ratio.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION E ARNINGS PER S HARE 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.11

E ARNINGS

PER

S HARE

T HE H I -T ECH C ORPORATION E ARNINGS PER S HARE —T HREE S CENARIOS 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.12

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E ARNINGS

PER

S HARE —T HREE S CENARIOS

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E XHIBIT 13.13

S TATEMENT OF

C ONSOLIDATED C ASH F LOWS

Net cash flows from (used by) financing activities Increase (decrease) in cash and cash equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year

Dividends to shareholders Changed (reduction) in short-term bank debt Additions to long-term debt Reduction in long-term debt

Cash Flows from (Used by) Financing Activities

Equity interest (Corp. X) Capital expenditures Proceeds from asset sales and retirements Net cash flows used in investing activities

Cash Flows from (Used by) Investing Activities

Working capital provided by operations Increase (decrease) in operating-related working capital items Net cash flows from operating activities

Net earnings Depreciation and amortization Deferred taxes, etc.

Cash Flows for Operating Activities

(303) 245 328 573

(53) (200) — (50)

— (100) 20 (80)

(221) 628

163 244 — 407

2005

(458) 43 573 616

(58) (150) — (250)

— (50) — (50)

(7) 551

318 240 — 558

2006

Plan Year

(298) 292 616 908

(58) — — (240)

— (50) — (50)

(55) 640

445 250 — 695

2007

Illustrative Financial Exhibits in the Plan Presentation 13.10

270 131 197 328

43 25 172 $197

13.10

(53) (135) 500 (42)

— (420) — (420)

149 281

212 214 4 430

2004

(52) 116 — (21)

— (118) 1 (117)

255 99

$176 174 4 354

Present Year (Indicated Final)

T HE H I -T ECH C ORPORATION S TATEMENT OF C ONSOLIDATED C ASH F LOWS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

225

(413) (391) 908 $517

(63) — — (350)

(800) (50) — (850)

(45) 872

$627 200 — 827

2008

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S TATEMENT OF

C ONSOLIDATED F INANCIAL P OSITION (A SSETS )

— 2,407 792 1,615 75 1,690 $3,521

Long-Term Assets Minority interests (Corp. X) Property, plant and equipment Less: accumulated depreciation and amortization Net Other assets Total Total Assets

E XHIBIT 13.14

$ 172 576 1,037 46 1,831 — 2,522 966 1,556 80 1,636 3,811

197 614 1,320 44 2,175

2003 (Indicated Final)

Actual

Y EAR E ND

2004

AT

— 2,942 1,180 1,762 80 1,842 4,250

328 640 1,400 40 2,408

T HE H I -T ECH C ORPORATION C ONSOLIDATED F INANCIAL P OSITION 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Current Assets Cash and equivalents Receivables Inventories Prepaid items Total

OF

2002

S TATEMENT

Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

Assets

226

— 3,022 1,404 1,618 80 1,698 4,021

573 510 1,200 40 2,323

2005

— 3,072 1,644 1,428 80 1,508 4,014

616 550 1,300 40 2,506

2006

At Plan Year End

— 3,122 1,894 1,228 80 1,308 4,106

908 650 1,200 40 2,798

2007

800 3,172 2,094 1,878 80 1,958 $4,315

$ 517 600 1,200 40 2,357

2008

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S TATEMENT OF

13.10

AT

4,021

30 310 1,419 1,729

750 500 110 1,360

100 50 540 160 37 15 902

2005

Y EAR E ND

4,014

20 310 1,679 1,989

500 500 110 1,110

— 50 590 170 65 20 895

2006

At Plan Year End

4,106

10 310 2,066 2,376

300 450 120 870

— 50 500 190 90 20 850

2007

$4,315

10 310 2,630 $2,940

$

— 400 120 $ 520

$

— 50 500 170 100 25 $ 845

$

2008

Illustrative Financial Exhibits in the Plan Presentation 13.10

E QUITY )

4,250

3,811 AND

40 310 1,309 1,619

800 500 110 1,410

300 — 610 200 43 28 1,181

50 310 1,150 1,460

842 — 140 982

435 21 590 212 34 27 1,319

2003 (Indicated Final) 2004

T HE H I -T ECH C ORPORATION C ONSOLIDATED F INANCIAL P OSITION 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Actual

OF

C ONSOLIDATED F INANCIAL P OSITION (L IABILITIES

$3,521

Total liabilities and equity

E XHIBIT 13.15

$ 47 $ 310 1,026 $1,336

$ 863 — 142 $1,005

$ 319 21 563 187 17 26 $1,133

2002

Shareholders’ equity Paid-in capital Retained earnings Total equity

Deferred Income Taxes

Senior debt—existing Senior debt—new Other long-term obligations Total

Long-Term Obligations

Notes payable to banks Current portion of long-term debt Accounts payable Accrued items Income tax payable Other current liabilities Total

Current Liabilities

Liabilities and Equity

S TATEMENT

227

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION P ERCENTAGE R ETURN ON A VERAGE A SSETS 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.16

P ERCENTAGE R ETURN

ON

A VERAGE A SSETS

T HE H I -T ECH C ORPORATION P ERCENTAGE R ETURN ON A VERAGE S HAREHOLDERS ’ E QUITY 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.17

P ERCENTAGE R ETURN

ON

A VERAGE S HAREHOLDERS ’ E QUITY

• Exhibit 13.20: Beyond the Five Years. Given some far-reaching changes in technology — the “supertechnology”—and the perceived opportunity for an advantageous acquisition, the technical staff briefly touched on this subject during the long-range technical activity over-

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13.10 Illustrative Financial Exhibits in the Plan Presentation

R ATIO

E XHIBIT 13.18

R ATIO

OF

229

T HE H I -T ECH C ORPORATION L ONG -T ERM D EBT TO N ET W ORTH 2004–2008 S TRATEGIC P LAN

OF

L ONG -T ERM D EBT

TO

N ET W ORTH

T HE H I -T ECH C ORPORATION C URRENT R ATIO 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.19

C URRENT R ATIO

view. Because the data are not yet firm enough to quantify, but because the opportunity may develop in about three years, the CEO wanted the board of directors to be made aware of a possible major use of cash, including related debt and equity sources, and possible diversion

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION

E XHIBIT 13.20

B EYOND

THE

F IVE Y EARS

of research talent. An estimate of the needs in a three-year time frame, beyond the long-range planning period, is shown.

13.11 ROLE OF THE CONTROLLER For the early phases of the strategic planning process—developing the company mission, objectives, and strategies— the controller generally provides financial data needed by other executives and makes financial analyses for them, to assist in setting appropriate objectives and testing the alternative strategies. But what are the controller’s functions when the task is to translate all operations and financial conditions into a time-phase plan expressed in financial terms? The long-range financial plan is not the plan of the financial executives, but rather the plan of each major executive, integrated into a single plan and expressed in financial terms. Because the chief sales executive will be responsible for meeting the sales plan and its related milestones, year by year, the controller must make certain that the sales segment, marketing segment, and the combining of continuing strategies or plans with the newly determined strategies, translates into a plan suitable to, or agreed to, by the sales executive. Comparable assistance must be given to all other nonfinancial executives. In the financial area itself, in conjunction with the CEO, the financial operations and financing activities must be translated into realistic plans on a year-to-year basis. Then the consolidated plan must be tested against prudent standards and the objectives set by company management. Accordingly, the responsibilities of the controller might be grouped into supportive facilitating functions, and exercise of the primarily financial functions in consolidating and testing the plan from a financial standpoint. A detailed outline of these responsibilities follows. 1. Supportive. In general to provide financial-type data, together with requested analyses, to the other executives involved in developing the plan, including: (a) Provision of analytical data (i) Sales, in units and value, as appropriate, by year, by requested breakdown: products, territories, channels of distribution (ii) Profit margin analyses; operating margin, contribution margin by sectors: products, territories, and the like

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13.11 Role of the Controller

231

(iii) Costs and expenses by functions, or appropriate organizational segment, type of expense, and/or other break-outs: marketing, R&D, engineering, administrative (iv) Data regarding asset utilization and/or investment (b) Assistance in organizing financial data, as needed, for the use of the other executives in their plan presentations (c) Assistance in goal setting, such as: (i) (ii) (iii) (iv)

Return on sales (or operating margin) Return on assets Return on shareholders’ equity Turnover on assets

on an overall basis and/or by segment of the organization (division, subsidiary, etc.). 2. Directly Financial (a) Consolidate all plans in financial terms, by year or other appropriate time segment (two years, or quarters, in some instances) for the planning period. The primary financial statements produced would include: (i) (ii) (iii) (iv)

Statement of planned income and expense Statement of planned cash flows Statement of planned financial position Statement of planned capital (fixed assets), both commitments and expenditures

(b) Evaluate or appraise the strategic plans as an overall management device against such standards as: (i) (ii) (iii) (iv)

Corporate goals Past performance or condition Selected competitors Industry performance

These tests could relate to: (i) Profitability — on sales, assets, or net worth (ii) Growth rates — sales, aggregate earnings, earnings per share (c) Judge the planned financial condition including that of any segments against such requirements as credit agreements, merger or acquisition contracts, indentures, or against selected ratios: debt to equity, current ratio, working capital, and the like. These calculations can be made to test yearly operating results or year-end condition. (d) Measure dividend policy, stock purchase plans, or other financial policies against perceived needs, and market requirements, as related to future capital requirements. (e) Evaluate the plan, or any segments, as to reasonableness, weaknesses, attainability, undue optimism, and so forth. (f) Finally, assuming the plan will be met each year, evaluate it in the context of market expectation (analysts), P/E ratio, etc. The consolidation of the strategic plan is not a simple, routine matter of adding some numbers: It involves a complete appraisal or judging of results in the eyes of not only management, but also the financial community. The company must be kept on a path that will enable it to secure the needed capital for growth or expansion, even under somewhat adverse economic conditions.

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CHAPTER

14

PROFIT PLANNING: ANNUAL PLAN 14.1

PROFIT PLANNING DEFINED 233

14.13 INVENTORY BUDGET 241

14.2

PURPOSE OF BUDGETING 234

14.14 OPERATING EXPENSE BUDGET 243

14.3

PLANNING BENEFITS 234

14.15 CAPITAL EXPENDITURES BUDGET 243

14.4

COORDINATION BENEFITS 235

14.16 COST OF GOODS SOLD 243

14.5

CONTROL BENEFITS 236

14.6

ANNUAL PLANNING CYCLE: ILLUSTRATIVE 237

14.17 STATEMENT OF ESTIMATED INCOME AND EXPENSE 243

14.7

SUPPORTIVE FINANCIAL STATEMENTS AND BUDGETS 238

14.19 STATEMENT OF ESTIMATED FINANCIAL CONDITION 245

14.8

SALES BUDGET 239

14.20 APPROVAL OF BUDGET 246

14.9

PRODUCTION BUDGET 240

14.21 CONTROL FUNCTION 247

14.18 CASH BUDGET 245

14.10 PURCHASES BUDGET 240 14.11 DIRECT LABOR BUDGET 241

14.22 CONTROLLER’S ROLE : A KEY PLAYER 247

14.12 MANUFACTURING EXPENSE BUDGET 241

14.23 MANAGEMENT APPROVAL OF THE PLAN 253

14.1 PROFIT PLANNING DEFINED Supportive of the long-range plan is short-range or short-term planning that usually concerns itself with the next year or two. It is the detailed planning that involves the development of operating programs that work to ensure the effective implementation of the long-range profit goals but recognize the limitations and opportunities of the present and near-term resources and business environment. Profit planning has been defined by several authorities as the process of developing detailed plans for a specified near-term period in the future and integrating these plans into a comprehensive whole. In this profit-planning process, expected revenues, costs, levels of operation, facilities, financial resources, and personnel are all considered and interrelated. The appropriateness of levels and types of costs and expenses are analyzed and interrelated by techniques discussed in Chapter 15. Modeling techniques may be involved in this profit-planning process to provide management with (1) a quantitative analysis of the probable effects on operating results, (2) the financial condition of alternative decisions, and (3) alternative uses of resources to optimize the return to the shareholders. Profit planning is an iterative process that aids the manager in revising and modifying plans until an acceptable one is reached. This entire short-term profit-planning and control process may be summarized as including these elements: • Arriving at an acceptable plan or program • Measuring actual performance against the plan (and against other related standards) • Deciding on, and implementing, corrective action 233

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Ch. 14 Profit Planning: Annual Plan

The detailed planning and control process of Emerson Electric1 is a classic of its kind and has been the subject of many schools of business case studies and involves the above three segments. It seeks to identify problems before they start and commence corrective action. For an extended period, the planning sessions focused on costs, margins, and profits. As a result, the managers had little incentive to emphasize growth or risky new products that would reduce near-term profits. That is changing because a primary need of the company now is growth — whether by going global, by acquiring new companies, or by participating in joint ventures. The annual plan should seek to address the perceived needs of the business. This chapter describes the short-term planning process, including a simplified illustrative plan, and the role of the controller as a chief player. Chapter 15 discusses some related financial analysis techniques that assist the company in developing an acceptable annual or short-range business plan. But, first, what is the need for and what are the advantages of this business planning and budgeting?

14.2 PURPOSE OF BUDGETING A fundamental purpose of business budgeting is to find the most profitable course through which the efforts of the business may be directed in meeting its primary service objective. Another purpose is to assist management in holding the business as nearly as possible on that charted course. In most business concerns there are numerous decisions to be made about the policies to be followed and the methods to be used. Decisions must be made, for example, about the choice of goods and services to be made and sold; the selection of customers; the level of prices; the methods of production, distribution, and financing; credit terms; the degree of integration of operating units; and so on, almost without limit. Which selection of policies and methods will be most profitable? Can any combination be found that gives reasonable promise of an adequate return on the investment? If none can, the venture should be stopped, the business merged with another, or the capital shifted to other channels, before further losses result. If profitable courses are open, each should be examined and translated into its profit possibilities. Although it is easy to speak in general terms of the desirability of budgeting, the practical advantages in an actual case are not always so apparent. Conditions change rapidly in business; the actions of customers and competitors cannot be entirely controlled, and after they become known a business must, to a degree, govern itself accordingly, regardless of any previously developed program. Plans, when made intelligently, require exhaustive study and research, and this constitutes an expensive procedure. What, then, are the specific advantages to be gained? The benefits of budgeting lie in three primary fields of business activity: (1) directly in the planning, (2) in the coordinating phase, and (3) in the control area. These activities are each very wide in scope and contain within themselves several supplemental or detailed advantages.

14.3 PLANNING BENEFITS Planning is needed to ensure that a company utilizes its assets in an orderly and efficient manner, which avoids a great deal of waste. The following points are the primary reasons for using planning: • To base action on thorough investigation, study, and research. Perhaps the cardinal advantage of systematic budgeting is that it tends to bring the executives to an early study of their problems and instills into the organization the habit of careful study before a decision about action is made. This is not easy to achieve. Intensive study is to many a distasteful exercise. Most of us prefer to postpone difficult decisions until necessity compels us to act. Businesses, like individuals, tend to become opportunist; they wait until a decision is forced, then turn quickly, often without time for careful study of the problems, in the direction offering the easiest immediate escape from their troubles.

1. Seth, Lubove, “It Ain’t Broke, but Fix It Anyway,” Forbes, Aug. 1, 1994, pp. 56 – 60.

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14.4 Coordination Benefits

235

If the executives, from general manager to foreperson, know that their plans are to be formally expressed and that they will be charged with responsibility for their execution, they can be brought to an earlier and more intensive study of the problems at hand. This habit of making plans will benefit every activity. Specifically, it will relate to financial requirements, inventory levels, production facilities, production, purchasing, advertising, selling, sales promotion, product development, organization growth or expansion, and labor relations— in short, the advantages can accrue to every function. • To enlist the assistance of the entire organization in determining the most profitable course. When budgeting is undertaken in ample time and on a regular schedule, there is full opportunity to enlist the assistance of foremen, salespeople, branch managers, department heads, and all operating officials—major and minor. In some lines of business the suggestions and counsel from such sources are essential to the development of the best operating plans, and in most lines of business such assistance is highly desirable. The final plans should be expressive of the combined judgment of the entire organization, thereby eliminating such bias or prejudice as frequently affects the judgment of individual groups. • To serve as a declaration of policies. Nothing so restrains the enthusiasm and energy of an organization as uncertainty. The budget procedure provides a vehicle through which basic policies are periodically reexamined, restated, and set forth as guiding principles for the organization at large. Basic policies, not temporary expediency, should be the guiding factors of a business, and the organization should be schooled in such policies. • To define objectives. The successful manager must be surrounded with capable associates who will accept leadership and execute the program. But a manager must demonstrate the ability to lead. People will follow a leader when they realize that the leader has a sensible plan of action and definite objectives in mind. Such objectives should be clearly expressed and, to a certain degree, should stand as goals of attainment for the entire organization. Objectives, however, must not be the product of hope but rather the logical consequence of carefully laid plans. The executive who can clearly define objectives and delineate a program that can logically be expected to reach such objectives will command cooperation and loyalty from associates. • To stabilize employment. No employer of labor, regardless of social or economic philosophy, can longer disregard the welfare of the employees. The time has passed when workers could be laid aside at will when not needed, like flasks or patterns in the foundry. To be sure, the responsibility to workers must be balanced with the responsibility to investors, and the welfare of both must be considered, but the business program must consider stability of employment. Intelligent business budgeting rather than governmental regulation offers the greatest hope for providing stability of employment. • To make more effective use of physical equipment. During the course of planning, the excess cost of idle capacity will be revealed. Moreover, in considering those plans that offer the greatest profit, the maximum use of available facilities will inevitably be a factor. The result normally would be the elimination of some of the social wastes related to the uneconomical use of physical facilities.

14.4 COORDINATION BENEFITS Assets are not properly utilized across all departments unless there is close coordination of the activities of all functions. This section notes the key reasons for emphasizing a high level of coordination. • To coordinate and correlate human effort within the business structure. In some respects this is the most important purpose of budgeting. In many concerns there is a definite lack of coordination of effort. This is a restraining factor. Full steam cannot be applied in some divisions of the business because of uncertainty about the program in other divisions. Only when the effort of all divisions is properly timed and coordinated can the full power of united action be realized.

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Ch. 14 Profit Planning: Annual Plan

This, however, emphasizes another important element of budgeting—the necessity of constant review and revision of the plans. If unforeseen and uncontrollable situations arise (and in many industries this is certain to happen) that materially alter the operations of one division, the machinery must be available for quick readjustment of the program in other divisions affected thereby. Wars, floods, droughts, strikes, price wars, political changes, collapse of foreign markets, and so on give rise to such situations. The success of business budgeting should be measured not so much by the nearness of the ultimate results to the original plans as by the extent to which all executives — major and minor— know at all times just what is the immediate program and what are their respective parts therein. There must be no restraint or uncertainty if the organization is to function with full power. The chief executive is the financial coordinating official, but the complexities of the modern business are such that this function cannot be exercised without the assistance and guidance of clearly defined objectives and detailed plans that are projected throughout the entire organization. • To relate the activities of the business to the expected general trend of business conditions. Numerous studies have been made which indicate that profits can be as much (if not more) the result of changes in fundamental conditions as of competitive efficiency. This emphasizes the importance of coordinating the plans of the business with the general trend of economic conditions. The failure of economists to agree on the causes of the business cycle and the frequent differences of opinion among business analysts about future trends have led many executives to the point of skepticism regarding the whole matter of forecasting. However, the fact remains that business activity moves through periods of high and low volume and that for particular businesses there are frequently signals for these changes. These signals must be watched and the plans of the business must reflect courage or caution, depending on the expected trend. • To direct capital and effort into the most profitable channels by means of a balanced and unified program. Before spending money, serious study should be given to the amount that can be profitably spent, where it is to come from, just how it should be spent, and what results may be reasonably expected. A certain amount of funds must be directed toward equipment and inventories and a certain amount to the promotion of sales, but these amounts must be kept in proper balance. No more ambitious project should be attempted than that for which there is available capital, no more production should be made than that which can be profitably sold, and no sales program should be developed beyond that needed for the planned production. Such a balance of factors directed toward a definite objective represents the ideal and, although it can seldom be fully achieved in practice, its attainment will be more likely as a result of careful advance planning. Without such planning, inventories are likely to be out of proportion to sales and production requirements, customers may be excessively financed, and irregularity is likely to arise in the use of production facilities. Where plans and decisions are made from day to day, the program frequently becomes unconsciously warped. Executives are often, through previous training or experience, biased in the direction of sales, engineering, or finance, with the result that one factor receives a disproportionate emphasis. A well-balanced program set up in advance and based on careful study will help avoid this danger. • To reveal weakness in organization. As plans are made and the responsibility for their execution delegated, weaknesses in organization will be revealed. Executives will not accept responsibility unless lines of authority are so delineated that they will be unhampered in the execution of their tasks. Where joint responsibilities are necessary, provision must be made in advance for an orderly procedure of joint action. No management activity so quickly reveals weakness in organization as the procedure of systematic budgeting.

14.5 CONTROL BENEFITS A high degree of control is needed to ensure that a company’s activities closely follow the original plan. This section notes the benefits of good control systems.

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14.6 Annual Planning Cycle : Illustrative

237

• To control specific operations or expenditures. Although the primary purpose of budgeting is to ascertain the most profitable course for the business to follow and to develop a balanced and coordinated program which will hold the company to that course, the budget also provides a valuable tool of control over certain business operations. Some operations and expenditures are subject to very definite control. It may be decided, for example, that $200,000 should be invested in plant expansion, that $100,000 should be appropriated for various sales promotion projects related to a new product, that 1,000 units of the new product should be sold during the period under consideration, and that these units should be manufactured at a cost of $200 each. Assuming that the plans have been predicated on careful study and the considered judgment of the entire organization, the foundation has been laid for a certain degree of control. The investment in the plant can be rigidly held to the prescribed limits in spite of the enthusiasm of production officials to be beyond. Likewise, the expenditure for sales promotion can be definitely held to the predetermined plan. The orders for 1,000 units may not be realized. This might result from the fact that (1) external conditions have changed rapidly and such changes could not be foreseen, or (2) the production of the units— either in quantity or cost—has not met expectations. In such cases the budget provides a certain degree of control. Expenditures are limited and directed into the channels that offer the most promise. If external conditions beyond the control of management change, the program must be promptly revised. If such conditions do not change and failure of execution lies within the organization, the budget serves as a very definite tool of control. The failure of sales and production performance to meet expectation provides the signal for corrective action. • To prevent waste. This is a more general aspect of control. A searching inquiry into every contemplated expenditure and the reason therefor—an analytical approach extending to every function and every department of the business—will constitute an effective preventive of waste. It can be seen that many of these specific advantages are very closely related to all three primary reasons for budgeting. However, the segregation should assist in a better understanding of the advantages of business planning and budgeting.

14.6 ANNUAL PLANNING CYCLE : ILLUSTRATIVE Given the desirability of an annual plan, what are the basic steps involved? Assuming a company with several operating divisions, whose managers are held responsible for operating results, an overview of the process of developing a plan and budget is shown in Exhibit 14.1. The four steps may be described briefly as: 1. Very specific guidelines concerning the plan are issued by the company management to the operating divisions and the corporate executives involved. Such constraints are intended to ensure: • Actions taken during the year will be consistent with corporate policy and strategy as decided in the strategic plan. • The financial assumptions will be consistent (where applicable) and realistic, that is, federal and state income tax rates, inflation rates, capital expenditure limits, Social Security tax rate, independent research and development expense levels, etc. • Sufficient detail is forthcoming to permit an evaluation of the division plan. 2. When received, the division plans, along with other related plans (corporate organization, special departments, etc.), are consolidated to secure the total company picture. The division plans are prepared by functional segments, as may be deduced from Exhibit 14.2. 3. The consolidated plan (and that of each operating unit, etc.) is evaluated in the corporate office (marketing, technical, financial, and general management). Some reiteration may be necessary to arrive at an acceptable plan (adequate profit rate, etc.). 4. When the overall picture is judged satisfactory at top management and board of director levels, the division is notified of the approved plan.

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Ch. 14 Profit Planning: Annual Plan

E XHIBIT 14.1

C OMPANY A NNUAL O PERATION P LAN P ROCESS

E XHIBIT 14.2

D IVISION O PERATING P LAN

14.7 SUPPORTIVE FINANCIAL STATEMENTS AND BUDGETS Finally, a business plan is expressed in financial terms. The plan should be summarized in these basic financial statements: • Statement of planned income and expense • Statement of planned sources and uses of cash (or statement of planned cash flows)

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14.8 Sales Budget

239

• Statement of planned financial position Such summaries should be supported by appropriate detailed plans or budgets on an organizational basis — showing in summary and by operational element, according to responsibility, these detailed plans that become budgets or standards on final approval: • Operational Budgets
Sales budget
Production budget
Materials units budget
Purchases budget
Labor budget
Manufacturing expense budget
Cost of goods sold budget
Administrative and general expense budget
Selling expense budget
Advertising budget
Research and development (R&D) expense budget
Other income and expense budgets

• Capital Assets Budget (including commitments) • Cash Budget • Other Working Capital Budgets
Receivables
Inventories
Short-term liabilities
Prepaid items • Other Long-Term Budgets
Investments
Liabilities
Shareholder equity All these budgets or plans are interrelated. Changes in the capital asset budget can affect the operational budgets and vice versa. The same can be said for the cash budget and the plans for longterm liabilities or shareholder’s equity. An overly simplified summary of these budgets that nevertheless illustrates the relationship of one to the other and the extent of planning involved is shown in the following sections. The complicated nature of each of the above-mentioned budgets, and the detailed analysis necessary for the preparation of a realistic budget or plan for each department and function, are described in Parts 3 and 4 of this volume. Given the complicated nature of this planning and control process, the specific functions and the key role of the controller are reviewed in some detail in Section 14.22.

14.8 SALES BUDGET Usually, the sales forecast is the starting point in budget preparation. The Illustrative Company manufactures and sells only four products. Based on the estimate of units received from the sales manager, and the expected unit prices, the sales budget is constructed as shown in Exhibit 14.3.

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Ch. 14 Profit Planning: Annual Plan

F OR

T HE I LLUSTRATIVE C OMPANY P RELIMINARY S ALES B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Product

No. of Units

Unit Selling Price

Total Sales

R S T U Total

20,000 30,000 50,000 5,000 105,000

$33.00 54.50 21.25 78.50

$ 660,000 1,635,000 1,062,500 392,500 $3,750,000

E XHIBIT 14.3

S ALES B UDGET

14.9 PRODUCTION BUDGET Once the tentative estimate of sales has been agreed on, the usual next step is a determination of the quantities of finished goods that must be produced to meet both the sales and inventory requirements. This calculation of units to be produced is illustrated in Exhibit 14.4.

14.10 PURCHASES BUDGET After the levels of production have been set, the next job to be undertaken is the sometimes laborious task of determining the quantities of raw material needed to meet the production and inventory requirements—a function made much easier by the personal computer. This function is, first, a matter of extending the units of production times the units of each raw material needed as shown in Exhibit 14.5. T HE I LLUSTRATIVE C OMPANY T ENTATIVE P RODUCTION B UDGET ( UNITS ) F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Products Description Quantity required for sale Desired ending inventory Total requirements Less: Beginning inventory Required production E XHIBIT 14.4

R

S

T

U

20,000 5,000 25,000

30,000 5,000 35,000

50,000 10,000 60,000

5,000 500 5,500

3,000 22,000

2,000 33,000

8,000 52,000

1,000 4,500

P RODUCTION B UDGET

T HE I LLUSTRATIVE C OMPANY C OMPUTATION OF U NITS OF R AW M ATERIAL Finished Product Raw Material AA BB CC E XHIBIT 14.5

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R

S

T

U

Total Unit Requirements

11,000 22,000 11,000

33,000 — 66,000

— 52,000 104,000

9,000 9,000 4,500

53,000 83,000 185,000

C OMPUTATION

OF

R AW M ATERIAL

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14.13 Inventory Budget

241

Then, after usage has been calculated, the value of purchases can be set, giving consideration to inventories. The dollar value is determined on the basis of expected unit cost prices that may be furnished by the purchasing department. The purchases budget is constructed basically in the manner of Exhibit 14.6. Very often it is necessary to group purchases by class of material rather than to enumerate each individual type of material. This practice is often used where unit prices are small.

14.11 DIRECT LABOR BUDGET Another budget dependent on the production budget is that relating to direct labor. This cost is computed as shown in Exhibit 14.7.

14.12 MANUFACTURING EXPENSE BUDGET Total manufacturing expenses for the expected production level must be ascertained on the basis of the activity of each type of expense and/or each department or cost center. The final estimate, arbitrarily assumed to be 50 percent of direct labor for this overly simplified illustration, is summarized in Exhibit 14.8.

14.13 INVENTORY BUDGET All information necessary to calculate the investment in inventories is now available. The value of the finished inventory would be computed as demonstrated in Exhibit 14.9.

F OR

T HE I LLUSTRATIVE C OMPANY T ENTATIVE P URCHASES B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Requirements Raw Material

Production

Ending Inventory

53,000 83,000 185,500

2,000 5,000 20,000

AA BB CC Total E XHIBIT 14.6

Total

Less: Beginning Inventory

Quantity to Be Purchased

Unit Price

Purchases Budget

55,000 88,000 205,500

3,000 10,000 20,000

52,000 78,000 185,500

$4.00 2.00 1.00

$208,000 156,000 185,000 $549,500

P URCHASES B UDGET

.

F OR

T HE I LLUSTRATIVE C OMPANY T ENTATIVE D IRECT L ABOR B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Product

Quantity

Standard Labor Hours per Unit

R S T U Total

22,000 33,000 52,000 4,500

1.0 2.5 .5 2.5

E XHIBIT 14.7

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D IRECT L ABOR B UDGET

Total Standard Labor Hours

Direct Labor Budget (At $6.00 per Std. Labor Hour)

22,000 82,500 26,000 11,250 141,750

$132,000 495,000 156,000 67,500 $850,500

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY T ENTATIVE B UDGET OF M ANUFACTURING E XPENSES F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Description

Amount

Indirect labor Payroll taxes and insurance (40%) Provision for vacation wages Power Supplies Repairs and maintenance Depreciation Property taxes Property insurance Total

$125,000 50,000 43,250 52,000 25,000 67,000 47,000 10,000 6,000 $425,250

E XHIBIT 14.8

B UDGET

OF

M ANUFACTURING E XPENSES

T HE I LLUSTRATIVE C OMPANY C OMPUTATION OF E STIMATED E NDING I NVENTORY OF F INISHED G OODS A S OF D ECEMBER 31, 20X5 Product

Quantity

Unit Cost

Total Sales

R S T U Total

5,000 5,000 10,000 500

$14.00 28.50 8.50 35.50

$ 70,000 142,500 85,000 17,750 $315,250

E XHIBIT 14.9

C OMPUTATION

OF FINISHED

G OODS I NVENTORY

A similar procedure would be followed with respect to raw materials, supplies, and work-inprocess. The total value of inventories might then be summarized as in Exhibit 14.10. In actual practice, these summaries would be supported by supplemental detail. These data would permit testing and checking of turnover rates and so on.

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED E NDING I NVENTORIES A S OF D ECEMBER 31, 20X5 Raw materials Supplies and parts Work-in-process Finished goods Total E XHIBIT 14.10

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$ 38,000 4,000 97,500 315,250 $454,750

T HE I NVENTORY B UDGET

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14.17 Statement of Estimated Income And Expense

243

14.14 OPERATING EXPENSE BUDGET Through detailed budgeting and summary by individual departments, the other expenses of the business are estimated. They are summarized in Exhibit 14.11. It is assumed that the only item of nonoperating income is discount on purchases, estimated to be $5,000.

14.15 CAPITAL EXPENDITURES BUDGET Based on a detailed review of facility requirements and the availability of cash, a budget for capital expenditures is prepared in Exhibit 14.12.

14.16 COST OF GOODS SOLD The requisite information is now available to prepare a tentative statement of income and expense. First, the statement of estimated cost of goods sold is computed. (See Exhibit 14.13.)

14.17 STATEMENT OF ESTIMATED INCOME AND EXPENSE The next logical step is the preparation of the statement of estimated income and expense. (See Exhibit 14.14.) T HE I LLUSTRATIVE C OMPANY S TATEMENT OF B UDGETED O PERATING E XPENSES F OR THE Y EAR E NDING D ECEMBER 31, 20X5

Items

Selling Expense

General and Administrative Expense

Salaries —executives Salaries —salespeople Commissions—agents Fringe benefits Advertising space Bad debts Traveling expenses Rent Supplies Interest expense Discount on sales Total

$ 74,000 198,000 17,500 108,800 50,000 — 220,000 12,000 21,000 — — $701,300

$ 90,000 — — 36,000 — 10,000 9,500 3,000 7,000 — — $155,500

E XHIBIT 14.11

B UDGETED O PERATING

AND

O THER E XPENSES

T HE I LLUSTRATIVE C OMPANY B UDGET FOR C APITAL E XPENDITURES F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Buildings Machinery and equipment Total E XHIBIT 14.12

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B UDGET

$120,000 132,500 $252,500 FOR

C APITAL E XPENDITURES

Financial Expense $

— — — — — — — — — 1,900 18,000 $19,900

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED C OST OF G OODS S OLD F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Raw Materials Inventory, January 1, 20X5 Add: Purchases (Exhibit 14.6) Total Available Less: Inventory, December 31, 20X5 Transfer to work-in-process Direct Labor (Exhibit 14.7) Manufacturing Expense (Exhibit 14.8) Total charges to cost of production Add: Work-in-process, January 1, 20X5 Total Less: Work-in-process, December 31, 20X5 Transfer to finished goods Add: Finished goods inventory, January 1, 20X5 Total Less: Finished goods inventory, December 31, 20X5 (Exhibit 14.9) Estimated cost of goods sold E XHIBIT 14.13

S TATEMENT

OF

E STIMATED C OST

OF

$

52,000 549,500 601,500 38,000 563,500 850,500 425,250 1,839,250 97,500 1,936,750 97,500 1,839,250 202,500 2,041,750 315,250 $1,726,500

G OODS S OLD

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED I NCOME AND E XPENSE F OR THE Y EAR E NDING D ECEMBER 31, 20X5

Net sales (Exhibit 14.3) Cost of goods sold (Exhibit 14.13) Gross profit Operating expenses: Advertising and selling (Exhibit 14.11) General and administrative expenses (Exhibit 14.11) Total operating expenses Operating profit Other income—discount on purchases Other expenses: Interest expense (Exhibit 14.11) Discount on sales (Exhibit 14.11) Profit before income taxes Income taxes (40%) Net income E XHIBIT 14.14

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S TATEMENT

OF

E STIMATED I NCOME

AND

Amount

% Net Sales

$3,750,000 1,726,500 2,023,500 701,300 155,500 856,800 1,166,700 5,000 1,171,700 1,900 18,000 19,900 1,151,800 460,720 $ 691,080

100.00 46.00 54.00 19.00 4.00 23.00 31.00 .01 31.00 .01 .05 .05 30.05 12.00 18.05

E XPENSE

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14.19 Statement of Estimated Financial Condition

245

In practice, the statement of estimated income and expense might be detailed by product lines, territories, or channels of distribution. Also, other significant relationships would be calculated for discussion purposes.

14.18 CASH BUDGET Another important budget statement relates to estimated cash receipts and disbursements. The summary of the cash transactions for the year is shown in the tabulation of Exhibit 14.15. In actual practice, the cash budget statement may simply summarize the cash receipts and cash disbursements, each separately. The source or use of cash generation may be grouped as from operations, investing activity, and financing activity. An example of this format, although not using figures from The Illustrative Company, is shown in Exhibit 14.16. It has the advantage of reconciling planned net income with the cash budget, but has the disadvantage of not identifying the specific details of the planned cash receipts and planned cash disbursements. T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED C ASH R ECEIPTS AND D ISBURSEMENTS F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Cash balance, December 31, 20X4 Estimated cash receipts: Collections on accounts receivable Proceeds from sale of common stock Proceeds from notes payable Total estimated receipts Total cash available Estimated cash disbursements: Accounts payable—materials and supplies Accounts payable—other Notes payable Salaries and wages Accrued income taxes Items —other Interest expense Dividends Capital assets Total estimated disbursements Estimated cash balance, December 31, 20X5 E XHIBIT 14.15

S TATEMENT

OF

$ 460,000 $3,672,500 500,000 50,000 4,222,500 $4,682,500 $ 580,600 428,000 300,000 1,330,000 785,050 202,050 1,900 210,000 252,500

E STIMATED C ASH R ECEIPTS

4,090,100 $ 592,400 AND

D ISBURSEMENTS

14.19 STATEMENT OF ESTIMATED FINANCIAL CONDITION The final effect of all the planning is reflected in the statement of estimated financial condition at the close of the budget period. Usually, such a statement is prepared in comparative form with the actual or expected condition at the beginning of the budget period as well as at the close. The concluding budget statement of estimated financial condition and the related statement of retained earnings are illustrated in Exhibits 14.17 and 14.18.

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Ch. 14 Profit Planning: Annual Plan

T HE G LOBAL C OMPANY S TATEMENT OF E STIMATED C ASH F LOWS F OR THE Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) Cash Flows from Operating Activities

Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Amortization Deferred income taxes Accounts receivable Inventories Other working capital changes Net cash provided by operating activities

$12,720)

1,063 420 (115) 476 (212) 140 14,492

Cash Flows from Investing Activities

Capital expenditures Disposals of plant and equipment Acquisitions and other investments Proceeds from divestitures Net cash used in investing activities

(4,210) 863 287 191 (2,869)

Cash Flows from Financing Activities

Proceeds from long-term debt Repayment of long-term debt Purchases of treasury stock Payment of dividends Net cash used in financing activities Effect of exchange rates on cash Net increase in cash and equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year E XHIBIT 14.16

S TATEMENT

OF

806 (610) (492) (1,026) (1,322) 166 10,467 5,437 $15,904)

E STIMATED C ASH F LOWS

14.20 APPROVAL OF BUDGET This comprehensive review of budget preparation has progressed from one step immediately to the next. In actual practice, the path is not as smooth or well defined. Usually, after each of the detailed budgets is prepared by the accounting staff, the figures are compared with past experience and tested by checking significant relationships. Discussions are held with the functional supervisors or department heads to clarify or correct any seemingly out-of-line condition. Such a process can well require several revisions. When agreement has been reached on the detailed budgets, then the pieces are put together and the master budget is prepared. This overall budget is presented to the president and/or budget committee for analysis and review. If management is not satisfied with the operating results or the expected financial condition, or if these executives are not convinced that the best possible program is reflected in the plan, then the alternative plans must be introduced and expressed in monetary terms. When the principals are in accord, the budget for the coming period may be submitted for approval to the board of directors.

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14.22 Controller’s Role : A Key Player

247

14.21 CONTROL FUNCTION Up to the stage of top-side approval, the planning function has predominated. Presumably, the best possible course of action was selected and every member of the organization was assisting with the expression of such a plan. However, once the budget is approved, the business enters a new phase. The budget must be attained; the ship must be kept on course. So the budget becomes a control tool. For this purpose, actual operating results of the day, week, or month are compared with the budget. Variances are analyzed, and corrective action is taken wherever necessary. Quite often, the strong winds force the ship off its course, so a new one must be charted; the plan or budget must be revised.

14.22 CONTROLLER’S ROLE : A KEY PLAYER The annual business plan, or budget, is the plan of all members of management, as the company moves toward its long-range objectives and goals. While it is expressed in financial terms for many phases, it is not the plan of the chief financial officer (CFO) or the controller. The financial executives, and especially the controller, usually play a key role in the planning process. Since the annual plan is quite detailed in nature—for example, by type of expense, by department, by function, by month or quarter—and because the plans of one function must be consistent and properly relate to each affected function, and must be tested or evaluated against selected criteria, either by department function, or overall, it is essential that necessary data be made available in the proper format, based on the proper assumptions, and contained within a given time frame. This section details many of the actions a controller might take in a typical entity. The financial arm of the company, whether the CFO or budget director, but most likely the controller in most instances, should ensure that these steps take place: • Designate in detail the data to be supplied by the departmental or function executive, through appropriate channels, to the controller. For example, as to the sales function, it might include unit and dollar sales for the planning period, by product, by salesperson, by territory, and by month, compared with prior performance at certain levels. As to expenses, it could include the amount of expense by department, by type of expense and by month, for the planning period, compared with the prior period. These expenses in total, or individually, for the period also might be compared with sales, or factory output (or selected competitors, if known). Much of this same data will be used later to compare actual performance with plan — another reason for the great detail. • Provide the format in which the data should be presented. The format should fit the needs of the controller and especially those of the cognizant operating executives. Instructions as to content and format are necessary to permit analysis and comparisons, and to facilitate consolidation of the financial data. • Provide historical or related financial data which the operating executives may use for comparable purposes in preparing the plan year data. Examples include:
Prior year comparative company data
Historical company trends and relationships
Industry comparative data, or selected competitor figures • Provide underlying guidelines to be used in preparing the data for the planning year. Information such as this might be needed:
Probable tax rates and data—federal, state, and local—including payroll tax rates property tax rates, income tax rates, and social security tax rates
Selected economic data, such as inflation rates (in general or on specific products), gross domestic product, selected regional economic growth rate, and regional unemployment rate

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248

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E XHIBIT 14.17

C OMPARATIVE S TATEMENT

Total liabilities and shareholders’ equity OF

900,000 811,680 $2,061,680 $2,373,150

500,000 330,600 $1,080,600 $1,869,000

F INANCIAL C ONDITION (C ONTINUED )

$ 350,000

80,400 50,000 55,000 46,070 80,000 $ 311,470

$

Estimated December 31, 20X5

$ 250,000

60,000 300,000 30,000 370,400 28,000 $ 788,400

$

Actual December 31, 20X4

Liabilities and Shareholders’ Equity

T HE I LLUSTRATIVE C OMPANY C OMPARATIVE S TATEMENT OF F INANCIAL C ONDITION OF D ECEMBER 31, 20X4, AND E STIMATED AS OF D ECEMBER 31, 20X5

Common stock, $5 par value, authorized 100,000 shares; outstanding, 50,000 sharesin 20X4, & 70,000 in 20X5 Capital contributed for common stock in excess of par value Retained earnings Total ownership equity

Ownership equity

Accounts payable Notes payable Accrued salaries and wages Accrued income taxes Accrued items—other Total current liabilities

Current liabilities

A CTUAL

Ch. 14 Profit Planning: Annual Plan

400,000 481,080 $ 981,080) $ 504,150)

$ 100,000)

$ 20,400 (250,000) 25,000 (324,330) 52,000 $(476,930)

Increase (Decrease)

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E XHIBIT 14.17

Total assets

AS

C OMPARATIVE S TATEMENT

Land and land improvements Buildings Machinery and equipment Total Less: Reserve fordepreciation

Fixed assets

Cash Accounts receivable Less: Reserve for doubtful accounts Inventories: Raw material Supplies Work in process Finished goods Prepaid items Total current assets

Current Assets

A CTUAL

OF

52,000 4,000 97,500 202,500

815,000 $1,869,000

356,000 3,000 $1,054,000

F INANCIAL C ONDITION

25,000 375,000 625,000 $1,025,000 210,000

$

$

38,000 4,000 97,500 315,250

25,000 495,000 757,500 $1,277,500 257,000

$

$

20,000

15,000

235,000

$ 322,500

14.22

205,500 $504,150

98,750 — $298,650

67,500

$132,400

Increase (Decrease)

Controller’s Role : A Key Player

1,020,500 $2,373,150

454,750 3,000 $1,352,650

302,500

$ 592,400

Estimated December 31, 20X5

$ 250,000

$ 460,000

Actual December 31, 20X4

Assets

T HE I LLUSTRATIVE C OMPANY C OMPARATIVE S TATEMENT OF F INANCIAL C ONDITION OF D ECEMBER 31, 20X4, AND E STIMATED AS OF D ECEMBER 31, 20X5

249

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED R ETAINED E ARNINGS A S OF D ECEMBER 31, 20X5 Balance, December 31, 20X4 Add: Estimated net income for the year 20X5 Total Less: Dividends to be paid in 20X5 Estimated balance, December 31, 20X5 E XHIBIT 14.18

S TATEMENT

OF

$ 330,600 691,080 $1,021,680 210,000 811,680

E STIMATED R ETAINED E ARNINGS


Interest rates, where applicable
Goals or constraints set by top management like return on assets (in total and for each

division), expected rate of sales increase (in total and/or for selected products), expected gross margin percent, and advertising expenditures
Capital asset expenditure limits • Set forth the time schedule of the due date for the relevant segment or phase of the annual plan. This may be a simple due date schedule each year of important steps as authorized by the chief executive officer (CEO). An example could be a simple letter from the controller to each division executive and the corporate functional executive (in a decentralized organization) outlining the dates: Steps

Completion Date

1. Submission of complete business plan (including monthly and other supporting detail) to corporate controller 2. Review and analysis of division plans by corporate staff of finance, marketing, manufacturing, and R&D, etc. 3. Consolidation of division plans and corporate operations, and overall financial appraisal by the finance department 4. Review (and revise if necessary) of final plan by CEO and senior management 5. Review and approval by board of directors

September 15, 20XX October 31, 20XX November 25, 20XX December 10, 20XX December 22, 20XX

In larger companies, where more follow-up might be necessary, and when the sequence is critical, a Gantt chart might be useful. See Exhibit 14.19, which indicates both the plan and the present status. • Review and analyze all segments of the plan for completeness, reliability, and reasonableness. • If applicable, make suggestions for improved productivity or profitability as the subplans are being prepared. • Consolidate the financial statements to determine the overall company picture: earnings, cash, capital expenditures, financial position, and so forth. • Evaluate the plan, and the important segments by reference to certain measures. One measure is conformance to CEO or board of director goals and constraints. Other measures are commonly used comparisons, like return on equity, return on assets, earnings per share, net income as percentage of sales, turnover ratios (receivables, inventory, and fixed assets), working capital, competitive or industry performance, and financial market expectations. Other measures to consider are conformance to major credit agreement terms, identification of possible weak spots and effect of not meeting the plan, and using some alternative scenarios (20% less than plan, 20% more than plan) to show financial impact or effect on working capital.

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14.22 Controller’s Role : A Key Player

251

(Status as of 10/15/20XX)

E XHIBIT 14.19

G ANTT C HART

FOR

S UBSIDIARY A NNUAL P LANNING C YCLE

• Summarize the plan in a form which communicates to management and the board of directors the significant aspects (see Section 14.23.) The detailed instructions on data content and format for the annual plan often are included as part of a finance manual (or planning manual) as they are often quite voluminous. It is desirable that the instructions be precise and in nonaccounting terms, so that the operating staff understands them. Those aspects being handled by the finance staff should be explicit. A section from a planning manual that describes the duties of the vice president of sales for the three annual plan segments for which he is responsible is shown in Exhibit 14.20. (See also Chapter 54.) The controller must be sensitive to relevant analysis and effective communication techniques. S ECTION

FROM A

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget Sales budget

E XHIBIT 14.20

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Action to Be Taken

Annually

Monthly

1. Provides product sales managers with sales history and related data, and requests sales estimates in physical quantities by product line, and by territory from product sales managers (in format denoted in this manual) 2. Requests unit price data

3 months before start of budget period

2 weeks before budget period

B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

~ OF

S ALES

~

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Ch. 14 Profit Planning: Annual Plan

S ECTION

FROM A

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget

Advertising expense budget

Action to Be Taken

Annually

Monthly

3. Reviews sales estimates of product sales managers for reasonableness and unfavorable trends. Gives consideration to past sales experience, price policies, advertising and sales promotion policy, general business conditions, competitive situation, etc. 4. Submits tentative sales budget to budget director for review as to completeness and format 5. Accepts approved sales budget from planning group and transmits to product sales managers 6. Receives comparison of actual and budgeted sales performance from budget director 7. Explains reasons for variances and corrective action taken

2 months before start of budget period

6 business days before budget period

6 weeks before start of budget period 2 weeks before start of budget period

4 business days before budget period 2 days before budget period

1. Requests advertising manager to prepare overall estimate of advertising expenditures, including detailed projects 2. Receives proposal and reviews

3. Transmits tentative budget to budget director for review in prescribed format 4. Receives approved advertising budget

4th working day of next month 9th working day of following period 3 months before start of budget period 2 months before start of budget period 6 weeks before start of budget period 1 month before start of budget period

5. Advises advertising manager of program 6. Receives reports on budget and actual expenditures

Selling expense budget

E XHIBIT 14.20

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7. Submits comments and corrective action statement on any significant departures from budget 8. Requests budget revision 1. Provides department managers with history of cost experience, plans for next year, etc. 2. Requests selling expense budgets in approved format 3. Reviews subjects budgets, checks reasonableness of expense correlation with sales program, etc. B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

5th working day of following month 10th working day of following month As needed 2 months before start of budget period

6 weeks before start of budget period OF

S ALES (C ONTINUED )

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14.23 Management Approval of the Plan

S ECTION

FROM A

253

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget

Action to Be Taken

Annually

4. Passes expense budgets to budget director for review 5. Receives approved budgets and advises department managers of results 6. Receives comparison of departmental budget performance with actual 7. Secures comments from managers and reports on variances 8. Requests budget adjustments when applicable E XHIBIT 14.20

B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

Monthly

6 weeks before start of budget period 2 weeks before start of budget period 5th day after month end 10th day after month end As needed OF

S ALES (C ONTINUED )

14.23 MANAGEMENT APPROVAL OF THE PLAN When the annual operating plan is approved by the board of directors, the plan, in effect, becomes a commitment and budget from the corporate management to the board and by appropriate organizational segment, from the managers of the segment to the top management of the company. The plan becomes the basic control tool against which actual performance is measured. Mindful that planning is a communicating process, there are four main points to consider when approval of the short-term plan — the profit plan — is sought: 1. The financial officers should ascertain that all significant factors be brought to the attention of the approving authorities in a timely manner and that appropriate recommendations are made. Perhaps the highlights summary should identify whatever the crucial or significant matters for the company or industry are—as viewed by management or the board of directors. An illustrative summary presentation is shown in Exhibit 14.21. This is supported by detailed schedules for all important elements. 2. The board of directors and top management should be made aware of the underlying major assumptions used in constructing the plan. 3. The higher levels of management should not be inundated with excessive accounting details. Only major or important data should be presented. 4. The probabilities of attaining the plan — or the degree of difficulty in achieving it — should be conveyed to the management. A EROSPACE I NDUSTRY I NC . 20X5 A NNUAL P LAN H IGHLIGHTS ( DOLLARS IN MILLIONS , EXCEPT PER SHARE )

Contract acquisitions Backlog Sales E XHIBIT 14.21

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H IGHLIGHTS

Increase (Decrease)

Plan

20X4 Estimated

Dollars

Percent

1,100.0 1,293.7 1,670.0

1,106.8 1,863.7 1,594.3

(6.8) (570.0) 75.7

(.6) (30.6) 4.7

OF THE

A NNUAL P LAN

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Ch. 14 Profit Planning: Annual Plan

A EROSPACE I NDUSTRY I NC . 20X5 A NNUAL P LAN H IGHLIGHTS ( DOLLARS IN MILLIONS , EXCEPT PER SHARE )

Plan

20X4 Estimated

Net income Amount Percent of sales Earnings per share Cash flow from operations Capital expenditures

71.4 4.3 5.03 95.4 42.0

65.7 4.1 4.77 88.5 33.0

Percent return Assets Equity

9.3 22.9

10.1 25.8

E XHIBIT 14.21

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H IGHLIGHTS

OF THE

A NNUAL P LAN (C ONTINUED )

Increase (Decrease) Dollars

Percent

5.7

8.7

.26 6.9 9.0

5.5 7.7 27.3

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CHAPTER

15

PROFIT PLANNING: SUPPORTING FINANCIAL ANALYSIS FOR THE ANNUAL PLAN 15.1

BASIC APPROACH IN PROFIT PLANNING 255

15.2

GENERAL COMMENTS ON THE COST– VOLUME–PROFIT RELATIONSHIP 256

15.14 INCREASED SALES VOLUME TO OFFSET REDUCED SELLING PRICES 266 15.15 MOST PROFITABLE USE OF SCARCE MATERIALS 267 15.16 ADVISABILITY OF PLANT EXPANSION 267

15.3

BREAK-EVEN CHART 256

15.4

CHANGES IN SALES REVENUE 258

15.5

CHANGES IN SALES MIXTURE 259

15.6

CHANGES IN SALES PRICE 260

15.7

CHANGES IN COSTS 261

15.18 WORKABLE STATEMENT OF INCOME AND EXPENSE 271

15.8

MARGINAL INCOME RATIO AND MARGIN OF SAFETY 262

15.19 SOME PRACTICAL GENERALIZATIONS 272

15.9

ANALYSIS BY PRODUCT 262

15.20 STATISTICAL TECHNIQUES FOR PLANNING 272

15.10 APPLICATION OF COST–VOLUME – PROFIT ANALYSIS 263 15.11 SELECTING THE MOST PROFITABLE PRODUCTS 265

15.17 BREAK-EVEN ANALYSIS TO EVALUATE A FORECAST 269

15.21 PROGRAM EVALUATION USING DISCOUNTED CASH FLOW 277

15.12 MINIMUM SELLING PRICE 266

15.22 FINANCIAL ANALYSIS OF UNACCEPTABLE OPERATING RESULTS 277

15.13 UNIT COSTS AT DIFFERENT VOLUME LEVELS 266

15.23 MORE SOPHISTICATED ANALYSES 294

15.1 BASIC APPROACH IN PROFIT PLANNING A fundamental objective of business management is to find the most profitable course that effort should be directed to and hold the enterprise to that course. This, indeed, is planning and control of profits. Thus the term “profit planning” has become associated with the flexible budget technique of planning and controlling operations. This involves, basically, a recognition of the fact that some costs or expenses vary with production or sales volume, whereas others are “time” costs and are more or less independent of volume. Changes in “time” or fixed costs are accomplished generally by management action. In terms of application, the utilization of cost and income data in determining what to produce and at what price to sell is all embodied in profit planning. Moreover, it involves the concept of variable costs and marginal income as contrasted with the use of conventional total costs. 255

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

It is not our purpose, in this chapter, to review budgetary procedures but rather to point out applications or problems associated with the cost –volume – profit relationship in business. Profit planning is here being restricted to special phases or applications of planning and control and does not involve the detailed techniques concerned with cost segregation. However, it should be emphasized that any valid cost–volume – profit studies reflect the true cost drivers — as in activity-based costing (ABC). The cost–volume–profit analyses reviewed in this chapter illustrate how the methodology may be used to answer questions that may arise in specific applications regarding alternative actions during the annual planning process.

15.2 GENERAL COMMENTS ON THE COST–VOLUME–PROFIT RELATIONSHIP Most business decisions involve the selection of alternatives — whether to accept certain business at a specified price, whether to sell aggressively products A or B, whether to expand in territory X or Y. In all these decisions, as well as in many others, three factors must be considered: volume, cost, and profit. An understanding of the relationship among these three forces, and of the probable effect that any change in sales volume would have on the business, should be extremely helpful to management in a broad variety of problems involving planning and control. The interrelationship of cost, volume, and profit makes up what may be described as the profit structure of a company. Through the knowledge and intelligent use of such information, it is possible to predict the effect of any number of contemplated actions. The data used in a review of this relationship may come from several channels and may differ considerably in adaptability or usefulness. In companies in which a rather complete sales analysis is made, and flexible budgets and standard costs are available, the records will provide the necessary information in readily usable form. Costs in all probability will have been segregated into the fixed and variable elements. If such sources are not available, then the conventional historical records might be utilized. Much analysis may be necessary to isolate the effect of changes in volume, selling prices, and variable costs. Moreover, if cost control has been poor, then the relationship between volume and costs will be difficult to detect and the margin of error will depend greatly on the reliability of the data and the validity of the assumptions. Very often, for investment or credit purposes, published financial statements are used as source data in studying the effect of volume on the business. It should be kept in mind that such statements are usually highly condensed and give little indication of the factors that may greatly influence the results — such as change in product mixture. Consequently, the extent of reliability is very limited.

15.3 BREAK-EVEN CHART The profit structure of a company is often presented in the familiar break-even chart form. By such a presentation, management can understand the interrelationship of cost, profit, and volume much more readily than by tables. The simple chart illustrated in Exhibit 15.1 is based on the assumptions that prices will remain unchanged, that fixed costs will remain the same up to the maximum capacity of the plant, that variable costs will vary in direct ratio to volume, and that income taxes will be 50% of all income before taxes. Exhibit 15.1 clearly presents the following information for management: • Fixed costs of the business are $50,000 monthly. • Under present tax laws, and with present facilities, the maximum net profit is $25,000 per month, or $300,000 per year. • At present prices, a monthly sales volume of $100,000 or 50,000 units is required to break even. This makes no provision for dividends to the stockholders. • To realize a net profit of $10,000 per month will require a sales volume of $140,000 per month. • Plant capacity expressed in sales dollars under existing prices and processes is $200,000 per month.

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15.3 Break-Even Chart

E XHIBIT 15.1

B REAK -E VEN C HART I LLUSTRATING V OLUME , AND P ROFIT

THE I NTERRELATIONSHIP OF

257

C OSTS ,

It may be observed that the net profit is measured by the vertical line between sales income and income taxes. Income taxes have been figured only from the break-even point. Another means of showing the relationship between net profit and sales volume is illustrated in Exhibit 15.2. It can be seen that some of the essential cost factors are not disclosed.

E XHIBIT 15.2

G RAPHIC P RESENTATION P ROFIT OR L OSS

AND

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OF

R ELATIONSHIPS

BETWEEN

S ALES V OLUME

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

A break-even chart that illustrates not only the operating factors but also the dividend requirements is shown in Exhibit 15.3. Needless to say, in most businesses the cost–volume–profit relationship is more complex than can be shown in any single break-even chart. This is discussed in 15.10. Moreover, it is not necessary to draw a chart to find the break-even point of a business. This can always be done by a simple calculation: Aggregate fixed expense 1 Break-even point  -----------------------------------------------------------------------------Ratio of variable income to sales

15.4 CHANGES IN SALES REVENUE In analyzing the revenue factor, the controller may find it necessary to consider three aspects of the problem: 1. Treatment of difference between sales and production volume 2. Changes in the composition of sales 3. Changes in sales prices When past experience is being analyzed, a problem is presented in which the sales volume is greatly different from the production volume, with a corresponding change taking place in the finished goods inventory. An adjustment must be made because two different indexes of activity are being used—the production volume for variable manufacturing costs and sales volume for certain selling and other expenses. The solution lies in converting to a common basis, namely, the sales dollar. First, manufacturing costs must be analyzed or compared to physical production converted to a sales basis — the sales value of production. Next, the nonmanufacturing costs are measured against

E XHIBIT 15.3

B REAK -E VEN C HART I LLUSTRATING S ALES I NCOME

AND ITS

D ISPOSITION

1. Variable income represents sales income less the variable expense applicable to such sales.

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15.5 Changes in Sales Mixture

259

the sales value. The costs can then be superimposed on each other at the respective levels, and the total costs for various levels of activity can be determined.

15.5 CHANGES IN SALES MIXTURE Most companies have a variety of product lines, each making a different contribution toward fixed expenses. Changes in the break-even point as well as the operating profit can result from shifts in the mixture of products sold, even though the sales prices are unchanged and the total dollar sales volume meets expectancy. Such results can occur also from changes in distribution channels or sales to different classes of customers if the rearrangement affects the contribution of the product over and above variable costs. Actually, when a break-even chart is used, an underlying assumption is that the proportion of each product sold, or sales through each channel of distribution, is unchanged. Very often this does not happen; the proportionate drop is not the same for all products. The higher-priced lines, for example, may decline much more rapidly than others. Such changes must be recognized in evaluating the data. The effect of a change in sales mixture can be illustrated by the following calculations. Assume the following proportion of sales among three products, the indicated variable costs, fixed costs, and profit: Sales Product A B C Total Fixed costs Operating profit

%

Amount

Variable Costs

40.00 50.00 10.00 100.00

$ 4,000.00 5,000.00 1,000.00 $10,000.00

$2,600.00 4,000.00 875.00 $7,475.00

Marginal Income over Variable Costs Amount

% of Net Sales

$1,400.00 1,000.00 125.00 2,525.00 1,200.00 $1,325.00

35.00 20.00 12.50 25.25

The break-even point can be calculated as: $1,200  $4,752 ---------------.2525 If, however, sales increase on the higher-margin items, the break-even point would naturally decrease. Such a change is illustrated as:

Sales Product A B C Total Fixed costs Operating profit

%

Amount

Variable Costs

60.00 35.00 5.00 100.00

$ 6,000.00 3,500.00 500.00 $10,000.00

$3,900.00 2,800.00 437.50 $7,137.50

Marginal Income over Variable Costs Amount

% of Net Sales

$2,100.00 700.00 62.50 2,862.50 1,200.00 $1,662.50

35.00 20.00 12.50 28.625

The break-even point would be: $1,200  $4,192 ---------------.28625 This break-even point has dropped by $560 only as a result of the changes in sales mixture.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

15.6 CHANGES IN SALES PRICE On the typical break-even chart the sales value is represented by a line that starts at zero and proceeds upward as the volume increases. Sales value equals unit selling price times number of units. It can be understood that the slope of the line changes if the unit sales price changes. The effect of a 10% increase in selling prices is illustrated in Exhibit 15.4. Quite often some of the variable costs (e.g., commissions or royalties) are related to the sales price. Consequently, the variable cost line as well as the sales value line might change as a result of selling price changes. In Exhibit 15.4 it has been assumed that variable costs relate only to units sold and not to value. As a direct result of the increase in selling price, the break-even point has dropped from $100,000 to $91,650, or by 8.35%. It should be clear that a change in selling price affects the break-even point and the relationship between income and variable costs. The controller should also be aware that a change in selling price may have an even greater effect on marginal income than a corresponding percentage increase in variable costs. For example, in the following illustration, a 10% drop in selling prices is equivalent to an 11.1% increase in variable costs as regards the break-even point and marginal income: With a 10% Reduction in Sales Price

At Present Selling Prices

Equivalent Increase in Variable Costs

Amount

% of Net Sales

Amount

% of Net Sales

Amount

% of Net Sales

Sales Variable costs Marginal income Fixed costs Operating profit

$50,000 20,000 30,000 15,000 15,000

100.00 40.00 60.00 30.00 30.00

$45,000 20,000 25,000 15,000 10,000

100.00 44.44 55.56 33.33 22.23

$50,000 22,222 27,778 15,000 12,778

100.00 44.44 55.56 30.00 25.56

Break-even volume

$25,000

E XHIBIT 15.4

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$27,000

G RAPHIC I LLUSTRATION E FFECT N ET I NCOME

OF

S ALES P RICE C HANGE

$27,000

ON

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15.7 Changes In Costs

261

Sales were reduced by 10% of $50,000 to a level of $45,000. As variable costs were not changed, these costs as a percentage of sales are 44.44% or an increase of 11.1% (44.44  40  4.44; 4.44  40  11.1%). Relating the revised variable cost as a percentage of net sales to the original $50,000 of sales produces a variable cost of $22,222. This is 11.1% higher than the original variable cost.

15.7 CHANGES IN COSTS Interpretation of the effect of changes in the cost level presents some interesting problems as well as opportunities for the controller. An increase or decrease in the amount of fixed cost has a twofold effect: (1) the operating profit is changed by a like amount, and (2) the break-even point is changed by a like percentage. To illustrate, assume a case where fixed costs are reduced by $10,000 or 33 1/3%. The operating profit and break-even points would be: Fixed Costs Reduces by $10,000

Present Amount

% of Net Sales

Amount

% of Net Sales

Net sales Variable costs Marginal income Fixed costs Operating profit

$200,000 120,000 80,000 30,000 50,000

100 60 40 15 25

$200,000 120,000 80,000 20,000 60,000

100 60 40 10 30

Break-even point sales

$ 75,000

$ 50,000

With a reduction of $10,000 in fixed costs, the operating profit naturally increased by a like amount. Moreover, fixed costs were reduced 331/3%, and so the break-even point also declined by 33 1/3% or from a $75,000 sales volume to $50,000. This calculation assumes that no change would take place in variable costs, but in practice a change in fixed costs may be accompanied by a change in the variable costs. For example, installation of a labor-saving device may increase depreciation and maintenance charges and decrease direct labor costs and related payroll charges. Such possibilities must be considered. Needless to say, if an increase in fixed costs is being discussed, the probability of an increased sales volume should be reviewed. Furthermore, it would be advisable to examine possible alternatives, such as subcontracting or renting of space and equipment in lieu of purchasing. Acquisition of permanent assets will decrease the concern’s ability to adjust its costs to lower levels should a reduced sales volume ever necessitate such action. Opportunities for the reduction of fixed expenses should not be overlooked in any attempt to reduce costs. A lowering of fixed costs increases the margin at any sales level and, by reducing the break-even point, enables the company to withstand a greater drop in income before losses appear. Changes in unit variable costs or expenses, of course, also affect the break-even point as well as the “marginal income” factor (see Section 15.8.) Perhaps most cost reduction programs center about this category. A great many possibilities are open. For example, changes in the type of material used, the purchase price of material, or the amount of scrap or waste, can affect variable costs. Changes in manufacturing processes, hourly labor rates, plant layout, employee training methods, or the introduction of incentive payments can all affect the labor costs. General economic conditions may influence the ability of a firm to reduce variable costs. Very often the reduced sales volume permits more effective maintenance of equipment in the shutdown periods. Then, too, in such periods the labor turnover rate and material prices are usually reduced. Of course, such conditions may force sales price reductions on the company’s own products. The effect of reduced fixed and variable costs is graphically illustrated in Exhibit 15.5.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.5

C HART I LLUSTRATING E FFECT AND F IXED C OSTS

ON

P ROFIT

OF

R EDUCTION

IN

V ARIABLE

15.8 MARGINAL INCOME RATIO AND MARGIN OF SAFETY In any review of the interrelationship of cost and volume, one of the most significant figures is the marginal income ratio. This may be defined as the residual value after deducting the variable cost from net sales, expressed as a percentage of the net sales. The marginal income ratio represents the share of the sales dollars remaining to cover fixed expenses, income taxes, and net profit. It is indeed a highly useful figure, for it can be employed to determine readily the break-even point or the added income resulting from increased sales volume. To illustrate, if sales are to be increased by $30,000 and the marginal income ratio is 40%, then such sales should result in additional income before taxes, all other factors unchanged, of $12,000 (40% of $30,000). To determine the break-even sales volume, it is necessary merely to divide total fixed costs by the marginal income ratio, as mentioned earlier. The marginal income ratio is useful, also, in determining how low a price may be quoted or what sales volume is required to support a salesperson in a territory. It is probably a much more useful figure than the break-even point. Where the marginal income ratio is high, a change in sales volume has a tremendous effect on profit. Thus an increase of $100,000 in sales will increase operating profit by $60,000 for a company with a 60% marginal income ratio but only $20,000 for a firm with a 20% marginal income ratio. A high ratio, of course, may carry with it high fixed charges. Incidentally, if the controller can prepare the income and expense statements to indicate the marginal income, the use of such statements will be greatly enhanced. Another figure often used in conjunction with cost–volume–profit analyses is the “margin of safety.” It is defined as the excess of actual or budgeted sales over the break-even sales volume and is a measure of the extent to which sales may drop before losses appear. The profit strength of a business might be said to be proportionate to the distance between its existing sales volume and its break-even point. Over the period of a business cycle, as between any two companies of the same size with the same percentage of net profit on present sales volume, the one with the greater margin of safety may have the greater earning power.

15.9 ANALYSIS BY PRODUCT Since most companies have more than one product or product line, a large number of business decisions relate to individual product lines. For this reason, it is desirable to apply the cost–volume–

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15.10 Application of Cost–Volume – Profit Analysis

263

profit analysis to specific product lines so that management can better understand the effect on profits of changes in volume of selected products or of the relative proportion of products sold. The same technique applied to overall operations can be applied to individual product lines. Decisions reached from such studies should be a guide in determining which products should be sold aggressively (or emphasized because of profits or sold through a particular channel of distribution); which products should be continued but not promoted, merely because of some contribution toward fixed expense; and which lines or commodities should be discontinued or replaced by more profitable lines. Obviously, general economic conditions, relative supply and demand, and the long-range effect on customer relationships are some noncost factors that must be weighed. In making any profit analyses the reliability of the results depends in part on the organizational structure and the extent or type of analysis made. To illustrate, a product manufactured in one plant and requiring all the plant’s facilities, which is then marketed through its own separate sales organization, presents few cost allocation problems. Only part of the general administrative expenses need be allocated to the line. Quite in contrast to such a situation is a product whose production and distribution facilities are shared by many other items. In such a case the allocation of fixed and indirect costs requires careful attention, for the reliability of break-even points is greatly dependent on the manner in which such common costs or expenses are distributed to product lines. If, however, the objective is not the determination of break-even points but rather a knowledge of marginal income by products, then no allocation of fixed costs would be necessary. The development of variable costs, depending on usage, would be relatively simple. And many companies predicate important decisions on the relative contribution of each line to fixed costs and profit. Any controller who has had the task of determining an overall break-even point for his company and then has determined the break-even point by product lines has perhaps been confused by the fact that the sum of the individual break-even points usually did not equal the overall break-even point. The reason for this difference is that there may be a significant difference in the sales mix for the various product lines. For example, one product line may have an inordinate share of the overall company sales, and so its break-even level will come fairly close to the overall break-even point for the entire company; alternatively, there may be several small product lines that have outstanding margins and low break-even points, but they have little impact on the overall break-even point due to their small proportion of overall sales. In the following example, Product A has the largest sales volume, so its break-even level tends to be the dominant factor in calculating the overall corporate break-even point, even though Products B and C have substantially different break-even points. Description Sales Gross margin (%) Fixed costs Break-even sales volume

Product A

Product B

Product C

Totals

$10,000,000 30 $ 3,000,000 $10,000,000

$1,000,000 70 $ 300,000 $ 428,571

$2,000,000 10 $ 100,000 $1,000,000

$13,000,000 30 $ 3,400,000 $11,333,333

Where several product lines are being analyzed, the controller may find it advantageous to prepare break-even charts for each product if they are useful to the executives in profit planning. The relative profitability can be determined by observing the slope of the profit line, assuming the same relative scale is used. It is difficult to construct a break-even chart for all products combined that would be of much practical significance. Some companies have used charts similar to Exhibit 15.6. Obviously, all the factors cannot be presented.

15.10 APPLICATION OF COST–VOLUME – PROFIT ANALYSIS Even if the controller is fully aware of all the ramifications of the cost, volume, and profit relationship, the question arises about how can this information be best put to work for management. The principal use of the data, of course, is in planning and policy-making decisions. The chief value of the data lies in the facility with which volume can be treated as a variable factor. Through applying

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.6

P ROFITABILITY

OF

P RODUCTS

IN

R ELATION

TO

B REAK -E VEN P OINT

such information, it is fairly simple to determine at various ranges of volume exactly what the effect on profits will be of contemplated changes. The traditional income and expense statement simply does not permit this. A great variety of questions are asked in the management of a business such as: • What will be the profit or loss at x sales level? • What additional sales volume will be needed to meet the fixed charges arising from the proposed plant expansion program? • What is the possibility of earning a profit on x product? • What sales volume is required to earn a certain designated profit? • At a sales level of x per month, what reduction in fixed and variable costs must be made to earn a profit, before taxes, of some designated amount? • What will be the effect of adding a second shift operation? • What effect will a 15% increase in sales volume have on profits? For questions such as these, the controller should find the answers very easily through the analyses just described. Stated positively, a thorough understanding and analysis of cost–volume–profit data can provide information for: • Sales and pricing policies
Determination of profit that will result from any given volume of sales
Analysis of the effect of changes in selling prices
Effect of change in product mixture
Additional sales volume needed to support a salesperson in a territory, a warehouse, etc.
Lowest prices at which business may be accepted to utilize facilities and contribute some-

thing toward net profit
The particular products to be emphasized to reflect the greatest net profit

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15.11 Selecting the Most Profitable Products

265

• Financial and production problems
Interpretation of proposed or alternative budgets and the effect of suggested cost and other changes—when the goals are not satisfactory to management
Determination of unit costs at various volume levels
Determination of the probable effect of investment in new plant and equipment
Determination of most profitable use of scarce materials
Assistance in choice between subcontracting work or manufacturing certain articles • General
General understanding of profit structure of the business and effect of volume changes— for the major executives
General educational purposes for plant supervision

15.11 SELECTING THE MOST PROFITABLE PRODUCTS When all the productive facilities of a company are fully occupied, and when the demand is much greater than supply, a decision must be reached about the products to be manufactured. The long-term customer reactions, the availability of material, and the probable continued price differential between different products must be weighed. But relative costs and profit should be important factors in the decision. Whether one or many products are manufactured, the principle is valid. Of course, where several products are manufactured by different processes and in different departments, the bottleneck department should be considered separately. In Section 15.8 the importance of marginal income was emphasized, and the greatest marginal income is desirable because it usually results in the highest net profit. However, when considering marginal income, the greatest income per piece or per pound is not the sole factor, for the effect of the rate of production must be reckoned with. To be specific, refer to Exhibit 15.7. The greatest marginal profit per unit of sale, per hundredweight, is realized on product A. Product B returns only $6.67 marginal income per unit. If only this “unit” marginal contribution were considered, the business would not be making the best use of the facilities. When the operating hour is taken into account, product B returns 11.12% more than A — $100.05 per machine hour as compared with $90 for product A. Product Description Per hundred pounds Selling price Costs Variable: Material Labor and overhead Total variable Fixed Total cost Operating profit

A

B

$35.00

$ 28.00

18.00 8.00 26.00 5.00 31.00 4.00

16.00 5.33 21.33 3.33 24.66 3.34

Marginal profit Per machine hour Rate of production (cwt.)

$ 9.00 10

15

Operating profit ($4.00 times 10; $3.34 times 15)

$40.00

$ 50.10

Marginal profit ($9.00 times 10; $6.67 times 15)

$90.00

$100.05

E XHIBIT 15.7

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C OMPUTATION OF M ARGINAL P ROFIT AND PER M ACHINE

PER

U NIT

OF

$

P RODUCT

6.67

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In making decisions of this nature, other cost factors must be kept in mind, for example, cost of carrying inventories and receivables, and changes in the relationship of fixed and variable expense.

15.12 MINIMUM SELLING PRICE In theory, perhaps, each product should yield a net profit. However, under our competitive economy this does not usually happen. Some products bear their own direct costs, a full share of indirect expenses, and return a net profit. Others may carry only a partial share of their indirect costs. In any event, the objective is to secure the greatest overall profit. When all the available capacity is not being utilized, the problem arises about the lowest price to be charged that will still contribute something to the overall profit. The obvious answer is recovery of variable costs, taking into account any additional maintenance or other costs. Such costs set the floor, and anything above this is making a contribution toward fixed expenses. The concept of fixed and variable costs is necessary to such a determination. Obviously, the controller should be realistic or conservative in the segregation of costs. Further, any legal implications — for instance, the possibility of violating the Robinson–Patman Act—must be reviewed.

15.13 UNIT COSTS AT DIFFERENT VOLUME LEVELS Another application of the cost–volume–profit relationship is in the determination of unit costs. Suppose, for example, that management desires to know what the unit cost would be at various sales volume levels, with prices remaining fixed. It may be assumed that, in the illustration at hand, the selling price is $2 per unit. What would be the unit cost were the sales to be increased to $240,000? It is assumed that the present sales consist of 50,000 units and that the present unit cost is $2.40, consisting of $.80 of fixed costs and $1.60 of variable costs. The proposed volume is 120,000 units ($240,000 ÷ $2). The new unit cost would then be: Fixed costs  ----------------------------------------------------  Present variable unit cost Proposed unit volume $40,000  -------------------  $1.60 120,000  $.333  $1.60  $1.933 At a sales volume of $240,000, the unit cost is $1.933.

15.14 INCREASED SALES VOLUME TO OFFSET REDUCED SELLING PRICES In the same illustration, let it be assumed that the sales department insists that the present low volume is due to the fact that the company’s prices are out of line with those of competing concerns or with competing products. A reduction of 10% in selling prices is advised. What percentage increase in volume will be necessary to yield a profit of $5,000 if selling prices are reduced 10%? The assumptions are the same as those mentioned previously, except for the change in prices. In this case: increased sales volume required to offset reduced selling price Profit desired plus fixed costs  ------------------------------------------------------------------------------------------------------------------------------------------Present variable ratio 1   --------------------------------------------------------------------------------------------------------------------------   1  Proposed percentage reduction in selling price  $5,000  $40,000 $45,000  --------------------------------------------  ------------------$80,000 1  .8 ------------------------$100,000 .9 1  ---------------------1  .10

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15.16 Advisability of Plant Expansion

267

$45,000  -------------------  $405,000 .111111 Therefore, a sales volume of $405,000 or 225,000 units must be secured to produce a profit of $5,000 if prices are reduced by 10%. If this goes beyond the capacity of the plant, such a program is impossible without further increase in fixed costs.

15.15 MOST PROFITABLE USE OF SCARCE MATERIALS Another interesting application of the cost and profit relationship is the determination of the best use of restricted or scarce materials. Assume, for example, that only partial requirements are available of a chemical common to five products. How should the ingredient “X” be distributed, considering only the greatest net profit to the company? It is assumed that rates of production are about the same and that all products are manufactured with the same facilities. The solution is evident from the following example: Unit

Product

Selling Price

Variable Cost

Marginal Income Contribution

Pounds of “X” per Lb. of Product

Marginal Profit per Lb. of “X”

1 2 3 4 5

$2.00 2.50 4.00 3.00 5.00

$1.00 1.50 2.50 1.00 2.50

$1.00 1.00 1.50 2.00 2.50

.5 .3 .5 1.5 2.0

$2.00 3.33 3.00 1.33 1.25

Product 2 yields the greatest profit per pound of “X,” and these requirements should be met first, all other factors being equal.

15.16 ADVISABILITY OF PLANT EXPANSION Break-even and related data are helpful when considering plant expansion. The following information would be useful in arriving at a decision: • The relative break-even points • The sales volume required to earn existing profits • The sales volume required to net a fair return on the investment • The maximum profit Assume the following present average earnings statement (monthly) of the company: Net sales Costs and expenses Variable (60% net sales) Fixed Total Net profit before taxes Income taxes (50%) Net profit Increased fixed costs with plant expansion—$50,000 Additional income desired on investment—$5,000 Maximum production in new plant—$300,000

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$500,000 300,000 100,000 400,000 100,000 50,000 $ 50,000

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Using the available data, these four determinations can be made: 1. Break-Even Points Present facilities: Fixed costs $100,000 -----------------------------------------------------  ----------------------  $250,000 sales volume Marginal income ratio .40 Proposed: Present  Additional fixed costs  $150,000  $375,000 sales volume --------------------------------------------------------------------------------------------------Marginal income ratio .40 2. Sales Volume Required to Earn Existing Profit Present fixed costs  Additional fixed costs  Existing profit  ----------------------------------------------------------------------------------------------------------------------------------------------------Marginal income ratio $100,000  $50,000  $100,000  -------------------------------------------------------------------------------.40 $250,000  ---------------------.40  $625,000 sales volume 3. Sales Volume to Net a Fair Return on Added Investment Assume a fair return on the added investment to be $500 (monthly) after income taxes or $10,000 before. Then a fair return equals at least existing profit, plus the above return. Present fixed costs  Additional fixed costs  Existing profit ---------------------------------------------------------------------------------------------------------------------------------------------------- Return on added investment  ----------------------------------------------------------------------------------------------------------------------------------------------------Marginal income ratio $260,000  ---------------------.40  $650,000 sales volume 4. Maximum Earnings with New Plant Net Sales ($500,000  $300,000) Costs and expenses Variable (60% of net sales) Fixed Total Net profit before taxes Income taxes (50%) Net profit

$800,000 480,000 150,000 630,000 170,000 85,000 $ 85,000

These computations may be summarized as: Item Break-even sales volume (monthly) Sales volume to earn existing profit Sales volume to earn 6% on new plant cost Maximum profit Sales volume to earn maximum profit

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Present

Prospective

Increase

$250,000 500,000 — 50,000 500,000

$375,000 625,000 650,000 85,000 800,000

$125,000 125,000 — 35,000 300,000

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15.17 Break-Even Analysis to Evaluate a Forecast

269

Management must consider the possibility of increasing sales by $125,000 monthly to maintain existing profits. It must also weigh the probability of sales remaining at least $125,000 higher, for profits before income taxes will be reduced by $50,000 per month if the expansion is made but sales continue at the present level. Sales must be increased by $125,000 just to retain existing profits, but this disadvantage may be offset by the higher potential earnings of $35,000 per month. Incidentally, these calculations illustrate the variety of simple arithmetical formulas that may be helpful in profit planning and control.

15.17 BREAK-EVEN ANALYSIS TO EVALUATE A FORECAST The discussion of the cost – volume – profit technique2 has been applied in large part to segments of the business — to individual products, or areas, or projects such as a new plant. Yet the same approach can be useful in judging the business plans of a division or a company. Typically, a projection is compared with some past year, usually the immediately preceding year, to determine whether it appears satisfactory. Such a comparison has value. It may be a gauge of the adequacy of the sales volume, and, in a general way, it may raise questions about cost or expense levels. However, such a comparison is not as sharp a tool as is available. Most of the time, the sales level and product mix in the forecast year will not be identical with that of the past year. Therefore, it may be difficult to measure more precisely the propriety of the costs and expenses in relationship to sales volume. To further complicate the problem, management, when looking at a higher sales volume and a net income that appears more favorable, tends to be less critical. In most instances, if net income expressed as a percent of sales is greater than the preceding year, the forecast is gleefully pronounced satisfactory. Why not use a superior tool that permits a more effective evaluation of the volume factor? Once management has agreed on a reasonable sales objective, a volume for the year under forecast, then it becomes practical to measure the proposed forecast against the break-even structure, that is, to apply the break-even economic structure of the company to the projected sales volume. Essentially, this means that management should decide on a reasonable cost – profit– volume relationship and that this standard should be used as a measure of the forecast. The results of the application of the break-even factors, as shown in Exhibit 15.8, to a projected sales volume (standard profit strucT HE S AMPLE C OMPANY P ROFIT S TRUCTURE Variable Costs Description

Fixed Costs

Net sales Cost and expenses Direct material Direct labor Manufacturing expenses Selling expenses Research and development expenses General and administrative expenses

(%) Net Sales

Combined $10,000,000

$ 500,000 400,000 250,000 150,000 $1,300,000

Profit before income taxes E XHIBIT 15.8

Total

$4,000,000 1,000,000 1,000,000 100,000 50,000 50,000 $6,200,000

40.00% 10.00 10.00 1.00 .50 .50 62.00%

7,500,000 $ 2,500,000

S TANDARD P ROFIT S TRUCTURE

2. Adapted in part from James D. Willson, “Practical Applications of Cost–Volume–Profit Analysis,” NACA Bulletin, March 1960, pp. 5–18.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

ture) and the comparison of such results with the aggregate costs and expenses as set forth in an illustrative forecast, are shown in Exhibit 15.9. It is to be noted that percentage relationships are developed to aid in detecting out-of-line conditions. The exhibit portrays one of the basic considerations in the preparation of forecasts, that is, that the company must not be allowed to develop or assume a less favorable cost structure. It is necessary to apply some overall tests quite distinct, for example, from individual departmental budget performance. The greatest dollar increase and relative increase is in prime material costs. This 5% or $250,000 increase must be analyzed to determine whether the cost increase results from changes in product mix or from cost increases in any given product line. The initial break-even application has isolated this apparently excessive cost relationship. Now it should be analyzed in more depth and a decision made about an acceptable plan. Perhaps the product mix is not the optimum believed to be attainable in the forecast year. Perhaps action can be taken on cost increases to reduce or eliminate them. Second, the next largest relative increase, amounting to $60,000, is in direct labor. A similar analysis should be made to localize the cause and seek an improvement in the plan. Next, manufacturing expenses have increased by 4% or $70,000. Departmental budgets should be reviewed to determine the areas of greatest increase and their causes. Management must then decide what corrective action must be taken. If, for example, the increase is in maintenance expense, is it sound to defer projects? What is the best approach when considering the longer-term interests of the business? Similar analyses should be made of the other expense areas. If expenses are under the standard, the accountant should ascertain that no omissions have been made erroneously. It is to be observed that the break-even point has risen by 8.6% to $3,714,290. Perhaps a better way to state the case is that the forecast is based on a somewhat changed cost structure. This change may be shown graphically as in Exhibit 15.10. The solid lines indicate the acceptable cost–volume– profit structure, and the dotted lines reveal the condition as planned in the forecast. Incidentally, T HE S AMPLE C OMPANY B REAK -E VEN A NALYSIS OF F ORECAST F ISCAL Y EAR 20XX Forecast Over (Under) Standard

Application of Standard Profit Structure

Tentative Forecast

Net sales Cost of sales Direct material Direct labor Manufacturing expenses Total Gross margin Operating expenses Selling Research and development General and administrative Total Profit before taxes Other Data

$12,500,000

$12,500,000

5,000,000 1,250,000 1,750,000 8,000,000 4,500,000

5,250,000 1,310,000 1,820,000 8,380,000 4,120,000

525,000 312,500 212,500 1,050,000 $ 3,450,000

540,000 310,000 190,000 1,040,000 $ 3,080,000

Break-even point Marginal income ratio

$ 3,421,050

$ 3,714,290

.38

.35

Description

E XHIBIT 15.9

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C OMPARISON

OF

S TANDARD

AND

Amount

%

$250,000 60,000 70,000 380,000 ( 380,000)

5.00% 4.80 4.00 4.75 ( 8.44 )

15,000 2,500) 22,500) 10,000) $370,000

2.86 ( .80 ) (10.59 ) ( .95 ) (10.72%)

$293,240

8.6%

( ( (

F ORECAST P ROFIT S TRUCTURE

15_controllership.fm Page 271 Monday, December 8, 2003 3:16 PM

15.18 Workable Statement of Income and Expense

271

T HE S AMPLE C OMPANY P ROFIT G RAPH (S TANDARD AND F ORECAST )

E XHIBIT 15.10

P ROFIT G RAPH C OMPARING S TANDARD

AND

F ORECAST P ERFORMANCE

any change in this relationship can be readily shown on the graph, whether in sales, variable costs, or fixed expense. In poor economic weather, a reasonable margin of safety is necessary. Accordingly, in the Sample Company, if management agrees that the standard profit structure must be maintained, every element should be analyzed and explored by the accountant so that the final business plan for the ensuing year retains the characteristics of this structure. As an alternative, once the most satisfactory cost – volume – profit relationship is determined, including the proper product mix, then the possibility of securing additional sales volume to offset cost increases is to be considered.

15.18 WORKABLE STATEMENT OF INCOME AND EXPENSE The conventional statement of income and expense can be quite misleading. In practice, managements have been known to take action on the basis of such statements, when the action was unwarranted on the basis of actual facts. Companies have discontinued products that showed losses on the conventional statements only to find that the loss increased as a result of the discontinuance. Further, goods have been sold at prices below cost in the belief that added volume would reduce the costs and result in a profit. Of course, the controller may explain that action should not be taken on the strength of a monthly statement of income and expense, which is very true. He may emphasize that all the facts should be marshaled in making a decision—which means a detailed analysis.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

But the fact remains that some executives may take corrective action, however ill-advised, after seeing the monthly statement. The chief accounting official should devise a form of statement that may be a little more informative or helpful in giving some clues and will give a better perspective of the situation. Basically, of course, this merely means making a distinction between fixed and variable costs or expenses. One such statement for internal management purposes is illustrated in Exhibit 15.11. The contribution of each product line toward fixed expenses and profits is shown, and a great deal of information can be gleaned from the supplementary data shown thereon. Such a statement may be supported by other schedules giving the details of actual and standard manufacturing expenses, as in Exhibit 15.12. Where desirable, a statement of cost of goods manufactured can be prepared using the same principle of segregating fixed and variable costs.

15.19 SOME PRACTICAL GENERALIZATIONS The primary purpose in any analysis of the cost–volume–profit relationship is to permit the planning of larger profits in the future. Such reviews may disclose basic weaknesses in the profit structure and assist in suggesting remedies. Because the field is so broad, it is desirable to summarize some generalizations that should be clearly understood by the controller and by other members of management as well. These general comments are: • A change in the amount of fixed costs changes the break-even point by a similar percentage and the operating profit by a like amount but does not affect the marginal income ratio. • A change in the selling price changes the break-even point and marginal income ratio. Such a change, percentage-wise, may be quite different in the effect on the marginal income ratio than a similar percentage change in variable costs. • A change in variable costs, likewise, changes the break-even point and marginal income ratio. • When the marginal income ratio is high, large profits may result from comparatively small increases in sales volume above the break-even point. For the same reason, small declines in revenue will cut sharply into profits. By like token, a low marginal income ratio requires considerable change in sales volume to reflect any significant change in profits. • A high margin of safety indicates that a substantial drop in sales volume can take place before losses develop. • When certain conditions exist, some general conclusions about points of attack can be suggested. Consider, for example, these two points: 1. A high marginal income ratio with a low margin of safety probably indicates an excess of fixed costs for the sales volume. The remedy lies in either reducing such fixed costs or increasing the sales volume. 2. A low marginal income ratio and a low margin of safety may indicate that selling prices are too low or variable costs are too high. If prices are as high as competition will allow, then variable costs should be combed for possible reductions.

15.20 STATISTICAL TECHNIQUES FOR PLANNING Business is complex, and the decisions faced by management become increasingly difficult as more alternatives need to be considered. The many products, the many processes, and the constant change simply accentuate the pressure for the most modern techniques in the planning and forecasting area. Speed is necessary if adequate attention is to be paid to the various possible courses of action. Moreover, once a business plan has been conceived, a review every three months may be too infrequent. As one month closes, and as more information about probable conditions in the following 30 days is available, management wants to know the outlook for the succeeding period. An analysis of such alternatives and the need for constant projections into the future places a tremendous burden on the accounting staff unless statistical techniques are utilized. The break-even analysis approach must be combined with linear programming, statistical decision theory, and the

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E XHIBIT 15.11

(

(

37.3

51,834

OF I NCOME AND

E XPENSES

56.7 6.0 62.7

79,006 8,245 87,251

.1)

11.6 —

16,145 69

137)

45.1

62,792

WITH

(

.1)

37.4

56.6 6.0 62.6

11.8 —

44.8

100.0

% of Net Sales

S EGREGATION

133)

50,774

76,890 8,169 85,059

15,977 —

60,913

7,742 135,833

100.0

7,750 139,085

Amount $143,575

(

% of Net Sales

OF

F IXED

—

7.72

11.69 1.24 12.93

2.43 —

9.26

$20.65

Per Cwt.

PLASTIC MOLDINGS

$146,835

S TATEMENT

O VER ( OR U NDER ) S TANDARD Material and freight —price

Sales Gross sales Less: Returns and allowances Net sales Cost of sales A T S TANDARD Variable Material Manufacturing expense Royalties Total variable cost Fixed Total Standard manufacturing profit

Amount

ALL PRODUCTS

AND

3)

(

.3)

42.8

53.4 3.8 57.2

8.7 —

44.7

100.0

% of Net Sales

(

.03)

4.39

5.47 .40 5.87

.89 —

4.58

$10.26

Per Cwt.

15.20

V ARIABLE M ANUFACTURING C OSTS

(

517

644 45 689

105 —

539

4 1,206

$ 1,210

Amount

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

1)

—

26.6

72.0 1.4 73.4

3.1 3.4

65.5

100.0

% of Net Sales

(

273

.03)

16.45

44.61 .94 45.55

1.91 2.09

40.61

$62.00

Per Cwt.

Statistical Techniques for Planning

(

543

1,472 31 1,503

63 69

1,340

4 2,046

$2,050

Amount

DISHWARE

15_controllership.fm Page 273 Monday, December 8, 2003 3:16 PM

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4.9 19.7

6,761 27,352 2,269 6,205

Operating profit (or loss) Other income (net)

S TATEMENT

12.6

17,484

E XHIBIT 15.11

2.2

3,107

OF I NCOME AND

1.6 4.4

21.3

3.6 16.0

5,023 22,213

29,621

10.2 12.4

14,112 17,190

M ANUFACTURING P ROFIT Operating expense Administrative Selling and advertising Research and development Total

% of Net Sales 2.3

Amount 3,215

ALL PRODUCTS

E XPENSES WITH

$ 2,199

1.6

4.9 19.7

12.5

2.3

21.3

3.7 16.1

10.2 12.4

% of Net Sales 2.3

S EGREGATION

6,603 26,712

17,075

3,034

28,911

4,977 21,863*

13,833 16,886

Amount 3,186

OF

.33 F IXED

$

1.00 4.04

2.59

.45

4.37

.77 3.35

2.10 2.58

Per Cwt. .48

PLASTIC MOLDINGS

AND

16)

(

1.5)

5.0 19.7

12.5

2.2

18.2

2.2 24.6

22.3 22.4

% of Net Sales .4

$(

.14)

.50 2.02

1.29

.23

1.88

.22 2.51

2.29 2.29

Per Cwt. .03

$

87

99 403

258

46

490

19 53

10 34

Amount 25

V ARIABLE M ANUFACTURING C OSTS (C ONTINUED )

$(

59 237

151

27

220

27 297

269 270

Amount 4

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Material usage Variable labor and manufacturing expense Subtotal Fixed manufacturing expense Total

274

4.3

4.9 19.7

12.6

2.2

24.0

.9 2.6

.5 1.7

% of Net Sales 1.2

DISHWARE

$ 2.66

3.00 12.18

7.80

1.38

14.84

.58 1.61

.30 1.03

Per Cwt. .76

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$

E XHIBIT 15.11

S TATEMENT

E XPENSES WITH

% of Net Sales

S EGREGATION

654,244

688,800

OF I NCOME AND

657,775

2.4 3.6

3,389 5,085

Amount

OF

F IXED

Per Cwt.

PLASTIC MOLDINGS

673,835

6.0

% of Net Sales

8,474

*See Exhibit 16.12 for details.

Profit before federal income taxes Federal income taxes Net profit Net shipments — pounds Production — pounds

Amount

ALL PRODUCTS

AND

% of Net Sales

Per Cwt.

1,000

3,300

Amount

15.20

% of Net Sales

DISHWARE

275

Per Cwt.

Statistical Techniques for Planning

V ARIABLE M ANUFACTURING C OSTS (C ONTINUED )

34,563

11,760

Amount

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

C OMPARISON

OF

T HE T OLEDO M ANUFACTURING C OMPANY A CTUAL AND S TANDARD M ANUFACTURING C OSTS OF P LASTIC M OLDINGS F OR THE M ONTH E NDED N OVEMBER 30, 20X1

Description

Actual (Over) or Under Standard

Actual

Standard

$ 41,277 3,061 44,338

$41,370 3,101 44,471

2,730 3,519 229 6,478

— 3,292 — 3,292

( 2,730) ( 227) ( 229) ( 3,186)

2,174 16,861 2,941 6,987 28,963

2,001 10,179 2,147 2,830 17,157

( 173) ( 6,682) ( 794) ( 4,157) (11,806)

873 2,016 910 2,110 1,847 1,994 9,750

862 1,698 920 1,742 1,074 1,427 7,723

38,713

24,880

(13,833)

1,204 677 11,806 850 14,537 53,250

1,016 623 7,118 803 9,560 34,440

( 188) ( 54) ( 4,688) ( 47) ( 4,977) (18,810)

$104,066

$82,203

$(21,863)

Price

Material Freight Total

$

93 40 133

Material Usage

Yield Containers Inventory shortages Total material usage Director Labor and Manufacturing Expense

Variable Direct labor Preforming Molding Polishing Packing Total direct labor Manufacturing expense Preforming Molding Polishing Packing Receiving Shipping Total manufacturing expense Total variable direct labor and manufacturing expense Fixed Expense Direct Overhead General manufacturing overhead Depreciation* Property taxes and insurance Total fixed expense Total direct labor and manufacturing expense Total *Includes $4,123 applicable to prior months.

E XHIBIT 15.12

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C OMPARISON

OF

A CTUAL

AND

S TANDARD M ANUFACTURING C OSTS

( ( ( ( ( (

11) 318) 10 368) 773) 567) 2,027)

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15.22 Financial Analysis of Unacceptable Operating Results

277

use of electronic computers if a satisfactory planning job is to be done. The controller must be knowledgeable of these latest mathematical techniques.

15.21 PROGRAM EVALUATION USING DISCOUNTED CASH FLOW Given the fact that short-term plans are used for the detailed analysis and coordination of new programs or projects, often it will be found desirable to know the financial impact in detail and to determine the expected return on assets employed and after leverage or borrowings. Assume plans to facilitate and commence the manufacture of a new electronic device. Management should know the probable rate of return and financial requirements before authorizing the project and approving the plan. If the cutoff rate of return on assets employed is 9.5% per year, a determination is made, as illustrated in Exhibit 15.13, about what rate reasonably may be expected and whether it satisfied the criterion. Detailed techniques are discussed in Chapter 31. In this project evaluation, an initial capital expenditure of $10,000,000 is required, together with $2,000,000 for working capital. Additional needs are projected in later years. The investment outflow by years and cash flow are shown. The return on gross investment calculates to be 9.9% per annum (assuming sale of the business after six years). With borrowing capacity, the return on “equity equivalent” is 41.9% per annum as shown in Exhibit 15.14. Since time value of cash received is very important, the discounted cash flow technique should be considered in planning.

15.22 FINANCIAL ANALYSIS OF UNACCEPTABLE OPERATING RESULTS Given an unacceptable segment of an annual plan, or actual operating results that depart significantly from plan, or loss operations, the financial staff often will be called on to make an in-depth review. Assuming the proper working relations with the operating staff, joint efforts, or at least cooperation, may provide information to correct unsatisfactory financial results. Illustrated in this section is an analysis prepared as the basis for executive discussion by the officers of an integrated chemical company. In this case, it is assumed that the company has operated heavily in the red in one of three divisions, and the management can see no immediate prospects of improving the condition. The seven general steps in the analysis, although partially evident from accompanying exhibits, are outlined as: 1. The operations for the past year were reviewed to secure some indication of the nature of the costs and the points of apparent waste or excessive costs. 2. Unit standard costs, budgets, and variances were analyzed and segregated into their fixed and variable elements. 3. Sales were analyzed to determine a representative product mixture by certain commodity groups. 4. With known product mixture, total costs and income at capacity were determined. 5. On the basis of information determined in step 4, profit graphs were prepared. 6. Within each product group, marginal income for each product was determined to suggest a more profitable sales mixture. 7. The data were interpreted in a narrative report containing recommendations for improvement. The remainder of this section reproduces in full the report prepared by the controller.

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Permanent

E XHIBIT 15.13

D ISCOUNTED C ASH F LOW

(3,000)

( 400) ( 300) ( 300)

(2,000)

Working Capital

Investment

ON

2,930

490 610 540 470 420 400

Depreciation (DDB)

10,260

950 1,500 1,880 1,930 1,930 2,070

Cash Flow $(12,000) 950 — 1,480 1,630 1,630 2,070 ( 4,240) 11,850 7,610

Cash Generation (Requirement)

T OTAL I NVESTMENT (D OLLARS IN

T HOUSANDS )

514 Discounted rate of return: 9%  1% --------------------------------  9.9% 514  (  51 )

7,330

460 890 1,340 1,460 1,510 1,670

Profit after Taxes and Depreciation

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

0 $(10,000) 1 2 ( 1,500) 3 4 5 6 Subtotal Salvage (net of tax) Total $(11,500)

Year

278

$(12,000) 871 — 1,142 1,154 1,060 1,224 7,063 514

.596

Amount

1.000 .917 .842 .772 .708 .650 .596

Factor

Discounted at 9%

.564

1.000 .909 .826 .751 .683 .620 .564

Factor

(

6,683 51)

$(12,000) 864 — 1,111 1,113 1,011 1,167

Amount

Discounted at 10%

Discounted Cash Flow

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E XHIBIT 15.14

2,930

7,330

OF

490 610 540 470 420 400

460 890 1,340 1,460 1,510 1,670

288) 303) 328) 344) 352) 178)

(1,793)

( ( ( ( ( (

Interest Expense (Net)

( 6,033)

(12,000) 662 ( 303) 1,152 1,286 1,278 1,892

Gross Cash Generation (Requirement)

47

9,600 — 1,350 360 270 270 — 11,850 (11,850)

Borrowings ( 2,400) 662 1,047 1,512 1,556 1,548 1,892 5,817 (11,850) 11,850 5,817

Net Cash Generation (Requirement)

IN

T HOUSANDS )

15.22

1.000 .709 .503 .357 .253 .179 .127

Factor

47

(2,400) 469 527 540 394 277 240 47

Amount

Discounted at 41%

1.000 .704 .496 .349 .246 .173 .122

Factor

$(

279

5)

$(2,400) 466 519 528 383 268 231 ( 5)

Amount

Discounted at 42%

Discounted Cash Flow

Financial Analysis of Unacceptable Operating Results

Discounted rate of return: 41%  1% ---------------------------  41.9% 47  (  5 )

10,260

950 1,500 1,880 1,930 1,930 2,070

Cash Flow

B ORROWING (D OLLARS

Depreciation (Double Declining Balance)

D ISCOUNTED C ASH F LOW , N ET

0 $(12,000) 1 — 2 ( 1,500) 3 ( 400) 4 ( 300) 5 ( 300) 6 — Subtotal Loan repayment Salvage (net) Total $(14,500)

Year

Gross Investment

Profit After Taxes and Depreciation

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280

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

C HEMICAL M ANUFACTURING C ORPORATION C HICAGO D IVISION R EPORT ON P ROFIT P OTENTIAL AND B REAK- E VEN P OINTS

G ENERAL C OMMENTS Operations at the Chicago Division for the year ended December 31, 20XX, resulted in a net loss of $730,142. It may be taken for granted that the past year was one of experimentation and inefficiency which might be expected normally as a part of the start-up cost of a new plant. However, the question which now can be asked is: “What is the normal profit expectancy, now that operating experience has been gained?” Other questions frequently posed include: • Would the company as a whole have lost less if the Chicago Division had not operated? • What are the earning possibilities of the Division? • What are the break-even points of the three major product lines? • What action can be taken to minimize losses or increase profits? It is hoped that some of the facts and opinions expressed in this report will stimulate thinking as to possible corrective action. O PERATIONS

FOR THE

Y EAR 20XX

A summary of operating results is presented in Exhibit 15.15. The loss of $730,142 represents 35.95% of net sales. It will be observed that the standard gross margin is only 13.25% of net sales, and that it was insufficient to cover the operating expenses. If the plant had operated close to capacity the excess fixed costs of $268,082 would have largely disappeared. Furthermore, the additional income, even at a low margin rate, probably would have been sufficient to offset a major share of the excess manufacturing costs and operating expenses. Even at the higher volume level, the results would have been disappointing. C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION S TATEMENT OF I NCOME AND E XPENSE F OR THE Y EAR E NDED D ECEMBER 31, 20XX

Net sales Cost of sales At standard: Material Variable expense Fixed expense Standard gross margin Over standard: Material Variable expense Fixed expense Manufacturing loss Operating expenses Operating loss Other income (net) Loss before income tax impact E XHIBIT 15.15

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S TATEMENT

$1,515,062 82,705 164,022

168,305 135,182 268,082

OF I NCOME AND

E XPENSE

Amount

% of Sales

$2,030,958

100.00

1,761,789 269,169

86.75 13.25

571,569 302,400 441,639 744,039 13,897 $730,142

28.14 14.89 21.74 36.63 .68 35.95

15_controllership.fm Page 281 Monday, December 8, 2003 3:16 PM

15.22 Financial Analysis of Unacceptable Operating Results

281

However, the overall company losses for the year would have been greater if the Chicago Division had not operated. This results from the fact that the sales income was greater than the direct out-of-pocket charges. A balance was available to cover either a share of the general office expenses, or Illinois Division expenses, or the depreciation and insurance costs which would have continued. The net advantage of operating the Chicago Division was $185,646, calculated as: Net sales Other income (net) Total Deduct: Direct out-of-pocket costs Material Expenses Income in excess of out-of-pocket costs

$2,030,958 13,897 2,044,855

$1,683,367 175,842

1,859,209 $ 185,646

This gain is reconciled with the net loss in this manner: Allocated expenses Illinois Division expenses General offices expenses Total allocated expenses Continuing fixed charges —depreciation, etc. Total costs Deduct: Income in excess of out-of-pocket costs Net loss

$510,859 214,114 724,973 190,815 915,788 185,646 $730,142

It is to be observed that the fixed charges of $190,815 would not have been incurred if the Chicago Division properties had not been purchased, and that they will continue until the property is either fully depreciated or disposed of. Moreover, the income in excess of out-of-pocket expenses, an amount of $185,646, was almost enough to cover the continuing fixed charges. P ROSPECTS

FOR THE

F UTURE

The severe losses of last year have prompted a thorough review of future possibilities. After extensive discussions with the General Sales Manager and Works Manager, together with a critical analysis of present sales trends and expected cost levels, it appears that present plans would result in an operating profit, at plant capacity, of $28,727 per month or $344,724 per year. While this is more encouraging than a loss of $730,142, yet overall profit is only 5.97% of net sales. The condensed statement by product lines is shown in Exhibit 15.16. A most serious aspect is the almost total lack of profit, even at capacity levels, on our most voluminous product — paints. Quite in contrast, the coke by-products show a possible operating profit of 19.31% of net sales at capacity. The Chicago Division, of course, has not yet attained 100% of plant capacity sales volume. P ROFIT P OTENTIALS

AT

V ARIOUS V OLUME L EVELS

Because the Division may experience several different monthly sales and production levels, it has been felt desirable to construct profit graphs so that the operating profit on any of the three product lines may be anticipated with a reasonable degree of accuracy. These are illustrated in Exhibits 15.17 through 15.19. The probable profit or loss at any selected volume level is measured by the

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.9835 18.6907 16.1591 1.1168 17.2759 1.4149 1.3827 $ .0322

14,099 267,951

231,657 16,010

247,667

20,284 19,823 461

1,433,600

$

$19.6742

$ 282,050

Per Cwt.

7.57 7.40 .17

92.43

86.45 5.98

5.26 100.00

105.26

% Net Sales

522,000

13,800 7,603 $ 6,197

85,063

75,621 9,442

4,754 98,863

$103,617

Amount

2.6437 1.4565 $ 1.1872

16.2956

14.4868 1.8088

.9107 18.9393

$19.8500

Per Cwt.

13.96 7.69 6.27

86.04

76.49 9.55

4.81 100.00

104.81

% Net Sales

Ammonia Derivatives

457,000

30,437 8,368 $ 22,069

83,862

70,308 13,554

4,521 114,299

$118,820

Amount

6.6602 1.8311 $ 4.8291

18.3506

15.3847 2.9659

.9893 25.0107

$26.0000

Per Cwt.

Coke By-Products

26.63 7.32 19.31

73.37

61.51 11.86

3.96 100.00

103.96

% Net Sales

2,412,600

$

64,521 35,794 28,727

416,592

377,586 39,006

23,374 481,113

$ 504,487

Amount

2.6743 1.4836 $ 1.1907

17.2674

15.6506 1.6168

.9688 19.9417

$20.9105

Per Cwt.

Total

13.41 7.44 5.97

86.59

78.48 8.11

4.86 100.00

104.86

% Net Sales

E XHIBIT 15.16

S TATEMENT OF

E STIMATED I NCOME AND

E XPENSE BY

P RODUCT L INE

expenses shown above are those indicated in Exhibit 15.20, except that freight costs have been deducted from sales (and not included in cost of sales) to arrive at a net sales figure consistent with the usual statement presentation.

a Variable

Net sales before freight allowance Less: Freight allowance Net sales Cost of sales Variable a Fixed Total cost of sales Manufacturing profit Operating expenses Operating profit Pounds manufactured and sold

Amount

Paints

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION S TATEMENT OF E STIMATED I NCOME AND E XPENSE A T P LANT C APACITY (5-D AY W EEK ) FOR O NE M ONTH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Description

282

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15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.17

283

B REAK- E VEN C HART —P AINT W ORKS

vertical difference between the sales income line and total cost line at that level. For example, at a 50% plant capacity level, the operating profit or loss would be about:

Product Paints Ammonia derivatives Coke by-products Total

Sales Volume at 50% Level

Monthly Operating Profit (or Loss)

$141,025

$(17,687)

51,810 59,410 $252,245

( 5,423) 73 $(23,037)

These figures have been calculated, but a close approximation can be read on the graphs.

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284

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.18

B REAK -E VEN C HART —A MMONIA P LANT

These charts also indicate the break-even points at which income balances expense. The breakeven points are quite dissimilar: Break-Even Point

Product Paints Ammonia derivatives Coke by-products

Sales per Month

% of FiveDay Capacity

Pounds

Dollars

98.7 73.4 49.9

1,415,161 383,148 228,043

$278,423 76,094 59,249

The details of costs and income on which these break-even points are predicated are set forth in Exhibits 15.20 through 15.22.

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15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.19

285

B REAK- E VEN C HART —C OKE B Y- P RODUCTS P LANT

The chief problem of the Chicago Division centers about the paint line, where a plant capacity operation is required in order to avoid a loss. This is, indeed, a disturbing condition; and the remaining comments relate chiefly to this product line. P AINTS —R ECOMMENDATIONS In reviewing the profit structure, a detailed analysis was made of each of the more popular items in each product group. The total income and standard variable costs are outlined in Exhibit 15.20. The hundredweight data and marginal income per machine or kettle hour are shown in Exhibit 15.23. It will be observed that items 103 and 105 contribute the greatest income over variable expense, per machine hour, to help meet the fixed expenses, income taxes, and profit. It would seem desirable, and is possible in the opinion of the general sales manager, to increase the proportion of sales of these two items. As items 102 and 104 contribute the lowest marginal income, these should not be promoted. Of course, until the system is at capacity, every drum of paint sold helps reduce losses or increase profits.

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E XHIBIT 15.20

89,180.00 29,640.00

343,000 114,000

Freight

E XPENSE

Material

U SE

IN

205.80 68.40

313.20

46.98 125.28 93.96 46.98

$ 141.12 141.12 201.60 94.08 188.28 94.08 860.28

Shipping

4,372.91 1,453.39

2,278.00

341.70 911.20 683.40 341.70

$ 2,373.87 2,373.87 3,391.25 1,582.58 3,167.18 1,582.58 14,471.33

Drums $

3,352.48 1,290.94

3,480.54

541.84 1,426.10 1,027.45 485.15

924.81 928.81 1,501.58 653.86 1,264.30 568.09 5,841.21

Processing

1,919.43 621.19

450.62

80.34 152.84 158.48 58.96

$ 367.85 489.92 593.38 190.04 560.45 266.87 2,468.51

Material Handling

VARIABLE COSTS (STANDARD)

P ROFIT G RAPH

42,062.78 12,536.92

68,212.67

9,703.41 26,307.76 20,492.83 11,708.67

$ 34,958.48 37,600.48 46,783.97 27,408.48 35,005.65 23,697.81 205,454.87

FOR

3,393.30 1,127.80

4,754.38

713.16 1,901.75 1,426.31 713.16

$ 2,312.73 2,312.73 3,303.89 1,541.81 3,085.60 1,541.81 14,098.57

AND

103,617.00

522,000

V ARIABLE I NCOME

14,877.00 41,760.00 31,320.00 15,660.00

78,300 208,800 156,000 78,300

OF

$ 47,040.00 47,040.00 67,200.00 34,496.00 53,346.00 32,928.00 282,050.00

Value

235,200 235,200 336,000 156,800 313,800 156,800 1,433,800

D ETAIL

PAINTS 101 102 103 104 105 106 Total paints A MMONIA D ERIVATIVES 205 206 207 208 Total ammonia derivatives C OKE B Y -P RODUCTS 301 302

Pounds

SALES

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION B REAKDOWN BY P RODUCT OF V ARIABLE I NCOME AND C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Product

286

— — — — — 14.11 14.11

— —

113.61

— — — 113.61

$

Royalties

55,306.70 17,098.64

79,603.02

11,427.43 30,824.93 23,882.43 13,468.23

$ 41,078.86 43,846.69 55,775.67 31,470.85 43,271.46 27,765.35 243,208.88

Total $

33,873.30 12,541.36

24,013.98

3,449.57 10,935.07 7,437.57 2,191.77

5,961.14 3,191.31 11,424.33 3,025.15 10,074.54 5,162.65 38,841.12

Marginal Income

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4,521.10

$23,374.05

$504,487.00

2,412,800

E XHIBIT 15.20

Freight

118,820.00

Value

457,000

Pounds

D ETAIL

$328,267.24

54,599.70

Material

$1,447.68

274.20

Shipping

OF

V ARIABLE I NCOME AND

E XPENSE FOR

U SE IN

682 786 — $80,375

2,055 1,660 — $245,756

15.22

546 1,436 1,371 $74,829

929 71,476

72,405.34

Total

$395,217.24

3,283 3,882 1,371 $400,960

2,793 392,424

Total $395,217

$127.72

—

Royalties

Coke By-Products $72,405

$5,459.75

2,540.62

Material Handling

287

$109,269.76

46,414.66

Marginal Income

Financial Analysis of Unacceptable Operating Results

696 78,907

1,168 242,041

P ROFIT G RAPH (C ONTINUED )

Ammonia Derivatives $79,603

$13,965.17

4,643.42

Processing

Paints $243,209

$22,575.63

5,826.30

Drums

VARIABLE COSTS (STANDARD)

Variable costs, as above Deduct: Costs assumed to be fixed in nature Net Add: Assumed material losses —1% Assumed overrun on standards (20% of processing and handling) Assumed short-term excess costs Total variable costs

COST DATA USED IN PROFIT GRAPH

Total coke by-products Total variable Income and costs — All products

Product

SALES

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION B REAKDOWN BY P RODUCT OF V ARIABLE I NCOME AND C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

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U SE

E XHIBIT 15.21

D ETAIL

OF

M ONTHLY F IXED C OSTS IN

P ROFIT G RAPH

1,591 82

2,106 47 FOR

208 6,673

624 11,689

Vacuum boilers (labor and related costs) Total direct manufacturing expense A LLOCATED General works cost Boiler house fixed costs

1,287

952

1,116

537 2,363 23 306 833

Control laboratory

$

826

$ 1,408 4,818 62 815 2,184

MANUFACTURING D IRECT Depreciation —buildings Depreciation —machinery and equipment Property insurance Real and personal property taxes Building costs (heat, lighting, janitor service, etc.)

Ammonia Derivatives

General plant costs

Paints

Product

$

2,499 1,221

— 8,305

1,765

1,530

710 2,783 31 386 1,100

Coke By-Products

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY F IXED C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Item

288

6,196 1,350

832 26,667

4,004

3,472

$ 2,655 9,964 116 1,507 4,117

Total

Budgeted cost—20X1 Budgeted cost—20X1

Actual expense —20XX Actual expense —20XX Actual expense —20XX Actual expense —20XX Average budgeted cost —20X1; allocated to products on cubic ft. basis Average budgeted cost —20X1; allocated to products on forecasted conversion cost basis Average budgeted cost —20X1; allocated to products on forecasted conversion cost basis Actual expense—20XX

Comments

15_controllership.fm Page 288 Monday, December 8, 2003 3:16 PM

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U SE IN

P ROFIT G RAPH (C ONTINUED )

$35,833

M ONTHLY F IXED C OSTS

$17,045

19,823

OF

7,603

1,000 1,168 16,010

D ETAIL

400 696 9,442

2,153 13,842

Total allocated costs Total fixed manufacturing expenses before adjustments Add: Share of undistributed water and steam costs 20% of processing costs assumed to be fixed Total fixed manufacturing costs for construction of profit graph OPERATING EXPENSES Administrative, selling, and advertising, technical, etc., per Exhibit 15.22 Total fixed expense for construction of profit graph

E XHIBIT 15.21

1,673 8,346

Paints

Item

Ammonia Derivatives

Product

15.22

$74,800

35,794

2,000 2,793 39,006

7,546 34,213

Total

289

Expected experience —20X1 budget

Comments

Financial Analysis of Unacceptable Operating Results

$21,922

8,368

600 929 13,554

3,720 12,025

Coke By-Products

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY F IXED C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

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290

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E XHIBIT 15.22

D ETAIL OF

IN

P ROFIT G RAPH

$8,368

$7,603

$19,823 FOR

761

691

1,802

338 166 442 667 347 229 177 2,366 7,607

295 144 385 580 301 198 154 2,057 6,912

840 412 1,097 1,653 858 565 439 5,864 18,021

$ 975 3,124 456 686 5,241

Coke By-Products

$1,146 2,717 395 597 4,855

U SE

Ammonia Derivatives

$ 1,587 7,743 1,126 1,701 12,157

Paints

M ONTHLY O PERATING E XPENSES

DIRECT Advertising and sales promotion Selling Technical service Research Total direct operating expense ALLOCATED Administrative Advertising and sales promotion Selling Technical service Research Engineering Patents Total allocated operating expense Total operating expense before adjustment Add: Assumed 10% overrun on budget Total operating expense for construction of profit graph

Item

Product

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY O PERATING E XPENSES U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

$35,794

3,254

1,473 722 1,924 2,900 1,506 992 770 10,287 32,540

$ 3,708 13,584 1,977 2,984 22,253

Total

Budget—20X1

Based on budget—20X1; allocated to Chicago Division on forecasted net sales for 20X1

冧

冧

Comments

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$20.00 20.00 20.00 22.00 17.00 21.00

12.2632 10.9973

12.3926 12.5995 13.0861 14.9536

$14.8633 15.9866 13.9238 17.4799 11.1554 15.1134

Material

C OMPARATIVE U NIT C OSTS

26.00 26.00

BY -P RODUCTS

E XHIBIT 15.23

C OKE 301 302

A MMONIA D ERIVATIVES 205 19.00 206 20.00 207 20.00 208 20.00

P AINTS 101 102 103 104 105 106

Sales Price

AND I NCOME

1.2749 1.2749

.4364 .4364 .4364 .4364

$1.0093 1.0093 1.0093 1.0093 1.0093 1.0093

Container

2.5863 2.7266

1.7654 1.7270 1.7281 1.8108

$1.5929 1.6464 1.6668 1.5815 1.6248 1.5848

Other

Variable Costs

16.1244 14.9988

14.5944 14.7629 15.2506 17.2008

$17.4655 18.6423 16.5999 20.0707 13.7895 17.7075

Total

15.22

9.8756 11.0012

4.4056 5.2371 4.7494 2.7992

$ 2.5345 1.3577 3.4001 1.9293 3.2105 3.2925

Marginal Income

5.0768 7.0240

.5304 1.4376 1.0181 ( .7736)

$(1.7336) (2.1881) ( .1665) (1.7688) .0384 ( .2906)

Operating Profit or (Loss)

895 831

963 947 985 1,032

1,032 884 943 775 852 774

Production (lbs.)

291

88.39 91.42

42.43 49.60 46.78 30.40

$26.16 12.00 32.06 14.95 27.35 25.48

Marginal Income

Per Machine Hour

Financial Analysis of Unacceptable Operating Results

4.7988 3.9772

3.8752 3.7995 3.7313 3.5728

$4.2681 3.5458 3.5666 3.6981 3.1721 3.5831

Fixed Costs and Expenses

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION C OMPARATIVE U NIT C OSTS AND I NCOME

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(000’s) Pounds

235.2 235.2 336.0 156.8 313.8 156.8 1,433.8

S TATEMENT

101 102 103 104 105 106 Total

E XHIBIT 15.24 OF

$ 5,961.14 3,191.31 11,424.33 3,025.15 10,074.54 5,162.65 $38.841.12

Marginal Income 235.2 117.0 461.0 77.5 400.0 124.6 1,415.3

(000’s) Pounds

S TANDARD M ARGINAL I NCOME G IVING E FFECT

16.4 16.4 23.5 10.9 21.9 10.9 100.0

% Total

Present Sales Mixture

TO

C HANGES

IN

16.6 8.3 32.6 5.4 28.3 8.8 100.0

% Total

Marginal Income

P RODUCTS S OLD

AND

$ 5,961.14 1,588.51 15,674.47 1,495.21 12,842.00 4,102.46 $41.663.79

Change in Sales Mixture

261.3 130.4 512.0 86.0 444.6 173.1 1,607.4

(000’s) Pounds

16.3 8.1 31.8 5.4 27.6 10.8 100.0

% Total

$ 6,725.34 1,821.95 17,637.38 1,695.06 14,453.06 5,761.98 $48,094.77

Marginal Income

10% Reduction in Cycle Time

M ANUFACTURING E FFICIENCY

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION P AINTS D ETERMINATION OF S TANDARD M ARGINAL I NCOME AT C APACITY

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Product

292

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15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.25

P ROFIT G RAPH G IVING E FFECT TO C HANGES I NCOME AND C OSTS —P AINT W ORKS

293

IN

A review of sales indicates that 85% of the volume is secured from 15% of the customers. Furthermore, from what information we piece together, it appears our operating expenses are out of line with our competitors. There is some indication, also, that the cycle time in production is on the high side. The works manager is of the opinion that reductions can be made in production time. Such improvement would, of course, reduce the variable cost per hundredweight and increase the plant capacity and therefore the potential marginal income. On the basis of available information, it is recommended that immediate steps be taken to: • Reduce selling expenses (fixed costs) by $3,300 per month through the release of three salesmen. The remaining staff can readily cover our large volume customers and contact other possible users. • Emphasize the more profitable products, increasing the proportion of 103 and 105. • Concentrate on a reduction of cycle times by 10%. The effect of each successive action, detailed in Exhibit 15.24 as to marginal income, would be:

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294

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Action

Break-Even Sales Volume (Monthly)

Monthly Operating Profit at Capacity $

Present plans

(a)

$278,400

Reduce fixed expenses by $3,330 per month

(b)

252,800

3,761

Change sales mixture to higher proportion of profitable items, plus (b)

(c)

214,000

9,131

210,770

15,561

Reduce cycle time by 10%, plus (b) and (c)

461

The accomplishment of these objectives would result in a net profit of 5.0% of sales at capacity. The profit graph on paints, with these changes incorporated, would appear as in Exhibit 15.25. As a long-range program, research should be intensified on material costs so as to increase the margin of selling price over such costs. Since the net profit as a percentage of investment, even with the improved results, would not be satisfactory, perhaps consideration can be given to new product lines with higher margins that could advantageously be manufactured in the paint facilities. Further details can be made available as requested. C ONTROLLER

15.23 MORE SOPHISTICATED ANALYSES The illustrations presented in this chapter have been some of the more simple applications of the cost-volume-profit relationship. They deal with the more frequently asked questions relating to near-term applications where, for the volume range under discussion, the cost behavior of the elements is largely determinable; that is, the techniques for determining whether a cost is fixed or variable, or for what proportion of a mixed cost is fixed, are valid over a shorter period for the range in volume levels. Of course, over a longer period additions often must be made to fixed costs (e.g., depreciation) to provide for greater capacity. Some would say this illustrates that fixed costs are often variable.

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CHAPTER*

16

TAXATION STRATEGY 16.1

INTRODUCTION 295

16.7

NEXUS 299

16.2

ACCUMULATED EARNINGS TAX 296

16.8

PASSIVE ACTIVITY LOSSES 300

16.3

CASH METHOD OF ACCOUNTING 297

16.9

PROJECT COSTING 300

16.4

INVENTORY VALUATION 297

16.11 S CORPORATION 301

16.5

MERGERS AND ACQUISITIONS 297

16.12 SALES AND USE TAXES 302

16.6

NET OPERATING LOSS CARRYFORWARDS 298

16.13 TRANSFER PRICING 303

16.10 PROPERTY TAXES 301

16.14 UNEMPLOYMENT TAXES 305

16.1 INTRODUCTION The obvious objective of tax strategy is to minimize the amount of cash paid out for taxes. However, this directly conflicts with the general desire to report as much income as possible to shareholders, since more reported income results in more taxes. Only in the case of privately owned firms do these conflicting problems go away, since the owners have no need to impress anyone with their reported level of earnings, and would simply prefer to retain as much cash in the company as possible by avoiding the payment of taxes. For those controllers who are intent on reducing their corporation’s tax burdens, there are five primary goals to include in their tax strategies, all of which involve increasing the number of differences between the book and tax records, so that reportable income for tax purposes is reduced. The five items are: 1. Accelerate deductions. By recognizing expenses sooner, one can force expenses into the current reporting year that would otherwise be deferred. The primary deduction acceleration involves depreciation, for which a company typically uses MACRS (an accelerated depreciation methodology acceptable for tax reporting purposes), and straight-line depreciation, which results in a higher level of reported earnings for other purposes. 2. Take all available tax credits. A credit results in a permanent reduction in taxes, and so is highly desirable. Unfortunately, credits are increasingly difficult to find, though one might qualify for the research and experimental tax credit, which is available to those companies that have increased their research activities over the previous year. The only type of expense that qualifies for this credit is that which is undertaken to discover information that is technical in nature, and its application must be intended for use in developing a new or improved

* Sections 16.1–16.7 were adapted with permission from Steven M. Bragg, The New CFO Financial Leadership Manual (Hoboken: Wiley, 2003,Chapter 3); Section 16.8 adapted with permission from Steven M. Bragg, Accounting Reference Desktop (Hoboken:Wiley, 2002,p. 528); Section 16.10 adapted with permission from Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002, p. 529.)

295

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296

Ch. 16 Taxation Strategy

business component for the taxpayer. Also, all of the research activities must be elements of a process of experimentation relating to a new or improved function, or that enhances the current level of performance, reliability, or quality. A credit cannot be taken for research conducted after the beginning of commercial production, for the customization of a product for a specific customer, for the duplication of an existing process or product, or for research required for some types of software to be used internally. There are more tax credits available at the local level, where they are offered to those businesses willing to operate in economic development zones, or as part of specialized relocation deals (normally available only to larger companies). 3. Avoid nonallowable expenses. There are a few expenses, most notably meals and entertainment, that are completely or at least partially not allowed for purposes of computing taxable income. A key company strategy is to reduce these types of expenses to the bare minimum, thereby avoiding any lost benefits from nonallowable expenses. 4. Increase tax deferrals. There are a number of situations in which taxes can be shifted into the future, such as payments in stock for acquisitions, or the deferral of revenue received until all related services have been performed. This can shift a large part of the tax liability into the future, where the time value of money results in a smaller present value of the tax liability than otherwise would be the case. 5. Obtain tax-exempt income. The controller should consider investing excess funds in municipal bonds, which are exempt from both federal income taxes and the income taxes of the state in which they were issued. The downside of this approach is that the return on municipal bonds is less than the return on other forms of investment, due to their inherent tax savings. There is no single tax strategy that will be applicable to every company, since the tax laws are so complex that the controller must construct a strategy that is tailored to the specific circumstances in which her company finds itself. Nonetheless, there are a number of taxation areas that a controller must be aware of when creating a tax strategy using the preceding five goals. Those areas are listed in alphabetical order through the remainder of this chapter, ranging from the accumulated earnings tax to unemployment taxes. The controller should carefully peruse these topics to see if they should be incorporated into her overall tax strategy.

16.2 ACCUMULATED EARNINGS TAX There is a double tax associated with a company’s payment of dividends to investors, because it first must pay an income tax from which dividends cannot be deducted as an expense, and then investors must pay income tax on the dividends received. Understandably, closely held companies prefer not to issue dividends in order to avoid the double taxation issue. However, this can result in a large amount of capital accumulating within a company. The IRS addresses this issue by imposing an accumulated earnings tax on what it considers to be an excessive amount of earnings that have not been distributed to shareholders. The IRS considers accumulated earnings of less than $150,000 to be sufficient for the working needs of service businesses, such as accounting, engineering, architecture, and consulting firms. It considers accumulations of anything under $250,000 to be sufficient for most other types of businesses. A company can argue that it needs a substantially larger amount of accumulated earnings if it can prove that it has specific, definite, and feasible plans that will require the use of the funds within the business. Another valid argument is that a company needs an amount of accumulated earnings sufficient to buy back the company’s stock that is held by a deceased shareholder’s estate. If these conditions are not apparent, then the IRS will declare the accumulated earnings to be taxable at a rate of 39.6 percent. Also, interest payments to the IRS will be due from the date when the corporation’s annual return was originally due. The severity of this tax is designed to encourage organizations to issue dividends on a regular basis to their shareholders, so that the IRS can tax the shareholders for this form of income.

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16.5 Mergers and Acquisitions

297

16.3 CASH METHOD OF ACCOUNTING The normal method for reporting a company’s financial results is the accrual basis of accounting, under which expenses are matched to revenues within a reporting period. However, for tax purposes, it is sometimes possible to report income under the cash method of accounting. Under this approach, revenue is not recognized until payment for invoices is received, while expenses are not recognized until paid. The cash basis of accounting can result in a great deal of manipulation from the perspective of the IRS, which discourages its use, but does not prohibit it. As an example of income manipulation, a company may realize that it will have a large amount of income to report in the current year, and will probably have less in the following year. Accordingly, it prepays a number of supplier invoices at the end of the year, so that it recognizes them at once under the cash method of accounting as expenses in the current year. The IRS prohibits this type of behavior under the rule that cash payments recognized in the current period can relate only to current-year expenses. Nonetheless, it is a difficult issue for the IRS to police. The same degree of manipulation can be applied to the recognition of revenue, simply by delaying billings to customers near the end of the tax year. Also, in situations where there is a sudden surge of business at the end of the tax year, possibly due to seasonality, the cash method of accounting will not reveal the sales until the following year, since payment on the invoices from customers will not arrive until the next year. Consequently, the cash method tends to underreport taxable income. In order to limit the use of this method, the IRS prohibits it if a company has any inventories on hand at the end of the year. The reason for this is that expenditures for inventory can be so large and subject to manipulation at year-end that a company could theoretically alter its reported level of taxable income to an enormous extent. The cash basis is also not allowable for any C corporation, a partnership that has a C corporation for a partner, or a tax shelter. However, within these restrictions, it is allowable for an entity with average annual gross receipts of $5 million or less for the three tax years ending with the prior tax year, as well as for any personal service corporation that provides at least 95 percent of its activities in the services arena. The IRS imposes some accrual accounting concepts on a cash-basis organization in order to avoid some of the more blatant forms of income avoidance. For example, if a cash-basis company receives a check at the end of its tax year, it may be tempted not to cash the check until the beginning of the next tax year, since this would push the revenue associated with that check into the next year. To avoid this problem, the IRS uses the concept of constructive receipt, which requires one to record the receipt when it is made available to one without restriction (whether or not it is actually recorded on the company’s books at that time). Besides the just-noted example, this would also require a company to record the interest on a bond that comes due prior to the end of the tax year, even if the associated coupon is not sent to the issuer until the next year.

16.4 INVENTORY VALUATION It is allowable to value a company’s inventory using one method for book purposes and another for tax purposes, except in the case of the LIFO inventory valuation method. In this case, the tax advantages to be gained from the use of LIFO are so significant that the IRS requires a user to employ it for both book and tax purposes. Furthermore, if LIFO is used in any one of a group of financially related companies, the entire group is assumed to be a single entity for tax reporting purposes, which means that they must all use the LIFO valuation approach for both book and tax reporting. This rule was engendered in order to stop the practice of having LIFO-valuation companies roll their results into a parent company that used some other method of reporting, thereby giving astute companies high levels of reportable income and lower levels of taxable income at the same time.

16.5 MERGERS AND ACQUISITIONS A key factor to consider in corporate acquisitions is the determination of what size taxable gain will be incurred by the seller (if any), as well as how the buyer can reduce the tax impact of the

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transaction in the current and future years. In this section, we will briefly discuss the various types of transactions involved in an acquisition, the tax implications of each transaction, and whose interests are best served by the use of each one. There are two ways in which an acquisition can be made, each with different tax implications. First, one can purchase the acquiree’s stock, which may trigger a taxable gain to the seller. Second, one can purchase the acquiree’s assets, which triggers a gain on sale of the assets, as well as another tax to the shareholders of the selling company, who must recognize a gain when the proceeds from liquidation of the business are distributed to them. Because of the additional taxation, a seller will generally want to sell a corporation’s stock, rather than its assets. When stock is sold to the buyer in exchange for cash or property, the buyer establishes a tax basis in the stock that equals the amount of the cash or fair market value of the property transferred to the seller. Meanwhile, the seller recognizes a gain or loss on the eventual sale of the stock that is based on its original tax basis in the stock, which is subtracted from the ultimate sale price of the stock. It is also possible for the seller to recognize no taxable gain on sale of a business if it takes some of the acquiring company’s stock as full compensation for the sale. However, there will be no tax only if continuity of interest in the business can be proven by giving the sellers a sufficient amount of the buyer’s stock to prove that they have a continuing financial interest in the buying company. A variation on this approach is to make an acquisition over a period of months, using nothing but voting stock as compensation to the seller’s shareholders, but for which a clear plan of ultimate control over the acquiree can be proven. Another variation is to purchase at least 80 percent of the fair market value of the acquiree’s assets solely in exchange for stock. When only the assets are sold to the buyer, the buyer can apportion the total price amongst the assets purchased, up to their fair market value (with any excess portion of the price being apportioned to goodwill). This is highly favorable from a taxation perspective, since the buyer has now adjusted its basis in the assets substantially higher; it can now claim a much larger accelerated depreciation expense in the upcoming years, thereby reducing its reported level of taxable income and reducing its tax burden. From the seller’s perspective, the sale price is allocated to each asset sold for the purposes of determining a gain or loss; as much of this as possible should be characterized as a capital gain (since the related tax is lower) or as an ordinary loss (since it can offset ordinary income, which has a higher tax rate). The structuring of an acquisition transaction so that no income taxes are paid must have a reasonable business purpose besides the avoidance of taxes. Otherwise, the IRS has been known to require tax payments on the grounds that the structure of the transaction has no reasonable business purpose besides tax avoidance. Its review of the substance of a transaction over its form leads the controller to consider such transactions in the same manner, and to restructure acquisition deals accordingly. There is a specialized tax reduction available for the holders of stock in a small business, on which they experience a gain when the business is sold. Specifically, they are entitled to a 50 percent reduction in their reportable gain on sale of that stock, though it is limited to the greater of a $10 million gain or ten times the stockholder’s basis in the stock. This exclusion is reserved for C corporations, and applies only to stock that was acquired at its original issuance. There are a number of other exclusions, such as its inapplicability to personal service corporations, real estate investment trusts, domestic international sales corporations, and mutual funds. This type of stock is called qualified small business stock. The unique set of conditions surrounding this stock make it clear that it is intended to be a tax break specifically for the owners of small businesses.

16.6 NET OPERATING LOSS CARRYFORWARDS Since income taxes can be the largest single expense on the income statement, the controller should carefully track the use and applicability of net operating loss (NOL) carryforwards that were created as the result of reported losses in prior years. An NOL may be carried back and applied against profits recorded in the two preceding years, with any remaining amount being carried forward for

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the next 20 years, when it can be offset against any reported income. If there is still an NOL left after the 20 years have expired, then the remaining amount can no longer be used. One can also irrevocably choose to ignore the carryback option and use it only for carryforward purposes. The standard procedure is to apply all of the NOL against the income reported in the earliest year, with the remainder carrying forward to each subsequent year in succession until the remaining NOL has been exhausted. If an NOL has been incurred in each of multiple years, then these should be applied against reported income (in either prior or later years) in order of the first NOL incurred. This rule is used because of the 20-year limitation on an NOL, so that an NOL incurred in an earlier year can be used before it expires. The NOL is a valuable asset, since it can be used for many years to offset future earnings. A company buying another entity that has an NOL will certainly place a high value on the NOL, and may even buy the entity strictly in order to use its NOL. To curtail this type of behavior, the IRS has created the Section 382 limitation, under which there is a limitation on its use if there is at least a 50 percent change in the ownership of an entity that has an unused NOL. The limitation is derived through a complex formula that essentially multiplies the acquired corporation’s stock times the long-term tax-exempt bond rate. To avoid this problem, a company with an unused NOL that is seeking to expand its equity should consider issuing straight preferred stock (no voting rights, no conversion privileges, and no participation in future earnings) in order to avoid any chance that the extra equity will be construed as a change in ownership. If a company has incurred an NOL in a short tax year, it must deduct the NOL over a period of six years, starting with the first tax year after the short tax year. This limitation does not apply if the NOL is for $10,000 or less, or if the NOL is the result of a short tax year that is at least nine months long, and is less than the NOL for a full 12-month tax year beginning with the first day of the short tax year. This special NOL rule was designed to keep companies from deliberately changing their tax years in order to create an NOL within a short tax year. This situation is quite possible in a seasonal business where there are losses in all but a few months. Under such a scenario, a company would otherwise be able to declare an NOL during its short tax year, carry back the NOL to apply it against the previous two years of operations, and receive a rebate from the IRS.

16.7 NEXUS A company may have to complete many more tax forms than it would like, as well as remit taxes to more government entities, if it can be established that it has nexus within a government’s area of jurisdiction. Consequently, it is very important to understand how nexus is established. The rules vary by state, but nexus is generally considered to have occurred if a company maintains a facility of any kind within a state, or if it pays the wages of someone within that state. In some locales, the definition is expanded to include the transport of goods to customers within the state on company-owned vehicles (though nexus is not considered to have occurred if the shipment is made by a third-party freight carrier). A more liberal interpretation of the nexus rule is that a company has nexus if it sends sales personnel into the state on sales calls or trains personnel there to educate customers, even though they are not permanently based there. To gain a precise understanding of how the nexus rules are interpreted by each state, it is best to contact the department of revenue at each state government. A recent issue that is still being debated in the courts is that Internet sales may be considered to have occurred within a state if the server used to process orders or store data is kept within that state, even if the server is merely rented from an Internet hosting service. If nexus has been established, a company must file to do business within the state, which requires a small fee and a re-filing once every few years. In addition, it must withhold sales taxes on all sales within the state. This is the most laborious issue related to nexus, since sales taxes may be different for every city and county within each state, necessitating a company to keep track of potentially thousands of different sales tax rates. Also, some states may require the remittance of sales taxes every month, though this can be reduced to as little as once a year if the company predicts that it will have minimal sales taxes to remit, as noted on its initial application for a sales tax license.

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Some states or local governments will also subject a company to property or personal property taxes on all assets based within their jurisdictions, which necessitates even more paperwork. Though the amount of additional taxes paid may not be that great, the key issue related to the nexus concept is that the additional time required to track tax liabilities and file forms with the various governments may very well require additional personnel in the accounting department. This can be a major problem for those organizations in multiple states, and should be a key planning issue when determining the capacity of the accounting department to process tax-related transactions. Some organizations with a number of subsidiaries will avoid a portion of the tax filing work by accepting the nexus concept only for those subsidiaries that are clearly established within each governmental jurisdiction, thereby avoiding the tax filing problems for all other legal entities controlled by the parent corporation.

16.8 PASSIVE ACTIVITY LOSSES Many individuals and some businesses passively participate in business activities that result in income or losses. They can claim passive activity losses on their tax returns based on these financial results. Passive participation is defined as having a trade or business activity in which one does not materially participate during the tax year, or participating in a rental activity (even if there is evidence of a substantial level of activity in the venture). One is considered to be an active investor if any of the following tests are true: • One annually expends more than 500 hours of participation in the activity. • One’s participation comprises essentially all of the activity for a business. • There were more than 100 hours of annual participation, which was at least as much as any other participant in the business. • One materially participated in the business in any five of the last ten tax years. • One materially participated in a personal service business for any three previous tax years. A limited partner is generally not considered to be materially involved in a business. A closely held corporation or a personal service corporation is considered to materially participate in a business if shareholders owning more than 50 percent of the corporation’s shares materially engage in the business. Also, an investing entity is considered to be materially engaged in a business if it has an interest in an oil or gas well that is held directly or through an entity that does not reduce its liability. Passive activity losses can be claimed only by individuals, estates, trusts, personal service corporations, and closely held C corporations. Conversely, passive activity losses cannot be claimed by grantor trusts, partnerships, and S corporations. If passive activity losses have occurred, they can be offset only against passive activity gains. Activities that are defined by the IRS as not passive are gains on sale of property that has not been used in a passive activity, investment income, and personal services income. If there is an excess credit from a passive loss after all offsets have been made against passive income, then the credit can be carried forward to the next tax year for a later offset. However, all passive losses that are carried forward can be recognized at the time when the passive investor liquidates the investment. The total amount of a passive loss will be limited to the total amount to which a passive investor is at risk. For example, if an entity invests $1,000 in a business venture, then it is only at risk for $1,000, and cannot deduct more than that amount under any circumstances as a passive loss.

16.9 PROJECT COSTING A company that regularly develops large infrastructure systems such as enterprise resource planning (ERP) systems for its own use will usually cluster all costs related to that project into a single account and then capitalize its full cost, with amortization occurring over a number of years. Though this approach will certainly increase reported income over the short term, it also increases income taxes. If the avoidance of income taxes is a higher priority for the controller than reported profits,

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then it would be useful to separate the various components of each project into different accounts, and expense those that more closely relate to ongoing operational activities. For example, a strong case can be made for expensing all training associated with a major system installation, on the grounds that training is an ongoing activity. Another approach is to charge subsidiaries for the cost of a development project, especially if the charging entity is located in a low-tax region and the subsidiaries are in high-tax regions. This transfer pricing approach would reduce the reported income in high-tax areas, effectively shifting that income to a location where the tax rate is lower. However, these cost-shifting strategies must be carefully documented with proof that the systems are really being used by subsidiaries, and that the fees charged are reasonable. A variation on the last approach is to create a data center in a tax haven that stores and analyzes company data and then issues reports back to other corporate divisions for a substantial fee. This approach has to involve more than simply locating a file server in a low-tax location, since the IRS will claim that there is no business purpose for the arrangement. Instead, a small business must be set up around the data center that provides some added value to the information being collected and disseminated. This approach is especially attractive if a company acquires another entity with a data center in a low-tax location, and simply shifts its own facilities to the preestablished location.

16.10 PROPERTY TAXES Local governments use property tax assessments as one of their primary forms of tax receipt. Personal property taxes are assessed based on a company’s level of reported fixed assets in the preceding year, and typically paid once a year. In order to minimize this tax, the accounting department should regularly review the fixed asset list to see which items can be disposed of, thereby shrinking the taxable base of assets. Also, by increasing the capitalization limit, fewer items will be classified as assets, and so will also not be taxed. Local taxing authorities can also impose a tax based on any real property owned by a business. The buildings and land that fall into this category will be appraised by the local assessor, with the resulting assessment being multiplied by a tax rate that is determined by the local government. The assessment can be challenged. If a recent assessment change results in a significant boost in the reported value of a business’s real property, it is certainly worthwhile to engage the services of a private assessor to see if the new valuation can be reduced. If a business rents its property, the tax on real property can be either absorbed by the landlord or passed through to the business, depending upon the terms of the lease. If subleasing from another business, the property tax can be either absorbed by that entity or passed through to the business, again depending on the terms of the lease.

16.11 S CORPORATION The S corporation is of considerable interest to the controller, because it generally does not pay taxes. Instead, it passes reported earnings through to its shareholders, who report the income on their tax returns. This avoids the double taxation that arises in a C corporation, where a company’s income is taxed, and then the dividends it issues to its shareholders are taxed as income to them a second time. The amount of income is allocated to each shareholder on a simple per-share basis. If a shareholder has held stock in the corporation for less than a full year, then the allocation is on a per-share, per-day basis. The per-day part of this calculation assumes that a shareholder still holds the stock through and including the day when the stock is disposed of, while a deceased shareholder will be assumed to retain ownership through and including the day when he or she dies. An S corporation has unique taxation and legal protection aspects that make it an ideal way to structure a business if there are a small number of shareholders. Specifically, it can be created only if there are no more than 75 shareholders, if only one class of stock is issued, and if all shareholders agree to the S corporation status. All of its shareholders must be either citizens or residents of

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the United States. Shareholders are also limited to individuals, estates, and some types of trusts and charities. Conversely, this means that C corporations and partnerships cannot be shareholders in an S corporation. The requirement for a single class of stock may prevent some organizations from organizing in this manner, for it does not allow for preferential returns or special voting rights by some shareholders. There are a few cases where an S corporation can owe taxes. For example, it can be taxed if it has accumulated earnings and profits from an earlier existence as a C corporation and its passive income is more than 25 percent of total gross receipts. It also can be liable for taxes on a few types of capital gains, recapture of the old investment tax credit, and LIFO recapture. If any of these taxes apply, then the S corporation must make quarterly estimated income tax payments. On the other hand, an S corporation is not subject to the alternative minimum tax. If the management team of an S corporation wants to terminate its S status, the written consent of more than 50 percent of the shareholders is required, as well as a statement from the corporation to that effect. If the corporation wants to become an S corporation at a later date, there is a fiveyear waiting period from the last time before it can do so again, unless it obtains special permission from the IRS.

16.12 SALES AND USE TAXES Sales taxes are imposed at the state, county, and city level — frequently by all three at once. It is also possible for a special tax to be added to the sales tax and applied to a unique region, such as for the construction of a baseball stadium or to support a regional mass transit system. The sales tax is multiplied by the price paid on goods and services on transactions occurring within the taxing area. However, the definition of goods and services that are required to be taxed will vary by state (not usually at the county or city level), and so must be researched at the local level to determine the precise basis of calculation. For example, some states do not tax food sales, on the grounds that this is a necessity whose cost should be reduced as much as possible, while other states include it in their required list of items to be taxed. A company is required to charge sales taxes to its customers and remit the resulting receipts to the local state government, which will split out the portions due to the local county and city governments and remit these taxes on the company’s behalf to those entities. If the company does not charge its customers for these taxes, it is still liable for them, and must pay the unbilled amounts to the state government, though it has the right to attempt to bill its customers after the fact for the missing sales taxes. This can be a difficult collection chore, especially if sales are primarily over the counter, where there are few transaction records that identify the customer. Also, a company is obligated to keep abreast of all changes in sales tax rates and charge its customers for the correct amount; if it does not do so, then it is liable to the government for the difference between what it actually charged and the statutory rate. If a company overcharges its customers, the excess must also be remitted to the government. The state in which a company is collecting sales taxes can decide how frequently it wants the company to remit taxes. If there are only modest sales, the state may decide that the cost of paperwork exceeds the value of the remittances, and will require only an annual remittance. It is more common to have quarterly or monthly remittances. The state will review the dollar amount of remittances from time to time, and adjust the required remittance frequency based on this information. All government entities have the right to audit a company’s books to see if the proper sales taxes are being charged, and so a company can be theoretically subject to three sales tax audits per year — one each from the city, county, and state revenue departments. Also, since these audits can come from any taxing jurisdiction in which a company does business, there could be literally thousands of potential audits. The obligation to collect sales taxes is based on the concept of nexus, which was covered earlier in this chapter. If nexus exists, then sales taxes must be collected by the seller. If not, the recipient of purchased goods instead has an obligation to compile a list of items purchased, and remit a use tax to the appropriate authority. The use tax is in the same amount as the sales tax. The only differ-

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ence is that the remitting party is the buyer instead of the seller. Use taxes are also subject to audits by all taxing jurisdictions. If the buyer of a company’s products is including them in its own products for resale to another entity, then the buyer does not have to pay a sales tax to the seller. Instead, the buyer will charge a sales tax to the buyer of its final product. This approach is used under the theory that a sales tax should be charged only one time on the sale of a product. However, it can be a difficult chore to explain the lack of sales tax billings during an audit, so sales taxes should be halted only if a buyer sends a sales tax exemption form to the company, which then should be kept on file. The sales tax exemption certificate can be named a resale certificate instead, depending on the issuing authority. It also can be issued to government entities, which are generally exempt from sales and use taxes. As a general rule, sales taxes always should be charged unless there is a sales tax exemption certificate on file — otherwise, the company will still be liable for the remittance of sales taxes in the event of an audit.

16.13 TRANSFER PRICING Transfer pricing is a key tax consideration, because it can result in the permanent reduction of an organization’s tax liability. The permanent reduction is caused by the recognition of income in different taxing jurisdictions that may have different tax rates. The basic concept behind the use of transfer pricing to reduce one’s overall taxes is that a company transfers its products to a division in another country at the lowest possible price if the income tax rate is lower in the other country, or at the highest possible price if the tax rate is higher. By selling to the division at a low price, the company will report a very high profit on the final sale of products in the other country, which is where that income will be taxed at a presumably lower income tax rate. For example, Exhibit 16.1 shows a situation in which a company with a location in countries Alpha and Beta has the choice of either selling goods in Alpha or transferring them to Beta and selling them there. The company is faced with a corporate income tax rate of 40 percent in country Alpha. To permanently avoid some of this income tax, the company sells its products to another subsidiary in country Beta, where the corporate income tax rate is only 25 percent. By doing so, the company still earns a profit ($60,000) in country Alpha, but the bulk of the profit ($125,000) now appears in country Beta. The net result is a consolidated income tax rate of just 28 percent. Country Alpha Location Sales to subsidiary: Revenue Cost of goods sold Profit Profit percentage

$1,000,000% $1,850,000% $1,150,000% $1,111,115%

Sales outside of company: Revenue Cost of goods sold Profit Profit percentage

$1,500,000% $1,000,000% $1,500,000% $1,111,133%

Income tax percentage Income tax

$1,111,140% $1,160,000%

Consolidated income tax Consolidated income tax percentage

$1,185,000% $1,111,128%

E XHIBIT 16.1

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I NCOME T AX S AVINGS

Country Beta Location

FROM

T RANSFER P RICING

$1,111,125% $1,125,000%

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The IRS is well aware of this tax-avoidance strategy, and has developed tax rules that do not eliminate it but that will reduce the leeway that a controller has in altering reportable income. Under Section 482 of the IRS Code, the IRS’s preferred approach for developing transfer prices is to use the market rate as its basis. However, very few products can be reliably and consistently compared to the market rate, with the exception of commodities, because there are costing differences between them. Also, in many cases, products are so specialized (especially components that are custom-designed to fit into a larger product) that there is no market rate against which they can be compared. Even if there is some basis of comparison between a product and the average market prices for similar products, the controller still has some leeway in which to alter transfer prices. The IRS will allow one to add special charges that are based on the cost of transferring the products, or extra fees, such as royalty or licensing fees that are imposed for the subsidiary’s use of the parent company’s patents or trademarks, or for administrative charges related to the preparation of any documentation required to move products between countries. It is also possible to slightly alter the interest rates charged to subsidiaries (though not too far from market rates) for the use of funds sent to them from the parent organization. If there is no basis on which to create prices based on market rates, then the IRS’s next most favored approach is to calculate the prices based on the work-back method. Under this approach, one begins at the end of the sales cycle by determining the price at which a product is sold to an outside customer, and then subtracts the subsidiary’s standard markup percentage and its added cost of materials, labor, and overhead, which results in the theoretical transfer price. The work-back method can result in a wide array of transfer prices, since a number of different costs can be subtracted from the final sale price, such as standard costs, actual costs, overhead costs based on different allocation measures, and overhead costs based on cost pools that contain different types of costs. If that approach does not work, then the IRS’s third most favored approach is the cost plus method. As the name implies, this approach begins at the other end of the production process and compiles costs from a product’s initiation point. After all costs are added before the point of transfer, one then adds a profit margin to the product, thereby arriving at a transfer cost that is acceptable by the IRS. However, once again, the costs that are included in a product are subject to the same points of variation that were noted for the work-back method. In addition, the profit margin added should be the standard margin added for any other company customer, but can be quite difficult to determine if there are a multitude of volume discounts, seasonal discounts, and so forth. Consequently, the profit margin added to a product’s initial costs can be subject to a great deal of negotiation. An overriding issue to consider, no matter what approach is used to derive transfer prices, is that taxing authorities can become highly irritated if a company continually pushes the outer limits of acceptable transfer pricing rules in order to maximize its tax savings. When this happens, a company can expect continual audits and penalties on disputed items, as well as less favorable judgments related to any taxation issues. Consequently, it makes a great deal of sense to consistently adopt pricing policies that result in reasonable tax savings, are fully justifiable to the taxing authorities of all involved countries, and that do not push the boundaries of acceptable pricing behavior. Another transfer pricing issue that can modify a company’s pricing strategy is the presence of any restrictions on cash flows out of a country in which it has a subsidiary. In these instances, it may be necessary to report the minimum possible amount of taxable income at the subsidiary, irrespective of the local tax rate. The reason is that the only way for a company to retrieve funds from the country is through the medium of an account receivable, which must be maximized by billing the subsidiary the highest possible amount for transferred goods. In this case, tax planning takes a back seat to cash flow planning. Yet another issue that may drive a company to set pricing levels that do not result in reduced income taxes is that a subsidiary may have to report high levels of income in order to qualify for a loan from a local credit institution. This is especially important if the country in which the subsidiary is located has restrictions on the movement of cash, so that the parent company would be unable to withdraw loans that it makes to the subsidiary. As was the case for the last item, cash flow planning is likely to be more important than income tax reduction. A final transfer pricing issue to be aware of is that the method for calculating taxable income may vary in other countries. This may falsely lead one to believe that another country has a lower

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tax rate. A closer examination of how taxable income is calculated might reveal that some expenses are restricted or not allowed at all, resulting in an actual tax rate that is much higher than originally expected. Consultation with a tax expert for the country in question prior to setting up any transfer pricing arrangements is the best way to avoid this problem.

16.14 UNEMPLOYMENT TAXES Both the state and federal governments will charge a company a fixed percentage of its payroll each year for the expense of unemployment funds that are used to pay former employees who have been released from employment. The state governments administer the distribution of these funds and will compile an experience rating on each company, based on the number of employees it has laid off in the recent past. Based on this experience rating, it can require a company to submit larger or smaller amounts to the state unemployment fund in future years. This can become a considerable burden if a company has a long history of layoffs. Consequently, one should consider the use of temporary employees or outsourcing if this will give a firm the ability to retain a small number of key employees and avoid layoffs while still handling seasonal changes in work loads. Also, if a company is planning to acquire another entity, but plans to lay off a large number of the acquiree’s staff once the acquisition is completed, it may make more sense to acquire the acquiree’s assets and selectively hire a few of its employees, thereby retaining a pristine unemployment experience rating with the local state government. The federal unemployment tax is imposed on a company if it has paid employees at least $1,500 in any calendar quarter, or had at least one employee for some portion of a day within at least 20 weeks of the year. In short, nearly all companies will be required to remit federal unemployment taxes. For the 2002 calendar year, the tax rate is 6.2 percent of the first $7,000 paid to each employee; this tends to concentrate most federal unemployment tax remittances into the first quarter of the calendar year. In many states, one can take a credit against the federal unemployment tax for up to 5.4 percent of taxable wages, which results in a net federal unemployment tax of only .8 percent. If a company is shifting to a new legal entity, perhaps because of a shift from a partnership to a corporation, or from an S corporation to a C corporation, it will have to apply for a new unemployment tax identification number with the local state authorities. This is a problem if the organization being closed down had an unusually good experience rating, since the company will be assigned a poorer one until a new experience rating can be built up over time, which will result in higher unemployment taxes in the short term. To avoid this problem, one should contact the local unemployment taxation office to request that the old company’s experience rating be shifted to the new one.

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PART

3

PLANNING AND CONTROLLING OPERATIONS

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CHAPTER

17

GENERAL DISCUSSION OF ACCOUNTING/STATISTICAL STANDARDS: BENCHMARKING 17.1

MEANING OF ACCOUNTING/ STATISTICAL CONTROL 309

17.10 BALANCED SYSTEM OF PERFORMANCE MEASURES 321

17.2

EXTENT OF ACCOUNTING/ STATISTICAL CONTROL 310

17.3

NEED FOR STANDARDS 310

17.11 SETTING THE STANDARDS 322 (a) Who Should Set the Standards? 322 (b) Method of Setting Standards 323

17.4

DEFINITION OF STANDARDS 311

17.5 17.6

ADVANTAGES OF STANDARDS 312 RELATIONSHIP OF ENTITY GOALS TO PERFORMANCE STANDARDS 313 TYPES OF STANDARDS NEEDED 314 (a) Standards for All Business Activity 314 (b) Standards for Individual Performance 315 (c) Material Quantity Standards 315 (d) Material Price Standards 315 (e) Labor Quantity Standards 315 (f) Labor Rate Standards 315 (g) Manufacturing Overhead Expense Standards 315 (h) Sales Standards 316 (i) Distribution Cost Standards 316 (j) Administrative Expense Standards 317 (k) Financial Ratios 317

17.7

17.8

TREND TO MORE COMPREHENSIVE PERFORMANCE MEASURES 318 (a) Time-Based Standards 319

17.9

BENCHMARKING 320

17.12 USE OF STANDARDS FOR CONTROL 323 (a) Technique of Cost Control 323 (b) Role of Statistical Process Control 324 (c) Who Should Control Costs? 324 (d) Level of the Standard 325 (e) Point of Control 325 (f) What Costs Should Have Standards? 326 17.13 PROCEDURE FOR REVISING STANDARDS 326 (a) Revision of Standards 326 (b) Program for Standard Revision 326 17.14 RECORDING STANDARDS 327 (a) Importance of Adequate Records 327 (b) Types of Records Necessary 327 (c) Administrative Controls 328 (d) Incorporation of Standard Costs in Accounts 328 17.15 APPLICATION OF STANDARD COSTS 328 17.16 MANAGEMENT USE OF STANDARD COSTS 328

17.1 MEANING OF ACCOUNTING/STATISTICAL CONTROL Control by definition assumes that a plan of action or a standard has been established against which performance can be measured. To achieve the objectives that have been set forth for the business enterprise, controls must be developed so that decisions can be made in conformance with the plan. 309

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In small plants or organizations, the manager or owner personally can observe and control all operations. The owner or manager normally knows all the factory workers and by daily observation of the work flow can determine the efficiency of operations. It is easy to observe the production effort of each employee as well as the level of raw materials and work-in-process inventory. In most cases, by the observation of the factory operation, inefficiencies or improper methods can be detected and corrected on the spot. The sales orders can be reviewed and determinations made about whether shipments are being made promptly. Through intimate knowledge of the total business and communicating on a daily basis with most employees and customers, the owner is able to discern the effectiveness of sales effort and customer satisfaction with the products. However, as the organization grows, this close contact or direct supervision by the owner or manager is necessarily diminished. Other means of control are required to manage effectively, such as accounting controls and statistical reports. By the use of reports, management is enabled to plan, supervise, direct, evaluate, and coordinate the activities of the various functions, departments, and operating units. Accounting controls and reports of operations are part of a well-integrated plan to maintain efficiency and determine unfavorable variances or trends. The use of the accounting structure allows for the control of costs and expenses and comparison of such expenditures to some predetermined plan of action. Through the measurement of performance by means of accounting and statistical records and reports, management can provide appropriate guidance and direct the business activities. The effective application of accounting controls must be fully integrated into the company plans and provide a degree of before-the-fact control. The accounting/statistical control system must include records that establish accountability and responsibility to really be effective.

17.2 EXTENT OF ACCOUNTING/STATISTICAL CONTROL Effective control extends to every operation of the business, including every unit, every function, every department, every territory or area, and every individual. Accounting control encompasses all aspects of financial transactions such as cash disbursements, cash receipts, funds flow, judicious investment of cash, and protection of the funds from unauthorized use. It includes control of receivables and avoidance of losses through inappropriate credit and collection procedures. Accounting control includes planning and controlling inventories, preventing disruption of production schedules and shipments or losses from scrap and obsolescence. It involves generating all the necessary facts on the performance of all functions such as manufacturing, research, engineering, marketing, and financial activities. It is mandatory that management be informed about the utilization of labor and material against a plan in producing the finished goods. The effectiveness of the sales effort in each territory or for each product must be subjected to review by management. Control relates to every classification in the balance sheet or statement of financial position and to each item in the statement of income and expense. In short, accounting/statistical control extends to all activities of the business. The accounting system that includes the accounting controls when integrated with the operating controls provides a powerful tool for management to plan and direct the performance of the business enterprise. Statistical control also may relate to the nonfinancial quantitative measurement of any business functions and their effect, for example, customer satisfaction, development time for new products, cycle time from receipt of customer order to delivery of product.

17.3 NEED FOR STANDARDS As industry has developed, grown, and become more complex, the need for increased efficiency and productivity has become more imperative. The successful executives developed more effective means of regulating and controlling the activities. It is no longer sufficient just to know the cost to manufacture or sell. There is a real need to know if we are using the most economical manufacturing techniques and processes. The distribution and selling costs must be evaluated and measured against some predetermined factors. Performance measurement should be applied to all activities. It is essential that a yardstick of desirable or planned results be established against which actual

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results may be compared if the performance measurement is to be effective. It is natural to compare current performance with historical performance such as last month, last quarter, or last year. Such a comparison points out trends, but it also serves to perpetuate inefficiencies. This comparison only serves a useful purpose if the measuring stick or past performance represents effective and efficient performance. Furthermore, changes in technologies, price levels, manufacturing processes, and the relative volume of production tend to limit the value of historical costs in determining what current costs should be. There certainly is a compelling need for something other than historical costs for the standard of performance. For planning and pricing, management needs cost information that is not distorted by defective material, poor worker performance, or other unusual characteristics. Scientific management recognizes the value and need for some kind of engineering standards to plan manufacturing operations and evaluate the effectiveness with which the objectives are being accomplished. Engineering standards, expressed in financial terms, become cost standards; these standards, based on careful study and analysis about what it should cost to perform the operations by the best methods, become a much more reliable yardstick with which to measure and control costs. Standards are the foundation and basis of effective accounting control. Standards provide the management tools with which to measure and judge performance. The use of standards is as adaptable to the control of income or expense as to the control of assets or liabilities. Standards are applicable to all phases of business and are an extremely important management tool.

17.4 DEFINITION OF STANDARDS A standard of any type is a measuring stick or the means by which something else is judged. The standard method of doing anything can usually be described as the best method devised, as far as humanly possible, at the time the standard is set. It follows that the standard cost is the amount that should be expended under normal operating conditions. It is a predetermined cost scientifically determined in advance, in contrast to an actual or historical cost. It is not an actual or average cost, although past experience may be a factor in setting the standard. Since a standard has been defined as a scientifically developed measure of performance, it follows that at least two conditions are implied in setting the standard: 1. Standards are the result of careful investigation or analysis of past performance and take into consideration expected future conditions. They are not mere guesses; they are the opinions, based on available facts, of the people best qualified to judge what performance should be. 2. Standards may need review and revision from time to time. A standard is set on the basis of certain conditions. As these conditions change, the standard must change; otherwise, it would not be a true measuring stick. Where there is really effective teamwork, and particularly, where standards are related to incentive payments, the probability of change is great. Most of the foregoing comments on standards relate to that phase of the definition on which there is general agreement. There are, however, differences of opinion that seem to relate principally to the following points: • Whether a standard should be (1) a current standard, that is, one that reflects what performance should be in the period for which the standard is to be used, or (2) a basic standard, which serves merely as a point of reference. • The level at which a standard should be set — an ideal level of accomplishment, a normal level, or the expected level. Where standard costs are carried into the formal records and financial statements, the current standard is generally the one used. Reference to the variances immediately indicates the extent to which actual costs departed from what they should have been in the period. A basic standard, however, does not indicate what performance should have been. Instead, it is somewhat like the base on which a price index is figured. Basic standards are usually based on prices and production levels

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prevailing when the standards are set. Once established, they are permanent and remain unchanged until the manufacturing processes change. They are a stationary basis of measurement. Improvement or lack of improvement involves the comparison of ratios or percentages of actual to the base standard. The level at which standards should be set is discussed later in this chapter under the subject of standards for cost control.

17.5 ADVANTAGES OF STANDARDS It has already been mentioned that standards arose, as part of the scientific management movement, from the necessity of better control of manufacturing costs. The relationship between this need and the advantages of standards is close. However, the benefits from the use of standards extend beyond the relationship with cost control to all the other applications, such as price setting or inventory valuation. Therefore, it may be well to summarize the principal advantages of standards, and the related scientific methods, by the four primary functions in which they are used: 1. Controlling costs
Standards provide a better measuring stick of performance. The use of standards sets out the area of excessive cost that otherwise might not be known or realized. Without scientifically set standards, cost comparison is limited to other periods that in themselves may contain inefficiencies.
Use of the “principle of exception” is permitted, with the consequent saving of much time. It is not necessary to review and report on all operations but only those that depart significantly from standard. The attention of management may be focused on those spots requiring corrective action.
Economies in accounting costs are possible. Clerical costs may be reduced because fewer records are necessary and simplified procedures may be adopted. Many of the detailed subsidiary records, such as production orders or time reports, are not necessary. Again, if inventories are carried as a standard value, there is no need to calculate actual costs each time new lots are made or received. Still further, much of the data for month-end closing can be set up in advance with a reduction in peak-load work.
A prompter reporting of cost control information is possible. Through the use of simplified records and procedures and the application of the exception principle, less time is required to secure the necessary information.
Standards serve as incentives to personnel. With a fair goal, an employee will tend to work more efficiently with the consequent reduction in cost. This applies to executives, supervisors, and workers alike. 2. Setting selling prices
Better cost information is available as a basis for setting prices. Through the use of predetermined standards, costs are secured that are free from abnormal distortions caused by excess spoilage and other unusual conditions. Furthermore, the use of standard overhead rates eliminates the influence of current activity. A means is provided to secure, over the long run, a full recovery of overhead expenses, including marketing, administrative, and research expense.
Flexibility is added to selling price data. Through the use of predetermined rates, changes in the product or processes can be quickly reflected in the cost. Furthermore, adjustments to material prices or labor rates are easily made. Again, the use of standards requires a distinction between fixed and variable costs. This cost information permits cost calculations on different bases. Since pricing is sometimes a matter of selection of alternatives, this flexibility is essential.
Prompter pricing data can be furnished. Again, the use of predetermined rates permits the securing of information more quickly.

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3. Valuing inventories
A “better” cost is secured. Here, too, as in pricing applications, a more reliable cost is secured. The effect of idle capacity, or of abnormal wastes or inefficiencies, is eliminated.
Simplicity in valuing inventories is obtained. All like products are valued at the same cost. This not only assists in the recurring monthly closings but also is an added advantage in pricing the annual physical inventory. 4. Budgetary planning
Determination of total standard costs is facilitated. The standard unit costs provide the basic data for converting the sales and production schedules into total costs. The unit costs can readily be translated into total costs for any volume or mixture of product by simple multiplication. Without standards, extensive analysis is necessary to secure the required information because of the inclusion of nonrecurring costs.
The means is provided for setting out anticipated substandard performance. A history of the variances is available, together with the causes. Since actual costs cannot be kept exactly in line with standard costs, this record provides the basis for forecasting the variances that can reasonably be expected in the budget period under discussion. This segregation permits a determination of realistic operating results without losing sight of unfavorable expected costs.

17.6 RELATIONSHIP OF ENTITY GOALS TO PERFORMANCE STANDARDS Much of the discussion in this chapter relates to detailed performance measures or standards. However, prior to any review of such standards, a key relationship to certain company goals or broad financial standards should be emphasized. Some of the overall financial goals for a business, as outlined in Chapter 6, include (1) measures of profitability, such as return on shareholder equity, return on assets, return on sales; (2) measures of growth, such as increase in sales, increase in net income, and increase in earnings per share; and (3) cash flow measures, including aggregate operating cash flow or free cash flow. But is there, or should there be, any relationship between such overall goals, which are a type of standard, and more specific performance measures, such as the direct labor hour standard in cost center 21 for manufacturing product A? A business usually has goals or objectives as well as strategies for reaching them. It is only logical, therefore, that the goals or standards of a cost center, or factory, or function or division, support the entity goals. The hierarchy of goals, or performance measures or standards, may be pictured as a pyramid. (see Exhibit 17.1.) In examining performance measures, beginning at the top of the pyramid (company goals) and moving down the structure, these characteristics exist (although not all are identified): • Performance measures usually become narrower and more specific. • The planning horizon becomes shorter. • In the lower levels, cost factors tend to dominate more; and the measurement or activity period shortens considerably from years to months, days, or even hours. Performance measures at the lower levels should be expressed in terms of what an individual employee can do. For example, an accounts payable clerk might have as a standard the number of invoices processed per day or the number of cash discounts taken (or lost). This activity level performance cannot be directly measured against a percent return on assets goal. As the standards are expressed in terms of smaller, specific tasks, the time span between assigning the task, accomplishing the task, and rewarding the employee should grow shorter. Care should be taken that objectives at the lower levels are not contradictory. For example, encouraging higher throughput should not be at the expense of causing excess inventories in another department. A given individual, cost center, or department should not be overpowered by having to meet too many different standards. Standards should be current; that is, they should relate to the

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Achieve a 20% return on equity by 20XX. Enhance shareholder value by 5% each year, over 5 years. Attain a 10% return on assets. Reach agreed-on profit levels. Gain 2% market share. Achieve market dominance. Expand profitably in another country. Reduce new product development time to 6 months. Increase on-time deliveries to 97%.

Company

Group Meet annual budget. Achieve quality goals. Integrate electronic data system. Division

Achieve quality goals. Complete just-in-time inventory system. Meet target quantity goals.

Function

Achieve output target on all products. Reduce scrap by 5%. Meet daily labor standards.

Factory

Cost Center E XHIBIT 17.1

H IERARCHY

OF

P ERFORMANCE M EASURES

processes or methods in use — not obsolete ones. They should be updated minimally each year, ideally, each quarter. Formulating consistent standards that move the company objective forward takes a great deal of thought and time and is a management task of great importance.

17.7 TYPES OF STANDARDS NEEDED (a) STANDARDS FOR ALL BUSINESS ACTIVITY. Managerial control extends to all business functions including selling, production, finance, and research. It would appear highly desirable, therefore, to have available standards for measuring effort and results in all these activities. The word standard in much of the accounting literature applies to manufacturing costs. But the fact remains that the principles underlying the development of standards can and should be applied to many nonmanufacturing functions. Business executives generally do not question the need or desirability of standards for the control of administrative, distribution, and financial activities; they do, however, recognize the difficulties involved. Some activities are more susceptible to measurement than others, but application of some standard is generally possible. Moreover, as business processes change, some performance standards will increase in importance, while others will decrease, for example, the use of a labor standard in which “direct” labor is less crucial and will be combined with related service support labor standards such as inspection or quality control.

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(b) STANDARDS FOR INDIVIDUAL PERFORMANCE. Costs are controlled by people. It is through the action of an individual or group of individuals that costs are corrected or reduced to an acceptable level. It is by the efforts of the individual salesperson that the necessary sales volume is secured. It is largely through the operational control of the departmental foreperson that labor efficiency is maintained. As a result, any standards, to be most effective, must relate to specific phases of performance rather than merely general results. In a manufacturing operation, for example, standards should relate to the quantity of labor, material, or overhead in the execution of a particular operation rather than the complete product cost standard. In the selling field, a sales quota must be set for the individual salesperson, perhaps by product, and not just for the branch or territory. Thus the setting of standards and measurement of performance against such yardsticks fit into the scheme of “responsibility accounting.” Keeping in mind these general comments, specific types of standards can now be examined. In addition to the remarks in this chapter, further observations are made in some of the chapters in which the relevant function is reviewed. (c) MATERIAL QUANTITY STANDARDS. In producing an article, one of the most obvious cost factors is the quantity of material used. Quantitative standards, based on engineering specifications, outline the kind and quantity of material that should be used to make the product. This measuring stick is the primary basis for material cost control. This quantity standard, when multiplied by the unit material price standard, results in the cost standard. When more than one type of material is involved, the sum of the individual material cost standards equals the total standard material cost of the product. (d) MATERIAL PRICE STANDARDS. To isolate cost variances arising out of excess material usage from those arising because of price changes, it is necessary to establish a material price standard. Usually, this price standard represents the expected cost instead of a desired or “efficient” cost. In many companies, this price is set for a period of a year, and, although actual cost may fluctuate, these changes are not reflected in the standard unit cost of material used. In other words, every piece of material used is charged with this predetermined cost. (e) LABOR QUANTITY STANDARDS. The labor content of many products is the most costly element. But whether it is the most costly or not, it is usually important. Because we are dealing with the human element, the labor cost is one of the most variable. It is indeed a fertile field for cost reduction and cost control. For these reasons, it is necessary to know the amount of labor needed to produce the article. The technique, determining the time needed to complete each operation when working under standard conditions, involves time and motion study. (f) LABOR RATE STANDARDS. The price of labor is generally determined by factors outside the complete control of the individual business, perhaps as a result of union negotiations or the prevailing rate in the area. In any event, it is desirable to have a fixed labor rate on each operation to be able to isolate high costs resulting from the use of an excess quantity of labor. Also, the utilization of labor within a plant is within the control of management, and some rate variances arise due to actions controllable by management. Examples are the assignment of the wrong people (too high a rate) to the job or the use of overtime. The standard time required, when multiplied by the standard rate, gives the standard labor cost of the operation. (g) MANUFACTURING OVERHEAD EXPENSE STANDARDS. One of the many problems most controllers must resolve is that of determining standards for the control of manufacturing overhead as well as absorption into inventory. The determination of these standards is somewhat more complicated than in the material or labor standards. Several conditions complicate their determinization:

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• Manufacturing overhead consists of a great variety of expenses, each of which reacts in a different fashion at varying levels of plant activity. Some costs, such as depreciation, remain largely independent of plant activity; others vary with changes in production, but not in direct proportion. Examples are supervisory labor, maintenance, and clerical expense. Still other overhead expense varies directly with, and proportionately to, plant volume. This may include certain supplies, indirect labor, and fuel expense. • Control of overhead expenses rests with a large number of individuals in the organization. For example, the chief maintenance engineer may be responsible for maintenance costs, the factory accountant for factory clerical costs, and foremen in productive departments for indirect labor. • The proper estimate of the rate and amount of production must be made to serve as the basis of setting standard rates. An improper level of activity not only affects the statement of income and expense, but also gives management an erroneous picture of the cost of an insufficient volume of business and distorts inventory values. Overhead expenses are best controlled through the use of a flexible budget. It requires a segregation of fixed and variable expenses. Proper analysis and control permit a realistic look at overhead variances in terms of cause: (1) volume, (2) rate of expenditure, and (3) efficiency. Standards for manufacturing overhead can be expressed in the total amount budgeted by each type of expense as well as unit standards for each item, such as power cost per operating hour or supplies per employee-hour. Such standards should reflect the impact of just-in-time (JIT) production techniques as well as the “cost drivers” (see Chapter 21). (h) SALES STANDARDS. Sales standards may be set for the purpose of controlling and measuring the effectiveness of the sales or marketing operations. They also may be used for incentive awards, stimulating sales efforts, or the reallocation of sales resources. The most common form of standard for a territory, branch, or salesperson is the sales quota, usually expressed as a dollar of physical volume. Other types of standards found useful in managing and directing sales effort are: • Number of total customers to be retained • Number of new customers to be secured • Number of personal calls to be made per period • Number of telephone contacts to be made per period • Average size of order to be secured • Amount of gross profit to be obtained (i) DISTRIBUTION COST STANDARDS. Just as production standards have been found useful in controlling manufacturing costs, so an increasing number of companies are finding that distribution cost standards are a valuable aid in properly directing the selling effort. The extent of application and degree of completeness of distribution cost standards will differ from production standards, but the potential benefits from the use of such standards are equally important. Some general standards can be used in measuring the distribution effort and results. However, more effective standards are those measuring individual performance. Some illustrative standards are: • Selling expense per unit sold • Selling expense as a percentage of net sales • Cost per account sold • Cost per call • Cost per day • Cost per mile of travel • Cost per sales order

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In addition to individual performance standards, another type of control relates to budgets for selling expenses. The procedure for setting budgets is similar to that used for manufacturing operations. (j) ADMINISTRATIVE EXPENSE STANDARDS. As business expands and volume increases, there is a tendency for administrative expenses to increase proportionately and get out of line. The same need for control exists for these types of expenses as for manufacturing or production costs. Control can be exercised through departmental or responsibility budgets as well as through unit or individual performance standards. The general approach to control administrative expenses is essentially the same as for control of selling and manufacturing expenses. It is necessary to develop an appropriate standard for each function or operation to be measured. Examples of types of standards to be considered are: Function

Standard Unit of Measurement

Purchasing Billing Personnel Traffic Payroll Clerical

Cost per purchase order Cost per invoice rendered Cost per employee hired Cost per shipment Cost per employee Cost per item handled (filed)

(k) FINANCIAL RATIOS. The types of standards discussed to this point relate primarily to human performance associated with elements of the statement of income and expense—sales revenues, cost factors, and expense categories of several types. Yet another category of standards deals with the utilization of assets or shareholders’ equity, or the liquidity of the entity. These measures relating to financial condition and profitability rates are of special interest to the financial executives in testing business plans and the financial health of the enterprise. Chapter 6 dealt in some detail with many financial and operating ratios, but a short list of some of the more important measures includes: • Current ratio • Quick ratio • Ratio of net sales to receivables • Turnover of inventory • Turnover of current assets • Ratio of net sales to working capital • Ratio of net sales to assets • Return on assets • Return on shareholders’ equity • Other profitability ratios:
Ratio of net income to sales
Gross margin percentage Generally speaking, the standards for these financial ratios may be developed from several sources: • Ratios accepted by the industry of which the company is a member, perhaps developed by the industry association • Ratios ascertained from the published financial statements of the principal competitors of the entity, or industry leaders • Ratios developed by computer modeling • Ratios based on the past (and best) experience of the company or on the opinions of its officers

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17.8 TREND TO MORE COMPREHENSIVE PERFORMANCE MEASURES The majority of the standards described relate to very specific activities and are largely cost standards (labor cost per unit). Additionally, some relate to number or size of functions performed (number of sales calls made), or financial relationships. It is common practice in U.S. companies to compare hourly, daily, weekly, or monthly actual performance with such a standard, or a budget, or prior experience. Such comparisons with the relevant internal activity of a prior period or calculated proper measure are useful. Managements are discovering that other types of measures may be helpful for a number of reasons: • Some non–cost-related measures can highlight functional areas that need improvement, for example, number of new customers, number of customer complaints, product development time. • For some activities, comparisons with an external standard, such as industry average or performance of a principal competitor, may provide useful guidelines. Examples include inventory turnover and research and development expenditures. • Quantified standards may cause supervisors to focus attention on the wrong objective. For instance, attention to the average size of sales orders may take attention away from the need for a profitable product mix. • On occasion, emphasis on output can create problems in, or transfer problems to, other departments (defects, excessive inventory, or wrong mix of parts). • Some standards may conflict with other management efforts, such as attempting to reduce indirect manufacturing expense as related to direct labor, when the overall trend is to automation. In the search for a broader base than accounting or financial standards to check or measure company performance, the controller, perhaps in collaboration with other functional executives, could take these actions: • Discuss with management members the critical success factors of the company, suspected areas of weaker performance, and what changes might be examined. • Review existing performance measures and try to ascertain whether they are relevant to the newer techniques or processes (JIT purchasing, delivery and manufacturing). • Seek to determine if the measures relate to the true cost drivers of the function under review. • Update practices, using the current literature or periodicals for possible leads to examine. • Talk with controllers, line managers, or workers, in other companies about the performance measures and other guides they use. • Consider hiring outside consultants to review areas of suspected weaknesses and to make recommendations. Such a review might lead to a starting list of (1) cost measures and (2) noncost performance measures for important internal activity checking (based on trends and relative internal importance, and relative cost and noncost measures when examined or compared to external factors). A sample outline of what could be measured is: 1. Internal Factors (a) Cost Measures Direct labor costs Direct material costs Manufacturing expense Marketing expense Research and development (R&D) costs Delivery costs Inventory carrying costs Accounts receivable carrying costs

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(b) Noncost Measures Length of design cycle Number of engineering changes Number of new products Manufacturing cycle time Number of parts/raw material deliveries Number of on-time customer deliveries Number of suppliers Number of parts 2. External Factors (Relative Measurement) (a) Cost Measures Relative R&D expense Relative material content cost Relative labor cost content Relative delivery expense Relative selling expenses (a) TIME-BASED STANDARDS. One group of standards receiving attention are time-based measures. Management which uses these diagnostic tools believes that time analysis is more useful than simple cost analysis because activity review identifies exactly what occurs every hour of the working day. It seems to encourage such time-oriented questions as: Why are the two tasks done serially and not in parallel? Why is the process speeded up in some departments only to then let the product lie idle? When points of time are identified, then related cost reduction possibilities can be examined. Examples of time-based standards that have been found useful in four key functions include: 1. Decision-making process: Time lost in waiting for a decision
Product development
Manufacturing
Marketing
Finance (accounting) 2. New product development
Total time required from inception of idea to marketing of product
Number of times (or percent) company has beat a competitor to market
Number of new products marketed in a given time period 3. Manufacturing or processing
Cycle time from commencement of manufacture through billing process
Inventory turnover
Total elapsed time from product development to first time acceptable output
Value added per factory hour
Credit approval time
Billing cycle time—from receipt of shipping notice to completion of invoice preparation
Collection time—from mailing of invoice to receipt of payment 4. Customer service
Number (or percent) of on-time deliveries
Response time to customer questions

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Quoted lead time for shipment of spare parts, repairs, and product delivery
Delivery response time

17.9 BENCHMARKING The practice by a company of measuring products, services, and business practices against the toughest competitor or those companies best in its class, or against other measures, has been named “benchmarking.” Technically, those who consult about the process differentiate between three kinds, depending on the consultant. Distinctions are made about these three types: 1. Competitive benchmarking 2. Noncompetitive benchmarking 3. Internal benchmarking Competitive benchmarking studies compare a company’s performance with respect to customer-determined notions of quality against direct competitors. Noncompetitive benchmarking refers to studying the “best-in-class” in a specific business function. For example, it might encompass the billing practices of a company in a completely different industry. Internal benchmarking can refer to comparisons between plants, departments, or product lines within the same organization. The benchmarking studies involve steps such as: 1. 2. 3. 4. 5. 6. 7.

Determining which functions within the company to benchmark Selecting or identifying the key performance variables that should be measured Determining which companies are the best-in-class for the function under review Measuring the performance of the best-in-class companies Measuring the performance of the company as to the function under study Determining those actions necessary to meet and surpass the best-in-class company Implementing and monitoring the improvement program

Although benchmarking has produced some legendary corporate successes, it often has not produced an improvement on the net income line. In part, this reflects the fact that it is a complicated process and does not consist merely of some random observations of different methods used by some businesses, or some short field trips. A successful benchmarking effort must be undertaken in a clearly defined and systematic manner. A benchmarking study wherein the only product or result is a report to management, with no modification of a substandard activity, could be regarded as a failure. To put the topic of benchmarking in the proper perspective, it should be recognized that successful benchmarking efforts have addressed a wide variety of issues, including: • Increased market share • Improved corporate strategy • Increased profitability • Streamlined processes • Reduced costs • More effective R&D activities • Improved quality • Higher levels of customer satisfaction In those instances when benchmarking activity has not met expectations, some of the reasons include: • Top management did not comprehend the full potential of the proposed changes and consequently did not push aggressively for their adoption.

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• The functions or activities selected for improvement may in fact have been improved, but the greater efficiency was too small to have a meaningful impact on overall business performance. • The study team made observations but failed to develop an actionable plan. • In some instances, the analysis was incomplete: the study team learned what the best-in-class companies were doing, but it did not learn how the actions were implemented. Another facet of benchmarking that should be noted is the makeup of the study team. It should include people in the company who have been performing the function. Those selected should be highly knowledgeable about the function, should be good communicators, and should be curious and highly analytical. It probably is preferable to have consultants, not company employees, make contacts with competitors. In some circumstances, the presence of a member of the board of directors might be the means of better communicating to the board the complexities and potential impact of the study. In summary, benchmarking is a complicated process, and full preparation should be made.

17.10 BALANCED SYSTEM OF PERFORMANCE MEASURES Performance measures range from broad company standards to detailed functional standards applied to a daily departmental manufacturing activity. Moreover, many of these standards are used for both planning and control purposes. Then, too, some are cost-related and others are noncost measures; some address the important subject of customer satisfaction, and others simple efficiency; and finally, some deal with innovation while others emphasize routine operations. Many years ago, the use of one type of standard (generally cost type) for control purposes was the point of emphasis. Since that time, management has recognized that it cannot rely on one set of measures to the exclusion of all others. Rather, a combination of measures are necessary that must properly relate to each other and take into account the critical success factors of the enterprise. This is to say that management needs a balanced set of performance measures. The article by Kaplan and Norton mentions a company that grouped its performance measures into four types, each with separate measures of performance, and each critical to the future success of the entity.1 The four measurement groups discussed, together with some added goals and measures of individual performance mentioned earlier in this chapter follow.

Financial Perspective Goals

Measures

Customer Perspective Goals

Measures

Survive

Cash flow

New products

Succeed

Sales and income growth Return on equity

Customer supply

Prosper

Preferred supplier

Internal Business Perspective Goals Manufacturing excellence New product introduction

Measures

Percentage of sales from new products Number of on-time deliveries Share of key account purchases

Innovation Perspective Goals

Measures

Unit cost cycle time

Time to market

Versus competition

Actual vs. planned introduction schedule

Technology leadership

Time to develop new process

1. Kaplan, Robert S., and David P. Norton, “The Balanced Scorecard — Measures That Drive Performance,” Harvard Business Review, Jan. – Feb. 1992, pp. 71–79.

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17.11 SETTING THE STANDARDS (a) WHO SHOULD SET THE STANDARDS? Standards should be set by those who are best qualified by training and experience to judge what good performance should be. It is often a joint process requiring cooperation between the staffs of two or more divisions of the business. Fundamentally, the setting of standards requires careful study and analysis. The controller and staff, trained in analysis and possessing essential records on the various activities, are in an excellent position to play an important part in the establishment of yardsticks of performance. Since standards are yardsticks of performance, they should not be set by those whose performance is to be measured. Sufficient independence of thought should exist. The standards should be reviewed with those who will be judged by them and any suggestions considered. However, final authority in establishing the standard should be placed in other hands. Exactly which staff members cooperate in setting standards depends on the standards under consideration. Material quantity standards, for example, are generally determined by the engineers who are familiar with the operation methods employed as well as the product design. Assisting the engineers may be the production staff and the accounting staff. The production people can make valuable contributions because of their knowledge of the process. Furthermore, permitting the production staff to assist usually enlists their cooperation in making the standards effective. The accounting department assists by providing necessary information on past experience. The determination of material price standards is usually the responsibility of both the purchasing and accounting departments. The purchasing department may indicate what expected prices are. These should then be challenged by the accounting department, taking into account current prices and reasonably expected changes. In other instances, the accounting department sets the standards, based again on current prices, but takes into consideration the opinion of the purchasing department about future trends. Quantitative labor standards are usually set by industrial engineers through the use of time and motion study. This is properly an engineering function in that a thorough background of the processes is necessary. On occasion, the accounting department furnishes information of past performance as a guide. Standard labor rates are set by the department that has available the detailed job rates and other necessary information, typically the cost department. The cost department must also translate the physical standards into cost standards. Manufacturing overhead standards, too, are often a matter of cooperation between the accounting and engineering departments. Engineers may be called on to furnish technical data, such as power consumption in a particular department, or maintenance required, or type of supplies necessary. However, this data is then costed by the accounting staff. In other instances, the unit standards or budgets may be set in large part on past experience. The role played by the accountant tends to be much greater in the establishment of overhead standards due to the familiarity with the techniques of organizing the data into their most useful form for cost and budget reporting. Setting the standards for distribution activities is best done through the cooperation of sales, sales research, and accounting executives. Reliance is placed on the sales staff for supplying information pertaining to market potentials and sales methods. The accountant contributes the analysis and interpretation of past performance, trends, and relationships. The sales and accounting executives jointly must interpret the available data as applied to future activity. Unit standards for the measurement of administrative expenses are usually determined on the basis of time and motion study by industrial engineers, observation of the functions, or a detailed analysis of past performance to ensure that standards reflect the norm. In many instances, the accountant is involved in either costing the data or analyzing past experience. Financial and operating ratios should be set by the controller based on the objectives for the company, experience in the particular company or industry, and special analysis or consideration of factors that have a significant influence on the ratio or external sources. In many instances, it may be desirable to have the assistance of independent consultants. For example, when sources outside the company are to be contacted, as in “benchmarking,” these noncompany personnel may be especially helpful.

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(b) METHOD OF SETTING STANDARDS. Those aspects of setting standards that are beyond the sphere of accounting responsibility are adequately covered in various management and engineering literature. Only the general steps taken in the establishment of standards will be considered here. Any outline of procedure regarding standards is basically only the application of logic and prudent judgment to the problem. The eight phases involved in the setting of standards are summarized below: 1. Recognition of the need for a standard in the particular application. Obviously, before action is taken, the need should exist. This need must be acknowledged so that the problem can be attacked. 2. Preliminary observation and analysis. This involves “getting the feel” of the subject, recognizing the scope of the problem, and securing a general understanding of the factors involved. 3. Segregation of the function, or activity, and/or costs in terms of individual responsibility. Since standards are to control individual actions, the outer limits of the responsibility of each individual must be ascertained in the particular application. 4. Determination of the unit of measurement in which the standard should be expressed. To arrive at the quotient, the divisor is necessary. And in many applications, the base selected can be one of many. 5. Determination of the best method. This may involve time and motion study, a thorough review of possible materials, or an analysis of past experience. It must also involve consideration of possible changes in conditions. 6. Statement or expression of the standard. When the best method and the unit of measurement have been determined, the tentative standard can be set. 7. Testing of the standard. After analysis and synthesis and preliminary determination, the standard must be tested to see that it meets the requirements. 8. Final application of the standard. The testing of a standard will often result in certain compromises or changes. When this has been effected, when the best judgment of all the executives concerned has been secured, then and only then can the standard be considered set and ready to be applied.

17.12 USE OF STANDARDS FOR CONTROL The fact that management has set standards for cost control by no means assures control of costs. It takes positive action by individuals to keep costs within some predetermined limits. It is a management challenge to communicate the value of standards to all concerned and convince them how the yardsticks can be utilized in accomplishing the goals and objectives. To be effective it must be demonstrated that the standards are fair and reasonable. The controller must have sufficient facts to illustrate the reasonableness of the standards when questions arise or the yardsticks are considered unfair. When standards are shown clearly to be unreasonable, the controller must be prepared to gather new data and make appropriate adjustments. (a) TECHNIQUE OF COST CONTROL. In the final analysis, the objective of cost control is to secure the greatest amount of production or results of a desired quality from a given amount of material, manpower, effort, or facilities. It is the securing of the best result at the lowest possible cost under existing conditions. In this control of performance, the first step is the setting of standards of comparison; the next step is the recording of actual performance, and the third step is the comparing of actual and standard costs as the work progresses. This last step involves: • Determining the variance between standard and actual • Analyzing the cause of the variance

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• Taking remedial action to bring unfavorable actual costs in line with the predetermined standards Control is established through prompt follow-up, before the unfavorable trends or tendencies develop into large losses. It is important that any variances be determined quickly, and it is equally important that the unfavorable variance be stated in terms that those responsible will understand. The speed and method of presentation have a profound bearing on the corrective action that will be taken and, hence, on the effectiveness of control. (b) ROLE OF STATISTICAL PROCESS CONTROL. One approach to cost control is to determine the variance between a standard and actual performance, seek out the cause of the variance, and take remedial action. Yet global competition is causing management to adopt more sophisticated strategies to remain or become competitive. Among these devices are automatic JIT, total quality management (TQM), and statistical process control (SPC). This latter technique can assist in properly setting standards and in better evaluating or interpreting variances. SPC is based on the assumption that process performance is dynamic, that variation is the rule. Consequently, proper assessment of performance requires correct interpretation of the variation over a period of time. Charts or graphic aids are used in SPC to understand and reduce the fluctuations in processes until they are considered stable (under control). A stable process would have only the normal variances. On the other hand, an unstable process is subject to uncommon fluctuations resulting from special causes. The performance of a stable process can be improved only by making fundamental changes in the process itself, while an unstable production process can be stabilized only by locating and eliminating the special causes. The statistical approach assists in identifying the character of the variance. An incorrect decision that a process is operating in an unstable manner may result in costs from searching for special causes of process variation that do not exist. An incorrect decision that a process is operating in a stable manner will result in failure to search for special causes that do exist. Suffice it to say that SPC is a complex subject that seeks to provide long-term solutions. Someone with a high level of statistical knowledge ordinarily will be needed to assist in implementing the strategy. Management accountants should understand the SPC approach. (c) WHO SHOULD CONTROL COSTS? Costs must be controlled by individuals, and the question is raised about who should control costs, the controller representing accounting personnel or the operating executive in charge of the activity (manufacturing sales or research) to be cost controlled. It has already been explained that operational control preceded accounting control. In many thousands of small businesses, operating control is the only type used. Cost control is not primarily an accounting process, although accounting plays an important part. Control of costs is an operating function. The controller, in the capacity of an operating executive, may control costs within the accounting department. Beyond this, the function of the controller is to report the facts on other activities of the business so that corrective action may be taken and to inform management of its effectiveness in cost control. The part played by the controller is advisory or facilitative in nature. In many instances, the development of the standards to be used in measuring performance is largely the work of nonaccountants, whether product specifications, operational methods, time requirements, or other standards. Likewise, decision about the corrective action to be taken is generally up to the operating personnel. However, the controller is in an excellent position to stimulate and guide the interest of management in the control of costs through the means of reports analyzing unusual conditions. The controller’s work is usually confined to summarizing basic information, analyzing results, and preparing intelligently conceived reports. It follows that the controller must produce reports that a non–accounting-trained executive or operator can understand and will act on. To do this requires being thoroughly conversant with the operating problems and viewpoints. The effectiveness of any cost control system depends on the degree of coordination between the accounting control personnel and the operating personnel. One presents the facts in an understandable manner; the other takes the remedial action.

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Cooperation at all levels is essential in the control of costs. Cooperation is secured, in part, through the application of correct management policies. The use of standards, when fully understood, should be of great assistance in securing this cooperation, for the measuring stick is based on careful analysis and not preconceived ideas or rule-of-thumb methods. (d) LEVEL OF THE STANDARD. Because one of the primary purposes of a standard is as a control tool—to see that performance is held to what it should be—it is necessary to determine at what level the standard should be set. Just how “tight” should a standard be? Although there is no clear-cut line of demarcation among them, the three following levels may be distinguished: 1. The ideal standard 2. The average of past performance 3. The attainable good performance standard The ideal standard is the one representing the best performance that can be attained under the most favorable conditions possible. It is not a standard that is expected to be attained but rather a goal toward which to strive in an attempt to improve efficiency. Hence variances are always unfavorable and represent the inability to reach the ideal level of efficiency. The use of an unattainably tight standard confuses the objectives of cost reduction and cost control. Cost reduction involves the finding of ways and means to achieve a given result through improved design, better methods, new layouts, new equipment, better plant layout, and so forth, and therefore results in the establishment of new standards. If the standards set are more restrictive than currently attainable performance, the lower cost will not necessarily be achieved until cost reduction has found the means by which the standard may be attained. Ideal standards, then, are not highly desirable as a means of cost control. Standards are frequently set on the basis of what was done in the past, without adjustments to reflect improved methods or elimination of wastes. A standard set on this basis is likewise a poor measuring stick in that it can be met by poor performance. Hence the very inefficiencies that standards should disclose are obscured by the loose standard. A third level at which a standard may be set is the attainable level of good performance. This standard includes waste or spoilage, lost time, and other inefficiencies only to the extent that they are considered impractical of elimination. This type of standard can be met or bettered by efficient performance. It is a standard set at a high level but is attainable with reasonably diligent effort. Such a standard would seem to be the most effective for cost control purposes. (e) POINT OF CONTROL. Costs are controlled by individuals, so it follows that the accounting classifications must reflect both standard and actual performance in such a manner that individual performance can be measured. As stated previously, “responsibility accounting” must be adopted. Provision must be made for the accumulation of costs, by cost centers, cost pools, or departments, that follows organizational structure. Furthermore, this cost accumulation must initially reflect only those costs that are direct as to the specific function being measured. Allocations and reallocations may be made for product cost determination and for certain other planning applications, but this is not desirable for cost control. If a great many prorations are made, it is often difficult to determine where the inefficiency exists or the extent of it. Therefore, it is desirable from a cost control standpoint to collect the costs at the point of incurrence. If, as in some companies, allocated costs are reflected in control reports, it is desirable to separate them from direct expenses or costs. Some companies show allocated costs so that the department manager will be aware of the cost of the facilities or services they use. Discussion of the point of control of costs involves, in addition to placement of responsibility, the matter of timing. Costs must be controlled not only at the point of incurrence but also, preferably, at or before the time of incurrence. Thus, if a department on a budget basis processes a purchase requisition and is advised at that time of the excess cost over budget, perhaps action can be taken then—either delaying the expenditure until the following month or getting a less expensive yet satisfactory substitute. Again, material control is best exercised at the point of issuance. Only

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the standard quantity should be issued. In the case of purchases, the price and type are best controlled at the time of purchase. (f) WHAT COSTS SHOULD HAVE STANDARDS? From the viewpoint of standards for cost control, a question may be raised about the extent to which attempts should be made to set standards. Factors to be considered include the relative amount of cost and the degree of control possible over the cost. It may be stated that standards should be set for all cost items of a significant or material amount. In many cases, the more important the cost, the greater is the opportunity or need for cost control. With such items as overhead, it may be necessary to combine certain elements but, so far as practicable, a standard should be set to measure performance. Another factor to be considered is the degree of control possible, needed, or desired over the cost. At first, it might appear that little control can be exercised over some types of cost, such as depreciation, salaries of key personnel, or personal property taxes. However, the fact is that most costs can be controlled by someone. The time and place and method of control of costs generally considered as “fixed” may differ from the control of material, direct labor, or variable overhead expense, but a certain degree of control is possible. Control of the fixed charges may be exercised in at least two ways: 1. By limiting the expenditure to a predetermined amount. For example, depreciation charges are controlled through the acquisition of plant and equipment. Any control must be exercised at the time of purchase or construction of the asset. This is usually done by means of an appropriation budget, which is a type of standard. A similar plan can be applied to the group of salaried personnel generally considered as a part of the fixed charges. In many instances, control of this type of expense or expenditure is a top-management decision. It may be observed, however, that control at this high level does exist. 2. By securing the proper utilization of the facilities and organization represented by the fixed charges. The controller can assist in this task by properly isolating the volume costs or cost of idle equipment. An acceptable standard might be the percent of plant utilization as related to “normal.” In the monthly statement of income and expense, the lack of volume costs should be set out as part of the effort to direct management’s attention to the excess costs and to a consideration of ways and means of reducing personnel, if necessary, or increasing volume through other products, intensified sales activity, and so on.

17.13 PROCEDURE FOR REVISING STANDARDS (a) REVISION OF STANDARDS. Whether standards are used for cost control or the related function of budgetary planning or whether standards are for the purpose of price setting or inventory valuation, they must be kept up to date to be most useful. From a manufacturing operations viewpoint, revision appears desirable when important changes are made in material specifications or prices, methods of production, or labor efficiency or price. Changes in the methods or channels of distribution and basic organizational or functional changes would necessitate standard changes in the selling, research, or administrative activities. Stated in other terms, current standards must be revised when conditions have changed to such an extent that the standard no longer represents a realistic or fair measure of performance. It is obvious that standard revisions should not be made for every change, only the important ones. However, the constant search for better methods and for better measurements of performance subjects every standard to possible revision. The controller constantly must be on the alert about the desirability of adjusting standards to prevent the furnishing of misleading information to management. (b) PROGRAM FOR STANDARD REVISION. The changing of standards is time consuming and may be expensive. For this reason, it should not be treated in a haphazard manner. It is desirable to plan in advance the steps to be taken in revising standards. Through the use of an orderly

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program for constant review and revision of standards, the time and money spent on standard changes can be less and the effort more productive. In planning the program of standard revision, the ramifications of any changes should be considered. For example, changes in manufacturing standards usually necessitate changes in inventory values. Accordingly, it may appear desirable to review the standards at the end of each fiscal year and make the necessary changes. A chemical plant may review material price standards every quarter because the selling price of the finished product is sympathetic to changes in commodity prices. This frequent revision would result in cost information that is more useful to the sales department. In some companies, a general practice is to change standards whenever basic selling price changes occur. This results in a more constant standard gross profit figure by which to judge sales performance. In considering frequent changes, however, the expense should be weighed against the benefits. In this connection, the value for cost control should be matched against the lessened degree of comparability of the variances from period to period. Judgment should be exercised about the necessity for, and extent of, changes in the records. For example, general changes in labor rates, raw material costs, standard overhead rates, or product design may dictate a complete revision of product and departmental costs, extending through every stage of manufacture. However, a change in one department, or in one part, or in a small assembly might necessitate the change of only one standard for control purposes. The difference between old and new, with respect to other stages of manufacture, or the finished product cost, could be temporarily written off as a variance until the time is ripe for a complete product standard revision.

17.14 RECORDING STANDARDS (a) IMPORTANCE OF ADEQUATE RECORDS. If the controller is to serve management most effectively and if the business is to have the advantage of accurate, reliable, and prompt cost information, then an adequate recording of the facts is necessary. This principle is as applicable to recording standards and standard costs as it is to actual costs—perhaps even more so. The degree of intelligence applied to the form and method of recording determines in large measure that: • The data underlying the development and revision of standards will be available as needed. • The facts relating to operating efficiency will be ascertainable and accurately analyzed. • The information will be made available on an economical basis. • The records will have the necessary flexibility to meet promptly the needs of the various applications of the standards. (b) TYPES OF RECORDS NECESSARY. In the manufacturing function, the records incident to the establishment and use of standards may be classified into four basic groups: 1. Physical specifications that outline the required material and the sequence of manufacturing operations that must be performed 2. Details of standard or budgeted overhead based on normal capacity 3. Standard cost sheets for each product and component part, which indicate standard cost by elements 4. Variance accounts that indicate the type of departure from standard The extent and form of these records depend on the size and characteristics of the business. In an assembly type operation, for example, there would be a product specification for each part. These, in turn, would form the basis for cost sheets on subassemblies and assemblies. In most cases this data would be recorded, accumulated, stored, and reported through the integrated computer processing system. This would include information from the production order, standard labor hours for each operation, and the ability to calculate the standard cost of each part and assembly. With the details of standards available, changes are easily made for substitution of parts in determining the standard cost of modifications of a basic product. Standards are equally applicable to pro-

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cessing operations like the chemical industry—the key is setting fair and reasonable standards for each operation or process and making adjustments for changed conditions. (c) ADMINISTRATIVE CONTROLS. Although the use of standards is not as well developed for administrative functions as for manufacturing operations, yardsticks can be established for such usage in most cases. Some companies collect and analyze statistical data from which some performance measurements can be made. The controller should continue to evaluate these functions to determine the best method or standard against which actual performance can be compared. (d) INCORPORATION OF STANDARD COSTS IN ACCOUNTS. Historically, some companies use standard costs for statistical comparisons only and do not incorporate them into the accounting record system. This is probably more true for administrative-type expenses than for direct manufacturing costs. With the data storage and processing capabilities of computers, it appears essential that the standard cost records be integrated into the accounting system. This will result in better cost control, inventory valuation, budgeting, and pricing.

17.15 APPLICATION OF STANDARD COSTS Even though standard costs are incorporated in the accounts, there is considerable difference about the period in the accounting cycle when the standards should be recorded. Whereas there are several variations in accounting treatment, the distinction may be twofold: 1. Recognition of the standard cost at the time of cost incurrence 2. Recognition of the standard cost at the time of cost completion The first method charges work in progress at standard cost, whereas the second method develops the standard cost at the time of transfer to the finished goods account. Recognition of costs at incurrence would imply a recording of material price variance at the time of purchase and material usage variance at the time of usage or transfer to work in process. However, many firms record material at actual cost and recognize price variances only as the material is used. This practice permits a write-off of excess costs proportionate to usage so that unit costs tend to approximate the actual cost each month.

17.16 MANAGEMENT USE OF STANDARD COSTS Extensive use of standard cost data can be made by management in directing the activities of the company. Some areas to be considered are: • Planning and forecasting • Motivation of employees • Rewarding employees • Performance measurement • Analyzing alternative courses of action — new products • Pricing decisions • Inventory valuation • Make or buy decisions • Control and cost reduction

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CHAPTER*

18

PLANNING AND CONTROL OF SALES 18.1

INTRODUCTION 330

18.2

SALES MANAGEMENT CONCERNS 330

18.3

CONTROLLER’S ASSISTIVE ROLE IN SALES MANAGEMENT PROBLEMS 331

18.4

CONTROLLER’S INDEPENDENT ROLE IN THE PLANNING AND CONTROL OF SALES 333

18.5

CONTROL OF SALES 334

18.6

SALES ANALYSIS 334 (a) Getting at the Facts 334 (b) Types of Sales Analyses Needed 334 (c) Deductions from Sales 335 (d) Typical Conditions Found by Sales Analysis 335 (e) Illustrative Use of Sales Analysis: Control Application 336 (f) Other Uses of Sales Analysis 337 (g) Sales and Gross Profit Analysis 338 (h) Limitations of Sales Analysis 338

18.7

SALES PLANNING: BASIS OF ALL BUSINESS PLANS 338

18.8

STEPS IN DEVELOPING THE NEAR-TERM SALES PLAN/ BUDGET 339

18.9

CONTROL PHASE 341

18.10 METHODS OF DETERMINING THE SALES LEVEL 341 (a) Mathematical/Statistical Methods 342 (b) Judgmental Methods 342 (c) Other Methods 344 18.11 USEFUL SOURCES OF FORECASTING INFORMATION 344 (a) Some Specific Sources 345 (b) Validity of Economic Indicators 345 18.12 FORECASTING THE BUSINESS CYCLE 345 (a) Nature of the Business Cycle 345

(b) Impact of the Business Cycle on the Corporation 346 (c) Elements of Business Cycle Forecasting 347 (d) Business Cycle Forecasting at the Corporate Level 349 18.13 SALES STANDARDS 350 (a) Definition of Sales Standards 350 (b) Purpose of Sales Standards 351 (c) Nature of Sales Standards 351 (d) Illustrations of Sales Standards 351 (e) Developing Sales Standards: Benchmarking 352 (f) Revision of Sales Standards 352 (g) Use of Sales Standards 352 (h) Sales Quotas as Standards 352 (i) Basis of Sales Quotas 353 (j) Method of Expressing Quotas 353 18.14 SALES REPORTS 354 (a) Effecting Sales Control 354 (b) Nature of Sales Reports 354 (c) Content of Sales Reports 354 (d) Illustrative Features in Sales Reports 355 (e) Frequency of Reports 355 18.15 PRODUCT PRICING : POLICY AND PROCEDURE 355 (a) Prices in a Competitive Economy 355 (b) Prices and the Controller 358 (c) Cost Basis for Pricing 362 (d) Elasticity of Demand 363 (e) Total Cost Method 363 (f) Marginal Cost Method 365 (g) Return-on-Assets-Employed Method 366 (h) Applying the Return-on-Assets-Employed Concept 367 (i) Conversion Costs for Pricing Purposes 367

* Section 18.12 adapted with permission from Steven M. Bragg, Financial Analysis: A Controller’s Guide (Hoboken: Wiley, 2000 Chapter 9.)

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18.1 INTRODUCTION Primary responsibility for the planning and control of sales, of course, rests with the chief sales or marketing executive of the company or the business segment. However, the chief accounting officer, with the knowledge of costs and cost behavior as well as the familiarity with sales accounting and analysis, is in a position to use these skills to assist the various marketing executives. Some of the areas where the controller might be helpful include: • Selection and application of mathematical/statistical methods to develop or verify sales level trends and relationships • Analysis of internal sales data to reveal trends and relationships • Analysis and assembling of the proposed sales plan/budget • Development and application of sales standards for use by the marketing executive, if applicable • Application of the relevant costs as a factor in setting product sales prices While the controller has a supporting role to the chief sales executive with respect to sales planning and control, there are also some basic independent responsibilities, as a member of the financial staff, to see that adequate procedures are followed and that the sales planning and control is sound from a financial or economic viewpoint. These subjects and others are discussed in this chapter. First, however, to provide background for the controller or for other readers, a brief review is made of the sales management function and some of its concerns.

18.2 SALES MANAGEMENT CONCERNS The tasks of any management function are many, varied and complex. Sales management is certainly confronted with a broad range of problems. It is a dynamic area, with changing conditions, constantly resulting in new and different problems. The controller can be an important influence on the resolution of these problems and decisions. An extensive and objective analysis of sales and distribution costs can assist sales executives in making prudent decisions consistent with the shortand long-range goals of the company. One problem area that has a significant impact on the planning process of the company is sales forecasting. The accuracy of the sales forecast is essential to good planning. The controller can work with sales management to realistically evaluate the degree to which the actual sales will relate to sales budget or forecast. There are many mathematical techniques available to establish standard deviations or variations that can be expected. Significant progress has been made in developing more sophisticated management tools for sales executives. With the utilization of personal computers, management can have available summarized information on sales activity allowing it to make effective decisions in a timely manner. The controller should be an active participant in the development of these information systems and reports. Although there are many types of problems encountered in the sales management function, there may be some that are found in most companies. The following is representative of some of the fundamental questions that are constantly raised: • Product. What product is to be sold and in what quantity? Is it to be the highest quality in its field or lower? Is the product to be a specialty or a staple? • Pricing. At what price is the article to be sold? Shall the company follow a policy of meeting any and all price competition? What are the terms of sale to be granted? • Distribution. To whom shall the product be sold; that is, shall the firm sell directly to the ultimate consumer or through others, such as wholesalers? What channels of distribution should be used? • Method of sale. How shall the goods be sold? Is it to be by personal solicitation, advertising, or direct mail? What sales promotion means shall be used?

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• Organization. How shall salespersons be selected, and how shall they be trained? What is to be the basic organizational setup? Are there to be branch offices? Will sales supervisors handle all lines of product, or will each specialize? Into what departments shall the sales organization be divided? How many salespersons should be employed? • Planning and control. How are sales territories to be set up? Shall sales standards be used as measuring sticks of performance? How will salespersons be compensated—salary, commission, bonus? What controls will be employed? Questions relating to these six categories are found in every company, regardless of size. The answers to many depend, in large part, on the facts available within each organization.

18.3 CONTROLLER’S ASSISTIVE ROLE IN SALES MANAGEMENT PROBLEMS As stated earlier, the final solution to sales management concerns must, of course, rest largely with the chief sales executive. However, an intelligent executive will always seek any assistance available. The controller can help by bringing to bear a scientific, analytical approach, using judgment as well as imagination. It should be realized that the solution in one firm may not be the solution in another and that the answers to today’s problems may not be the answer tomorrow. The controller is of value primarily in getting the facts. In presenting the facts, though, it is necessary to merchandise or sell the product; the controller’s approach must be one that invites reception. The degree of assistance the controller can render in solving the previously mentioned sales problems is indicated in the following outline: 1. Problems of product. The initial selection of the product or consideration of changes in the line, sizes, and colors should generally be based on the collective judgment of the marketing considerations by the sales manager, of production problems by the manufacturing executive, and of cost considerations by the controller. Costs are not the only factor in the decision, but they are an important factor. The chief accounting official should be able to indicate the probable margin on the product, as well as the margins on alternative choices. The controller should also be able to indicate the probable effect of volume on the margin or the effect of changes in quality, composition, and manufacturing processes on the cost to make or sell. In the continuous reviews of sales trends, the controller may be able to identify unfavorable trends that might call for redirection of the sales effort or a change in product. 2. Problems of price. In many companies, pricing procedures are not reviewed on a periodic or methodical basis. The pricing procedure may not be responsive to increased costs. Although cost is not the only determining factor, it must be considered in maximizing the return on investment. The controller must be able to provide all the available information. Total costs, marginal or differential costs, out-of-pocket costs, or cost differences must be considered in developing the price structure. This is true for competitive bids or establishing price lists for the usual type of sale. In an analysis of sales volume and related prices, it may be revealed that unfavorable variances often have resulted from salespersons or sales managers having too much authority in setting a selling price. As production costs change, the information should be communicated to the sales executives for consideration of appropriate price changes. Also, assistance should be provided in setting volume price breaks for different sizes of orders. 3. Problems of Distribution. The controller contributes the cost analysis necessary, as well as a review of statistics for unfavorable trends in distribution. Being able to provide indications of the selling cost through the various channels of distribution, the controller should be on the alert for major changes in sales trends through particular channels or margins thereon. Frequently, there are chances to show ingenuity in analysis regarding types and sizes of accounts and orders to be sought. Questions of policy may relate to:

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(a) The minimum order to be accepted (b) Restriction of the sales effort on large volume accounts that purchase only low-margin products or are unprofitable because of special laboratory service (c) Desirability of servicing particular types of accounts through jobbers, telephone, mail order, and so forth (d) Discontinuance of aggressive sales effort on accounts where annual sales volume is too low (e) Best location for branch warehouses 4. Problems relating to the method of sale. Many factors will determine the method of sale, and the sales management must make this determination in view of the long-term goals and objectives. The controller can assist by providing information on historical costs and preparing alternative cost estimates for various methods. For example, analyses could be made related to the distribution of samples and the impact on costs and sales trends. Cost data related to advertising programs are useful in making decisions for future media communications. Special cost structures can be developed for market-test situations to determine the cost effectiveness. In the long run, of course, the best method should result in achieving the greatest sales volume with the best return on investment. 5. Problems of organization. Because the sales management function is dynamic, organizational changes are necessary to satisfy the new requirements. In making these changes, information related to potential sales by product or territory may assist in reassigning or hiring new salespersons. Also, comparative cost data on different organizational structures are useful in determining the change. 6. Problems of planning and control. So numerous are the applications where the controller can be of assistance in planning and controlling the sales effort that only a few can be indicated. The controller is able to aid the sales executive in solving some of the previously mentioned problems through special studies, yet in the planning and control fields many of the controller’s functions are repetitive. The accounting official may contribute in the following ways: (a) Sales budgets and quotas. Detailed records and knowledge about the distribution of sales by territory, product, and customer, coupled with the knowledge of the sales manager on product changes and trends, provide basic information necessary in an intelligent setting of sales budgets, quotas, and standards. The controller also may provide services in connection with forecasting and market studies. (b) Distribution expense budgets and standards. A history of past expenses as recorded in the accounting department provides much needed data in setting budgets and standards for the measurement and control of selling effort. (c) Monthly or periodic income and expense statements: (i) (ii) (iii) (iv) (v) (vi)

By territories By commodities By methods of sale By customers By salespersons By organization or operating divisions

These and other analytical statements can provide a vast amount of useful information. The disclosure of the contribution to the net profit of each territory or some other factor analyzed, over and above the direct expense, may reveal spots of weakness. (d) Special analyses to reveal conditions needing correction or as an audit of performance: (i) Sales incentive plans. The probable cost of various plans as applied to the business and degree to which they are mutually profitable for the company and salesperson.

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333

A determination about whether they direct salespeople’s efforts toward the most profitable products. (ii) Branch office and warehouse expense. Periodic reviews of expense, in relationship to sales, growth, and earnings of the activity. (iii) Customer development expense. Analysis of entertainment expense or other business development expense by customer, salesman, or territory, with emphasis on necessity and possible alternatives — all with reference to the related margin or profit. (iv) Salespersons’ compensation and expenses. Review and analysis of salespersons’ salaries, bonuses, and expenses related to budgets, salary structure, and industry.

18.4 CONTROLLER’S INDEPENDENT ROLE IN THE PLANNING AND CONTROL OF SALES As previously stated, the primary responsibility for the development of the sales plan and its subsequent implementation is that of the chief sales executive. But, as just commented on in the preceding section, the controller can be of substantial assistance to the sales executive in supplying analytical and historical data for use in planning and control decisions. However, it should not be assumed that the controller will provide only the data the sales executive wants and that the controllership role is by and large a passive one as to sales activity. Given the analytical background of controllers and their knowledge of the financial data concerning the company, they have a series of independent functions to perform in furtherance of a sound business plan and prudent control procedures. Some of their conclusions might not be in agreement with the initial thinking of the sales executive; and some of the procedures they develop might appear redundant to some salespersons. Yet to one sensitive to the need for financially sound policies and procedures, and the desirability of proper checks and balances, the role of the controller is indispensable. For most companies, the responsibility of the controller and staff extends to the following outline of functions in the development of a sound annual sales plan (as well as the entire annual business plan) and the related implementation: 1. The planning phase (a) Development, and revision when required, of a practical set of systems and procedures for arriving at a suitable sales plan (and the entire financial aspects of the annual plan). This would include: (i) Outlining the steps in the planning procedure (ii) Assigning responsibility for each specific procedure to specific executive positions (with the concurrence of executive management) (iii) Providing the format in which the sales plan (quantified data) must be presented (iv) Examining the economic justification for certain decisions (v) Providing the schedule when the data are to be submitted (vi) Ensuring that the cognizant sales executives have the necessary statistical and historical internal sales data required to develop a sound sales plan (b) Supplying the relevant analyses of past sales performance, including the significant trends and relationships, for the appropriate executives sales management. (c) Providing for an in-depth financial analysis and evaluation of the tentative sales plan, when completed by the marketing executives. The analysis should bring to the attention of the appropriate executive any inconsistencies, questionable assumptions, reasonableness tests, or other matters that warrant discussion. These could include adequacy of margins, comparisons with competitive prices, questions about market growth, economic comparisons of different product sales mixes, etc. (d) When the iteration is complete, preparing the consolidated sales plan with related supplemental adjustments for such matters as returns, allowances, and other sales deductions.

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(e) Incorporating the sales plan into the total business plan for the period involved, including comparative profit data. 2. The control phase (a) Develop and revise (when necessary) appropriate financial control systems for the use of the cognizant executive. (b) Provide the useful and timely comparisons of budget and actual sales performance for the sales executive, by appropriate segment, and in an understandable form (by product, by territory, by salesperson, etc.). (c) Provide useful supplemental analytical data such as sales trends, gross margin trends, and relationships, market share information, sales effectiveness, and other control type information. These data can be furnished on a regular basis or when an observed unfavorable condition seems to be arising. These are some of the basic functions performed by many controllers. In each situation, accounting executives will find ways in which their analytical capability and business acumen may be put to use.

18.5 CONTROL OF SALES Sales must be controlled to achieve the best or expected return on investment. The optimum net income is realized only when a proper relationship exists among these four factors: (1) investment in working capital and facilities, (2) volume of sales, (3) operating expenses, and (4) gross margins. The accounting control of sales, therefore, relates to the reports analyzing sales activity that bring to light undesirable trends and relationships or departures from goals, budgets, or standards in the manner best calculated to secure corrective action.

18.6 SALES ANALYSIS (a) GETTING AT THE FACTS. The stress sometimes placed on sales volume can be misleading. If a business were to ignore the profit factor, it could probably secure any desired volume. Through the cutting of prices or through the spending of huge amounts on direct selling expense or sales promotion or advertising, volume itself could be secured. Yet what good would result? It is obvious that the implied factor is profitable sales volume. If business is to achieve profitable sales, it must know where the areas of greatest profit are. This means both sales analysis and cost analysis. There is little doubt that the analysis of sales has reached different peaks of achievement in different firms and industries. Many large companies devote a great deal of time to this phase of marketing control and have well-developed programs. A large number of medium-sized or small firms have little or none. It is also probably true that the sales executive in consumer goods lines has many more facts than the industrial marketing executive. The evidence is unmistakably clear in any business that overall or average figures are not sufficient. Such general information is of little value in making key marketing decisions and directing sales efforts. The data must be specific and related directly to the problem on which a resolution must be achieved. (b) TYPES OF SALES ANALYSES NEEDED. What is needed, then, is detailed analysis to guide sales effort. Some required analysis relates solely to past sales performance as such. Other studies involve the determination of trends by comparison with previous periods. Still other reviews show the relationship to budget or standard, to gross profit, selling expense, or net profit. Analyses may be expressed in physical units, or dollar volume, or both. The types of analyses frequently used are: • Product— type of product sold, colors, sizes, price lines, style, quality (reclaimed material, odd lot, first quality)

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• Territory— area used for sales direction — states, cities, counties, other marketing areas • Channel of distribution — wholesalers, retailers, brokers, agents • Method of sale—direct mail, house call, ad or coupon, delivered vs. nondelivered • Customer —domestic vs. foreign, industrial vs. ultimate consumer, private vs. governmental, tabulated according to volume of purchases • Size of order —average size of individual purchase • Terms of sale— cash, cash on delivery (C.O.D.), regular charge account, installment, lay-away • Organization— branches, departments • Salesperson — either individual or groups These analyses may be developed, not merely with regard to sales but through gross profit to profit after direct selling expense or ultimately to the net profit of the segment being measured. Other analyses relating to unrealized sales may also be useful, for example: • Orders received • Unfilled orders • Cancellations • Lost sales These studies may be used as an integral part of sales planning or to eliminate reasons for ineffective effort. Analysis of orders may be important where production is made to order. For example, all sales of a given size or type may be summarized to necessitate only one production run in the period. Many subanalyses can be prepared. Thus, management may want to know not merely the overall sales by product but the product sales in each territory. The controller may find that the sales manager can use certain of these analyses monthly or periodically — for example, sales by territory, by product lines, or by salesperson. Other analyses may be made only as a special investigation, when it is expected the tabulation will reveal out-of-line conditions. In any event, it is the controller’s responsibility to design and install procedures and records in such a fashion that the maximum information is made available with the minimum of time and effort, both clerical and analytical. It is axiomatic that in many situations the company getting the information most quickly is in a better competitive position. This information will answer the typical questions of an analytical sales executive: What was sold? Where was it sold? Who sold it? What was the profit? (c) DEDUCTIONS FROM SALES. In any analysis of sales the importance of sales deductions should not be overlooked. Although reviews may relate to net sales, the clue to substandard profits may lie in the deductions—high freight cost, special allowances, or discounts. These factors may reveal why unit prices appear low. Useful analyses and reports on sales deductions can be prepared. For example, an informative summary may be compiled to indicate the general types and amounts of sales deductions, namely, returns, freight allowances, price adjustments, or customer sales policy adjustments. It may be helpful, also, to prepare an analysis of deductions by responsibility — the manufacturing division for defective product, the traffic department for erroneous freight allowances, the sales division for allowances to retain customer goodwill. (d) TYPICAL CONDITIONS FOUND BY SALES ANALYSIS. In many businesses, a large proportion of the sales volume is done in a small share of the product line. Likewise, a relatively small proportion of customers will provide the bulk of the volume. Such conditions reflect the fact that only a very small part of the selling effort is responsible for most of the business. This information should prove useful to the sales executive. It might permit the concentration of sales effort and the consequent reduction in selling expense. Again, it might mean a change in territorial assignments of sales staff. Where product analysis reveals unsatisfactory conditions, a simplification of the product

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line may be indicated. Although the line may not be limited to only volume items, many sales managers are beginning to realize that not all sizes, all colors, and all varieties need be carried. Smart executives will let their competitors have the odd sizes or odd colors and concentrate on the more profitable articles. After all, the economies of production also must be considered in developing the product line. (e) ILLUSTRATIVE USE OF SALES ANALYSIS: CONTROL APPLICATION. Some examples will help in illustrating certain benefits to be gained from sales analysis. Assume a case where the sales executive has just been advised by the accountant that sales for the month then ended total $125,000. Assume further that this is $15,000 lower than the preceding month and that the aggregate volume failed by $25,000 to meet the commitment to the chief executive. What can the sales manager do with merely the information that sales were $125,000? The answer, of course, is not very much. It is the position of a hunter who has a shotgun but needs a high-powered rifle. This sales manager’s controller has done a poor job. Now assume that an analysis of sales by territories is made available. The results might be as shown in Exhibit 18.1. This analysis gives the sales executive some useful information. Instead of prodding the managers of all territories, the sales manager can concentrate on the poor performers — B, D, and C, probably in just that order. If more than one salesperson is assigned to a territory, a further analysis of the substandard territories could prove useful. Although territory B, for example, was badly under budget, it could well be that some of the salespersons did a good job. The picture might appear as in Exhibit 18.2. It is evident that something went wrong in the areas covered by Smith, Jones, and Black. Where did they fall down? A subanalysis of the sales by Smith might reveal the data in Exhibit 18.3. Now we are beginning to get at the root of the trouble! Smith has done much better than expected on hard resins and glue, getting what sales management feels is the maximum share of hard resin sales in the territory. While there is still an unrealized share of the potential sales, Smith exceeded Total Sales Territory A B C D E F Total E XHIBIT 18.1

Over (or Under) Budget

Actual

Budget

Value

%

$ 15,000 50,000 10,000 25,000 13,000 12,000 $125,000

$ 12,500 70,000 12,500 37,500 8,500 9,000 $150,000

$ 2,500) (20,000) ( 2,500) (12,500) 4,500) 3,000 $(25,000)

20.00 (28.56) (20.00) (33.33) 52.94 33.33 (16.67)

A NALYSIS

OF

S ALES

BY

T ERRITORIES

T ERRITORY B—A NALYSIS

BY

S ALESPERSON Over (or Under) Budget

Total Sales Salesperson

Actual

Budget

Value

%

Knight Black Smith Jones Nesser Total

$17,000 11,500 8,500 8,000 5,000 $50,000

$14,000 15,000 20,500 16,000 4,500 $70,000

$ 3,000) ( 3,500) (12,000) (8,000) 500 $(20,000)

21.43 (23.33) (58.54) (50.00) 11.11 (28.56)

E XHIBIT 18.2

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OF

S ALES

BY

S ALESPERSON

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18.6 Sales Analysis

337

Over (or Under) Budget

Sales Product

Potential

Actual

Budget

Value

%

Urea molding compound Alkyd molding compound Hard resins Powdered glue Total

$20,000 4,000 1,000 6,000 $31,000

$2,500 500 1,000 4,500 $8,500

$12,000 3,600 900 4,000 $20,500

$( 9,500) ( 3,100) 100 500 $(12,000)

(79.17) (86.11) 11.11 12.50 (58.54)

E XHIBIT 18.3

S UBANALYSIS

OF

S ALESPERSON

BY

P RODUCT

the budget. However, Smith has performed very poorly on molding compound. A review of Smith’s call reports indicates that important users of molding compound have not been called. For example, Smith is completely overlooking the molders of electrical fixtures, yet this is where the greatest potential lies. The sales, as an analysis by customers shows, have been only to molders of bottle caps and the like. Now the sales manager has the facts and can take corrective action, and the controller can feel that the analysis has been useful. (f) OTHER USES OF SALES ANALYSIS. In many businesses, particularly small concerns, budget applications are neither well developed nor applied. Budget information by product or by salesperson is not available. In some instances, the cost of maintaining an elaborate budget system is not cost effective. Sales analyses may be made that are useful but not related to a budget. An analysis by customer by commodity class, indicating sales this month, sales same month last year, sales year to date, and sales last year to date will provide some comparative data as well as trends. If the sales executive has detailed knowledge of each territory and general level of activity by customer, the report can be of use in directing the sales effort. Observations can be made about which customers are growing or declining in sales volume. With knowledge of the margin by commodity class, it can be determined if growth is in the profitable lines or on the low margin products; this may indicate that prices should be reviewed. There are many simple analyses that can be made to guide the sales effort. The controller should continuously work with sales executives to develop those reports that are most useful, like special or one-time reports. The information developed should be interpreted and the important trends or measures should be highlighted. Other uses of sales analyses that may be considered are: • For sales planning and setting of quotas. Past experience is a factor. • For inventory control. To properly plan inventories, a business should be familiar with past sales and probable future trends in terms of seasonal fluctuations and type of product. • For the setting of certain sales standards. Here, also, past experience is a factor. • For the better distribution of sales effort in territories. It may well prove that the business is concentrating its effort in too restrictive an area. Consideration of potential sales, competitive conditions, and cost factors may dictate a wider coverage. Again, analysis might reveal that the territory is not being fully covered. • For better direction of sales effort on products. A study of sales and the potentials may reveal the restriction of sales effort to certain products to the neglect of other and more profitable ones. Also, a comparison of sales by product with previous periods will reveal trends. If the trends are away from the more profitable lines, corrective action may be necessary. • For better direction of sales effort in terms of customers. Analysis by customers should reveal trends about the types of merchandise purchased by each customer. Also, comparison with the sales of a similar period for the previous year will reveal facts on whether the company is making headway in securing the maximum amount of profitable business from the customer. Analysis by customer account, coupled with other information and discussions with the sales

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manager, will show certain accounts that cannot possibly provide a profitable volume, even if developed. This, too, may permit greater utilization of sales effort elsewhere. (g) SALES AND GROSS PROFIT ANALYSIS. Sales efforts, as previously stated, should be directed and focused on profitable volume. To accomplish this, sales executives must be provided with all the facts related to profit. Therefore, analysis of sales must include a detailed analysis of contribution margin and/or gross profit. For example, a sales report by a salesperson should indicate the comparative gross profit by periods as well as sales. Although high gross profit does not necessarily signify a high net profit, since the selling costs may be excessive, it is an indicator. It certainly serves as a guide, however, in determining areas for concentration of the sales effort. One other aspect of gross profit deserves comment. Variations in gross profit may result from changes in the selling price, product sales mixture, returns, or volume (largely controlled by the sales executive) or from changes in manufacturing efficiency (controlled by the production executive). These facts should be recognized when reviewing changes in gross profit. The causes should be isolated. If a standard cost system is in operation, this process is simplified somewhat. In this case, the best measure of sales performance will be standard gross profit. When the standard eliminates the manufacturing efficiency factor, then the sales department is generally responsible for the result, as well as the volume variance. (h) LIMITATIONS OF SALES ANALYSIS. Sales analysis is only one management tool used by the sales executive. Such analysis, however, is no substitute for the professional leadership needed to properly direct and manage the sales function. It is obvious that analysis of the actual sales volume must be used in conjunction with other factors like sales potential, plans, budgets, standards, historical performance, industry comparisons, manufacturing costs, and operating expenses. Most important, the sales executive must use the data to make effective decisions. Although sales volume analyses can be used extensively in measuring or studying sales performance, those using the data must recognize that high volume does not mean high profits. Profits will certainly vary, and a business does not earn the same rate of profit on all products. An analysis of sales volume alone will not provide sufficient information to maximize the return on investment on any given product. Many other factors must be considered. Even with some limitations, the analysis of sales is an integral part of any well-managed sales function.

18.7 SALES PLANNING: BASIS OF ALL BUSINESS PLANS Sales analysis is a useful function. As mentioned in the prior section, it may be applied to better direct and control sales effort, and for other related sales control activities. Yet, one of the other principal applications is to sales planning; that is, in helping to determine a proper sales level (by product or territory or salesperson, etc.) for the next year or two of the annual business plan. The application to sales planning is also used in selecting the more profitable sales potential areas for the strategic, or long-range, plan. It will bear mentioning that the sales plan is the foundation for the entire system of plans (see Chapters 12 and 14) including: the production plan, the marketing plan, the research and development plan, the administrative expense plan, the facilities plan, the working capital plan, and the financing plan. Thus, the sales plan is so pervasive and fundamental that it is in the interest of the company to develop the best possible plan, using all fairly available information (both internal and external). A reasonable amount of time will be spent in developing the short-term sales plan or budget for the next year in considerable detail. But the chief sales executive has to keep in perspective the relationship of the immediate short-term or tactical plan to the strategic longer-term plan. The flow of products and services in these two plans may be as illustrated in Exhibit 18.4. As a practical matter, the sales manager often will view the marketing task as threefold: 1. Sales of existing products and/or services to existing customers

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18.8 Steps in Developing the Near-Term Sales Plan/Budget

Historical Sales

Annual (Tactical) Plan

339

Strategic Plan Products from Acquisitions

160

New Products

Sales (in millions of dollars)

120

Present Products New Customers 80

40

Present Products Present Customers

0 X0

X1 Years

E XHIBIT 18.4

S TRATEGIC

AND

T ACTICAL S ALES P LAN

2. Sales of existing products/services to new customer 3. Sales of new products to existing, as well as new customers Sales often may be estimated by these segments. These facets of the near- and long-term sales plans, as well as the increase in sales from acquisitions (newly acquired companies or products), are shown in Exhibit 18.4. All these sales targets may be necessary to avoid the natural decline in sales over a period of time and to reach the longterm corporate sales objective.

18.8 STEPS IN DEVELOPING THE NEAR-TERM SALES PLAN/BUDGET Each company has its own way of developing the sales plan or budget, and providing such information to those executives, who, in turn, use it for developing their segment of the total business plan. The planning steps outlined next are somewhat typical when industry estimates of future sales levels are available, or when some useful external data may be secure, and when the involved executives are accustomed to being provided with relevant sales and gross profit analyses.

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1. The chief sales executive who is responsible for preparing the sales plan, also called the sales budget, and meeting it, is given some or all of the following data: (a) Computer sheets or other worksheets in proper format for providing the sales estimate, by month, and by product or salesperson, for the planning year (b) Sales performance for the last year (estimated for the balance of current year) or two by salesperson, and perhaps subanalyzed by territory or customer—in monetary or physical units (c) Industry data on expected next-year total sales (d) Any other analyses based on external information, developed by the market research department or economist or perhaps the controller, giving a clue as to expected sales (correlation techniques, etc.; U.S. government statistics) or business conditions for the coming plan year (e) Any other data the sales manager or salespersons reasonably request as helpful in developing sales estimates (f) Analyses, if available, giving the estimated sales impact of planned sales promotions, and reasons for the cause or precise location of below-plan performance in the sales area (current year) (g) Any guidance, or expected sales levels that the CEO or other influential executives (e.g., manufacturing executives as to new production capacity) may wish to provide 2. The sales executive provides an estimate of sales for the planning year in appropriate detail (by product, salesperson, or territory). While the sales executive may prepare such an estimate unaided, it is preferable to ask each salesperson (through appropriate organization channels) to make an estimate of sales for that person’s assigned area or product, in appropriate detail, by month or other time period, for the coming year. The chief sales executive, directly or acting through territorial or product sales managers, will provide guidance to the sales staff on such subjects as:
Percent sales increase expected
Estimated impact of planned promotional programs
Competitive actions and the like

Assuming each salesperson prepares their own estimate (by customer, product, etc.), as the plan is forwarded up the organization structure to the chief sales executive, it may be modified by the intervening sales executives — each giving reasons for the changes. 3. Finally, at the top executive level, the estimates are consolidated (probably by the controller’s staff) and company totals determined. The summarized sales plan, following the territorial organization structure is illustrated in Exhibit 18.5. Supporting territorial budgets for each territory sales manager, by salesperson, would be available from the database. Other analyses, such as by product, could be prepared. 4. Each proposed sales level is discussed by executive management as to acceptability, reasonableness, etc. 5. When the sales budget is tentatively approved (an iterative process) then other functional executives who need the data are provided with it so they can develop their segments of the annual plan (the marketing plan, production plan, research and development plan). Several iterations can take place (adjusting for capacity, competitive actions, probable lack of raw material, etc.) until an operating plan is agreed upon. 6. The operating budget and capital budget, together with the related financial statements, are consolidated and tested for financial acceptability, and so on. Through iteration a final plan is arrived at. 7. When the board of directors approves the plan, each segment becomes a commitment for the plan period by the relevant or responsible executive.

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341

T HE I LLUSTRATIVE C OMPANY S ALES P LAN BY T ERRITORY F OR THE Y EAR 20XX ( DOLLARS IN THOUSANDS ) Plan Quarter

Territory

Sales This Year

Total

1

2

3

4

West Rockies Southwest Central Plains Midwest Southeast Total

$212,400 75,000 134,600 53,400 171,300 91,400 $738,100

$230,000 78,750 150,750 56,100 186,700 95,100 $797,400

$ 46,000 15,750 37,690 14,000 33,600 19,000 $166,040

$ 63,720 23,620 45,200 16,900 65,300 28,500 $243,240

$ 79,040 31,500 45,200 16,900 50,000 21,000 $243,640

$ 41,240 7,880 22,660 8,300 37,800 26,600 $144,480

E XHIBIT 18.5

S ALES P LAN

BY

T ERRITORY

18.9 CONTROL PHASE In the context of the budgeting process (a two-pronged device consisting of the planning phase and the control phase) the steps discussed in Section 18.8 complete the planning phase when the sales plan is approved by the board of directors. Then, the task consists of, among other things, monitoring actual sales results and directing the sales effort so that the plan is achieved. This is generally identified as the control phase. The implementing steps are essentially as: • Actual performance is compared with plan (or quota), for each salesperson involved in the sales effort, for the appropriate time period, which may be the day (cumulative), week, or month. • The data are analyzed, much as described earlier, to determine the cause of the subperformance. • Corrective action, if needed, is taken by the sales executive to get sales “on plan.” This might include special sales promotion, etc., especially if the cause of under-plan sales is a general condition, that is, not one induced by the lack of effort of a salesperson. • Aside from analysis of actual and planned sales, a review of some selected statistical performance measures may provide clues on how sales could be improved (e.g., conversion rate of prospects to customers). See the sections on standards and benchmarking.

18.10 METHODS OF DETERMINING THE SALES LEVEL The development of a sound sales plan, together with the program for directing the sales effort, ultimately must rest largely on the judgment of the cognizant sales executive. The means used to arrive at a decision obviously may influence its quality. Ordinarily, weight must be given to both external and internal factors. External factors (including such elements as general economic conditions, industry trends, total market potential, and competitive actions or reactions) are beyond the control of the individual company, but nevertheless may largely prescribe the sales potential. Internal factors relate to conditions within the entity and are composed of matters such as production capacity, product quality, sales experience, history, special advertising and sales promotion programs, pricing policy, and sales method changes. In this section, some of the more commonly used methods of estimating sales levels, to help the sales executive reach decisions or judgments, are discussed. What system will be used may depend on several related attributes: • Time. The time span available, the frequency of the data • Resources needed or available. Manpower, computers, financial sophistication, cost

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• Data input. What is needed, consistency, availability, variability • Output. Reliability, extent of detail, capability of detecting trend changes, capability of revealing direction changes that have taken place For the knowledge of the controller, the more or less proven techniques of forecasting sales demand may be categorized in these three groups: 1. Mathematical/statistical methods
Time series analysis
Correlation 2. Judgmental methods (nonstatistical)
Estimates of salespersons
Customer surveys
Executive opinion composites 3. Other methods
Share of market
End-use analysis
Product line analysis
Market simulation
Combinations of methods (a) MATHEMATICAL/STATISTICAL METHODS. The various mathematical/statistical methods usually require the services of a person or persons skilled in the techniques (statisticians, economists, and perhaps accountants). Basically, a statistical technique is applied to a series of relevant numbers to arrive at a forecast of sales for the industry or company. Then, this forecast is modified by the expected impact of sales efforts, promotional campaigns, and so forth, to arrive at a sales plan for the company. Two types of mathematical applications are addressed here. (i) Time Series Analysis. With the use of a model already programmed in the computer, or by the application of the well-known least squares method, an existing series of values is converted into a trend, and extrapolated for a future time period. Basically, the existing series of values is isolated into its statistical components: • Secular or long-term trend • Cyclical movements • Seasonal patterns • The remaining random fluctuations The long-term trend is projected to estimate the future sales for the planning periods. (ii) Correlation Analysis. As the name implies, a series is located with which the company sales, or sales of a particular product line, seem to correlate or move sympathetically. Presumably, the data are readily and timely available, are reliable, and are those that lead the company sales. The annual product sales are plotted against the index and, based on the leading factor, calculated for the planning period. Some illustrative correlation bases could be the U.S. Department of Commerce composite index of leading indicators (discussed later) or Series No. 20, contracts and orders for plant and equipment, also issued by the U.S. Department of Commerce, or the Federal Reserve Index of Industrial Production. Other statistical methods, such as the Box-Jenkins computer-based iterative procedure, or use of moving averages, can be employed. (b) JUDGMENTAL METHODS. Another popular method is the gathering of opinions or estimates from several groups. Some common variations of this method are discussed.

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(i) Estimates of Salespersons. In using the estimates of salespeople, one method involves securing the estimates of the sales staff itself. Each salesperson is provided with a record of his or her sales, by month, for the past year or two. With this data and that person’s knowledge of the sales territory and customer, an estimate by product and/or customer is obtained from the person who will be responsible for securing the sale. A variation of this procedure is to have the sales manager to whom the salesperson reports and the salesperson jointly arrive at a sales estimate. Another procedure involving the sales department personnel is to secure the opinions of the various sales managers — the product sales managers, division sales managers, or territory sales managers, together with the general sales manager. Through discussions and cross-checking, and considering the impact of sales programs, many believe a reliable estimate can be secured. Of course, the extent of knowledge of the sales manager level must be considered. Hopefully, they are close enough to the firing line to know the sales conditions, products, and customers. The use of only sales department personnel has both advantages and disadvantages: • Advantages
The knowledge of the persons closest to the sales picture is used.
Those who must meet plan have a voice in setting it. • Disadvantages
The level may be biased in that sales personnel often tend to provide optimistic estimates when the business level is high, and too low estimates when the level is poor.
The participants may not give proper weight to broad economic trends that the sales force or managers either do not recognize or fail to properly evaluate.
If compensation levels depend on meeting the sales plan, a deliberate effort might be made to keep the estimate on the low side so that enhanced remuneration is more likely. Care must be taken (by the CEO, other top executives, or the controller) in weighing the sales personnel opinions. (ii) Customer Surveys. The practice of asking customers for their estimate of purchases for the coming year often is used when there is no other source of reliable and specific data to make a sales estimate. It may be employed when there is a good relationship between the salesperson and the customer, and when the customers tend to be very large and limited in number. An example is the glass companies who make the windshields and glass windows used by automobile manufacturers. The disadvantages include the facts that: • The user may be ill-informed or uncooperative in such sensitive matters. • It is time consuming if many customers must be contacted. The possible advantages are: • It may be the only suitable manner of preparing a sales plan. • It gives the questioner an opportunity to delve into the thinking of the customers about the business outlook. • It is an opportunity to secure information directly from those who will be using the product. (iii) Executive Opinion Composites. Another commonly used and convenient method of estimating future sales volume is by securing opinions from a group of top and middle management executives who have reason to be familiar with the industry and company sales picture. The method involves simply securing the estimates from a group of executives, perhaps weighting them, and then combining the opinions. Thus, the CEO and sales, production, research, and financial executives may be contacted, and weightings given to their opinions, depending on their knowledge of the market and perhaps on the accuracy of their past estimates. Each executive may determine his expectation based on his own methods; and the groups may meet to discuss the levels and the basis for the opinion.

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While this method may provide a broader base than from sales personnel only, and be more convenient, if the executives don’t really know the market, then the opinion may be one big guess, based on few facts. (c) OTHER METHODS. There are numerous other methods for developing sales forecasts or plans, some of which may be used alone or in combination with other procedures. A few brief comments follow. (i) Share of Market. For some types of products the total market is well known. In addition to the industry total unit volume and/or dollar volume, the rate of growth has been calculated, and often the estimated sales for the next year or two have been determined — perhaps by the industry association. In any event, the planner knows what share of the market the company has secured in the past. This market share, say 27 percent, adjusted for the estimated impact of special sales promotions, or guessed competitive activity is applied to the projected total market to arrive at the company segment of, for example, 29 percent of the estimated industry sales for the coming year. (ii) End-Use Analysis. This technique depends on having a sound estimate of the total end-use market for which products the company’s articles serve as component parts or elements. Again, to use the automotive industry as an example, if the expected unit sales of automobiles are known or have been estimated, then the supplier company can estimate its probable sales for the planning period for its product, the new car business. This market, plus the estimated replacement business, or other business, can be combined to arrive at sales expectations. This method bears a close relationship, in some cases, to the customer survey procedure. (iii) Product Line Analysis. Quite often major products are sold through different channels of distribution or methods of sales than other products, and the sales and sales effort may be managed by product line. Under these circumstances, a company’s internal sales (and gross profit) analyses by product, subanalyzed by territory, and so on (as discussed earlier in Section 18.6) may be the starting point of determining the sales estimate, supplemented by some of the other techniques to arrive at the sales plan. (iv) Market Simulation. This technique ordinarily involves the use of a computer, and the construction of a mathematical model of the market. Modifying input for the different factors that influence the market permits the calculation of various sales estimates. This is another helpful tool, often developed by the market research organization, that can assist in arriving at a realistic sales plan. It should be understood that, whatever estimating technique is used: • Even a good forecast reduces only some of the risk that confronts sales management. • It is often helpful to compare the results of several forecasting methods. • Some of the simplest methods work best, because they are more easily understood; the heart of good forecasting probably often is intelligently based intuition on the part of sales management.

18.11 USEFUL SOURCES OF FORECASTING INFORMATION Business executives long have been intrigued by the promise of a practical indicator of business trends that could be useful in their business forecasting. Some have found broad economic measures helpful, such as gross national product (GNP), new car sales in a given territory, etc. But for many, no practical guide has been located either for the business as a whole or for major lines. Many of the broad indicators have suffered from late availability, significant revisions, inaccuracies in compilation, and components out of touch with the market, to name a few. These executives, therefore, have encouraged their staffs to develop in-house models, perhaps based on some readily available indicators. Sometimes these models have been built from data furnished by commercial banks, or in other instances developed from a factor, such as regional car sales, that an

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executive has noticed appears to correlate quite closely with the company’s sales experience on certain products. Given the conflicting or indecisive signals put out by some indicators and the inability to find a suitable one, sometimes the intuition of the chief executive or chief sales executive is one of the best guides. The controller should be aware of external sources of sales forecasting data just in case the present sales estimating techniques could stand some testing or improvement. (a) SOME SPECIFIC SOURCES. There are numerous sources, ranging from the federal government to selected financial services, such as Standard & Poor’s (S&P) and Moody’s, that supply information which may be useful in sales forecasting. Market planners, market research analysts, and many financial executives often are familiar with them. Of course, libraries may provide assistance on this subject. The secret is to find an index or economic data useful in a particular business. A partial outline of some sources follows: 1. U.S. government Department of Commerce (a) Bureau of Economic Analysis (BEA) Includes cyclical indicators and economic measures published in the Survey of Current Business (b) Department of Labor Bureau of Labor Statistics (c) Department of Agriculture (d) Bureau of Mines (e) U.S. Government Printing Office 2. Commercial banks1 3. Other sources (a) Trade associations (b) State governments (c) Federal Reserve Board (d) Universities (economics departments and schools of business, etc.) (e) Financial services providing economic data for pay (f) Numerous business magazines, such as: (i) Survey of Current Business (ii) Business Week, with its weekly “Business Week Leading Index” (iii) Fortune magazine (its “Forecast”) (g) Libraries (b) VALIDITY OF ECONOMIC INDICATORS. While the wealth of economic data provided by Washington is useful, the data need careful interpretation by those who know what to look for.

18.12 FORECASTING THE BUSINESS CYCLE (a) NATURE OF THE BUSINESS CYCLE. A business cycle is a recurring series of expansions and contractions, involving and driven by a vast number of economic variables, that manifests itself as changes in the level of income, production, and employment. As will be described in the next

1. The controller can check through the appropriate company channel or directly from its commercial bankers as to data available.

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section, these swings can have a profound impact on a company. A business cycle tends to be longterm in nature, and is very difficult to predict in terms of length or intensity. It is driven by so many variables, most of which interact with each other, that it is excruciatingly difficult to determine the exact causes of previous cycles and the timing of the next one based on those variables. Though the exact causes of the business cycle are difficult to discern, there are essentially two types of variables that cause business cycle changes to occur. The first is an exogenous variable. This is a variable that impacts the economic system, though it is not an integral component of the system. For example, a bad rainy season will impact the crop yields in the farming community, which in turn reduces the amount of purchases by farmers for the next season’s crop, which in turn impacts the activity of the suppliers of those purchases, and so on. Another exogenous variable is a war, which can wreak enough destruction to entirely shatter an economy. These types of variables can, to some extent, be called “acts of God.” The other type of variable is the endogenous variable. This is a variable that impacts an economic system from within. For example, overcapacity in the resin-production industry causes suppliers to reduce their resin prices to plastic molding companies, which in turn can now reduce the prices of their products, which creates an increase in sales, and contributes to an increase in the level of economic activity. Other examples of this type include the demand for products, and pricing changes. The typical company operates within a single sector of the economy, where a single major shock, either of the endogenous or exogenous variety, can cause immediate and massive changes, since individual sectors are much smaller than the national economy, and so can be severely impacted by smaller events. For example, an increase in the price of aviation jet fuel will cause the airlines to increase their prices, which reduces the number of seats filled, which drives down airline profits and forces them to postpone orders for new jets, which in turn harms the airline manufacturing companies and their supporting groups of suppliers — all due to an increase in the price of jet fuel, which is just a single variable. Consequently, a controller may not be overwhelmingly concerned with the operations of the entire national or international economy, since the typical economic contraction corresponds to a drop in GNP of only a few percentage points. However, industry-specific changes within that larger economy can be truly catastrophic, and it is within this smaller economic environment that a company operates and must make management changes. This leads us to the next section, which covers the specific problems a company faces as a result of changes in the business cycle. (b) IMPACT OF THE BUSINESS CYCLE ON THE CORPORATION. What happens to a company when the business cycle changes to a new phase, either upward or downward? We will begin with the impact of an economic contraction. When management realizes that sales have declined, it must contract the business. One of the first steps taken is to reduce inventories, so that the company is not stuck with a large investment of products that will be at risk of becoming obsolete before they can be sold. One way to reduce inventories is to sell them off at reduced prices, but this cuts into gross margins and also fills the distribution pipeline, so that no additional sales can be made until the pipeline clears. The more common approach is to reduce the production staff and all related overhead staff with a layoff, the extent of which will be driven by management’s perception of the depth of the upcoming cyclical decline. Management will also likely curtail capital expenditures and increase controls over incidental expenses. Further, the controller will be called on to tighten credit to customers and heighten collection activities to ensure that accounts receivable do not include any bad debts, and that collections are made as soon as possible. If there are excess funds available, management will likely use them to pay down debt, so that fixed costs are reduced to the bare minimum in anticipation of poor sales conditions at the bottom of the economic cycle. Also during business downturns, there will be a few adventurous companies that will buck the industry trend and expand. They do this because they anticipate a short downturn in the economy, and they want to pick up new business, either by undercutting competitors or (more commonly) by waiting until financially weaker companies begin to fail, and then buying them. They may also take advantage of lower real estate and equipment costs during these periods to add to their capacity with inexpensive new production facilities. This strategy is possible only if a company has sub-

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stantial cash reserves or available debt, and has an aggressive management team that is willing to take chances. When the economy begins to turn in an upward direction, management must make several contrary decisions. The first one is to ramp up existing production capacity, which may have been shuttered, and now requires refurbishment before production can begin. Then management must determine the extent to which it wants to rebuild its inventory levels to anticipate renewed sales. This is a critical decision, for overproduction in a weakly rebounding economy will create more inventory than is needed, whereas producing too little in the midst of a strong economic rebound will result in sales being lost to more aggressive competitors. If the rebound is sudden, the company must spend more money on staff overtime and rush equipment deliveries to bring production back up to speed as soon as possible. Credit policies likely will be loosened in order to bring in new business, and management must decide on how much new capital equipment to purchase, and the most appropriate time for when to acquire it. All of the changes noted here, for either an increase or decrease in the business cycle, call for changes in a company’s operations that will certainly have some impact on profits, but even more so on the level of working capital and fixed assets. For example, waiting too long to cut back production will result in an excess investment in inventory, as well as any new capital projects that were not curtailed in time. The reverse problem arises during an economic upswing, when reacting too slowly will result in a cash inflow from the sale of all inventory, followed by the loss of additional profits because all of the inventory has been sold, and there is none left to sell. Thus proper management of working capital and fixed assets lies at the heart of management’s decisions regarding how to deal with changes in the business cycle. (c) ELEMENTS OF BUSINESS CYCLE FORECASTING. In this section, we will review who does forecasting, what information they forecast, and the methods they use for doing so. Forecasting is conducted not only by various branches of the federal government, such as the Department of Commerce and the Federal Reserve Board, but also by a number of universities and private institutions. The governments and schools do so as a public service, but the private groups do so for an entirely different reason — they create tailored forecasts that churn out estimates on very specific items, such as stock prices or exchange rates, that are requested by top-paying clients. These forecasts commonly cover a series of quarterly periods, which, due to the short time frames involved, are much more difficult to predict with any degree of reliability than the annual forecasts that were more common in the last few decades. The governments and universities focus on such macro issues as the Gross National Product or the rate of inflation. The trade group to which most of these organizations belong is the National Association of Business Economists. There are four primary methods used to arrive at forecasts. Since each one is based on different information and may arrive at somewhat different results, it is common for forecasters to blend the results of two or more methods to arrive at their estimates of future conditions. The methods are: • Anticipation surveys. These are surveys of key people in the business community. The purpose of these surveys is to collect information about the intentions of the survey participants to engage in capital purchases, acquisitions, changes in headcount, or any other steps that may impact the economy, and then aggregate this information to arrive at general estimates of trends. • Time series models. These are trend lines that are based on historical information. For a forecast, one finds the trend line that fits a similar set of previous conditions, and fits it to the current conditions to arrive at a trend line of future expectations. These can be relatively accurate in the short run, but do not generate good results very far into the future. • Econometric models. These are highly complex and iterative models that simulate the real economy, and are frequently composed of hundreds of variables that interact with each other. These can yield good results over periods longer than those predicted by time series models. However, changes in the results of the models are difficult to explain, given the complexity of the underlying formulas. • Cyclical indicators. These are the leading, coincident, and lagging indicators that foretell changes in the economy. This method is a good way to confirm the existence of business cycle

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changes that have been predicted by other forecasting methods. A leading indicator is something that changes in advance of an alteration in a business cycle, such as the number of new business formations, new capital expenditure requests, construction contracts, the length of the average work week, layoff rate, unemployment insurance claims, profit margins, new orders, investments in residential structures, capacity utilization, and new bond or equity issues. These can change anywhere from a few months to over a year in advance of a related change in the phase of the business cycle. A lagging indicator is something that changes after an alteration in the business cycle has occurred, and is used by forecasters to confirm the business cycle change that was indicated by leading indicators. Examples of lagging indicators are investments in nonresidential structures, unit labor costs, and the amount of consumer credit outstanding. The exact forecasting method used depends on the person doing the forecasting, and is largely influenced by judgment. The reason why judgment is such a necessary factor in forecasting is that all of the forecasting methods, with the exception of anticipation surveys, are based on the interpretation of historical economic data, which may no longer impact the economy in the same manner as it did when the various models were constructed. Thus, having an in-depth knowledge of the current economic situation, and using their information to adjust the results of quantitatively derived forecasts is the key difference between a quantitative analyst who does nothing but tweak the numbers, and a great forecaster who consistently outperforms the outcomes predicted by the various models. In addition to judgment, forecasters will use numeric weighting schemes, where they give greater value to the results of certain forecasting models or specific variables, depending on their experience of past forecasting results, or their guesses regarding changes in the economy for the period being predicted. Some forecasters will even combine and average out the predictions of groups of other forecasters, on the grounds that this will create a consensus opinion that has a better chance of being accurate. However, there may be a wide dispersion in the various forecasts being predicted, which makes it difficult to arrive at a time period for forecasted changes in the business cycle based on this approach. Once the forecasters make their predictions, they also compare their forecasts to the actual results as that information arrives. They will then spend a great deal of time modifying their forecasting methods to make their next set of forecasts more closely match the future results. This is an ongoing process that never ends, because the underlying variables that drive business cycles are constantly altering the degrees of force with which they impact the economy. Also, old variables may eventually have so little impact on business cycles that they are dropped entirely from the forecasting systems, while new variables must be researched and inserted into the models. Thus, the after-the-fact review of forecasting models and their component parts is a major forecasting task. When reviewing the effectiveness of the variables that comprise a forecast, there are several factors to consider. One is that a small pool of variables may result in an incorrect forecast, because each of them may be adversely impacted by exogenous variables that yield results not truly representing their impact on the business cycle as a whole. However, by using a large number of variables in a forecasting model, one can tolerate a minority of variables that yield incorrect results, while still arriving at an overall forecast that is made accurate by the sheer volume of variables included in the model. Another item to review is the number of months by which leading indicators presage a change in the business cycle. Though there may be historical justification for using a certain number of months in a forecasting model, these periods can change, sometimes to the extent of having a leading indicator turn into a lagging indicator. Also, the selection process for variables needs to be very in-depth before they are added to a forecasting model. For example, a new variable should be thoroughly researched to determine the extent of its linkage to a business cycle, how well it predicts business cycle behavior, how consistently it does so, and also how frequently information about the variable is reported (so that it can be included in the forecast in a timely manner). Only if all these questions receive favorable answers should a new variable be included in a forecasting model. Having briefly described who creates forecasts, what information they issue, and how they arrive at these forecasts, we now turn to the role of the controller in creating forecasts that are tailored for the use of company management.

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(d) BUSINESS CYCLE FORECASTING AT THE CORPORATE LEVEL. What can a controller do in his or her role as a financial analyst to provide business cycle predictions to the management team? There are several possible routes to take. The main factor a controller must decide on is balancing the time needed for forecasting against the perceived value of the information. For example, if a company has a stable sales base that rarely varies, irrespective of what stage the business cycle is currently in, then there is no reason to track cycles very carefully. Also, if the accounting function is understaffed, the needs of day-to-day activities will probably supersede any demands for forecasting. However, if a controller can prove that the deleterious effects of not tracking business cycle conditions will lead to company losses that significantly exceed the cost of having extra staff on hand to perform the analysis, then this second factor disappears. Let us assume that there is some time available for forecasting work, and that business cycles have a sufficient impact on company conditions to be worthy of review. If so, here are some possible actions to take to obtain, analyze, and report on business cycle forecasts. They are listed in ascending order of difficulty: • Report on published forecasts. There are forecasts published by nearly every major business magazine for the economy at large, which can be easily extracted, reformatted into an internal report, and presented to management, perhaps as part of the monthly financial statements. Several key advantages are that the information is fairly accurate for the entire economy, it is prepared by professional forecasters, and it is essentially free. The problem is that each company operates in a smaller industry within the national economy, and as such is subject to mini-business cycles that may not move in lockstep with that of the national economy. For this reason, the reported information may be only generally relevant to a company’s specific situation. • Subscribe to a forecasting service. A company can pay a significant fee, probably in the fiveto six-figure range, to a forecasting service for more specific reports that relate to the industry in which it operates. This is a good approach for those organizations that do not have the resources to gather, summarize, and interpret economic data by themselves. However, some industries are too small to be serviced by a specialized forecasting service, or the fee charged is considered too high in comparison to the value of the information received. • Develop an in-house forecasting model. In cases where a company either wants to run its own forecasting model, or there are no forecasting services available that can provide the information, and it is deemed relevant, it is time to try some in-house forecasting. This effort can range from a minimalist approach to a comprehensive one, with each level of effort yielding better results. The first step is to go through the steps noted in the preceding section to find the right kinds of data to accumulate, followed by implementing a data-gathering method that yields reliable data in a timely manner. Then, one must work with management to determine what resulting information is desired (usually a sales estimate). Then the controller must arrive at a methodology for translating the underlying data into a forecast. Then the controller should develop a standard reporting format that imparts the results to management. This report should include the underlying assumptions and data used to arrive at the forecast, so that any changes in the assumptions are clearly laid out. Finally, there should be a methodology for comparing the results against actual data, and adjusting the forecasting methodology based on that information. Though this approach is a time-consuming one, it can yield the best results if a carefully developed forecasting system is used. For example, let us assume that a controller of a sport rack company has elected to use the last of the above options for creating forecasting information. Sport racks is a very small niche market that creates and sells racks for skis, snowboards, bicycles, and kayaks that can be attached to the tops of most kinds of automobiles. The controller wants to derive a forecasting system that will give management an estimate of the amount by which projected sales can be expected to vary. She decides to subdivide the market into four categories, one each for skis, snowboards, bicycles, and kayaks. Based on a historical analysis, she finds that 25 percent of ski purchasers, 35 percent of

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snowboard purchasers, 75 percent of bicycle purchasers, and 30 percent of kayak purchasers will purchase a car-top rack system to hold their new equipment. The typical delay in these purchases from the time when they bought their sports equipment to the time they bought sport racks was six months. The controller finds that she can obtain new sports equipment sales data from industry trade groups every three months. Given the lag time before users purchase car-top racks, this means that she can accumulate the underlying data that predict sport rack sales and disseminate them to management with three months to go before the resulting sport rack sales will occur. Thus, she concludes that these are usable data. The next task is to determine the company’s share of the sport rack market, which is readily obtainable from the industry trade group for sport racks, though this information is at least one year old. Given the stability of sales within the industry, she feels that this information is still accurate. She then prepares the report shown in Exhibit 18.6. It shows total sports equipment sales for the last quarter, uses historical percentages to arrive at the amount of resulting sport rack sales, and then factors in the company’s market share percentage to determine the forecasted sales of each type of sport rack. By comparing this information to the previously forecasted sales information, the report reveals that the company should significantly ramp up its production of snowboard sport racks as soon as possible. The example used was for an extremely limited niche market, but it does point out that a modest amount of forecasting work can yield excellent results that are much more company-specific than would be the case if a company relied solely on the forecasts of experts who were concerned only with general national trends. For most companies, there will be a number of additional underlying indicators that should be factored into the forecasting model; however, the work associated with tracking these added data must be compared to the benefit of more accurate results, so that a controller arrives at a reasonable cost-benefit compromise.

18.13 SALES STANDARDS (a) DEFINITION OF SALES STANDARDS. A standard has been defined as a scientifically developed measure of performance. It was further noted that standards can be adapted to the measurement of sales performance in somewhat the same way they have been used to judge performance in the factory. The primary requirements in developing tools for the sales executive are threefold: 1. Sales standards are the result of careful investigation and analysis of past performance, taking into consideration expected future conditions. Sales standards represent the opinion of those best qualified to judge what constitutes satisfactory performance. Judgment about detailed operations must rest largely with the sales executives. Opinions about expected general business conditions and market potentials should represent the combined judgment of the executive staff, including the chief executive, the sales manager, and the controller. 2. Sales standards must be fair and reasonable measures of performance. Nothing will be so destructive of morale as a sales quota, or any other standard, set much too high. Experience shows that such standards will be ignored. The standards must be attainable by the caliber of salesman the company expects to be representative of its selling staff. 3. Sales standards will need review and revision from time to time. As sales conditions change frequently, so the measuring stick must change.

Description

Sports Equipment Unit Sales

% Buying Sport Racks

Company Market Share

Forecasted Company Unit Sales

Original Company Forecast

Variance

Ski Snowboard Bicycle Kayak

3,200,000 2,700,000 2,500,000 450,000

25% 35% 75% 30%

40% 40% 30% 30%

320,000 378,000 562,500 40,500

300,000 300,000 550,000 45,000

20,000 78,000 16,500 4,500

E XHIBIT 18.6

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(b) PURPOSE OF SALES STANDARDS. Sales managers are sometimes of the opinion that sales standards are not welcome. Some sales executives feel that sales standards are an attempt to substitute impersonal statistics for sales leadership. There is no substitute for dynamic and farsighted sales executives; there is no intent that sales standards in any way replace personal guidance. But sales standards do provide management with an important tool of sales control, a basis for fairly rewarding merit, and a stimulating device under many circumstances, but not all. As a tool of control they reveal weaknesses in performance that, if properly analyzed in terms of causes, open the way for correction and strengthening. As a basis for rewarding merit they result in a fairer and more accurate relationship between compensation and performance. As a stimulating device they provide each salesperson and executive with a goal of accomplishment and with assurance of fair reward. (c) NATURE OF SALES STANDARDS. The sales standards may be expressed in terms of effort, results, or the relation of effort to result. For example, a salesperson may be required to make three calls a day or fifteen calls per week. Making this number of calls meets this particular standard of effort. As a result of these calls, the expectations may be to secure ten orders for every fifteen calls or a certain dollar volume per call. Doing this meets this particular relationship standard. Securing a certain dollar volume from a given territory, regardless of the number of calls made or the orders and sales per call, meets another particular standard of results. Again, the standards may involve a relationship between selling cost and sales results. For example, in a retail furniture store, the standard may require that one prospective customer be attracted to the store for every $2 expended in advertising or that $1 of sales be secured for every $0.07 expended for advertising. If these goals are achieved, those responsible for the advertising expenditures are meeting the standards of advertising results. (d) ILLUSTRATIONS OF SALES STANDARDS. Although the applicability of sales standards to various industries and types of trading concerns may differ, suggestive standards the controller may consider discussing with the sales manager are: 1. Standards of effort
Number of calls to be made per period
Number of calls to be made on prospective customers
Number of dealers and agencies to be established
Number of units of sales promotional effort to be used (e.g., demonstrations or pieces of direct mail sent) 2. Standards of results
Percentage of prospects to whom sales are to be made
Number of customers to whom new articles are to be introduced or sold
Number of new customers to be secured
Amount of dollar volume to be secured
Number of physical units to be sold
Amount of gross profit to be secured
Amount of profit to be secured (here profit is frequently considered as the excess of gross profit over the expenses that are subject to the control of the salesperson or executive to whom the standard is to apply)
Amounts to be sold to individual customers (especially larger customers)
Dollar or physical volume of individual products or product classes to be sold
Percentage of gross profit to be returned (where there is a varied line or where the salesperson has price latitude)
Average size of order to be secured
Relation of sales deductions to gross sales

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3. Standards expressing relationship of effort and result
Number of orders to be received per call made
Number of new customers to be secured per call made on prospects
Number of inquiries or orders to be received per unit or per dollar of sales promotional

effort expended
Relation of individual direct selling expense items to volume or gross profit
Relation of sales administration or supervision costs to volume or gross profit

(e) DEVELOPING SALES STANDARDS: BENCHMARKING. Now that sales standards have been defined, their purpose and nature explained, and illustrations provided, the question arises as to how sales standards are and should be developed. To be effective, the standards must be accepted by those who use them as fair and reasonable, not the product of the whim of some overzealous bean counter. Benchmarking is used by a company to measure its products, services, and business practices against the toughest competitor, or those companies best in its class, or other comparisons. Brief commentary on this process and results are presented in Section 17.9. (f) REVISION OF SALES STANDARDS. Some standards of sales performance can be set with a high degree of exactness. The number of calls a salesperson should make, the percentage of prospects to whom sales should be made, and the physical units that should be sold to each customer are illustrative of performances that frequently lend themselves to accurate measurements. On the other hand, there are many factors in sales performance that are so governed by conditions beyond the control of the salespeople that the standards must be promptly revised to meet important changes in such conditions. Where a salesperson is given some latitude in price setting, the gross profit percentage may vary with competitive conditions beyond the salesperson’s control. Strikes, droughts, and floods may suddenly affect the sales possibilities in a particular territory. If the sales standards are to be effective measures of sales performance, they must be promptly revised as conditions change. Careless measurement of performance soon leads to discouragement, resentment, and disinterest in the task. (g) USE OF SALES STANDARDS. As stated previously, the purposes of sales standards are to control sales operations, to reward merit, and to stimulate sales effort. The standards in themselves are of limited value, except as they are made effective in the accomplishment of such purposes. To make the standards effective requires the following be done: • The variations between actual and standard performance be promptly determined • The causes of such variations be investigated and explained • The responsibility for the variations be definitely fixed • The individuals held responsible be given full opportunity to present their explanations • Prompt action be taken to correct any weaknesses revealed • The method of compensation shall provide a fair and accurate reward for performance (h) SALES QUOTAS AS STANDARDS. The most widely used sales standard is the sales quota. As usually constituted, the sales quota is the dollar amount of of physical volume of sales assigned to a particular salesperson, department, branch, territory, or other division as a measure of satisfactory performance. The quota may, however, involve other considerations, such as gross profit, new customers, collections, or traveling expense, thereby representing something of a composite or collective standard of performance. The quota does not differ in its purpose and use from other sales standards as discussed earlier. The applicability of the quota to various types of concerns depends largely on the extent to which sales and other results are actually affected by the direct efforts of the salespeople involved and the extent to which such results are affected by other factors, such as expenditures for advertising,

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special sales promotion, styles, and acceptability of products. Where the former is the dominant factor, sales quotas constitute a valuable type of sales standard. (i) BASIS OF SALES QUOTAS. Generally speaking, sales quotas are of value only to the extent that they are based on known facts relative to sales possibilities. They must not be based on the greed of the company or fanciful ideas of what might be done but on actual facts relating to past sales, sales in allied industries, population, buying power, or territorial conditions. The sales representative should be thoroughly informed about the method of arriving at the quota and convinced that the amount of sales assigned is entirely justified according to the existing conditions. Then, and only then, will the salesperson exert full effort in meeting the quota. The quota should not be thought of primarily as a basis for contests. The salesperson should consider the quota as representing a careful measurement of the task rather than a temporary target at which to shoot. Actual experience with sales quotas, as with all standards, will reveal that sales representatives react to them somewhat differently, particularly at first. Some are stimulated to their highest efficiency, whereas others are discouraged. Some sales executives place considerable emphasis on this human element in setting their quotas. In general, however, good salespeople will, in the long run, respond favorably to intelligently devised quotas, particularly when compensation is fairly adjusted to performance. The objection sometimes raised, that efforts are lessened after quotas are reached, is seldom valid if performance is properly rewarded. The chief difficulty arises when quotas are exceeded as a result of some fortuitous circumstance in which the sales representative has had no part or for which the share of the credit is uncertain. The solution here usually rests with extreme fairness in handling individual cases and with the development of confidence in the knowledge and integrity of sales executives. The method of establishing sales quotas is still unsatisfactory in many concerns. The matter is frequently given insufficient study, and the results are ineffective. There has, however, been a vast improvement in such methods in recent years, and alert controllers have made a substantial contribution to this improvement. Past performance is greatly influenced by conditions beyond the control of the individual salesperson. Hence a quota set when business is poor is likely to result in undue reward to the salesperson. Conversely, one set when business is good is likely to prove too high to serve as an effective incentive, or even provide fair compensation. (j) METHOD OF EXPRESSING QUOTAS. Insofar as practicable, quotas should be broken down into their detailed elements. This helps to show the sales representative where, how, and to whom the goods should be sold. To illustrate, a certain company gives each of its sales representatives the following details relative to the sales quota: • The proportion of the quota assigned to each product line • The part of the quota that represents an expected increase in business from new customers • The part of the quota that represents an expected increase in business among old customers • The part of the quota to be secured in cities of various sizes • The part of the quota assigned to particular kinds of outlets or classes of customers • The part of the quota to be secured from special or exceptional sources • The distribution of the quota by months Although such a plan entails considerable work, it tends to balance the sales effort and to assist the sales representative in directing work most effectively. It should be realized that such details require the necessary detailed analysis of past performance by the controller’s staff. Furthermore, such detail is indicative of a well-developed program. Many firms, particularly the small and medium sized, will express quotas in general terms only— so many dollars of sales or so many overall units. Where quotas are relatively new, the controller

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should proceed cautiously and develop the details gradually so that the sales executives can be guided step by step. Only when the data are available and the sales staff realizes the advantages of detailed planning can the quota type of standard serve most usefully. It frequently happens that the quota cannot be fairly expressed directly in money or physical volume. For example, a sale of $100 of class A goods may deserve more credit than a like amount of class B goods, or a sale to a new customer may deserve more credit than a similar sale to an old customer. In such cases, the quota may be expressed in points that give effect to a weighting for different types of sales performance. Thus a sale of $100 class A goods may be counted as 10 points, whereas $100 of class B goods would be counted as only 5 points. The “point” system may likewise be extended to include other types of service, such as calls on new prospects, demonstrations, or collections. The final requirement for effective standards is an adequate method of compensation as a reward for good performance.

18.14 SALES REPORTS (a) EFFECTING SALES CONTROL. Fundamentally, control is the prompt follow-up of unfavorable trends or conditions before they develop into large losses. In the small business, the owner or manager can exercise current control of sales through a review of orders received and so forth. In the larger businesses, however, such personal contact must be supplemented by reports that indicate current conditions and trends as well as current performance. It is the function of the controller, of course, to furnish the sales executives with the sales facts. However, it is one thing to furnish the information; it is quite another thing to see that it is understood and acted on. To assure the necessary understanding, the controller must adapt the report to the reader. Information for the needs of the chief executive will be different from that for the sales manager, and reports for subordinate sales executives will differ even more. The extent of the information required and the form of presentation will depend on the capabilities of the individual, the type of organization, the responsibilities of the vender, and the philosophy of sales management. (b) NATURE OF SALES REPORTS. Sales executives have many management styles and backgrounds. Some sales managers can effectively use vast amounts of statistical data, whereas others prefer summarizations. Accordingly, the controller should offer to develop reports to meet the requirement. The use of charts, graphs, and summaries will greatly enhance the communication of the sales data to sales management. In many instances, a narrative report citing the significant issues or problems is the most effective tool. Depending on the seriousness of the problem, or where major actions are being recommended, a meeting may be in order. It is up to the controller to ensure that the information provided is understood and can be properly used. (c) CONTENT OF SALES REPORTS. The matters that may be included in a sales report cover a broad front. Such reports might contain: • Actual sales performance, with month- or year-to-date figures • Budgeted sales for both the period and year to date • Comparison of actual sales by firm with industry figures, including percentages of total • Analysis of variances between budgeted and actual sales and reasons for differences • Sale – cost relationships, such as cost per order received • Sales standards—comparison of actual and quota sales by salesperson • Unit sales price data • Gross profit data These data often may be expressed in physical units or in dollars. Aside from actual or standard sales performance, some may relate to orders, cancellations, returns or allowances, or lost sales.

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(d) ILLUSTRATIVE FEATURES IN SALES REPORTS. As stated previously, the content of sales reports must be varied to suit the needs and personality of the user. Reports to the chief executive and top sales executive, for example, should present the overall view in summary fashion. A simple comparison of actual and planned sales by major product line or territory, as shown in Exhibit 18.7, summarizes the sales in a brief but informative manner. Summary information is also presented comparing the company performance against industry by months (or years) in Exhibit 18.8. A graphic comparison of actual with planned sales as illustrated in Exhibit 18.9 is also useful. Sales executives also find trend reports on product lines to be of value. A percentage bar chart, illustrated in Exhibit 18.10, would be particularly significant if the profit by product group is greatly different. Trends in sales volume are easily shown by vertical bar charts similar to that pictured in Exhibit 18.10. Sales managers typically need information on the probable future course of sales. For this purpose, timely reports summarizing the orders-on-hand picture are helpful. Such a report, which may be desired daily, weekly, or monthly, is illustrated in Exhibit 18.11. The graphs and reports presented thus far have been rather simple in nature. Whereas reports always should be understood, in many cases, particularly in larger companies, they must be more analytical or detailed in nature. Moreover, for control purposes and adopting the concept of “responsibility reporting,” the performance of each segment of the sales organization should be made known to the supervisor responsible. It follows, therefore, that reporting must be available for each division, district, area, branch, or salesperson. A typical branch report is illustrated in Exhibit 18.12 and is very brief. However, as reports relate to increasingly lower levels of management, such information can become massive in extent. Therefore, although data may be periodically prepared on each segment of the organization, it has been found practical to apply the “exceptional principle” in a great many cases. This method eliminates data where performance was satisfactory and details only that which did not reach acceptable levels. An example is Exhibit 18.13, indicating only those salespersons who were 5 percent or more under budget. Another report prepared on only out-of-line performance is that shown in Exhibit 18.14. Only customers on which a loss was realized are listed. It is to be noted that two profit or loss computations are made: 1. Actual out-of-pocket losses, using the direct costing concept 2. Gross loss, wherein all fixed and allocated charges are considered (e) FREQUENCY OF REPORTS. The frequency of any report will depend on the individual requirements of each executive or staff member and may be daily, weekly, monthly, or quarterly. For example, the top executive and general sales manager may want a daily report on sales, orders received, and orders on hand; a weekly report may suffice; or a report may be wanted daily during a critical period and less frequently thereafter. In those cases where sales data are collected by use of data input devices from remote locations and stored in the computer, reports and data can be provided on a visual display unit on a real-time basis.

18.15 PRODUCT PRICING : POLICY AND PROCEDURE (a) PRICES IN A COMPETITIVE ECONOMY. From the economic viewpoint, prices are the regulator of our economy in that they determine the distribution of goods and services. Over the long run, when prices in a given industry are insufficient to provide an adequate return, capital and labor tend to shift to more attractive fields. In the individual business, also, skill in setting prices has a tremendous impact on the profitability of the operation and therefore on its economic life. Product pricing is a difficult area in which to make decisions because of the many forces at play. It is so complex a subject that it is not ordinarily a one-man job or one-activity job. Rather the combined talents of marketer, accountant, engineer, and economist may be needed. It might be said that pricing is one-third computation and two-thirds judgment. From the accounting viewpoint, however, the one-third computation is an essential aid to the judgment factor. Factors that influence prices include market conditions, costs of manufacturing and distribution, plant capacity, competitive activity, capital investments, financial liquidity, government pressures, and a multitude

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E XHIBIT 18.7

C OMPARISON

Comments (to be coded to figures) *Significance variance. (1) Action assigned to. (2) Strike. (3) Other —(explain).

Product line “B” Item 1 Item 2 Item 3 Item 4 Total Total

Product line “A” Item 1 Item 2 Item 3 Item 4 Total

OF

A CTUAL

Actual

TO

Over (under) Plan

Month

P LANNED S ALES

Plan

Ch. 18 Planning and Control of Sales

Product or Territory

356

Last Year Actual Actual

Plan

Over (under) Plan

Year to Date

ABC M ANUFACTURING C OMPANY C OMPARATIVE S TATEMENT OF S ALES M ONTH OF _________________ 200X

Last Year Actual Indicated Final

Plan

Total Year Over (under) Plan

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ABC M ANUFACTURING C OMPANY C OMPARISON OF C OMPANY AND I NDUSTRY S ALES

E XHIBIT 18.8

G RAPHIC C OMPARISON

OF

C OMPANY

VS . I NDUSTRY

ABC M ANUFACTURING C OMPANY P RODUCT A S ALES

E XHIBIT 18.9

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A CTUAL

AND

P LANNED S ALES ; S ALES T REND

S ALES

357

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Ch. 18 Planning and Control of Sales

ABC M ANUFACTURING C OMPANY S ALES OF P RODUCT L INES , BY M ONTHS

E XHIBIT 18.10

P ERCENTAGE

OF

S ALES

BY

P RODUCT L INES

ABC M ANUFACTURING C OMPANY S UMMARY OF O RDERS ON H AND

Description Vehicles Type A Type B Type C Type D E XHIBIT 18.11

Orders on Hand July 31, 20XX

Orders on Hand June 30, 20XX

Orders Received

Orders Canceled

Orders Delivered

Units

Sales Value ($ in thousands)

50 100 150 60

25 — 50 10

5 5 — —

10 20 5 5

60 75 195 65

120.0 262.5 838.5 97.5

R EPORT

ON

S ALES O RDER A CTIVITY

of others. It is therefore understandable that there exists a diversity of approaches to the problem. But this situation presents an equally valid reason to attempt to set out some guiding principles. (b) PRICES AND THE CONTROLLER. The accountant’s contribution to the accounting control of sales is in most cases largely after the fact. That is, comparisons of actual performance are made with budget, forecast, or standard; or sales data are analyzed to reveal unfavorable trends and relationships. In the field of product pricing, however, the controller may be able to exert “preventive” accounting control before the occurrence by bringing facts to bear on the problem before unwise decisions are made. This activity is closely related to profit planning as well as control. The influence of prices on company profits is obvious, and the finest controls on costs and expenses will not succeed in producing a profit if selling prices are incorrectly set. If the controller is charged with a responsibility for protecting the assets of the company, or of exercising the control function on costs and expenses or capital expenditures, then an important role should also be played in price determination.

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E XHIBIT 18.12

C OMPARISON OF

B UDGETED AND

A CTUAL S ALES

BY

B RANCH

18.15

Product Pricing: Policy and Procedure

359

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E XHIBIT 18.13

2609 2671 2685 2716 2804 2827 2982 3007 5066

32,016 17,433 19,811 24,033 8,995 27,666 4,277 39,474 43,189 216,894 $1,044,326

$ 827,432 1,760 1,390 1,320 1,470 480 1,820 600 3,800 4,400 17,040 $ 95,570*

$112,610*

Amount

Under Budget

Current Month

5.2 7.4 6.2 5.8 5.1 6.2 12.3 8.8 9.6 7.3 10.1*

15.8*

%

TO

102,600 61,080 70,100 84,390 31,600 97,010 15,020 138,400 151,800 752,000 $5,375,096

$4,623,096

Actual Sales

ABC M ANUFACTURING C OMPANY S ALESPERSON —U NDER B UDGET 5% OR M ORE —Y EAR D ISTRICT P ITTSBURGH A PRIL 20XX AND Y EAR TO D ATE

Actual Sales

BY

E XCEPTION R EPORTING —S ALESPERSON P ERFORMANCE

*Better than budget.

Performance Satisfactory: Under Budget Performance: Abernathy Bristol Caldwell Fischer Gorder Inch Long Mather Owens Subtotal District Total

Salesperson No.

S ALES A NALYSIS

Ch. 18 Planning and Control of Sales

Description

360

6,300 4,270 4,600 5,090 1,810 5,930 900 8,540 9,080 46,520 $451,310*

$497,830*

Amount

%

5.8 6.5 6.2 5.7 5.4 5.8 5.7 5.8 5.6 5.8 9.2*

12.1*

Under Budget

Year to Date

D ATE

$ 1,520 1,080 1,150 1,270 450 1,480 230 2,150 2,270 $11,600

“Lost Gross”

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C USTOMERS —E XCEPTION B ASIS

S ALES A NALYSIS

E XHIBIT 18.14

127 243 182 24 281 19 76 32 984 $225,374

839 876 11314 207 436 920 800 392

$224,390

Net Sales

Margins satisfactory Gross losses year to date: American Steel Co. Barrett Machine Corp. Benson Mfg. Co. Central Heating Co. Fagan Steel, Inc. Jones Iron Co. Luckey Bridge Corp. Oppowa Metals Co. Subtotal District total

Customer

Customer No.

94 246 189 20 307 22 70 43 991 $157,421

$156,430

Direct Costs

33 3 7 4 26 3 6 11 7 $67,953

$67,960

Amount

18.15

13 62 23 12 56 9 6 20 201 $37,100

$37,301

Amount

10.2 25.5 12.6 50.0 19.9 47.4 7.9 62.5 20.4 16.5

16.6

361

% Net Sales

Gross Margin or Loss

Product Pricing: Policy and Procedure

25.9 1.2 3.8 16.7 9.3 15.8 7.9 34.4 .7 30.2

30.3

% Net Sales

Gain or Loss over Direct Costs

ABC M ANUFACTURING C OMPANY S ALES A NALYSIS BY C USTOMER —G ROSS L OSSES O NLY D ISTRICT C ALIFORNIA Y EAR TO D ATE THROUGH J UNE 30, 20XX ( DOLLARS IN THOUSANDS )

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Ch. 18 Planning and Control of Sales

And just what should the function be in price determination and related accounting control? It is hoped that it will not be merely as a source of information, providing data only when requested, and even then in the form and of the content specified. In many companies, it is questionable whether the pricing officials are fully aware of the kinds of facts required. Therefore, the controller should be expected to show some initiative and supply intelligent information from the legitimate sphere of activity. More specifically, the chief accounting official ordinarily can be of assistance by performing the following functions: • Help establish a pricing policy that will be consistent with the corporate objectives—for example, earning the desired return on investment. • Provide unit cost analysis, in proper form, as one factor in price setting. • Project the effect on earnings of proposed price changes and alternatives. • To the extent necessary or practicable, gather pertinent information on competitive price activity (this may be the function of the market research group or economics department in some companies). • Analyze the historical data on prices and volumes to substantiate probable trends as they may influence proposed price changes. • Determine for management, on a regular basis (such as the monthly operations report) the influence on profit of changes in price, product mix, sales volume, etc.; in other words, focus attention on the price problem where such action may bring about intelligent direction. Some of these procedures are reviewed in the sections that follow. (c) COST BASIS FOR PRICING. There is a great tendency to either underrate or overrate costs as a factor in setting prices. Frequently, the statement is heard that “prices are based on competition.” Less often, the statement is made that “prices are based on costs.” There are certainly circumstances where these comments apply. Rarely, however, can costs be ignored entirely. Over any extended period, no business can consistently sell all or most products at less than cost, cost that results from production and distribution functions and the related service activities. It is further recognized as a highly desirable condition that a profit be made on every product, in every territory, with every customer. Although this may not always be practicable, the closer such conditions are approached, the more certain or assured is the net profit. Hence, it is apparent that adequate cost information is absolutely indispensable. In summary, costs may be viewed as the point of departure or starting place in product pricing. And the role to be played by the cost factor depends on the circumstances. If the product is built to customer order, and is not a stock item, costs will be more important. Further, if competition is weak or if the company is a price leader, cost information will play a larger part than if the opposite situations exist. Also, elasticity of demand influences the weighting of costs in that an inelastic demand probably will cause costs to be a greater factor and costs at various volume levels must be studied to maximize earnings. The question then arises, “What kinds of costs are required?” For different purposes, different types of costs may be desirable. One type of cost may be suitable for a short-range decision and quite another type for longer-term purposes. Moreover, for pricing, the usual historical cost approach may not meet the requirement. In summary, then, the controller is expected to be aware of the several costing methods and the limitations of each and to select that concept most suited to the purpose at hand. Before reviewing several alternative costing techniques, some general observations are desirable. First, prices relate to the future. Therefore, costs to be used in determining prices must be prospective. Recognition should be given to cost levels expected to prevail in the period under review. Probable raw material and labor costs should be considered. Prospective changes in process ought to be reflected in the cost estimates. Inflation must be considered, and the best available information should be obtained to recognize what future rates of inflation can be expected. In this forecasting or projecting, the modern

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scientific tools should be utilized to the extent practicable, such as statistical sampling, sound economic principles, simulation methods, decision analysis techniques, price level analysis. Consideration should also be given to replacement cost of the productive capacity or capital assets. Prices must provide for the future replacement of these productive assets at the projected costs. Finally, it should be obvious that all costs related to a product should be considered and not merely the cost to manufacture. It defeats the purpose if manufacturing costs are carefully calculated but selling or other expenses are applied as an overall percent without regard to the direct expense and effort specifically applicable to the product. Although many costing methods or variations are in use, there are three basic approaches that warrant discussion: 1. Total cost method 2. Marginal or direct cost method 3. Return on assets method As a prelude to reviewing costing methods, it seems desirable first to review an example of the influence of costs on profit at differing volume levels. Further, the role of competitive conditions and demand in relation to costs needs to be understood. (d) ELASTICITY OF DEMAND. In exercising judgment on prices, elasticity of demand should be given proper weighting in any cost–profit–volume calculations. Normally, the pricing executives will have some general knowledge of the extent to which demand will react to changes in price. However, to provide supplemental assurance, perhaps controlled experimentation will be helpful in gauging this factor. If demand is relatively inelastic, and competitive conditions permit, then it may be possible to pass cost increases on to the customers. Under such circumstances, the controller can show the effect of cost changes on profits and the desirability of effecting price changes. If demand is highly elastic, and the market is somewhat noncompetitive, unit costs can be employed to determine the optimum price with which to produce the optimum profit. Under such circumstances, it is desirable to determine the sales price that will produce the greatest net profit over a long period of time. Too high a profit over a short term might invite competition or governmental regulation. Where conditions approach monopoly, it is perhaps of interest to review a typical procedure in setting selling prices. Basically, an estimate is secured from the sales manager about the probable number of units that can be sold at various price levels. Then the unit cost and total cost at the corresponding production level are calculated. That volume at which the greatest total profit is secured can then be determined. Exhibit 18.15 illustrates the application of this procedure. Here, it is suggested that the unit selling price may be set at $12, $10, $8, $6, $4, or $2. Estimates are then made about the number of units that can be sold at each price. These are indicated by the sales line. Thus it is estimated that 1,600 units can be sold at a price of $10 per unit, whereas 4,000 units can be sold at a price of $4. Likewise, the cost line shows the estimated total unit cost (including interest on investment) at each volume level. Thus it is estimated that the unit cost will be $5 when volume reaches 2,400 units. The spread between selling price and costs constitutes the unit profit that, multiplied by the number of units, gives the total profit at various price levels. At a price of $10, the profit will be $2 per unit, the volume 1,600 units, and the total profit $3,200. At a price of $8, the total profit will be $7,200. At a price of $6, the total profit will be $6,400. It is apparent here that the greatest profit will be made at a unit price of $8. (e) TOTAL COST METHOD. Now let us consider the three important costing techniques, the first of which is the “total cost” or “full cost” method. Under this concept, the cost of the individual product is determined, and to this figure is added the desired profit margin. Such a margin is usually expressed as a percentage of either cost or the selling price. As an example, the proposed selling price might be calculated as shown in Exhibit 18.16.

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Ch. 18 Planning and Control of Sales

$12

2 s le Sa

8

3 6

Co st

Selling Price and Unit Cost

10

5

2

4 1 2 *Denotes red 0 0

800

0

3200*

E XHIBIT 18.15

1600 2400 3200 4000 Quantity which will be taken 3200

7200 Profit

6400

4000

4800 3600*

M ETHODS OF S ETTING S ELLING P RICE C ONTROLLED M ARKET

IN A

Unit Cost and Selling Price

Cost and expenses Raw material (quantity  expected purchase cost) Direct labor (hours  expected hourly rate) Manufacturing overhead (150% of direct labor) Total manufacturing cost Research and development expense (10% of manufacturing cost) Selling and advertising expense (20% of manufacturing cost) General and administrative expense (10% of manufacturing overhead) Total cost Desired profit margin (25% of total cost) Proposed selling price E XHIBIT 18.16

Product A

Product B

$10.00 4.00 6.00 20.00 2.00 4.00 .60 26.60 6.65 $33.25

$ 3.00 8.00 12.00 23.00 2.30 4.60 1.20 31.10 7.78 $38.88

T OTAL C OST M ETHOD

In Exhibit 18.16, costs were used as the basis for determination of the markup, as well as the charge for each of the nonmanufacturing expense levels. As an alternative, each cost element could have been calculated in relation to the proposed selling price. Thus the profit margin might have been expressed in the formulas as 20 percent of the selling price, and expenses might have been treated in the same manner.

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Such a method has at least two advantages: (1) it is simple in application, and (2) it bases selling prices on all costs expected to be incurred — thus tending to assure full cost recovery, if the product sells and if the costs are generally as estimated. Over the longer run, all costs must be recovered. From the cost viewpoint, at least four disadvantages exist in using such a method exclusively: 1. It fails to distinguish between out-of-pocket costs and total costs. In the short run and with available plant capacity, there will be circumstances when business should be accepted on something less than a total cost basis. 2. It does not recognize the inability of all products to return the same rate of profit. Moreover, it fails to distinguish the elements of cost creating the profit, some of which cannot be expected logically to generate the same rate of income. For example, a product that is largely purchased materials may not reasonably return the same percentage of profit on total cost as one constituted mainly of labor and a consequent higher relative share of factory overhead and management talent. 3. The method does not recognize the optimum profit potential. The effect of elasticity in demand and the consequent point of greatest return are ignored. 4. This method of calculating tends to encourage a constant overhead application percent to the exclusion of volume factor likely to be applicable. The cost calculations can be modified to overcome the second objection. Then, too, several computations can be made to compensate partially for differing volumes. (f) MARGINAL COST METHOD. The marginal cost approach to prices gives recognition to the “incremental” or “marginal” costs of the product. These are costs directly associated with the product that would not be incurred if the product were not manufactured or sold. Any selling price received above this floor represents a contribution to fixed expenses and/or profit. The application of this principle to products A and B described in the full cost method might produce a picture as shown in Exhibit 18.17. In Exhibit 18.17, incremental costs have been segregated from direct expenses of a fixed nature applicable to the product, and these direct costs have been identified separately from the allocated costs of a fixed nature. If the product must be sold for the incremental costs or less, then the company would earn no less a profit, or possibly even a higher profit, by not manufacturing and selling such product. Full consideration must be given, of course, to related profit results, namely, sales of other products to the customers, and so on, if the withdrawal of a given product would in fact cause loss of the other business. From the longer-range viewpoint, the minimum price to be charged would be that covering all direct costs, and for the company to continue in business over the longer term, all costs must be recouped. Unit Cost

Raw materials Direct labor Variable manufacturing expense Variable selling expense Variable administrative expense Total variable or incremental cost Fixed expense directly applicable to product Total direct costs E XHIBIT 18.17

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M ARGINAL C OST M ETHOD

Product A

Product B

$10.00 4.00 1.50 1.50 .30 17.30 2.50 $19.80

$ 3.00 8.00 2.00 1.90 .40 15.30 3.10 $18.40

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It can be appreciated that marginal and direct cost data — before allocated continuing costs — are of value in any one of several situations: • Where additional sales may be made at reduced prices, over and above direct costs, to another class of customer, namely, private brand business, or under another trade name and so forth. • Where idle plant capacity can be utilized only at reduced prices and in other than regular sales outlets • Under circumstances where these added sales at reduced prices do not create problems in the regular marketplace The use of marginal costs is for short-term decisions only. The great danger is the tendency to secure a larger and larger volume of sales on an incremental basis, with an ultimate deteriorating effect in the market and a large share of business that does not return its full and proper share of all costs. Furthermore, under such conditions there is no return on assets employed from the products priced at not more than total costs. (g) RETURN-ON-ASSETS-EMPLOYED METHOD. From the profit viewpoint, the most desirable costing method is that which maximizes the return on total assets employed. This is the approach that has been given more attention in recent years. It is to be noted that under the two costing procedures just reviewed, no consideration has been given, for example, to the capital invested in manufacturing or sales facilities or in working capital. Yet, as discussed in Chapter 6, the real test of business efficiency is the rate of return on total assets employed. Growth generally takes place only when the product yields a reasonable return on the funds devoted to it. If the business objective is to maximize return on capital, then, as a starting point at least, the price of each product required to achieve the desired rate of return should be known. This method of determining markup over total costs for the desired percent return on assets rather than markup for a percent return on costs (or percent of net sales) has considerable merit in the opinion of the authors. Some of the assets employed are fixed in nature, such as plant and equipment. But a share of the investment—primarily current assets—is a variable of volume and prices. For example, accounts receivable will be higher as sales volume and sales prices are higher. Investment in inventory will increase or decrease as volume changes and as manufacturing costs and raw material prices fluctuate. In view of the variables, a formula may be employed to calculate the sales price required to produce a planned return on assets employed: Cost  (Desired % return  fixed assets) --------------------------------------------------------------------------------------------------Annual sales volume in units Unit price  ---------------------------------------------------------------------------------------------------------Desired %  Variable assets expressed  1  ------------------------- ------------------------------------------------------------ return   as % of sales volume  In the formula: Cost represents total cost of manufacturing, selling, administrative, research, etc. % return represents that rate desired on assets employed (before income taxes). The fixed assets represent plant and equipment, although some of the current assets might be placed in this category. The variable assets represent the current assets that are a function of volume and prices. Applying some assumptions, a unit price on product A may be calculated as: $2,660,000  (.20  $300,000) ----------------------------------------------------------------------------100,000  ----------------------------------------------------------------------------1  (.20  .30) $2,720,000/100,000 units  ------------------------------------------------------------1  .06

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  27.20 -  $28.936  -----------.94 The proof is computed in this manner: Income and costs Sales (100,000 units at $28.936) Costs Income before taxes Assets employed Variable (30% of $2,893,600) Fixed Total assets employed 20% Return on assets employed of $1,168,080 (fractions ignored)

$2,893,600 2,660,000 $ 233,600 $ 868,080 300,000 $1,168,080 $ 233,600

The foregoing is intended to show the method of determining unit sales prices to provide a target or planned return on investment. Although applied to a single product, the percentages used were those of the product class or group of which product A is one segment. (h) APPLYING THE RETURN-ON-ASSETS-EMPLOYED CONCEPT. The simple example just cited purposely avoided some of the controversial or problem areas in using the return-on-assetsemployed concept. Some brief observations on the subject may prove helpful. Under this procedure, total assets employed is considered to include all assets used in manufacturing and selling the product (including related services). It is immaterial how the funds were provided — whether by debt or equity. The management of a company should effectively use all assets, whether owner supplied or creditor supplied. Another question often raised is the basis of valuation of assets. Should replacement value be considered? Should fixed assets be included on a gross or depreciated basis? Essentially, policies of valuation will have no appreciable effect on price determination. Recognition can be provided directly or indirectly in the rate of return objective. Consistency is the important consideration. In a multiproduct company, a problem to be solved is the allocation of capital employed to the various product lines. On reflection, this need not be a major stumbling block. Just as controllers have been allocating costs to products for years, so also they can allocate assets on a reasonable basis consistent with the facts of the particular business. Some suggested methods of prorating assets to product lines are: Item Cash Accounts receivable Raw material Work in process Finished goods Fixed assets

Possible Bases In ratio to total product cost In ratio to sales, adjusted for significant differences in terms of sale In ratio to actual or expected usage In ratio to actual or expected usage In ratio to cost of manufacture In ratio to conversion costs (labor and variable manufacturing overhead) or labor hours—either actual, normal, or standard

(i) CONVERSION COSTS FOR PRICING PURPOSES. Still another economic concept useful in pricing is termed the “conversion cost theory of value.” In essence, this view holds that profits are, or should be, earned commensurate with the effort and risk inherent in converting raw materials into finished products. This approach has merit, particularly in situations where relative material content varies widely by product. For example, if one product is largely an assembly of purchased

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parts and another requires extensive processing in expensive facilities, application of the same markup to each probably would result in a price too high on the assembly item and too low on the fabricated product. Differences in types of costs may therefore need to be recognized. A combined use of the return-on-assets concept and direct costs may be illustrative. Assume the following is a typical pricing and profit-planning problem: • A given product line R is made up of products of varying material content. • $24,000,000 are the gross assets employed for the line. • Management desires a 20% return (before taxes) on the assets employed. • The pertinent profit data are:
Period (fixed or continuing) expenses are $6,000,000.
The profit to volume or contribution margin (P/V) ratio is 30%.
Direct materials and conversion expenses are, on the average, in a 4 to 3 ratio.
Material turnover is twice a year. With these premises, it is necessary to calculate the following: • The sales volume needed to produce the desired rate of return • The markup to be applied on each of the direct cost factors in the product line Net sales and aggregate costs by element may be determined in this manner: Required operating profit (20% of $24,000,000) Add: Continuing or period expenses Required margin over direct costs Required sales [$10,800,000  30% (P/V ratio)] Deduct: Margin Direct costs Segregated on a 4 to 3 ratio as: Direct material Conversion

$ 4,800,000 6,000,000 10,800,000 36,000,000 10,800,000 25,200,000 $14,400,000 10,800,000

$25,200,000

Inasmuch as the material turnover is two times per year, the investment is $7,200,000 ($14,400,000  2). Twenty percent of this figure is $1,440,000. Consequently, the additive factor is 10% ($1,440,000  $14,400,000), and the portion of sales revenue needed to provide a 20% return is $15,840,000 ($14,400,000  $1,440,000). The additive factor on conversion costs may be determined by the difference method as: Total required income (sales) Less: Direct material and related profit additive Balance attributable to conversion factor

$36,000,000 15,840,000 $20,160,000

Thus, the conversion markup is 1.867 ($20,160,000  $10,800,000). If the direct costs of product R162 in the line are known, the target or “ideal” selling price is then determined in this fashion: Unit Direct Cost Direct material Conversion Total

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$16.10 20.30 $36.40

Factor 1.100 2.867

Unit Selling Price $17.71 58.20 $75.91

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Such proposed prices are only a starting point — they must be considered in relationship to competitive prices. The setting of product prices is complex and includes the evaluation of many variables. It is the task of the controller to provide for management’s judgment all pertinent facts. The various costing methods must be considered and the most appropriate applied in the particular company set of circumstances. In addition to the applicable costs, other factors in setting product prices to be summarized for management’s review are: • Return on invested capital or assets employed • Assets employed and turnover • Percentage of plant capacity utilized • Percentage of product line for each product • Percentage of market • Competition pricing and percentage of market • Margin over direct costs Recognizing the numerous “what-if” situations in setting prices, the controller should be familiar with the many computer models available for evaluating such business decision as price formulation. The variable inputs can be provided to the system, and when combined with the stored data, the alternatives can be quickly and easily evaluated. From a control viewpoint, a key responsibility for the controller is to participate actively in the costing and pricing function.

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CHAPTER

19

PLANNING AND CONTROL OF MARKETING EXPENSES 19.1

INTRODUCTION 371

19.2

DEFINITION 371

19.3

SIGNIFICANCE 372

19.4

FACTORS INCREASING THE DIFFICULTY OF COST CONTROL 372

19.5

SALES MANAGER AND MARKETING EXPENSES 373

19.6

BASIC APPROACH IN THE PLANNING AND CONTROL OF MARKETING EXPENSES 373

19.7

MARKETING EXPENSE ANALYSIS 373

19.8

TYPES OF ANALYSES 374 (a) Analysis by Nature of Expense 374 (b) Analysis by Functional Operations 374 (c) Analysis by Manner of Application 375 (d) Contribution Margin Approach 376 (e) Technique of Analysis by Manner of Application 377 (f) Analysis by Territory 377 (g) Analysis by Product 378 (h) Analysis by Customer 380 (i) Analysis by Size of Order 382 (j) Other Analyses 384 (k) Using Mathematical Techniques 385

(l) Interpreting the Results of Analysis 385 19.9

PLANNING MARKETING EXPENSES 386 (a) Administrative-Type Budget 386 (b) Project-Type Budget 387 (c) Variable Volume Budget 388 (d) Competitive Service Budget 392 (e) Summarized Marketing Expense Budget 392

19.10 SPECIAL COMMENTS ON ADVERTISING AND SALES PROMOTION EXPENSE 392 19.11 CONTROL OF MARKETING EXPENSES 397 19.12 MARKETING EXPENSE STANDARDS 397 (a) Standards and Control 397 (b) Can Standards Be Established for Marketing Activity? 397 (c) Types of Marketing Expense Standards 398 (d) Other Considerations in Setting Marketing expense Standards 399 (e) How to Set Marketing Expense Standards: Benchmarking 399 (f) Additional Information Needed 400 (g) Use of Standards for Control 402

19.1 INTRODUCTION The planning and control of sales are discussed in the preceding chapter. But the relationship between sales and the effort (the marketing effort) to achieve the sales plan is so close, that it is practical to now review the planning and control of marketing expenses.

19.2 DEFINITION In a broad sense, marketing expenses may be defined as the costs relative to all activities from the time goods are produced/manufactured or from the time of purchase in a nonmanufacturing company until the products reach the customer — the cost of marketing or selling. This would include the 371

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applicable portion of all costs, including general, administrative, and financial expenses. For our purposes here, however, the discussion is limited to those expenses, exclusive of general, administrative, and financial expenses, that are normally under the control of the marketing or sales executive. They may include, but are not limited to, the following general classifications: • Direct selling expense. All the direct expense of order-getting costs, including direct expenses of salespersons, sales management and supervision, branch sales offices, and sales service (the expenses generally incident to the solicitation of orders). • Advertising and sales promotion expense. All media advertising expenditures, expenses relating to various types of sales promotions, market development, and publicity. • Transportation expense. All transportation charges on outbound goods to customers and returned sales and costs of managing and maintaining the operation of outbound transportation facilities. • Warehousing and storage expense. Includes all costs of warehousing, storing, inventory handling, order-filling, packaging, and preparation for shipment. • Market research expense. The expenses of the various project studies, including the expenses of administering the department activity, undertaken to test or obtain information on the various products, markets, channels of distribution, or other distribution segments. • General distribution expense. All other expenses related to distribution functions under sales management that are not included in the foregoing items. They may include general sales management expenses, recruitment and training, and staff functions such as accounting, if applicable.

19.3 SIGNIFICANCE The costs of getting the manufactured products to the customer, consumer, or user have become increasingly more significant in recent years. In fact, for many companies the total costs of distribution of the products are in excess of the production or procurement costs. In general, it may be stated that the manufacturing costs have been decreasing, whereas the costs of selling and distributing the product have been increasing. To some degree, the increase in selling expense that results in increased sales volume has enabled companies to achieve greater efficiency in the manufacturing process. In most companies, more effort has been directed toward analysis and control of production costs, and the costs of marketing have either not been available in usable form or not communicated to responsible marketing management for decision making. Executives responsible for the selling and distribution of the products must be made aware of the cost components to effectively plan and carry out a proper distribution system effort. The controller must develop the control mechanisms, secure the facts and interpret them, and communicate the information to the marketing executives. To be effective, the marketing executive must understand the accounting control information and use it in developing his marketing plans and resolving any problems that may develop. The increasing costs of marketing can be effectively controlled and even reduced if the controller works with the sales and marketing management to develop the necessary control techniques and thus obviously have a positive impact on the bottom line — net profit.

19.4 FACTORS INCREASING THE DIFFICULTY OF COST CONTROL Any controller who tackles the matter of marketing expenses control will find that the problems usually are much more complex than those relating to production costs. First, the psychological factors require more consideration. In selling, the attitude of the buyer as well as the salesman is variable, and competitive reaction cannot be overlooked. This is in sharp contrast to production where the worker is generally the only human element. Moreover, in marketing activities the methods are more flexible and more numerous than in production, and several agencies or channels of distribution may be used. Such conditions make the activities more difficult to standardize than production activities. Also, the constant changes or switches in method of sale or channel of distribution are factors that make it harder to secure basic information. Even when the information

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is secured, great care must be used in interpretation. Finally, the nature of the activities requires different types of costs than might be needed in production. Where the indirect or allocated costs are significant, the analyses may require a more relative marginal or incremental cost approach under various circumstances. Such conditions create problems that may test the ingenuity of the controller.

19.5 SALES MANAGER AND MARKETING EXPENSES The sales manager is responsible for two primary functions in a business: (1) the requisite sales volume of the right products, and (2) the planning and control of marketing expenses. These may seem like two diametrically opposed objectives. However, the situation may be described as a problem of balance: If more money is spent for the distribution effort, what does the business receive in return? Usually, the sales manager will be under continuous pressure to increase sales and yet reduce selling expenses. It is obvious, then, that the sales manager must be in a position to know whether marketing expenses really are too high, and if they are too high, just where—what salesperson? what territory? what expense? The sales effort must be wisely guided, and if this is to be done the controller must provide the necessary financial facts. The sales manager must have an intelligent analysis of distribution costs as a basis on which to work. Marketing decisions must be based on adequate knowledge.

19.6 BASIC APPROACH IN THE PLANNING AND CONTROL OF MARKETING EXPENSES The many variables already mentioned in connection with marketing costs should make it fairly obvious that the problem of control is complex and difficult. In production cost control, a usual procedure is to compare actual and standard or budgeted expenses and exert continuous pressure on actual expenses until they are brought in line with the standard or budget. To an extent this can be done with respect to marketing costs, particularly those of a routine, repetitive, and nonselling nature, such as order handling or warehousing. But by and large, a more positive approach is necessary to avoid an injurious curtailment of necessary distribution services. That approach consists in securing the greatest possible effectiveness in the selling or marketing operations. As a matter of experience, any controller will find many occasions when suggestions that selling costs be reduced will arouse resentment on the part of the sales force. But almost any sales manager will listen when the approach is that of getting more distribution effort and results for the same money. Unit selling costs can be effectively reduced by getting greater volume from the same sales force, whether by securing larger orders, more customers, or otherwise. This does not obviate the fact that there will be many instances where costs must and will be reduced, but it does emphasize the consideration necessary about the effect on sales volume of reduced marketing expenses. Since emphasis in the marketing operations is in large measure directed to securing more effective results (more earnings per dollar of distribution cost) it can be seen that much of the study and effort will be applied in a preventive way. Comparative margins and distribution costs may be used in setting future action, in changing plans to secure improved results.

19.7 MARKETING EXPENSE ANALYSIS Marketing costs are analyzed for three primary purposes: 1. Cost determination 2. Cost control 3. Planning and direction of the selling and distribution effort Perhaps the least important of these is cost determination. Yet costs must be ascertained to establish selling prices, formulate distribution policies, and prepare various operating statements. However, the most important purpose is to supply the marketing executives with the necessary information in the planning, direction, and control of the marketing effort. Sales plans must be

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developed on the basis of those programs or projects that seem to offer a reasonable return. The sales effort must be directed along the most profitable channels, and inefficiencies eliminated. The what, when, and where questions of sales direction must be answered. An analysis of marketing expenses will not provide all the answers to all the sales manager’s problems, but it can play an important part in making decisions. Therefore, since marketing cost analysis is useful in the early stages of both the planning and control of costs, it seems logical to review this function before proceeding to the detailed planning and control procedures.

19.8 TYPES OF ANALYSES There are three basic methods of analyzing marketing expenses: 1. By nature of the expense or object of expenditure 2. By functions or functional operations performed 3. By the manner of application of the distribution effort The effective direction and control of sales effort usually require all these various types of analyses if the sales manager is to be furnished with the necessary information. (a) ANALYSIS BY NATURE OF EXPENSE. Generally, the ledger accounts in even the smallest companies provide for a recording of marketing expenses by nature of expense or object of expenditure. For example, salaries, payroll taxes, supplies, rent, traveling expense, and advertising space are usually set out in separate accounts. This is often the first, and sometimes the only, analysis made of marketing expenses. Such an analysis does provide some information for cost control purposes, general though it may be. With the type of expense segregated month by month, it is possible to follow trends and compare the expense with the previous month and with the same month last year. The ratio of the expense to net sales can also be determined. But a comparison with other periods serves to perpetuate inefficiency, and weaknesses will be revealed only in extreme instances. It should be clear that an analysis by nature of the expense is of limited value. The cost of marketing generally is known. Yet the controller cannot tell the sales manager the traveling expense is too high or that too much is being spent on advertising. It must be known whose selling expenses are too high and how it is known they are too high. The points of high cost must be clearly defined and responsibility placed, and possibly even the solution suggested. The controller cannot expect cooperation from the sales manager or chief executive on the basis of generalities. The excess cost of specific operations or the excess cost of securing particular results must be set out if an intelligent effort is to be made in reducing the cost or improving the effectiveness of the effort. The limitation of analysis by the nature of the expense, from a control standpoint, is obvious. And since the information provided is very general, it serves little useful purpose for the direction of the sales effort. (b) ANALYSIS BY FUNCTIONAL OPERATIONS. An analysis that has been found useful, particularly for the control of marketing expenses, is that by functions or functional operations. It is of assistance in measuring the performance by individual responsibility, especially in those applications where the organization is complex or large. The approach is substantially similar to that used in analyzing production costs and may be outlined as: 1. Establish the functional operations to be measured, taking care to see that the functions are properly segregated in terms of individual responsibility. Some illustrative functional operations are: (a) Salesperson’s calls on prospects or customers (b) Shipments from warehouse (c) Circular mailing

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2. Provide for a cost segregation of these functions. In this connection the classification should provide for those costs that are direct in regard to the function. For cost determination, perhaps cost allocations should be made. Generally, however, for cost control, emphasis must be on the direct expenses only. Thus in a small branch warehouse such expenses as the indirect labor, supervisory salaries, and fuel should be known, but these costs should be distinct from the allocated share of the regional sales office expense. 3. Establish units of measurement of functional service to the extent practicable. For example, the pounds of shipments might be the measure of the shipping expense, or the number of salesperson’s calls might serve as one measurement of direct field selling expense. 4. Calculate a unit cost of operation by dividing the total controllable functional cost by the number of units. 5. Take corrective action if out-of-line conditions appear. This situation may become more readily apparent if standards are established and actual performance is measured against them. It will be appreciated that this method cannot be applied to all marketing costs, but it may extend to a considerable portion. The functional approach is useful in control and also in analysis by manner of application. For example, if an analysis is being made by territories, it is necessary to record the number of functional units of the particular activity used in that territory and then simply multiply this number by the unit cost to arrive at a fair cost of the function for each territory. A specific application of the functional analysis in controlling costs is discussed in Section 19.12. (c) ANALYSIS BY MANNER OF APPLICATION. It is one thing to have an efficient organization from the standpoint of performance of the individual functions and quite another thing to see that the performance is so directed and coordinated that it is productive of the most fruitful results. For example, the controller might well show the sales manager that the cost per call is very reasonable or that the cost per hundredweight of handling material in the New York warehouse is below standard. Yet the controller must go much further in his analysis. It is as important, perhaps even more important, that the controller provide information about income or results achieved in relation to the effort or cost expended. Sales effort must relate to sales possibilities, and these factors must be brought into proper balance. Analysis by manner of application is primarily for the purpose of providing information in the direction of sales effort. The income from a particular factor is being measured against the cost applied against that factor. This type of analysis indicates the distribution cost of different territories, products, customers, channels of distribution, methods of sale, or salespeople. Depending on the problem, the controller must counsel with the sales manager and decide which ones are most useful. These analyses probably will extend to various subanalyses. For example, the breakdown of territorial costs among different products distributed or expected to be distributed might be necessary. In making any analysis by manner of application, an important consideration is the proper segregation of costs. The value of the cost study will depend in large part on this factor. For this type of analysis, marketing expenses may be divided into three main groups: direct costs, semidirect costs, and indirect costs. As the name implies, direct costs are those immediately identified with a segment and need no allocation. For example, in an analysis by salesperson, the field expense of salary, traveling expense, and entertainment incurred by that salesperson is direct. However, in an analysis by product these expenses might be semidirect or indirect. Expenses that are direct in one application are usually not in another. Ordinarily, the classification of accounts is such that one application is direct for many of the expenses. Semidirect costs are those related in some measurable way with the particular segments under study. The variability factor responsible for the amount of the expense is known and recorded quantitatively, and the costs may be distributed in accordance with the service required. Thus, the cost factor of the warehousing function might be pounds handled. The order-handling costs might relate to the number of item lines. Stated in other terms, the basis of allocation is less arbitrary than a basis selected at random, such as net sales; and the cost results are therefore of more signifi-

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cance. This might be said to be the distinction between the semidirect costs and those other common or joint costs here designated as indirect. Indirect expenses are a general charge against the business and must be allocated on a more or less arbitrary basis. No simple measure is available to identify the expense with one territory or product, as distinguished from any other. In practice this may be found to be due as much to records kept as to the nature of the expense. Common examples are institutional advertising or the salaries of general sales executives. There perhaps is little relationship between institutional advertising and the sales in the Western territory as contrasted with the Middle Atlantic territory. There might be little relationship between the costs of general sales administration and sales of product X as compared with product Y. Where it is practical for the general sales executive to keep a time record, the allocation of the expense may be less arbitrary and of more significance. For marketing expense analysis, as for any intelligent analysis, the type of costs most suitable will depend on the purpose of the study. For long-term decisions, total costs should be known; hence allocated costs need to be identified. If, however, decisions are of limited scope and for a short period, such as the sale to a private brand customer for the next year, then perhaps only direct expenses ought to be considered. The advisability of making arbitrary allocations of indirect costs may be questioned. It is most important, however, that those who use the figures are knowledgeable about limitations. (d) CONTRIBUTION MARGIN APPROACH. In making a choice between alternative business decisions, usually some costs are unaffected regardless of the conclusions reached. For this reason, among others, it has been found practical to isolate and identify those costs that do change to the exclusion of those costs that do not. The contribution margin approach adopts this concept, although such a segregation may be made in a total cost study as well. The “contribution margin” is calculated by deducting from sales income those costs incurred in obtaining that segment of the sales income being analyzed. It may be the sales and costs of a given territory or product or customer and need not relate to the company’s entire sales of the period. These costs may be described as costs that would not be incurred if the segment being reported on were not present. Such costs are sometimes known also as “variable costs” or as “direct costs.” As costs are defined in the preceding section, the costs deducted would include all direct costs, plus, in some instances, the semidirect costs. The inclusion of the latter would depend on the extent to which some of the content is fixed or continuing in nature. As an example, if the bulk of warehousing expense is variable, the period expense content, such as the foreman’s salary, might be ignored. In such a case, the entire semidirect costs for the warehousing function might be included. (As a practical matter, the authors assume in all illustrations of semidirect costs that such costs relate basically to an activity factor and would be reduced generally in proportion to volume.) The costs and expenses not deducted from sales income in computing contribution margins are those not changed in the total amount by the decision under review. The contribution margin, therefore, is the contribution that the activity under question makes toward meeting the fixed or continuing expenses and profit. The use of such an approach does not ignore the period costs. Rather it recognizes that the separation of the common expenses in relation to the business decision at hand serves little useful purpose and emphasis should be placed on the “contribution” or provision made by the segment toward the joint expenses and profit. The contribution margin approach and the related “direct costing” have these advantages: • Measurement of the immediate gain to the company’s overall profit by the transaction or segment under review. • Facilitation of management’s decision because those costs to be changed are already separated from costs not affected. • Avoidance of errors and controversy that arise by reason of cost allocations and allocation methods. • Simplicity of application, since direct costs usually are identifiable more readily than total costs, including the necessary allocations. • Data can be secured much more quickly and with less effort.

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In practice, marginal costs are used for short-term tactical decisions and their value can be appreciated. However, over the longer term, a business must recover total costs and a reasonable profit if it is to survive. Under the circumstances, there is no good reason why the total cost method and contribution margin approach cannot be used jointly. Such a statement would indicate the immediate profit effect of the business decision and, by inclusion of the joint or pooled costs, can reveal the operating income picture. Management's needs and the judgment of the controller will ordinarily dictate the type of costing most adaptable. For reasons of prudence, sometimes distribution costs will be segregated on a contribution basis, whereas manufacturing costs will be shown in total. An example of such a situation would be in circumstances where top management adopts the viewpoint that a sale must always recoup all manufacturing expenses, plus, at a minimum, the direct selling expenses. (e) TECHNIQUE OF ANALYSIS BY MANNER OF APPLICATION. There has been sufficient experience with marketing expense analysis by manner of application to prove the value of the technique. Although the degree of refinement may vary in different companies, the general approach may be outlined as: 1. Determine which analysis (or analyses) needs to be made. Determine which might be required in a particular application, such as an analysis by method of delivery. Again, some may be recurring and others may be made only as weaknesses are indicated. 2. Classify marketing expense according to those that are direct, semidirect, and indirect. 3. Select and apply the allocation bases to the semidirect and indirect expenses. This includes a segregation and proper treatment of variable, as contrasted with fixed, costs where such a segregation is a factor. 4. Prepare the analysis and commentary for the use of the proper executive. This will involve the following steps in arriving at significant cost and profit relationships: (a) Determine the gross profit by segment (e.g., territory, product, size of order). (b) Accumulate the direct expense by segment, and deduct this from gross profit to arrive at profit after direct expense. (c) Distribute the semidirect expenses, and deduct these to arrive at profit after semidirect expense. (d) Prorate the indirect expense to arrive at the final net profit (in some instances steps c and d will be combined). (e) Prepare the necessary subanalyses to pinpoint the conditions needing correction. These comments should indicate the principles and technique involved so that any controller can proceed to prepare the facts necessary in his particular situation. Comments on the need and use of certain analyses by manner of application are made hereafter. (f) ANALYSIS BY TERRITORY. A territory may be defined, for this purpose, as any geographical area, whether city, trading area, county, state, or sales district, used by a company for sales planning, direction, or analysis. Where, or in which territory, goods are sold has a great effect on the net profit. There are striking variations between territories in terms of sales potentials, net profit, and gross margins. If goods are sold free on board (F.O.B.) a central point and at the same price, the gross profit, of course, is unchanged. But if the product is sold on a delivered price basis, the gross margin is different because of transportation charges. In different areas the consumers' wants and needs are different, and this factor affects the total gross margins. Even aside from these considerations, experience has shown that the costs to sell and distribute are different in different territories. The cost to sell in densely populated New York is much different from the cost to sell in Western Texas. Because of all these dissimilar conditions, executives must have an analysis of distribution costs by territory. Such information permits the sales manager to rearrange sales effort where necessary and direct sales effort into the most profitable areas. Control of marketing costs is

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Ch. 19 Planning and Control of Marketing Expenses

facilitated through this same analysis, perhaps with the aid of cost standards. Sales planning, of course, with respect to new territories and new markets is affected by distribution cost considerations. Not every concern will find analysis by territory necessary. Such an analysis applies largely in those instances where a large geographical area is covered. Thus a manufacturer covering a national market would greatly benefit from such an analysis, whereas a retail store probably would not. Exactly what type of territorial analysis needs to be made depends on the problem and type of organization. If a territorial sales executive is largely responsible for costs and results, a complete analysis by this responsibility area is desirable. Or if the problem is one of costs to sell in small towns versus cities, such a segregation is to be made. A statement of income and expense by territory is shown in Exhibit 19.1. Once the points of weakness are discovered through analysis, corrective action needs to be taken. Some of the possibilities for such are: • Reorganization of territories to permit effort more nearly in line with potentials • Rearrangement of territorial boundaries to reduce selling expense, secure better coverage, and so forth • Shifting of salespersons • Increased emphasis on neglected lines or customers in territory • Change in method of sale or channel of distribution (shift from salesperson to agent, etc.) • Changes in physical facilities (warehouses, etc.) in territory • Elimination of unprofitable territories (potentials of area and out-of-pocket costs vs. allocated costs considered) • Change in advertising policy or expenditure in territory (g) ANALYSIS BY PRODUCT. In our dynamic and competitive economy, the design or style or type of product a firm sells may change constantly. The tremendous strides of research, among other factors, are repeatedly bringing new products into the market. Hence, every company is sooner or later faced with the problem of what products it should sell. Will the firm sell the best or the cheapest line? Will it promote the use of a new plastic? Should it introduce a silent airplane motor? The answer to questions like these are twofold. First, through market analysis a determination must be made about what the consumers want and what price they will pay. Then, through cost analysis it must be determined whether the company can make and sell the article at a profit. Therefore, an analysis by products is desirable. Many firms, in their urge to increase sales volume to better utilize facilities and personnel, often add new products to the line. Sometimes these new products “fit” into the line and permit certain economies. Often, however, the different products require services in varying degree. For this reason, too, an analysis by product is necessary to determine the cost to sell, as well as the net profit. Generally speaking, sales effort should be directed toward those products with the greatest net profit possibilities, and cost analysis is necessary to know just which products these are. This is not to say that a company should drop a low-margin item; it may be contributing more than out-of-pocket costs, or it may be necessary for customer convenience. Furthermore, there may be little possibility of selling a high-margin item to a customer. For example, there may be no chance of selling to a paint manufacturer any quantity of a high-profit glue instead of a low-margin paint vehicle. There are more factors than merely cost considerations in selling. But such conditions must be watched and held within reasonable limits. Marketing expense analyses by commodity, then, are of use in the direction of the sales effort. Many controllers may find, in making product cost analyses, that the net profit on an entire line of products is not great enough or even that losses are being sustained. When such conditions are revealed, steps are usually taken to increase that margin because the firm may not be in a position to drop an entire line. This is but another way of saying that analysis is a means of controlling costs, because the manufacturing costs or marketing costs may be too high.

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI OF I NCOME AND

E XPENSE BY

2.00 20.23

15,780 $159,662

S TATEMENT

24.49 2.26 22.23

193,296 17,854 175,442

E XHIBIT 19.1

100.00 69.73 30.27 5.78

36,692 $850,000 92.8

4,200 750 670 5,620 44,380 31,066 13,314 2,219

35,359 5,000 10,650 51,009 788,991 550,127 238,864 45,568

T ERRITORY

2,000 $85,000 52.2

888 $ 9,207

11,095 1,000 10,095

$50,000

$840,000

Amount

Gross sales Less: Freight Returns Allowances Total sales deductions Net sales Cost of sales Gross profit Direct selling expenses Profit after direct selling expenses Semidirect expenses Profit after semidirect expenses Allocated share of general expenses Profit before income taxes Other Data Units sold Sales potential % of potential

% of Net Sales

Amount

Description

Total

2.00 20.75

25.00 2.25 22.75

100.00 70.00 30.00 5.00

% of Net Sales

West

17,333 $400,000 92.9

7,431 $ 98,095

113,326 7,800 105,526

13,500 1,050 3,890 18,440 371,560 241,514 130,046 16,720

$390,000

Amount

2.00 26.40

30.50 2.10 28.40

100.00 65.00 35.00 4.50

10,550 $225,000 99.4

4,473 $ 24,983

35,786 6,330 29,456

10,750 1,840 3,750 16,340 223,660 167,745 55,915 20,129

$240,000

19.8

2.00 11.17

16.00 2.83 13.17

100.00 75.00 25.00 9.00

% of Net Sales

Middle Atlantic Amount

Territory

% of Net Sales

Middle West

T HE P C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY T ERRITORY F OR THE M ONTH E NDED J ANUARY 31, 20XX

379

2.00 18.33

22.15 1.82 20.33

100.00 73.50 26.50 4.35

% of Net Sales

Types of Analyses

6,809 $140,000 106.7

2,988 $ 27,377

33,089 2,724 30,365

6,909 1,360 2,340 10,609 149,391 109,802 39,589 6,500

$160,000

Amount

New England

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Ch. 19 Planning and Control of Marketing Expenses

Finally, product cost analyses are helpful in setting selling prices when the company is in a position to use costs as a major guide. Such analyses are desirable in conjunction with determining maximum price differentials to particular customers. It is probably self-evident to most controllers or accountants that a product analysis of distribution costs should be made when the characteristics of the commodity or their methods of marketing are such that a uniform basis of allocation is not indicative of the effort or cost to sell. Thus, pounds or units of sale or sales dollars may be a fair measure of selling expense. There are numerous circumstances when such an apportionment is inaccurate or misleading: • If there are differences in the time or amount of sales effort required. Thus product A that sells at $0.60 each may require about three times the effort of product V which sells at $0.30 each. Neither sales dollar nor units would be a fair basis. Perhaps one product would require a high degree of technical assistance with frequent callbacks as compared with another. Again, specialty salespeople may merchandise one product, and a general-line salesperson may handle another. All such circumstances result in different costs to sell, and should be so reflected in the analyses. • If there are differences in the method of sale. Obviously, if one product is sold exclusively by mail order and another by salespeople, the selling cost cannot be prorated on a sales dollar or unit basis. • If there are differences in the size of the order. When one product is sold in 10-pound lots and another is sold in tank cars, many of the distribution costs can be different. • If there are differences in channels of distribution. One product may be sold directly to retailers, whereas another is distributed through wholesalers. Here, also, there is a difference in distribution cost. The analysis by product ordinarily will reveal areas of weakness about which corrective action can be taken in some degree, such as: • Shifting emphasis of the sales effort to more profitable lines or bringing effort in line with sales potential • Adjusting sales prices • Eliminating certain unprofitable lines, package sizes, colors, and so forth • Adding product lines related to the “family,” with consequent sharing of fixed distribution expense • Changing the method of sale or channel of distribution • Changing the type, amount, and emphasis of advertising • Revising packages, design, quality, and the like A statement of income and expense that incorporates the contribution margin concept by products is shown in Exhibit 19.2. (h) ANALYSIS BY CUSTOMER. It is no secret that many manufacturers or distributors carry unprofitable accounts or customers. Such a condition may result from a philosophy of “get the volume,” or from insufficient effort to do something about the status quo, or probably because the sales executive just does not have sufficient knowledge about marketing costs. Yet it costs more to sell to some types of customers than to others and more to one customer within a type than another. Some customers require more services than others, such as warehousing, delivery, or financing. Some customers insist on different prices, particularly where different size orders or annual purchases are factors. Again, the types of products sold to some classes differ from others. All these are reasons why analyses by customers are necessary to measure the difference in net profit. Aside from use in the direction of sales effort, these analyses serve in setting prices and controlling distribution costs.

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E XHIBIT 19.2

S TATEMENT

OF I NCOME AND

Hundredweight Sold Average Sale per Call (when sold) Number of “No Sale” Calls Lack of Volume Manufacturing Costs

Other Data

Less: Sales Deductions Net Sales Variable Cost of Sales Profit After Direct Mfg. Costs Direct Marketing Expense Semidirect Distribution Expense (Variable) Contribution Margin Fixed Expenses Manufacturing Marketing Total Profit (or Loss) Before Income Tax

Gross Sales

Description

18.4 4.4 22.8 29.4

4,900 1,170 6,070 $ 7,815

E XPENSE BY

P RODUCT

100.0 30.5 69.5 4.7 12.6 52.2

$27,890 1,295 26,595 8,100 18,495 1,255 3,355 13,885

1,950 $348.63 20 $ 2,800

% of Net Sales

Amount

All Products

1,000 $486.67 10 $ 600

3,000 600 3,600 $ 4,100

$14,600 600 14,000 5,000 9,000 500 800 7,700

Amount

A

3.00 .60 3.60 $ 4.10

$14.60 .60 14.00 5.00 9.00 .50 .80 7.70

Per Cwt.

100 30 130 (45)

620 25 595 300 295 25 185 85

50 $124.00 3 $ 500

$

$

Amount

B

T HE B EST C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT F OR THE M ONTH E NDED J UNE 30, 20XX

2.00 .60 2.60 $( .90)

$12.40) .50 11.90 6.00 5.90 .50 3.70 1.70

Per Cwt

Product

800 $736.00 4 $ 1,400

1,600 480 2,090 $ 3,440

$11,040 640 10,400 2,400 8,000 640 1,840 5,520

Amount

C

19.8

100 $54.33 3 $ 300

200 60 260 $ 320

$1,630 30 1,600 400 1,200 90 530 580

Amount

Types of Analyses

2.00 .60 2.60 $ 4.30

$13.80 .80 13.00 3.00 10.00 .80 2.30 6.90

Per Cwt.

D

381

2.00 .60 2.60 $ 3.20

$16.30 .30 16.00 4.00 12.00 .90 5.30 5.80

Per Cwt.

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Ch. 19 Planning and Control of Marketing Expenses

In most firms, the analyses by customers will not be continuous. Perhaps the sales manager will be interested in whether money is being made on a particular account, or changes may be contemplated only on certain groups of accounts. On these occasions special analyses can be made. Although analyses may be made by individual customers, particularly when there are a few high-volume accounts, by and large the analyses will relate to certain groups or categories. The two basic factors in selecting the classification to be used are the amount of marketing services required, for this is the primary reason for differences in marketing costs, and the practicability of segregating the marketing costs. Classifications that have proved useful are: • Amount of annual purchases • Size of orders • Location • Frequency of salespersons' calls • Type of agent (retailer, wholesaler, or jobber) • Credit rating of customers In making an analysis by classification of customer, one approach is to segregate all customers in the applicable group and determine total costs for each group. This may often be time consuming. Another method involves a sampling procedure, wherein representative customers in each category are selected and the cost of servicing them is determined. A modification of this approach is to make a thoroughly detailed analysis in some areas and a sample run in other areas. It will be appreciated that relatively few marketing expense items can be charged directly to customers and that allocations must be made. Statistical data from various reports will be found necessary, namely, the number of calls made to customers or customer classes and the time spent with customers or the number of orders. Presentation of the analysis by customers may take the form of an income and expense statement as shown in Exhibit 19.3. This example classifies customers according to type, but a similar analysis could be made by annual volume of sales. Occasions will arise when a decision must be made about whether the business with a specific customer should be continued or whether the method of sale ought to be changed. The use of unit analysis of individual customers, the contribution margin concept, and an alternative method of sale for small customers are illustrated in Exhibit 19.4. In this instance, changing the selling method from field calls to a phone basis resulted in the retention of valuable business and securing a contribution margin in line with normal operating requirements. Other data may be presented in graphic form, as in Exhibit 19.5. An analysis by customers will provide information of great value to the sales manager. It will give a clear view of the number of accounts in various volume brackets and the average value of orders. In using this information for corrective action, consideration must be given to potential volume and the absorption of fixed production costs. But it will furnish facts for executive discussion regarding: • Discontinuance of certain customer groups • Price adjustments • The need for higher margin for certain groups • Change in method of sale (i) ANALYSIS BY SIZE OF ORDER. Another analysis that may be made advantageously in many business concerns is that by size of orders. It has been recognized for some time that one of the causes of both high marketing expense and unprofitable sales is the small order — generally not because it is small in itself but because the prices arenot high enough to cover the costs and leave a profit. There are many instances where small orders cannot be discontinued. But again, the problem can be solved. Corrective action can be taken; it can be brought under control. Obviously, the first step a controller must take is to get the facts through an analysis of marketing costs by size of order.

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E XHIBIT 19.3

S TATEMENT

E XPENSE

67,700 BY

C USTOMER C LASS

5.7

100.0 80.7 19.3 9.1 10.2 4.5

$1,220,000 33,000 1,187,000 957,600 229,400 108,300 121,100 53,400 $

% of Net Sales

Amount

OF I NCOME AND

Less: Sales deductions Net sales Cost of goods sold Gross profit Direct customer marketing costs Profit remaining after direct costs Indirect customer marketing costs Profit (or loss) after marketing costs (and before income taxes)

Gross Sales

Description

Total

42,900

$690,000 20,000 670,000 503,800 166,200 82,400 83,800 40,900

Amount

6.4

100.0 75.2 24.8 12.3 12.5 6.1

% of Net Sales

Retailers

$(

Jobbers

400)

$220,000 3,000 217,000 187,700 29,300 20,800 8,500 8,900

Amount

T HE B EST C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY C USTOMER C LASS F OR THE M ONTH E NDED A PRIL 30, 20XX

(

.2)

100.0 86.5 13.5 9.6 3.9 4.1

% of Net Sales

19.8

383

8.4

100.0 88.7 11.3 1.7 9.6 1.2

% of Net Sales

Types of Analyses

$ 25,200

$310,000 10,000 300,000 266,100 33,900 5,100 28,800 3,600

Amount

Mail Order Houses

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Ch. 19 Planning and Control of Marketing Expenses

T HE R OTH C OMPANY S ELECTED C USTOMER A NALYSIS ON A S ALES U NIT B ASIS F OR THE S IX M ONTHS E NDED J UNE 30, 20XX Proposed Centralized Phone Order Desk

By Calls of Field Force

Net sales Direct costs Manufacturing Transportation Warehousing Selling Total Contribution margin Units sold Aggregate contribution E XHIBIT 19.4

Customer W

Customer X

Customer Y

Customer Z

$10.09

$10.16

$10.13

$10.21

$10.21

8.07 .11 .02 .09 8.29 $ 1.80 1,200 $2,160

8.09 .12 .02 .10 8.33 $ 1.83 1,090 $1,995

8.08 .14 .02 .09 8.33 $ 1.80 800 $1,440

8.08 .18 .04 .22 8.52 $ 1.69 390 $ 559

8.08 .18 .04 .09 8.39 $ 1.82 390 $ 710

C USTOMER A NALYSIS

ON

Customer Z

C ONTRIBUTION M ARGIN B ASIS

The problem is naturally more important in some concerns than in others, particularly where the order-handling costs are relatively large or fixed. By and large, the procedure for analyzing marketing expense by size of order is similar to that for other analyses. It involves segregating costs by factor of variability and applying the factors. In this case, certain costs will be recognized as fixed for all sizes or orders, others will vary with the money volume, and still others will vary with physical volume. By way of general suggestion, the steps to be followed might be: 1. Determine the size of the order groups to be studied (e.g., below $25, $25 to $50). 2. Classify the costs according to (a) those that vary with the size of the order (e.g., packing); (b) those uniform for orders of all sizes (e.g., accounts receivable bookkeeping); and (c) those that must be considered as general overhead with no direct relation to orders (e.g., certain advertising and supervision costs). 3. Identify the factors that appear to govern the amount of the variable expense (expense that varies with the size of the order) applicable to orders of different sizes (e.g., dollar value, weight, or handling time). 4. Apply the factors of variability to the variable expenses and add the uniform costs, thereby arriving at a direct cost of orders by sizes. 5. Apply the overhead costs by some suitable factor, such as hundredweight or dollar value, to arrive at the total order cost. (j) OTHER ANALYSES. for example:

There are other analyses that may prove useful in a particular concern,

• By channel of distribution. Useful where a choice in channel of distribution may be made in order to direct sales into the most profitable channel. The analysis needs to be made from time to time as cost trends change. • By method of sale. The same comments are applicable as in the case of analysis by channels of distribution.

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19.8 Types of Analyses

385

C OMPARISON OF P ROFITABLE AND U NPROFITABLE C USTOMERS N UMBER OF C ASES , N UMBER OF C USTOMERS , S ALES V OLUME , G ROSS M ARGIN AND S ELLING E XPENSE B ASED ON A NNUAL S ALES V OLUME % of Total 130

100

9%

18% 80

58% 130%

60

40

89%

88%

91%

82%

42%

20 11%

0 Profitable Customers

12%

Unprofitable Customers (Less than $200 Annual Sales)

30%

–30 Number of Calls

E XHIBIT 19.5

Number of Customers

Sales Volume

C OMPARATIVE D ATA

ON

Gross Profit

P ROFITABLE

AND

Selling Expense

Net Profit

U NPROFITABLE A CCOUNTS

• By salesperson. For the purpose of measuring the salesperson's performance in terms of profit and to better direct salespeople in their activity. • By organization or operating division. Useful where there are separate and distinct selling divisions. Such an analysis is used to measure performance of the divisional executive. Examples are analyses by departments in a department store, by stores in a retail chain store company, or by branches in a manufacturing organization. (k) USING MATHEMATICAL TECHNIQUES. The analyses indicated herein are only illustrative. The many variables and alternatives in the distribution or marketing function can indeed make the task of analyzing seem overwhelming. Problems to be solved include warehouse locations, transportation routes, most economical shipment patterns, and a host of others. To perform the needed review, and to effect economies in these functions, use of mathematical formulas or “models” in conjunction with a personal computer can be most helpful. By using mathematical symbolization and techniques, the many relationships and quantities can be expressed and dealt with. (See Chapter 34.) (l) INTERPRETING THE RESULTS OF ANALYSIS. It has already been stated that the primary purpose of distribution cost analysis is to supply the marketing executives with the necessary information for the planning, direction, and control of marketing effort. The preceding section has suggested the technique and purpose or use of various analyses. It is clear, however, that these methods and studies will be varied as the controller finds necessary. The controller must be alert to the pitfalls or limitations of any figures prepared. Perhaps the problem will be attacked from several sides. In some cases only the variable marketing expenses (or even production costs) will be used, whereas in others both the fixed and variable will be included.

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Ch. 19 Planning and Control of Marketing Expenses

Again, in making recommendations based on the marketing expense analysis, the decisions reached must consider every possible effect on every activity of the business. For example, the conclusion that a certain territory must be dropped must consider the net effect on profit — the change in factory volume with the same fixed expense and resulting differences in unit costs.

19.9 PLANNING MARKETING EXPENSES Just as sales must be planned in attempting to reach the annual profit objective, so also must marketing expenses. It is usually the task of the controller or the budget director to develop the procedures for estimating the expense levels, and to provide the proper format and supporting data so that the chief marketing executive can furnish the financial data for consolidating the annual business plan. But marketing costs differ in nature especially as to how the costs vary, or should vary, with volume and how they are best planned and controlled. Depending on industry practice and company experience, budgetary control of distribution costs may be achieved through one of these types of budgets: • Administrative • Project • Volume—variable • Competitive service (a) ADMINISTRATIVE-TYPE BUDGET. Probably the most commonly used budget for planning and controlling marketing expenses is what is described here as an “administrative-type” budget. The circumstances when this kind of planning and control device is most applicable include: • The expense level is not, and should not be, influenced by the day-to-day variations in the sales level. To be sure, expenses must bear a certain relationship to sales, but this is accomplished over a longer time span, say from year to year. • The output is not necessarily or easily quantified over very short periods, but rather over months — if then. Moreover, often the function is subjective in nature and relates to planning and controlling sales or to some other distribution effort. • The number of routine and recurring functions is limited. • Most of the expense is in the form of “people costs,” represented largely by the expense of salaries, fringe benefits, occupancy, and travel and entertainment. • The function is such that it cannot be planned and controlled on a project or program basis (as discussed in the next section). Typical departments whose expenses usually are managed by an administrative budget include direct selling, field sales offices, general and territorial or product sales management units, and possibly the order department. A typical procedure for developing an administrative-type planning budget is (see also Chapter 24): 1. The controller or budget administrator provides each marketing department manager (who will use this kind of budget) with last year's budget, and with the current head count and year-to-date expenses (by type of expense). This may be furnished through computer access or by worksheet. 2. The department manager estimates expenses for the remaining period of the current year (as in Exhibit 19.6), thus having two years of cost experience as a guide. 3. The sales executive estimates the departmental expenses by type of expenses and by month or quarter for the coming year. The sales executive takes into account the activity level expected, special tasks to be performed, general pay increases, and any other expected change in the function. Of course, the controller provides the sales executive with appropriate guidelines, such as fringe benefit rates, and other needed data. If traveling expenses are

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19.9 Planning Marketing Expenses

387

T HE I LLUSTRATIVE C OMPANY A NNUAL B UDGET S ALES A DMINISTRATION D EPARTMENT ( DOLLARS IN THOUSANDS ) Current Year Prior Year

Item No. of staff Expenses Salaries and wages Fringe benefit costs (40%) Travel Entertainment Communication Occupancy Supplies Depreciation Insurance Dues and subscriptions Miscellaneous Total E XHIBIT 19.6

4. 5.

6. 7.

Actual (9 mos)

Estimated (3 mos)

Total

Plan Year Total

Increase (Decrease)

6

8

8

8

10

2

$209 84 110 49 8 25 12 8 6 5 1 $517

$194 78 90 40 7 19 12 6 6 5 1 $458

$ 65 26 32 13 2 7 2 2 1 — — $150

$259 104 122 53 9 26 14 8 7 5 1 $608

$306 123 133 60 10 28 16 8 8 6 1 $699

$47 19 11 7 1 2 2 — 1 1 — $91

A DMINISTRATIVE- T YPE B UDGET

applicable, the marketing executive must estimate them, based on the number and types of trips to be made, etc. The completed estimate is forwarded by the marketing manager through organization channels for review and approval, before reaching the financial representative. The controller or budget officer reviews the departmental estimates for completeness and reasonableness. When the data seem in order, they are summarized for the marketing function. An administrative-type departmental marketing budget might appear as in Exhibit 19.6. When the business plan is completed and approved, the departmental executive is so informed. (Of course, there may be iterative changes.) After the planning period has commenced, the marketing executive is provided periodically (usually monthly) a comparison of actual and budgeted expenses for information and for corrective action, if warranted. (See Exhibit 19.7.)

(b) PROJECT-TYPE BUDGET. Probably the second most widely used budget in the planning and control of marketing expenses is the project type. This is so designated because many of the cost elements are best. planned on a project basis; that is, certain tasks or programs or projects are planned, then executed, and then the results are measured sometime in the future. The level of planned expense is not directly related to the immediate sales, but rather future sales over perhaps a year or two. The project is completed and the expense largely stops until another project is undertaken. The expense level bears a necessary relationship to sales, but only indirectly and over a period of time. Emphasis is on getting a certain task done within a certain time and within cost constraints. Typical activities handled largely on a project basis are advertising and sales promotion expense or market research. The budgetary procedure for a project type budget is essentially: 1. The marketing executives agree or decide what projects of a given departmental type are necessary to attain the planned sales objective or are otherwise desirable.

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Ch. 19 Planning and Control of Marketing Expenses

T HE I LLUSTRATIVE C OMPANY B UDGET R EPORT S ALES A DMINISTRATION D EPARTMENT ( DOLLARS IN THOUSANDS )

Month: June

Current Month

Item No. of staff Expenses Salaries and wages Fringe benefit costs (40%) Travel Entertainment Communications Occupancy Supplies Depreciation Insurance Dues and subscriptions Miscellaneous Total

Actual

Budget

9

10

$23 10 14 4 1 3 2 .5 .7 .5 .1 $58.8

$25 10 11 5 1 3 1 .5 .7 .5 .1 $57.8

Year to Date (Over) Under Budget 1 (a) $2 — (3)(b) 1 — (1) — — — — $(1)

Actual

Budget

9

10

$138 55.2 75 29 5 14 8 4 4 3 .5 $335.7

$150 60.0 67 30 5 14 8 4 4 3 .5 $345.5

(Over) Under Budget 1 $12. 4.8 (8.0)(b) 1 — — — — — — — $ 9.8

Notes: (a) Market analyst not yet located. (b) No provision made for London trips.

E XHIBIT 19.7

B UDGET R EPORT —A S ALES D EPARTMENT

2. The department manager (e.g., advertising or market research) estimates the cost for each project by type of expense, if applicable—usually in a format suggested by the controller. In some instances, budget limits are set based on estimated unit sales, or as related to prior year expenses (e.g., advertising). 3. The various projects are summarized and included in the departmental budget for the planning period. (See Exhibit 19.8.) 4. After appropriate review and change, if necessary, the budget is approved as part of the annual plan. (In many companies the advertising budget is approved by the board of directors as a special budget.) 5. Periodically, perhaps monthly, the actual expenses and commitments are updated and compared with the project budget and corrective action taken if necessary or possible. (See Exhibit 19.9.) (c) VARIABLE VOLUME BUDGET. A limited number of distribution activities are highvolume repetitive tasks that probably can be directly related to the immediate physical volume handled. The loading and unloading of trucks, freight cars, or packaging products are examples. Giving recognition to the need to have an adequate number of workers available, even when the volume fluctuates greatly, these activities can be planned, measured, and controlled much like some factory operations.) The steps involved in this type of variable budget are (see also Chapter 21): 1. For each department or activity grouping, expenses are identified by type (salaries and wages, fringe benefits, supplies, etc.).

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19.9 Planning Marketing Expenses

389

T HE I LLUSTRATIVE C OMPANY , I NC . A DVERTISING AND S ALES P ROMOTION B UDGET ( DOLLARS IN THOUSANDS ) Current Year Project Budget

Category

Plan Year Requested Budget

(Increase) Decrease over Current Year

Comments

Broadcast media

Radio —local Television

$

525

$( 25)

1,300

1,400

(100)

2,500 3,800 4,300

2,625 4,025 4,550

(125) (225) (250)

400 700

420 700

( 20) —

Price increase

1,200 2,300 900 350 1,900 5,450 9,750

1,100 2,220 900 300 2,000 5,420 9,970

100 80 — 50 (100) 30 (220)

Elimination of Oregon

400 160 140 100

420 168 120 90

( 20) ( 8) 20 10

General wage increase o f 5%

All other Total administration Grand total Percentage of sales

90 890 $10,640 8.0%

90 888 $10,858 7.4%

— 2 $(218)

E XHIBIT 19.8

AND

Regional Local spots Total Total broadcast media

500

$

Price increase Price increase ($65,000) Expanded coverage 5% price increase

Print media

Local newspapers Business publications General public magazines Subtotal Catalogs Newspaper stuffers Direct mail Total print media Total media Advertising administration

Salaries and wages Fringe benefits Travel Communications

A DVERTISING

No foreign trips Negotiation Pac Bell and AT&T

S ALES P ROMOTION B UDGET

2. Such expenses are segregated into their fixed and variable components for the planning period. Recognition must be given to the true cost drivers, as in activity-based costing. (See Chapters 5 and 21.) 3. For the planning budget, the estimated expenses are determined for each applicable time period (monthly or quarterly) by applying the estimated units to be handled to the unit variable expense rate, and adding the fixed components. (See Exhibit 19.10, which is expanded to show budget structure.) This planning budget is approved by the supervisor, when in order, and consolidated with the other distribution cost budgets to arrive at the total marketing department budget.

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E XHIBIT 19.9

$ 220 600 1,125 1,725 1,945 140 450 510 1,100 400 100 1,300 2,900 4,845 210 84 50 40 50 434 $5,279

525 1,400 2,625 4,025 4,550 420 700 1,100 2,220 900 300 2,000 5,420 9,970

420 168 120 90 90 888 $10,858 7.4%

$

60

— — — — — — $3,120

60 150 400 610 300 50 900 1,860 3,120

700 500 1,200 1,260

$

Commitments

Actual to 6/30/XX

210 84 50 40 50 434 $8,399

200 600 910 1,710 700 150 2,200 4,760 7,965

1,300 1,625 2,925 3,205

$ 280

Total

T HE I LLUSTRATIVE C OMPANY , I NC . A DVERTISING AND S ALES P ROMOTION B UDGET S TATUS R EPORT AS AT J UNE 30, 20XX ( DOLLARS IN THOUSANDS )

Expenditures

A DVERTISING B UDGET —S TATUS R EPORT

Broadcast media Radio —local Television Regional Local spots Total Total broadcast media Print media Local newspapers Business publications General public magazines Subtotal Catalogs Newspaper stuffers Direct mail Total print media Total media Advertising administration Salaries and wages Fringe benefits Travel Communications All other costs Total administration Grand total Percentage of sales

Project Budget

Ch. 19 Planning and Control of Marketing Expenses

Category

390

210 84 60 50 40 444 $2,589

200 150 200 550 200 150 — 900 2,145

200 800 1,000 1,245

$ 245

Estimated Cost to Complete

1,500 2,425 3,925 4,450

525

420 168 110 90 90 878 $10,988 7.5%

400 750 1,110 2,260 900 300 2,200 5,660 10,110

$

Indicated Total Cost

— — 10 — — 10 $(130)

— (200) (240) (140)

20 ( 50) ( 10) ( 40)

(100) 200 100 100

$ —

(Over) Under Budget

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700 2,500 100 $43,190

— .70 — .07

$15,000 6,000 1,500 600 23,100 9,240 1,000 1,000 400 500 1,000 3,000 650 — — .05

.10 .30 .10 .20 .03 — .15

Variable

Fixed

8,400 30,000 1,200 $518,280

V ARIABLE V OLUME B UDGET

8,400 30,000 17,200 $1,241,160

$ 180,000 324,000 18,000 32,400 554,400 221,760 48,000 120,000 40,800 78,000 22,800 36,000 61,800

Total

8,400 30,000 1,200 $537,684

$189,000 75,600 18,900 7,560 291,060 116,424 12,000 12,000 4,800 6,000 12,000 36,000 7,800

Fixed

— — 21,000 $886,578

— $323,400 — 30,870 354,270 141,708 42,000 126,000 42,000 84,000 12,600 — 63,000

Variable

Estimated Budget—200X

8,400 30,000 22,200 $1,424,262

$ 189,000 399,000 18,900 38,430 645,330 258,132 54,000 138,000 46,800 90,000 24,600 36,000 70,800

Total

Estimated Units —200W 360,000 200X 420,000

19.9

Planning Marketing Expenses

391

4. When approved, and when the year is underway, actual costs are measured monthly against the budgeted expense (fixed costs plus unit variable expense multiplied by the units handled) and corrective action taken if necessary. (See Exhibit 19.11.)

E XHIBIT 19.10

— — 18,000 $722,880

— $252,000 — 25,200 277,200 110,880 36,000 108,000 36,000 72,000 10,800 — 54,000

Variable

Est. Budget—Current Year 200X

$180,000 72,000 18,000 7,200 277,200 110,880 12,000 12,000 4,800 6,000 12,000 36,000 7,800

Fixed

Notes: Increases requested: 5% on all salaries and wages and incentive pay. No other changes.

Salaries Hourly wages Incentive pay —M Incentive pay—H Subtotal Fringe benefits Supplies Gas and oil Repairs —regular Repairs—special Communications Occupancy Utilities Property taxes and insurance Depreciation Miscellaneous Total

Item

Mo. Budget Structure

A NNUAL

T HE I LLUSTRATIVE C OMPANY L OS A NGELES T ERMINAL P LANNING B UDGET FOR THE Y EAR 200X

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Ch. 19 Planning and Control of Marketing Expenses

(d) COMPETITIVE SERVICE BUDGET. In a limited number of cases, the competitive servicetype budget, or profit or loss-type budget, may be useful. Basically, it can be applied when the costs of a distribution operation can be readily compared with an independent and similar service activity. Examples include building maintenance or warehousing activities. The procedure is closely related to the variable budget system just reviewed, combined with an in-house billing rate based on competitive prices. Steps in the process are: 1. The competitive price to be charged for each type of service is determined based on the area prevailing practice. 2. Expenses are accumulated on a responsibility accounting basis for the department. 3. Expenses are analyzed or identified into their fixed and variable components. 4. For the planning budget, the expected unit volumes are estimated and applied to the budget structure of fixed and variable elements: (a) To the competitive unit service prices to arrive at the net billings. (See Exhibit 19.12.) (b) To unit variable cost rates to arrive at the variable budget. This is added to the fixed expense budget, by type of expense, to arrive at the budget level for each type of expense. (c) As to “billings,” these should be properly handled in the distribution budget consolidation (i.e., eliminated in most cases). 5. For control purposes, the unit budget times the actual volume handled, plus the budgeted fixed costs, is compared to actual expense to determine budget performance. (See Exhibit 19.12.) 6. Corrective action is taken as required. (e) SUMMARIZED MARKETING EXPENSE BUDGET. When the individual department planning budgets are approved, they are summarized by the controller's staff to arrive at the tentative marketing expense budget as in Exhibit 19.13. For illustrative purposes only, this summary budget identifies the supporting types of budgets in the marketing function. When the complete annual plan is approved, the chief sales executive is advised by the chief executive officer (CEO) of the approved budget. This becomes a commitment by the CEO as to expense levels for the year.

19.10 SPECIAL COMMENTS ON ADVERTISING AND SALES PROMOTION EXPENSE In discussing marketing expenses, the example selected for a project-type budget (see Exhibit 19.8) was advertising and sales promotion expense. This expense, as well as market research expense, often is planned and controlled on a project basis. Planning and controlling advertising and sales promotion expense is the responsibility of the chief sales executive, and such expenses are included in the marketing expense budget for internal administration purposes. However, the approval process at the board-of-director level often considers this kind of expense in a separate budget review. For this reason, among others, some special comments appear appropriate. First, it may be well to define advertising as any paid form of nonpersonal presentation and promotion of ideas, goods, and services by an identified sponsor. Inherent in this and similar definitions is the fact that presentations are nonpersonal, that is, there is no face-to-face personal selling to the customer. It is a controlled, paid-for service, not free publicity. Sales promotion ims more difficult to describe. It may be supplementary to either advertising or personal selling. Typically, it takes the form of a special effort, usually for a limited time only, of inducements such as price reductions, cents-off coupons, cash refunds, or contests or prizes, to induce the purchase of the goods or service. The campaign may be directed to consumers, or salespeople, or other intermediaries.

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— $26,460 — 2,646 29,106 11,642 3,600 10,800 3,600 7,200 1,080 — 5,400 — — 1,800 $74,228

700 2,500 100 $44,807

Variable

$15,750 6,300 1,575 630 24,255 9,702 1,000 1,000 400 500 1,000 3,000 650

Fixed

700 2,500 1,900 $119,035

$ 15,750 32,760 1,575 3,276 53,361 21,344 4,600 11,800 4,000 7,700 2,080 3,000 6,050

Total

March

700 2,500 1,300 $117,975

$ 15,750 32,500 1,575 3,250 53,075 21,230 4,300 12,120 4,600 7,200 2,000 3,000 5,950

Actual

— — 600 $1,060

— $ 260 — 26 286 114 300 (320) (600) 500 80 — 100

(Over) Under Budget

2,100 7,500 5,700 $357,105

$ 47,250 98,280 4,725 9,828 160,083 64,032 13,800 35,400 12,000 23,100 6,240 9,000 18,150

Budget

2,100 7,500 5,900 $354,225

$ 47,250 98,000 4,725 9,800 159,775 63,910 13,900 35,000 12,000 21,100 6,040 9,000 18,000

Actual

Year to Date

Supervisor Units Handled

E XHIBIT 19.11

V ARIABLE B UDGET C ONTROL R EPORT

19.10

— 280 — 28 308 122 (100) 400 — 2,000 200 — 150

Special Comments on Advertising and Sales Promotion Expense

393

— — (200) $2,880

$

(Over) Under Budget

Johnsen 36,000

Notes: Telephone companies have announced an 8% increase in the tariff. Since no budget was provided for such an increase, Johnsen is requesting a budget adjustment.

Salaries Hourly wages Incentive pay —M Incentive pay—H Subtotal Fringe benefits (40%) Supplies Gas and oil Repairs —regular Repairs—special Communications Occupancy Utilities Property taxes and insurance Depreciation Miscellaneous Total

Item

Budget

T HE I LLUSTRATIVE C OMPANY L OS A NGELES T ERMINAL B UDGET —R EPORT — MONTH OF M ARCH

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Ch. 19 Planning and Control of Marketing Expenses

T HE I LLUSTRATIVE C OMPANY O REGON D ISTRIBUTION C ENTER B UDGET R EPORT

Item Net billings to using activities Operating Expenses Salaries and wages Supplies Vehicle maintenance Repairs Occupancy charges Depreciation Property taxes Miscellaneous Total Operating profit (or loss) E XHIBIT 19.12

Month of Units handled

January 200,000

Budget

Actual

Favorable (Unfavorable) Variance

$242,330

$201,100

$(41,230)

162,500 4,900 18,760 5,800 25,000 10,000 3,000 300 $230,260 $ 12,070

164,100 4,810 16,440 5,900 25,000 10,000 3,000 310 $229,560 $(28.460)

( 1,600) 90 2,320 ( 100) — — — ( 10) $ 700 $(40,530)

C OMPETITIVE S ERVICE B UDGET R EPORT

Second, the reasons for often separate consideration or approval by a board of directors (or internal management) include these factors: • For many companies, such as retail stores or consumer goods producers (e.g., Procter & Gamble, Kimberly-Clark, or Coca-Cola, Inc.), it is a major expenditure. • It is difficult to measure the effectiveness of advertising or sales promotion programs. • Closely related to the difficulty of measurement is the fact that the results of the program may be less immediate and less direct than some other type of marketing effort, such as direct selling. • Finally, advertising and sales promotion effort is usually organized as a separate department or as an outside agency, as compared with other selling efforts. All of these factors are among the reasons for separate budgetary treatment. Third, the type of expenses involved here differ somewhat from other marketing expenses. A large portion will represent media costs, whether for television or radio broadcasts, for printed media (such as newspapers and/or magazines), or for direct mail costs, or other public media costs (such as outdoor advertising). Associated with the media costs are the usual administrative expenses: salaries and wages, fringe benefits, travel, occupancy costs, automobile maintenance, and so on. Fourth, the purpose of advertising will vary in differing circumstances. While the general purpose is to support the broad marketing objectives, more specific goals may include: • Educate consumers in the use of the product or service. • Reduce the cost of other selling effort. • Increase sales. • Establish or maintain trademarks or brand names. • Develop new markets. • Meet or outdo competition.

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Variable Variable Variable Variable

E XHIBIT 19.13

S UMMARY M ARKETING E XPENSE B UDGET

Grand total—division

Project

Warehousing Portland Denver Chicago New Orleans Total

Administrative Administrative Administrative Administrative Administrative

Administrative Administrative Administrative

Administrative Administrative Project

Advertising and sales promotion

West Rocky Mountains Great Plains Southwest Middle West Total

Direct selling

San Francisco Chicago New Orleans Total

Branch offices

V.P. sales Customer relations Market research Total

General and administrative

Department

Type of Budget

2,960 1,840 3,480 1,710 9,990 $65,390

10,470

8,310 6,120 5,870 7,960 9,540 37,800

410 620 360 1,390

$ 3,840 780 1,120 5,740

Prior Year Actual

F OR

3,170 1,990 3,495 1,725 10,380 $67,760

10,560

9,120 6,230 6,040 8,170 9,980 39,540

415 630 365 1,410

$ 3,910 820 1,140 5,870

Total

19.10

2,220

2,270 1,550 1,510 2,020 2,470 9,820

104 158 91 353

950 205 280 1,435

2,610

2,290 1,570 1,510 2,050 2,510 9,930

103 157 91 351

990 205 290 1,485

780 500 870 430 2,580 $16,956

$

2

Quarter

Plan Year

810 510 865 460 2,645 $16,641

2,140

2,310 1,590 1,530 2,070 2,500 10,000

105 159 92 356

$ 1,010 205 285 1,500

3

3,590

2,250 1,520 1,490 2,030 2,500 9,790

103 156 91 350

960 205 285 1,450

790 500 900 415 2,605 $17,785

$

4

5 10 5 20

70 40 20 130

395

210 150 15 15 390 $2,370

90

810 110 170 210 440 1,740

$

Annual Budget (Increase) Decrease

Special Comments on Advertising and Sales Promotion Expense

790 480 860 420 2,550 $16,378

$

1

T HE J OHNSON C OMPANY , I NC . S UMMARY M ARKETING D IVISION B UDGET THE P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS )

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• Maintain prices. • Introduce new products or services. • Create favorable public opinion. • Avoid unfavorable legislation. Fifth, two basic ways are currently in use of establishing an advertising and sales promotion budget: the lump-sum appropriation method estimating the amount required to attain certain objectives. Comments on each follow. The simple lump-sum appropriation method consists of authorizing the expenditure for advertising and sales promotions related to some factor. Under this plan the total amount to be spent could be based on: • A percentage of planned or budgeted sales • A percentage of the prior year sales or perhaps of an average of several past years • A fixed amount per unit of product expected to be sold (the units are obtained from the sales plan) • An arbitrary percentage increase over the prior year's expenditure • A percent of gross profit on the product for the prior year or the planning year • A percentage of net income of the prior year or the planning year The advantage of the lump-sum appropriation method is sheer simplicity. Basically it seems to lack any scientific basis, although there may be a perceived long-term relationship between advertising expenditures and level of sales. The estimated “cost of attaining the objective” procedure seems a more logical process: Objectives are set; the detailed steps to reach the objective are decided upon; the relevant costs for each such program are estimated and are summarized to arrive at the total cost for the planning year. This estimating process may be performed by the advertising department, perhaps assisted by an outside advertising agency, or sometimes it is done by the agency itself. Obviously, a skilled financial analyst should review such costs for any evidence of waste. Moreover, in some cases the marginal or gross profit from the additional units estimated to be sold can be compared with the advertising expense to determine if the project seems to make financial sense. This can be done on an incremental advertising expense and quantity basis to ascertain at which point, if any, the incremental unit advertising cost exceeds the incremental marginal profit all direct expenses.

Incremental Block 1 2 3 4 5 6 7 8 9

Incremental Advertising Expense $ –0– 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000

Additional Units Estimated to Be Sold 20,000 30,000 70,000 50,000 50,000 30,000 30,000 20,000 10,000

Estimated Marginal Unit Income* $1.00 1.20 1.30 .90 .80 .70 .60 .50 .40

Incremental Unit Advertising Cost $ — .83 .36 .50 .50 .83 .83 1.25 2.50

Unit Increment or (Decrement) Margin (1.00) .37 .94 .40 .30 ( .13) ( .23) ( .75) (2.10)

Total Margin $ 20,000 11,100 65,800 20,000 15,000 ( 3,900) ( 6,900) (15,000) (21,000)

*After all direct costs and before advertising cost.

E XHIBIT 19.14

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I NCREMENTAL A DVERTISING E XPENSE C OMPARED

TO I NCREMENTAL

P ROFIT M ARGIN

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19.12 Marketing Expense Standards

397

A simple example is shown in the matrix illustrated in Exhibit 19.14. If these estimates are valid, then not more than $100,000 (incremental block 5) should be spent in advertising Product 10. Financial analysis would sometimes identify some possibly uneconomic programs. It is beyond the scope of this section to review the many facets of advertising and sales promotion that might interest the controller or staff in attempting to financially appraise the advertising and sales promotion budget. Books on advertising and sales promotion are worth perusing for more detailed information.

19.11 CONTROL OF MARKETING EXPENSES As already explained, the budgetary control process involves comparing the actual expenses with the budgeted expenses (or the budgeted rates time the actual volume handled for variable expenses) and taking corrective action. Where budgets are not used, actual expenses may be compared with the unit standards and actual unit volumes, as reviewed in the next section.

19.12 MARKETING EXPENSE STANDARDS (a) STANDARDS AND CONTROL. The very foundation of marketing cost control lies in the correlation of sales effort with the potential and the use of analysis to avoid misdirection. Although this may be done, and although the income and expense statement may reveal a satisfactory result for a time, still this is not enough. It must be known that the business is being operated efficiently, and this requires measuring sticks — standards. A complete analysis of past operations must be taken as a starting point. By this it may be determined that 1,000 calls have been made by salespeople in a given territory, at a cost of $5 per call, and with certain sales results. But the questions are left unanswered about how many calls should have been made by the salespeople and what the cost per call should have been. These also must be ascertained if effective control of sales effort is to be exercised. It may be known that 1,000 orders have been handled at a clerical cost of $0.50 per order, but it needs to be known also what the cost would have been if the clerical work had been efficiently directed. In brief, standards are needed by which to judge the distribution performance and signal its weaknesses. Knowing in detail what it has been is not enough; it needs also to be known in detail what it should be in the immediate future. (b) CAN STANDARDS BE ESTABLISHED FOR MARKETING ACTIVITY? It would be foolish to contend that all distribution activity can be highly standardized. In fact, it is never possible completely to standardize production activities. The answer to just exactly what results should be obtained from a dollar expended for advertising or direct sales effort when developing a new territory or a new product or just what costs will be necessary to accomplish certain definite ends pertaining to customer goodwill is frequently problematic. But it would be equally foolish, and a fatal management error, to evade the fact that standards can be successfully applied to a vast amount of the distribution activity. If no one is competent to judge what distribution effort is necessary to secure certain results and what it will cost to do it, then management must indeed be in a helpless position. Although a new venture may be undertaken here and there on something of an experimental basis, the entire distribution effort will scarcely be directed along such lines continuously. It is hardly to be expected that an intelligent executive will direct $1 million into the distribution effort in the vain hope that profit will result at the end of the year. Rather the executive may be expected to provide for the continuous measurement of individual and group performance as expressed in costs and results. Knowledge is needed of when billing clerks are wasting time, when automotive equipment is too costly, when direct mail prices fail to “pull,” when bad debt losses are excessive, when warehouse labor hours are too high, when long-distance telephone costs are exorbitant, and

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when salespeople produce insufficient orders. If these costs and performance factors are not under constant control, the executive's profit goal is almost certain to be unmet. But such control implies standards and depends entirely on the establishment and use of standards. Warehouse labor hours never appear too high in the absolute. They become too high only when measured against what they should be under the circumstances—only when a standard is applied. Although it must be admitted that it is difficult to establish standards for some marketing activities; that psychological factors are relatively more, and physical and mechanical factors relatively less, influential than in production; that relatively more depends on the judgment of executives and relatively less on objective measurements; and that a somewhat greater tolerance must be allowed in the consideration of variances, it should be understood that this applies only to a part of the marketing activity. Much of the marketing activity is fully as measurable as production. There is no important difference, for example, between the method of establishing standards for order handling, warehousing, shipping, delivery, and clerical work and the methods employed in production. Even those distribution activities that are largely affected by psychological factors, such as advertising and personal selling, are usually capable of reasonably accurate measurement when the activities are continuous or repetitive. The types of standards needed, as well as the techniques used for their establishment, change as circumstances change, such as increased globalization. Whereas at one time much attention was focused on internal unit cost standards and unit revenue standards, now other facets are involved. While internal comparisons of internal trends and relationships are still made, there is a movement to measure against external standards. Moreover, some standards are now time related, such as the time required to develop a new product. Standards might relate to customer satisfaction, such as number of prospects converted to customer status. Some of the newer standards, some of which are applicable to marketing efforts, are reviewed in Chapter 17. (c) TYPES OF MARKETING EXPENSE STANDARDS. Marketing expense standards may be either (1) of a very general nature, and applicable to distribution functions as a whole, or by major divisions, or (2) units that measure individual performance. Illustrative of the former are: • Selling cost as a percentage of net sales • Cost per dollar of gross profit • Cost per unit sold • Cost per sales transaction • Cost per order received • Cost per customer account Standards such as these are useful indicators of trends for the entire distribution effort. Furthermore, such standards can be applied to individual products, territories, branches, or departments. However, these general standards do not necessarily indicate points of weaknesses in terms of individual responsibility. If costs are to be controlled, the performance of the individual must be measured. Hence it is necessary to set standards for controllable costs of individual cost items or functions. In warehousing, for example, standards might be set for direct labor as: • Cost per item handled • Cost per pound handled • Cost per shipment • Cost per order filled Similar standards might be set for shipping supplies or delivery and truck expense. In the direct sales field, standards might be set for a salesperson's automobile expense in terms of the following: • Cost per mile traveled • Cost per day • Cost per month

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19.12 Marketing Expense Standards

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Again, entertainment expense standards might relate to cost per customer or cost per dollar of net sales. (d) OTHER CONSIDERATIONS IN SETTING MARKETING EXPENSE STANDARDS. The controller has a joint responsibility with the sales executives in setting marketing expense standards. In fulfilling this responsibility, it is well to keep in mind the complications. For example, in manufacturing there is usually only one standard cost for the product. There are, however, many standard costs for distribution of the same article. Thus, the cost per call may be different in every territory or sales district. Even in the same territory the standard cost to sell to different classes of customers may vary. By and large, the same principles applicable to manufacturing expense standards apply to distribution costs. Thus, standards will require revision when operating conditions change materially. Also, where fixed elements of cost are included in the standards, the effect of volume must be recognized. (e) HOW TO SET MARKETING EXPENSE STANDARDS: BENCHMARKING. The methods of establishing standards vary depending on whether external or only internal standards are the objective. A procedure of measuring products, or services, or business practice against the toughest competitor, or the companies best in their class, or other measures — benchmarking — is discussed in Section 17.9. Another method that may be somewhat more internally oriented, but also involves an analytical approach is reviewed next. When the need for standards has been agreed to with the sales executive, the detailed work of setting standards can proceed. The first step in setting the marketing expense standards is to classify the costs according to functions and activities expressive of individual responsibility. How far such classification can and should be carried depends, of course, on the nature of the business, its size, methods of operation, and internal organization. The cost of such major functions as direct selling, advertising, transportation, warehousing, credit and collection, and financing can be separated in most businesses and subjected to individual study and control. Even such a general classification as this is not universal. For example, in a concern doing a house-to-house business, the functions of direct selling and credit and collection are merged, since the work is done by the same people under the same supervision. The costs of the major functions should be further classified by individual activities that make up the functional service. For example, the credit and collection costs may be separated into credit approvals, posting charges, posting credits, preparing customers' monthly statements, writing collection letters, and so on. The second step is to select units or bases of measurement through which the standards can be expressed. Such units or bases will vary with the type of measurement to be applied; thus the measurement may apply to effort used, to cost, to results achieved, or to the relationship of these factors. To illustrate, a salesperson may be expected to make a given number of calls per day. This constitutes a measure of effort used and the unit of measure is the call. The cost of writing orders in the order department may be measured in terms of the number of orders or order lines1 written. This is a measure of costs, and the unit of measurement is the order or order line. Salespeople may each be expected to produce a certain number of orders or to secure a certain number of new accounts. This is a measure of results, and the units of measurement are orders and new accounts. Finally, salespeople may be required to hold their direct costs within 8 percent of their sales volume. Here, the measurement is in terms of the relationship of particular costs to the results in the sales volumes and the basis of measurement is the ratio of one to the other.

1 Order line here means the writing of one line on a sales order (e.g., “200 1/2” Malleable Iron Nipples No. 682 at $8.00 = $16.00).

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Although such specific units of measurement are not available for all distribution activities, some basis must be selected before the standards can be applied. Where specific units are not available, more inclusive or composite bases must be used. For example, the entire credit and collection cost may be measured by the number of accounts carried, or the entire advertising cost may be measured by its ratio to dollar sales volume. The third step is to analyze past experience relative to the cost of the functions and specific activities involved with a view to selecting the best experience and indications about the best procedure. This may involve intensive study of individual methods of procedure and operation similar to that employed in the development of production standards. The fourth step is to consider the effect on costs of expected changes in external conditions and of the sales program as planned. If increased sales resistance is expected, an estimate must be made about its effect on such costs as advertising and direct selling. If the program calls for a lengthening of the installment credit period, the effect on the financing cost must be estimated. The final step is to summarize the judgment of those executives, division heads, department heads, and salespersons whose experience and training qualify them to judge the measures of satisfactory performance. The standards set must be the final expression of such judgment, based on an intelligent study of past experience and future outlook. Standards as finally set will result in much overlapping. Thus a standard cost may be applied to the warehousing function as a whole. Within this general function, many individual cost standards may be applied that relate to specific activities such as clerical costs of order handling and physical assembling. Finally, different standards must frequently be set for different territories, products, channels of distribution, classes of customers, departments, and so forth, wherein different conditions prevail. (f) ADDITIONAL INFORMATION NEEDED. To establish and use marketing expense standards successfully, a concern must accumulate and have available a considerable amount of information relative to marketing activities and the cost factors pertaining to such activities. This includes a considerable body of information not available in the regular accounting records. Permanent records must be designed for regularly recording and accumulating these data in readily usable form. Just as it is now the custom to record regularly such production factors as labor hours, chargeable hours, idle hours, machine hours, power loads, and number of operations, records must likewise be made of the marketing factors. Illustrative of such data are: • Analyses of sales in physical units • Number of sales transactions classified in terms of size, hour of day, and so on • Number of quotations made • Number of orders classified in terms of size, period in which received, and the like • Number of order lines written • Average number of salespersons • Number of salesperson days • Number of calls on old and new customers • Number of days of salespersons' travel • Number of miles of salespersons' travel • Average number of customers classified with regard to location, annual volume, and so forth • Number of labor hours of salespeople advertising and display people, warehouse workers, truck drivers, delivery people, maintenance workers, clerical workers, and so on • Number of returns and allowances classified in terms of cause • Number of units of advertising space or time used in the various advertising media • Number of advertising pieces mailed: letters, circulars, folders, calendars, and so on

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• Number of pieces of advertising material distributed: window cards, store displays, inserts, and the like • Number of samples distributed • Number of demonstrations made • Number of inquiries received • Number of new customers secured • Number of shipments • Analyses of shipments in physical units • Dollar value of shipments • Number of ton-mile units of shipping • Number of deliveries • Number of parcels delivered • Number of miles of truck operation • Number of shipping claims handled • Physical volume of goods handled in warehouses • Average size of physical inventory carried • Rates of turnover in dollars and physical units • Average number of accounts carried • Number of invoices • Number of invoice lines • Number of remittances received • Number of credit letters sent • Average number of days accounts are outstanding • Average amount of receivables carried • Number of mail pieces handled • Number of postings • Number of letters written — distribution sections • Number of units filed • Percentage of sales from new products • Percentage of on-time customer deliveries • Number of customers for which company is sole supplier Many of the foregoing items must be further classified by territories, commodities, and departments to supply the full information needed. Such information will be found useful for many purposes in the direction of distribution activity but is essential to a program of standards. Many concerns have in the past neglected to accumulate and use such information. It is not uncommon to find a concern that has the most exacting records of a production machine (the date of its purchase, full detail about its cost, working hours, number and cause of idle hours, and cost of maintenance) almost to the point of a complete diary of the machine's daily routine over a long period of years. During the same time, the concern may have been employing a salesperson whose total cost through the years has greatly exceeded the cost and maintenance of the machine, but little detailed record of activities has been kept. How the salesperson has spent time, the number of calls made, the number of prospects interviewed, orders received, gross profit, and even the type of goods sold has not always been recorded. The salesperson's activity report can provide some of these data. With many concerns the distribution information is entirely too meager. More information must be collected if the distribution program is to be wisely directed.

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(g) USE OF STANDARDS FOR CONTROL. The essence of control is the prompt follow-up of unfavorable trends before they develop into large losses. Once the standards are determined, the stage is set for action. The controller compares actual and standard performance and reports the results to the sales executive.

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CHAPTER

20

PLANNING AND CONTROL OF MANUFACTURING COSTS: DIRECT MATERIAL AND DIRECT LABOR 20.1

GENERAL ASPECTS OF MANUFACTURING 403 (a) Responsibilities of the Manufacturing Executive 403 (b) Objectives of Manufacturing Cost Accounting 404 (c) Controller and Manufacturing Management Problems 405 (d) Types of Manufacturing Cost Analyses 406 (e) Types of Cost Systems 407 (f) Factory Accounts and General Accounts 407

20.2

(h) Using Quantity Standards for Cost Control 412 (i) Limited Usefulness of Material Price Standards 414 (j) Setting Material Price Standards 414 (k) Other Applications of Material Control 414 20.3

DIRECT MATERIAL COSTS: PLANNING AND CONTROL 408 (a) Scope of Direct Material Involvement 408 (b) Benefits from Proper Material Planning and Control 408 (c) Defining and Measuring Direct Material Costs 408 (d) Planning for Direct Material 409 (e) Basic Approach to Direct Material Cost Control 411 (f) Setting Material Quantity Standards 412 (g) Revision of Material Quantity Standards 412

LABOR COSTS: PLANNING AND CONTROL 416 (a) Labor Accounting under Private Enterprise 416 (b) Classification of Labor Costs 416 (c) Expanded Definition of Direct Labor 416 (d) Planning of Labor Costs 417 (e) Controller’s Contribution to Control 417 (f) Setting Labor Performance Standards 418 (g) Revision of Labor Performance Standards 419 (h) Operating under Performance Standards 419 (i) Use of Labor Rate Standards 420 (j) Control through Preplanning 420 (k) Labor Accounting and Statutory Requirements 422 (l) Wage Incentive Plans: Relationship to Cost Standards 422

20.1 GENERAL ASPECTS OF MANUFACTURING (a) RESPONSIBILITIES OF THE MANUFACTURING EXECUTIVE. To those not familiar with the intricacies of the modern manufacturing processes, it might seem that once a determination has been made of the products to be manufactured and sold, and of the quantities required, then the remaining task is simple: proceed to manufacture the articles. As compared with the task of the sales executive, many of the variables in manufacturing are more subject to the control of the executive than they are in selling, many are more easily measured, and the psychological factors may be less 403

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pronounced. But the job is by no means an easy one, and many difficulties plague the manufacturing manager who is attempting to deliver a quality product, within cost, and on schedule. Consider some of the numerous decisions the manufacturing executive is called upon to make— in many of which the controller is not involved at all, others with which he may be only tangentially concerned, and yet others where he may be, or should be, of assistance to the production executive. While any number of classifications may be used, these groupings of the duties seem practical: • Physical Facilities
Acquisition of plant and equipment
Proper layout of machinery and equipment, storage facilities, and so on
Adequate maintenance of plant and equipment
Proper safeguarding of the physical assets (security)

• Product and Production Planning
Product design
Decisions on product specifications
Determination of material requirements — specifications and quantities
Selection of manufacturing processes
Planning the production schedule
Decisions on manufacturing or purchasing the components—“make-or-buy” decisions
Material purchases
Labor-requirements—skill needs, employment, training, and job assignment and transfer
Inventory levels required
Preparing the production and manufacturing plans—short and long term

• Manufacturing Process
Planning and controlling labor
Receiving, handling, routing, and processing raw materials and work-in-process in an eco-

nomical manner
Controlling quality
Coordinating manufacturing with sales
Planning and controlling all manufacturing costs—direct and indirect

And the list could go on. For some phases, the controller may coordinate procedures and see that adequate internal controls exist, that needed economic analysis is made, as in acquisition of plant and equipment or as part of the annual planning process. But perhaps the biggest contribution of the controller is the development and maintenance of a general accounting and cost system that will assist the manufacturing executive, and that will provide the necessary information for the planning and control of the business. (b) OBJECTIVES OF MANUFACTURING COST ACCOUNTING. A manufacturing cost accounting system is an integral part of the total management information system. In analyzing costing systems for control, the controller must recognize the purpose of the manufacturing cost accounting system and relate it to the production or operating management problems. The objectives must be clearly defined if the system is to be effectively utilized. There are four fundamental purposes of a cost system that may vary in importance from one organization to another: 1. Control of costs 2. Planning and performance measurement

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3. Inventory valuation 4. Deriving anticipated prices Control of costs is a primary function of manufacturing cost accounting and cost analysis. The major elements of costs — labor, material, and manufacturing expenses — must be segregated by product, by type of cost, and by responsibility. For example, the actual number of parts used in the assembly of an airplane section, such as a wing, may be compared to the bill of materials and corrective action taken when appropriate. Closely related to cost control is the use of cost data for effective planning and performance measurement. Some of the same information used for cost control purposes may be used for the planning of manufacturing operations. For example, the standards used for cost control of manufacturing expenses can be used to plan these expenses for future periods with due consideration to past experience relative to the established standards. Cost analysis can be utilized, as part of the planning process, to determine the probable effect of different courses of action. Again, a comparison of manufacturing costs versus purchasing a particular part or component can be made in making the determination in make-or-buy decisions. The use of costs and analysis would extend to many facets of the total planning process. One of the key objectives of a costing system is the determination of product unit cost and the valuation of inventories. This is also a prerequisite to an accurate determination of the cost of goods sold in the statement of income and expense. The manufacturing cost system should recognize this fact and include sufficient cost details, such as layering part costs and quantities for items in inventory, to accomplish this purpose. A critical purpose of cost data is for establishing selling prices. The manufactured cost of a product is not necessarily the sole determinant in setting prices, since the desired gross margin and the price acceptable to the market are also significant factors. As more companies realize that direct labor and materials are relatively fixed costs, management will concentrate on designing the product to fit a specific price, cost, and gross margin; the controller should be included in this process to advise management about indirect and direct costs. (c) CONTROLLER AND MANUFACTURING MANAGEMENT PROBLEMS. A fundamental responsibility of the controller is to ensure that the manufacturing cost systems have been established to serve the needs and requirements of production executives. The controller is the fact finder regarding costs and is responsible for furnishing factory management with sufficient cost information on a timely basis and in a proper format to effect proper control and planning. Unfortunately, under a just-in-time (JIT) system, manufacturing managers need feedback regarding costs far more frequently than on a monthly basis. JIT products are manufactured with little or no wait time, and consequently can be produced in periods far less than was the case under the line manufacturing concept. Therefore, if a cost problem occurred, such as too many direct labor hours required to finish a part, the formal accounting system would not tell the line managers until well after the problem had happened. Fortunately, JIT principles stress the need to shrink inventories and streamline processes, thereby making manufacturing problems highly visible without any product costing reports. A subset of JIT is cellular (i.e., group) manufacturing, in which equipment is generally arranged in a horseshoe shape, and one employee uses those machines to make one part, taking the piece from machine to machine. Consequently, there is little or no work-in-process (WIP) to track, and any scrapped parts are immediately visible to management. Based on this kind of manufacturing concept, line managers can do without reports, with the exception of daily production quantities versus budgeted quantities that meet quality standards. Just-in-time manufacturing places the controller in the unique position of looking for something to report on. Since direct labor and materials costs are now largely fixed, the controller’s time emphasis should switch to planning the costs of new products, and tracking planned costs versus actual costs. Because the JIT manufacturing environment tends to have small cost variances, the controller should seriously question the amount of effort to be invested in tracking direct labor and materials variances versus the benefit of collecting the data.

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