Moving toward zero inventory

With the widespread adoption of technologically advanced planning software and supply-chain communications, the zero-inventory door has opened wider than ever. So why are many distributors and manufacturers still finding it difficult to reach their inventory-management goals?

The concept of zero inventory has been around since the 1980s, and it's simple: Pare your inventory to a minimum and boost your profit margins by eliminating the need for warehousing and other associated expenses. Recent technological advances have made it easier (at least in theory) to execute a zero-inventory strategy.

At the fore is the development and widespread adoption of nimble, sophisticated software systems such as manufacturing resource planning (MRP II), enterprise resource planning (ERP), and advanced planning and scheduling (APS) systems, as well as dedicated supply-chain management software systems. These systems offer manufacturers greater functionality. For example, they can calculate resource-limited schedules, track orders of raw materials and monitor shop-floor production. They also can elevate both the visibility and transparency of internal order-fulfillment and manufacturing processes.

A second key technological advance - the development of more-robust security systems - also enables organizations to provide a high level of transparency and insight into inventory-management processes. Manufacturers can grant suppliers access to their planning software, typically via the Internet, with confidence that only appropriate, designated information will be viewed.

As a result of these developments, when a customer places an order, suppliers can immediately see that the manufacturer needs additional raw materials. Or, if a customer cancels an order, suppliers can immediately stop their activity. This increased level of responsiveness and awareness creates better cash flow and increased profitability. It also fosters less adversarial, more partnership-oriented relationships between suppliers and manufacturers. As a result of these technological advances, manufacturers can be more responsive to both their suppliers and their customers - that is, of course, if they follow through with everything else it takes to effectively move toward zero inventory.

Zero inventory: Pie in the sky?
Even after embracing MRP, ERP, APS or other technologies, many companies haven't even scratched the surface when it comes to reaching zero inventory, inventory-management experts agree. That maybe because the concept of zero inventory is an unreachable, theoretical ideal.

Steven A. Melnyk, professor of production and operations management in the Eli Broad Graduate School of Management at Michigan State University, prefers to speak of "lean" rather than "zero" inventory. This shift in nomenclature is just the beginning of a systematic approach that Melnyk says any business can use to reduce inventory in a productive, ong-lasting way.

"Inventory is not the problem; it is a symptom," says Melnyk, a widely recognized authority and consultant on supply-chain management. "Inventory is the result of waste and variance. The way to reduce inventory is simple: You get rid of waste and you reduce variance."

Such an approach sounds basic, but many companies aren't willing to do what it takes.

"Instead, they jump around from program to program, trying to slash inventory here and there, like a dieter trying to lose weight," Melnyk says. "Just as a dieter can't realistically expect to stop eating for a day, jump on a scale, and magically hit his weight-loss goals, a company can't take a few superficial steps and significantly reduce inventory."

Indeed, experts agree that most companies striving for zero inventory must fundamentally change their manufacturing and handling processes. That requires going well beyond simply investing in the latest software to making key operational changes in order to make real progress.

Low-hanging fruit
"If you attack from the right perspective, there's lots of stuff you can do to reduce inventory," Melnyk says. "This is low-hanging fruit."

Melnyk offers the following tips to get started slashing inventory:

Revisit your customer base. Ensure you understand who your critical customers are and what they value. Then communicate that data throughout your organization so your employees can focus on creating value for key customers instead of trying to satisfy everyone - an unfocused approach that can lead to unnecessary inventory.

Examine your processes and establish a baseline. Before you can address problems,you have to recognize them. Consider the surprising experience of an engine manufacturer. An internal audit revealed that one component of the company's engines stayed in its system for 1,500 hours, traveled four miles, was touched by 106 people and passed through 122 steps - of which only 27 changed or added value to the component.

Identify your company's critical processes. Focus on critical processes to quickly identify which parts of your overall system most significantly affect inventory, then begin to make necessary changes. Critical processes include bottlenecks or constraints in your system, processes visible to your customers (your customer will judge you on the basis of process), unique core competencies or skills, the process withthe highest amount of variance, or the process that requires the most resources.

One proven strategy for improving inventory management is a "kaizen event." In a kaizen event, a small team gathers for perhaps several days to focus exclusively on revamping a process. By changing the process, you can reduce the need for inventory. Once you improve one inventory-management process, you can move on to another.

Staying focused
Like most management efforts, controlling inventory requires ongoing commitment.

"Really successful companies understand the basics and master them," Melnyk says. "They keep doing the simple things right, all the time. They understand that you need inventory - you can't ever get away from it. But you have to manage it intelligently."

Experts recommend the following tips to distributors and manufacturers zeroing in on inventory management:

Develop a lean infrastructure. Establish a program, place someone in charge of it and be sure senior managers support it.

Recognize and reward successes. Publicize your successes and the people who helped achieve them to underscore their importance.

Share information. If some parts of your organization become more adept than others at minimizing inventories, they should spread best practices across the company.

Be patient. Give employees enough time to install, learn and become proficient with new inventory-management systems.

Zero inventory may be wishful thinking, but embracing new technology and processes to manage your inventory more efficiently could move you much closer to that ideal.

Pricing Products and Services

Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern.

Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered.

the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price.

Selling price = Cost + (Markup × Cost)

For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products.

Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists.

Price Elasticity of Demand--Economists' Approach to Pricing:

If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. Click here to read full article.

Absorption Costing Approach to Cost Plus Pricing:

The absorption costing approach to cost plus pricing differs from the economists' approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost rather than variable costing. Click here to read full article.

Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. Click here to read full article.

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used

Definition and Explanation of Time and Materials Pricing:
Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used. This pricing method is used in repair shops, in printing shops, and by many professionals such as physicians and dentists. The time and material rates are usually market determined. In other words, the rates are determined by the interplay of supply and demand and by competitive conditions in the industry. However, some companies set the rates using a process similar to the process followed in the absorption costing approach to cost plus pricing. In this case, the rates include allowances for selling, general and administrative expenses; other direct and indirect costs; and a desired profit. This page will show how the rates might be set using the cost-plus approach.

Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is computed by adding together three elements:

The direct costs of the employee, including salary and fringe benefits.
A pro rata allowance for selling, general, and administrative expenses of the organization.
An allowance for a desired profit per hour of employee time.
In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which employee actually works on the job; in other organizations, the rate may vary by employee. For example, in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less than the rate charged for an experienced senior accountant or for a partner.

Material Component:
The material component is determined by adding a material loading charge to the invoice price of any materials used on the job. The material loading charge is designed to cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin on the materials themselves.

Example of Time and Material Pricing:
To provide a numerical example of time and material pricing, consider the following:

Quality Auto Shop uses time and material pricing for all of its repair work. The following costs have been budgeted for the coming year:

Repairs Parts
Mechanics' wages $300,000
Service manager--salary 40,000
Parts manager--salary $36,000
Clerical assistant--salary 18,000 15,000
Retirement and insurance--16% of salary and wages 57,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
Invoice cost of parts used 400,000

Total budgeted cost

The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair time is considered to be feasible, given the competitive conditions in the market. For parts, the competitive markup on the invoice cost of parts used is 15%.

The following schedule shows the calculation of the billing rate and the material loading charge to be used over the next year.

TIME AND MATERIALS PRICING

Time Component: Repairs Parts: Material Loading Charge
Total Per Hour* Total Percent**
Cost of mechanics' time:
Mechanics' wages $300,000
Retirement and insurance (16% of wages) 48,000
--------
Total cost 348,000 $14.5
For repairs--other cost of repair service. For parts--cost of ordering handling, and storing parts:
Repairs service manager--salary 40,000
Parts manager salary $36,000
Clerical assistant salary 18,000 15,000
Retirement and insurance (16% of salaries) 9,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
-------- ---------
Total cost 204,000 8.50 120,000 30%
-------- --------
Desired profit:
24,000 hours × $7per hour 168,000 7.00
15% × $400,000 60,000 15%
------- ------- ------- -------
Total amount to be billed $720,000 $30.00 $180,000 45%
====== ===== ====== ====
*Based on 24,000 hours
**Based on $400,000 invoice cost of parts. The charge for ordering, handling, and storing parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30%

Note that the billing rate, or time component, is $30 per hour of repair time and the material loading charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as follows:

Labor time: 4.5 hours $30 per hour $135
Parts used:
Invoice cost $200
Material loading charge: 45% $200 90 290
-------- ------
Total price of the job $425
=====


Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop, or a similar organization might use machine-hours.

This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising that is suffers from the same problem. Customers may not be willing to pay the rates that have been computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the profit objectives will not be met and the company may not even break even.

Gross Profit Analysis Part 2. Case Study

Gross Profit analysis of time sharing computer programs:

The senior system analysis of Tyrene, Inc. Bob Canedy, developed in his spare time three unique packages of computer programs: Package 1, inventory control; Package 2, sales analysis; Package 3; report preparation. After realizing their marketability, he struck out on his own, forming data-Pack Co., a computer time sharing service bureau. He rented an adequate computer and leased some data communication lines and terminals, then placed the packages on-line. Once operational, he planned to sell the use of his packages to industrial customers by the system-connect-hour, i.e., total time elapsing while the customer's terminal is directly connected to the central computer.

In the process of establishing profitable sales prices, Candey decided to project costs for the first year. Using processing information provided by the computer sales representative, he allocated the total cost to the packages as follows:

Computer Rental ($56,000) Other Common Costs ($14,000)
Package (1)

Core Requisitions (000s Bits) % of Total Core Requisitions CPU* Hrs
System Connect Hrs (2)
% of Total CPU to System Connect Hrs. Weighted Average [4 × Col. (1) - Col. (2)] - 5 Common Cost Traceable Cost Total Cost
1 80 60% 0.18 10% 50% $35,000 $10,000 $45,000
2 33 25 0.90 50 30 21,000 14,000 35,000
3 20 15 0.72 40 20 14,000 6,000 20,000
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total 133 100% 1.80 100% 100% $70,000 $30,000 $100,000
====== ====== ====== ====== ====== ====== ====== ======

*Central Processing Unit

Working from expected costs, Canedy computed the desired markup for each of the packages. Since he knew that the useful lives of the programs were only a few years, he decided to recoup the investment in time that he had spent on developing the programs by using that criterion in computing a sales price, as follows:

Package Workdays Spent in Developing Programs (1)
% of Total Development Projected Sales (Hrs.) (2)
Hourly Cost (Per unit) Unit Markup
(1) × (2) Unit Sales Price Total Sales (Hrs. × Sales Price)
1 27 15% 900 $50 $7.50 $57.50 $51,750
2 108 60 1,000 35 21.00 56.00 56,000
3 45 25 500 40 10.00 50.00 25,000
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total 180 100% 2,400 $132,750
======== ======== ======== ======== ======== ======== ========




After the first year of operation, Data-Pack's income statement appeared as follows:

Sales:
Package 1: 1,200 hrs. @ $53 $63,600
Package 2: 900 @ 58 52,200
Package 3: 700 @ 46 32,200
------------- $148,000
Cost of goods sold: Common Traceable Total
Package 1: $40,000 $14,000 $54,000
Package 2: 24,000 12,000 36,000
Package 3: 16,000 5,000 21,000
----------- 111,000
-------------
Operating income $37,000
======

Although the firm exceeded planned profits by $4,250, it was evident that changes in demand for the packages and changes in costs and sales prices made this gain only coincidental.

Required:

A gross profit analysis to determine the effects of the demand and fluctuating prices on sales revenue, so that a new price for the most profitable package can be established.

Solution:
Analysis of Sales Price and Sales Volume Variance
Package 1 Package 2 Package 3
Actual sales $63,600 $52,200 $32,200
Actual sales hours × budgeted unit sales price
#1: 1,200 hrs. × $57.50
69,900
50,400
35,000
------------ ------------ ------------
Sales price variance $5,400 unfav. $1,800 fav. $2,800 unfav.
======== ======== ========
Actual sales × budgeted unit sales price $69,000 $50,400 $35,000
Budgeted sales 51,750 56,000 25,000
------------- ------------- -------------
Sales volume variance $17,250 fav. $5,600 unfav. $10,000 fav.
======== ======== ========

Analysis of Cost Price and Cost Volume Variance:
Package 1 Package 2 Package 3
Actual cost of goods sold $54,000 $36,000 $21,000
Actual sales hours × budgeted hourly unit cost
#1: 1,200 hrs. × $50
60,000
31,500
28,000
------------- ------------- ---------
Cost price variance $6,000 fav. $4,500 unfav. $7,000 unfav.

Actual sales hours × Budgeted hourly unit cost $60,000 $31,500 $28,000
Budgeted cost 45,000 35,000 20,000
------------ ------------ ---------
Cost volume variance $15,000 unfav. $3,500 fav. $8,000 unfav.
======= ====== ======

Recapitulation of Sales Price Variance, Sales Volume Variance, Cost Price Variance, and Cost Volume Variance:
Sales Price Sales Volume Cost Price Cost Volume
Package 1 $ 5,400 U* $17,250 F** $ 6,000 F $15,000 U
Package 2 1,800 F 5,600 U 4,500 U 3,500 F
Package 3 2,800 U 10,000 F 7,000 F 8,000 U
---------- ---------- ---------- ------
Net variance $6,400 U $21,650 F $8,500 F $19,500 U
======= ======= ======= =======
* Favorable
** Unfavorable

Combining the net favorable sales volume variance of $21,650 with the net unfavorable cost volume variance of $19,500 leads to a net favorable volume variance of $2,150 that can be further analyzed into the sales mix variance and final sales volume

Gross Profit Analysis (GP Analysis): Part 1

Gross profit is the difference between the cost of goods sold and sales.

Since the adherence of the actual to the budgeted or standard gross profit figure is highly desirable, a careful analysis of unexpected changes in gross profit is useful to a company's management. These changes are the result of one or a combination of the following.

Changes in sales prices of the products.

Changes in volume sold.
a. Changes in number of physical units sold.
b. Changes in the types of products sold, often called the product mix or sales mix.

Changes in cost elements, i.e., materials, labor, and overhead costs.

Procedures for analyzing gross profit:
The determination of the various causes for an increase or decrease in gross profit is similar to the computation of standard cost variances, although gross profit analysis is often possible without the use of standard costs or budgets. In such a case, prices and costs of the previous year, or any year selected as the basis for the comparison, serve as the basis for the calculation of the variances. When standard costs and budgetary methods are employed, however, a greater degree of accuracy and more effective results are achieved.

Gross Profit Analysis Based on the Previous Years Figures
Gross Profit Analysis Based on Budgets and Standard costs
Discussion Questions and Answers about Gross Profit Analysis
Gross Profit Analysis Solved Problems
Gross Profit Analysis Case Study

Uses of Gross Profit Analysis:

The gross profit analysis based on budgets and standards costs depicts the weak spots in the year's performance. Management becomes able to outline the remedies that should correct the situation. The planned gross profit is the responsibility of the marketing as well as the manufacturing department. The gross profit analysis brings together these two major functional areas of the firm and points to the need for further study by both of these department. The marketing department must explain the changes in the sales prices, the shift in the sales mix, and the decrease in units sold, while the production department must account for the increase in cost. To be of real value, the cost price variance should be further analyzed to determine variances for materials, labor, and factory overhead.

Gross Profit Analysis Based on the Previous Year's Figures:




As the basis for illustrating the gross profit analysis using the previous year's figures, the following gross profit section of a company's operating statements for 19A and 19B are presented.

19A
19B
Changes

Sales (net)
Cost of goods sold
Gross profit
$120,000
$100,000
----------
$20,000
=======
$140,000
$110,000
---------
$30,000
=======
+$20,000
+$10,000
----------
+$10,000
=======



In comparison with 19A, sales in 19B increased $20,000 and costs increased $10,000, resulting in increase in gross profit of $10,000.

Additional data taken from various records indicate that the sales and the cost of goods sold figure can be broken down as follows:

19A Sales
19A Cost of goods sold

Product Quantity Unit Price Total Unit Cost Total
X 8,000 Units $5.00 $40,000 $4.000 $32,000
Y 7,000 Units $4.00 $28,000 $3.500 $24,500
Z 20,000 Units $2.60 $52,000 $2.175 $43,500
---------- ----------
$1,20,000 $1,00,000
======= =======
19B Sales
19B Cost of goods sold

Product Quantity Unit Price Total Unit Cost Total
X 10,000 Units $6.60 $66,000 $4.00 $40,000
Y 4,000 Units $3.50 $14,000 2.50 $14,000
Z 20,000 Units $3.00 $60,000 2.80 $56,000
-------- -------
140,000 110,000
====== =====

In analyzing the gross profit of the company, the sales and cost of 19A are accepted as the basis (or standard) for all comparisons. A sales price variance and a sales volume variance are computed first., followed by the computation of a cost price variance and a cost volume variance. The sales volume variance and cost volume variance are analyzed further as a third step, which result in the computation of a sales mix variance and a final sales volume variance.

Calculation of sales price and sales volume variance:
The sales price and sales mix variances from the above data are calculated as follows:

Actual 19B sales $140,000
Actual 19B sales at 19A price:
X: 10,000 units @ $5.00 $50,000
Y: 4,000 units @ $4.00 $16,000
Z: 20,000 units @ $2.60 $52,000
------- $118,000
-------
Favorable sales price variance $22,000
=======
Actual 19B sales at 19A price $118,000
Total 19A sales (used as standard) $120,000
------
Unfavorable sales volume variance $2,000
======

Calculation of Cost Price and Cost Volume Variance:
The cost price and and cost volume variances are calculated as follows.

Actual 19B cost of goods sold $110,000
Actual 19B sales at 19A cost:
X: 10,000 units @ $4.000 $40,000
Y: 4,000 units @ $3.500 $14,000
Z: 20,000 units @ $2.175 $43,500
--------- $97,500
---------
Unfavorable cost price variance $12,500
========
Actual 19B sales at 19A cost $97,500
Cost of goods sold in 19Aused as standard $100,000
---------
Favorable cost volume variance $2,500
========

The result of the preceding computations might explain the reason for the $10,000 increase in gross profit.

Favorable sales price variance $22,000
Favorable volume variance (net) consisting of:
Favorable cost volume variance $2,500
Less unfavorable sales volume variance $2,000
--------
Net favorable volume variance $500
--------
$22,500

Less unfavorable cost price variance $12,500
-------
Increase in gross profit 10,000
=====

Calculation of the sales mix and final sales volume variance:
The net $500 favorable volume variance is a composite of the sales volume and cost volume variance. It should be further analyzed to determine the more significant sales mix and final sales volume variances. To accomplish this analysis, one additional figure must be determined―the average gross profit realized on the units sold in the base (or standard) year. The computations is:

Total gross profit ÷ Total number of units sold

= $20,000 ÷ 35,000

= $0.5714

The $0.5714 average gross profit per unit sold in 19A is multiplied by the total number of units sold in 19B (34,000 units). The resulting $19,427 is the total gross profit that would have been achieved in 19B if all units had been sold at 19A's average gross profit per unit.

The sales mix and final sales volume variance can now be calculated:

Actual 19B sales at 19A sales price $118,000
Actual 19B sales at 19A cost $ 97,500
-------------
Difference $20,500
19B sales at 19A average gross profit $19,427
---------
Favorable sales mix variance $ 1,073
======
19B sales at 19A average gross profit $19,427
Total 19A sales (used as standard) $120,000
Cost of goods sold in 19A (used as standard) 100,000
--------- 20,000
---------
Unfavorable final sales volume variance $573
======

Recapitulations of Variances:
The variances identified in the preceding calculations are summarized below:

Gains
Losses

Gain due to increased sales price $22,000
Loss due to increased cost $12,500
Gain due to shift in sales mix $1073
Loss due to decrease in units sold
$573
--------- ---------
Total $23073 $13073
Less $13073
---------
Net increase in gross profit
$10,000
=======


Gross Profit Analysis Based on Budgets and Standard Costs:




As the basis for illustrating the analysis of gross profit using budgets and standard costs, three financial statements for a company are presented:

The budgeted income statement prepared at the beginning of the period
The actual income statement prepared at the end of the period.
An income statement prepared at the end of the period on the basis of actual sales at budgeted sales prices and at standard costs.
Statement 1:
Income Statement (Budgeted)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 6,000 $15.00 $90,000 $12.00 $72,000 $3.00 $18,000
B 3,500 $12.00 $42,000 $10.00 $35,000 $2.00 $7,000
C 1,000 $10.00 $10,000 $8.75 $8,750 $1.25 $1,250
------- ------- -------- ------- ------- ------- --------
10,500 $13.52* $142,000 $11.02* $115,750 $2.50* $26,250
===== ===== ===== ===== ===== ===== =====
*Weighted average


Statement 2:
Income Statement (Actual)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 5,112 $16.00 $81,792 $13.98 $71,466 $2.02 $10,326
B 4,208 $12.00 $50,496 $9.72 $40,902 $2.28 $9,594
C 1,105 $9.00 $9,945 $8.83 $9,757 $0.17 $188
------- ------- -------- ------- ------- ------- --------
10,425 $13.64* $142,233 $11.71* $122,125 $1.93* $20,108
===== ===== ===== ===== ===== ===== =====
*Weighted average


Statement 3:
Income Statement (Actual units at budgeted prices and costs)

Product Units Sales Cost Gross Profit
Unit price Amount Unit cost Amount Per unit Amount
A 5,112 $15.00 $76,680 $12.00 $61,344 $3.00 $15,338
B 4,208 $12.00 $50,496 $10.00 $42,080 $2.00 $8,416
C 1,105 $10.00 $11,050 $8.75 $9,669 $1.25 $1,381
------- ------- -------- ------- ------- ------- --------
10,425 $13.26* $138,226 $10.85* $113,093 $2.41* $25,133
===== ===== ===== ===== ===== ===== =====
*Weighted average


According to statement 1, the company expected a gross profit of $26,250, based on an estimated production of 10,500 units and an average gross profit of $2.50 per unit. As shown in statement 2, the company actually made a gross profit of only $20,108, or $1.93 per unit. Statement 3 Indicates that the average gross profit for the actual units sold would have been $2.41 per unit if the budgeted sales price and costs per unit had been achieved.

The $6,142 difference between the budgeted gross profit and the actual gross profit is the result of changes in sales price, sales volume, sales mix, and costs. For example, on the basis of the budget, A is the most profitable product and C is the least profitable per unit. Due to variations in sales price and cost, B is actually the most profitable while C is the least profitable per unit. The dollar effect of such changes is shown by the calculation of the sales price, sales volume, cost price, cost volume, sales mix and final sales volume variances.

Calculation of sales price variance and sales volume variance:
Using the figures from the statements above, the sales price variance and sales volume variance for the company are calculated as follows:

Actual sales $142,233
Actual sales at budgeted price $138,226
-----------
Favorable sales price variance $4,007
=======
Actual sales at budgeted price $138,226
Budgeted sales 142,000
------------
Unfavorable sales volume variance $3,774
========

Calculation of Cost Price Variance and Cost Volume Variance:
Using the figures from the statements above, the cost price variance and cost volume variance for the company are calculated as follows:

Cost of goods sold - Actual $122,125
Budgeted cost of actual units sold $113,093
-----------
Unfavorable cost price variance $9,032
=======
Budgeted cost of actual units sold $113,093
Budgeted cost of budgeted units sold 115,570
------------
Favorable cost volume variance $2,657
========

Calculation of the Sales Mix and Final Sales Volume Variance:
In the above calculation two volume variances appear:

Unfavorable sales volume variance $3,774
Favorable cost volume variance $2,657
--------
Net unfavorable volume variance $1,117
=====

The net volume variance should be further analyzed to determine the sales mix and final sales volume variance. These variances are computed as follows:

Actual sales at budgeted prices $138,266.00
Budgeted cost of actual units sold 113,093.00
--------------
Difference $25,133.00
Budgeted gross profit of actual units sold
10,425 actual units × $2.50 budgeted gross profit per unit $26062.50
---------------
Unfavorable sales mix variance $929.50
=======
Budgeted gross profit of actual units sold $26062.50
Budgeted sales $142,000
Budgeted cost of budgeted units sold $115,750
------------- 26,250.00
---------------
Unfavorable final sales volume variance $187.50
========

Check:

Unfavorable sales mix variance $929.50
Unfavorable final sales volume variance 187.50
-----------
Net unfavorable volume variance 1,117.00
======

Recapitulation of Variances:

Gains Losses
Gain due to increased sales prices $4,007
Loss due to increased cost $9,032.00
Loss due to shift in sales mix 929.50
Loss due to decrease in units sold 187.50
---------------
Total $10,149.00
Less 4,007.00
---------------
Net decrease in gross profit $6,142.00
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Critical Path Analysis and Scheduling for Game Development

Critical Path Analysis and Scheduling for Game Development


So, how do you go about developing your projects? If you're anything like me (until recently) then you will have just worked out what you need to do, and then got on with it – picking and choosing at tasks in some sort of correct order, and working from the foundations upwards. Whilst there isn't anything particularly wrong about this method, it's hardly an efficient and quick method of completing the project. In this article I'm going to cover a method that will help you complete your project in the most time-efficient manner.

The first time you get the feeling that the first method (the 'Old' one) doesn't work is when you forget to do something and have to go back and do it – pausing all other development in the process. This is particularly bad when working as a team. If this happens you may be working your socks off trying to correct what you missed whilst the rest of your team are twiddling their thumbs because they can't do anything till you've finished. If you'd planned it properly you could have gotten someone who wasn't busy earlier on in development to do it, while you (and others) were still working on other things.

By the end of this short guide you'll be able to work out, in almost no time at all, the quickest and most efficient route to completion.

Critical Path Analysis: Step 1

The first step to using critical path analysis is to set out the activities that must be completed in order for the project to be completed. If we take a simple game framework it might look something like this:

[A] Graphics Engine
[B] Sound Engine
[C] Music Engine
[D] Input Engine
[E] Gameplay/general programming
[F] Physics
[G] 2D Artwork
[H] 3D Artwork
[I] Sound effects
[J] Music recording
[K] Level Design
Anyone who's completed a game will probably realise that there's much more to it than the above list, but this is only an example – and it can easily be extended. You could go as far as doing a separate analysis for the development of the graphics engine. It's only limited to the detail that you include.

Critical Path Analysis: Step 2

Now that you know what activities you must complete in order to complete the project you need to decide what dependencies there are. This will involve creating a hierarchy for the activities – what activities must be completed before you can start this activity? Notice that the original list (in Step 1) has a letter for each activity. This is just for convenience. Later on when you start drawing out diagrams it'll get a little crowded and complicated to put the complete activity name in, so we're referring to them by letter.

[A] depends on:
[B] depends on: I
[C] depends on: J
[D] depends on: A
[E] depends on: B, C, D
[F] depends on: E
[G] depends on:
[H] depends on: G
[I] depends on:
[J] depends on:
[K] depends on: F
The above list is what I think the dependency list should look like. You may well disagree, but you can change it all around when we're done. Notice that [K] only depends on [F]. You may be thinking that level design doesn't only require physics to be completed – it requires almost everything else to be completed as well. But if you look closely, [F] requires that [E] is completed, and [E] can't be completed until almost everything else has been. Therefore [F] effectively implies that everything before it has been completed – in this case [E], so Level Design (K) does actually require that (almost) everything else is completed.

Critical Path Analysis: Step 3

You're now starting to get a clearer picture of what will need to be done to complete your project efficiently. However this is still very murky compared with the final result. This step is the beginning of things getting complicated> In this step we must draw a graph.

But this isn't quite like the normal graphs you're used to – bar charts, scatter diagrams and so on. This graph doesn't represent a series of data. If you've done much discrete mathematics/path finding algorithms the chances are that you'll know most of this – feel free to skip forward. The rest of you will need a quick crash-course in graph theory. A graph as we're using it can also be referred to as a network - a series of points (nodes or vertices) connected by lines (arcs or edges). Nodes represent events, positions (of buildings for example) and the edges represent a path between them (a road for example). Edges are normally straight lines (and don't actually represent the real-world path). For Critical Path Analysis we'll be using a digraph – a graph with directed edges. These edges will have an arrowhead on them indicating that you can only 'travel' in that direction along the edge. Finally, a couple of conventions: 1) where possible edges should not cross each other, 2) for Critical Path Analysis graphs time is represented across the graph from left-right, it's not fixed to any scale; all it really means is that the start is on the left and the finish is on the right.

Bet that was confusing! It's best if you look at an example graph now. The following diagram is basically the dependency list (Step 2) converted into a graph.



Not too complicated really, but trust me – they can get unbelievably complex in some cases. Each of the edges in the above graph represent an activity (or task): the red dots (nodes) represent the completion of that task, and they also represent a junction – where you can possibly enter/exit from multiple routes. The length of the edges isn't important, nor is the positioning of the vertices; just juggle it around till it fits together nicely.

Critical Path Analysis: Step 4

You're starting to get somewhere now, but you need to put some information on your graph. Currently all it represents is the dependency list, and you require more. The first step is to add the activity lengths. This is very ambiguous – how can you tell how long it takes to develop the graphics engine? You can take a good guess – but you can't always be sure, especially if you are part of a part-time team (where you don't always do an 8 hour working day for example). The algorithm does take this into account though – events that are important (on the critical path) will dictate the length of the project, so if one activity on it is delayed the whole project is delayed.

The following list is my estimation for the length of time (in days) that it will take to complete each activity. The predictions made here will be the basis for the final path. Putting strange numbers in here will mean that you get a strange (and probably inefficient) path.

[A] Graphics Engine = 14 days
[B] Sound Engine = 5 days
[C] Music Engine = 5 days
[D] Input Engine = 10 days
[E] Gameplay/general programming = 31 days
[F] Physics = 7 days
[G] 2D Artwork = 14 days
[H] 3D Artwork = 21 days
[I] Sound effects = 14 days
[J] Music recording = 9 days
[K] Level Design = 21 days
Chances are you will have a different prediction for all of the above, but bear with me – it's the process that counts here. Also note that the times above are for a single person doing the task, assuming that he/she works on the task for all of the hours they can (be it an 8 hour working day).

Now that you have some times you need to add them to your network. By convention they go in brackets after the activity label. The graph now looks like this:


Critical Path Analysis: Step 5

Now you have analysed the project, worked out what activities are involved, decided what the dependency list is, and calculated some times for those activities – and it's all included in your graph. You can now start the algorithm.

There is one final thing that you must do (to make it easier for you), which is to add in events. So far you've just added activities. Events are actually already in the graph – the red dots - but you need a way of identifying them. As you're already using letters for activities you'll use numbers for the events. Below is the revised graph:




Now, on with the algorithm. The first step is to work out what the earliest times are for each of the events (the numbered boxes). The value that you calculate will be the earliest possible time that you can arrive there with all incoming events completed. To work them out you scan forward through the network adding the previous events' earliest time and the activity length together. If there are multiple activities coming into an event you must select the largest one – this is simply because you cannot get to the event until ALL activities are complete, and you know all activities are complete when the one with the longest duration is complete.

While the above isn't too complicated, we'll work through the example graph to see how it all works. You're going to use a simple table to accumulate all the results:

EVENTS 0 1 2 3 4 5 6 7 8
Ei
Starting at event 0: there are no incoming activities, and as it's the start you know the earliest time it can be reached is 0 (days).

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0
Moving to event 1 now, this only relies on activity G being completed, which has a duration of 14 days. Therefore the earliest time that you can get to Event 1 is 14 days.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14
Event 2 only has activity A to depend on; therefore the earliest arrival time will be 14 days

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14
Event 3 only depends on activity I being complete; earliest time is therefore 14 days

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14
Event 4 only depends on activity J, so the earliest time of arrival is 9.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9
Event 5; has 3 incoming activities; the 3 possible earliest times are:

(2)->(5) = 14 + 10 = 24
(3)->(5) = 14 + 9 = 23

(4)->(5) = 9 + 5 = 14

You must choose the largest value (see the rules at the top), so the earliest time you can get to event 5 is 24 days

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24
Event 6 only depends on activity E, so the earliest time of arrival is the earliest time of arrival at event 5 plus the duration of activity E, or 24 + 31 = 55.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55
Event 7 only depends on event 6 and activity F, so the earliest time is 55 + 7 = 62.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62
Finally, Event 8. Event 8 depends on two activities:

(1)->(8) = 14 + 21 = 35

(7)->(8) = 62 + 21 = 83

You must choose the largest value, which in this case is 83.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Hardly a complex task, but if you have a complicated network it can get a little tedious after a while! From the data that you've just calculated you can tell that the earliest time the whole project can be completed is 83 days. If nothing goes wrong then this is how long it will take.

You aren't finished yet though; you need to calculate another set of numbers (and then some more). The next set of numbers is the latest time – the latest time that you can arrive at the event and still complete the project on time. You'll see why this is important later on in the process.

To calculate the latest time of arrival you use a very similar method to the earliest time method. The only main difference is that you start from the end and go backwards, and in the case of multiple choices you choose the lowest value (instead of the largest value). Here goes then:

Event 8, as with the start node. The latest you can get here and still complete the project on time is the total project length – 83 days.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 83
Event 7 only has 1 activity coming out of it – K, so you take K away from 83 and you'll have the latest time of arrival: 83 – 21 = 62.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 62 83
Event 6 only has activity F coming out of it, so the latest time of arrival is (7) – F(7) = 62 – 7 = 55.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 55 62 83
If you're starting to notice a pattern here you're on the right track – I'll explain this pattern later.

Event 5 only has E(31) coming out of it, so the latest time of arrival is (6) – E(31) = 55 – 31 = 24.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 24 55 62 83
Now event 4, which only has activity C(5) coming out of it. The latest time of arrival is therefore (5) – C(5) = 24 – 5 = 19.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 19 24 55 62 83
The pattern seems to have stopped – you may be thinking. But you don't know what the pattern means yet…

Event 3 only has B(5) coming out of it, the latest time of arrival is (5) – B(5) = 24 – 5 = 19.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 19 19 24 55 62 83
Event 2 only has activity D(10) coming out of it, so the latest time of arrival is (5) – D(10) = 24 – 10 = 14.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 14 19 19 24 55 62 83
Event 1 only has activity H(21) coming out of it, so the latest time of arrival is (8) – H(21) = 83 – 21 = 62.

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 62 14 19 19 24 55 62 83
Finally, Event 0 has 4 activities coming out of it:

(0)->(1) via G(14) = (1) – G(14) = 62 – 14 = 48

(0)->(2) via A(14) = (2) – A(14) = 14 – 14 = 0

(0)->(3) via I(14) = (3) – I(14) = 19 – 14 = 5

(0)->(4) via J(9) = (4) – J(9) = 19 – 9 = 10

You have to pick the smallest value, which in this case is 0. So your final table looks like:

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 0 62 14 19 19 24 55 62 83
Critical Path Analysis: Step 6

You now have a fair amount of data about your project, but I haven't really explained what it all means.

Earliest Time Of Arrival: This indicates that if you were very quick and worked hard, then this is the earliest time that you could get to that event.

Latest Time Of Arrival: This is more important as far as the analysis goes. The value you have for the event indicates the latest time of arrival while still completing the project on time. Take event (1) for example, you could get there by day 14, yet you could put it off until day 62. If you start it before day 14 any other dependencies won't be ready (therefore it's impossible). If we start after day 62 the project will be delayed; yet we can start on any day between 14 and 62 and not hold the project up at all.

Those people that are working quickly today will have realised what the pattern means – the pattern where the Earliest time and Latest time are the same. All it really indicates is that you must be at that event by that day or the project will be delayed. If you only get to event (5) on day 26 the whole project will be delayed by 2 days, meaning that you cannot complete it until day 85.

You have a further calculation for this called the float and the slack. Float is for activities and slack is for events.

Float = Dest_Max – Src_Min – Activity_Length

Slack = Latest_Time – Earliest_Time

If the alack and/or the float is equal to 0 it is a critical event/activity; a critical activity must be completed on time and in order to avoid delays to the project.

A slack at any event means that if a person has completed the activity(s) prior to the event (and is ready to go onto the next event) they can rest/pause for that much time. A slack of 0 would mean that they can't pause at all and must carry on, but a slack of 10 means that they could spend 10 days spinning around in their chair. Later on when we look at scheduling we'll examine the possibility that instead of letting him/her spin around in their chair we get them working on another activity.

The float is similar, but it indicates how much extra time you can take, if it's a 10 day task and has a float of 3 then you can take up to 13 days to complete the task without delaying the project. It therefore makes sense that critical activities have a float of 0, because that activity must be done in the specified time period (or the project is delayed).

EVENTS 0 1 2 3 4 5 6 7 8
Ei 0 14 14 14 9 24 55 62 83
Li 0 62 14 19 19 24 55 62 83
Slack 0 48 0 5 10 0 0 0 0
The revised table now shows the slack for each event. You can straight away see that events 0, 2, 5, 6, 7, and 8 are all critical events, and are said to be on the critical path. We can use this to find out what the critical activities are, those activities between 0-2, 2-5, 5-6, 6-7, 7-8. It's not always that simple, so we'll do it the proper way – work out the float for each activity: A = 14 – 0 – 14 = 0
B = 24 – 14 – 5 = 5
C = 24 – 9 – 5 = 10
D = 24 – 14 – 10 = 0
E = 55 – 24 – 31 = 0
F = 62 – 55 – 7 = 0
G = 62 – 0 – 14 = 48
H = 83 – 14 – 21 = 48
I = 19 – 0 – 14 = 5
J = 19 – 0 – 9 = 10
K = 83 – 62 – 21 = 0

I've made all the critical activities bold, and you can see what sort of float the other activities have. Combining this information you can calculate the critical path from start to finish:



This critical path indicates that you must complete these tasks back-to-back with no delay:

A – Graphics Engine
D – Input Engine
E – General Programming
F - Physics
K – Level Design
Makes sense really, and it is quite likely that you would have come up with something similar without using the algorithm. But this is only a simple example.

However, that doesn't mean that you can skip the other activities. They're still just as important in the overall plan. The key point is that the critical activities and events must be reached by the designated time, or the project will be delayed.

Critical Path Analysis: Step 7

You've now finished with the actual CPA algorithm, and now you're moving on to synthesising the data you've gathered from using the algorithm. The most popular and easiest method of doing this is through scheduling, which is usually done by Gantt charts.

Designing Gantt charts and scheduling using them is done purely by eye – there is no magic algorithm to find the most optimal pattern. It does have it's weaknesses though; one particular example is specialist skills. The algorithm doesn't take into account any differences between the workers. For example, Bob can't do graphics engines, but can do general programming. You may well find that the optimal route only works properly in some cases – where there is always someone who can do the task at the given time; if there isn't then you have to wait until someone is available – and this could delay the project.

The first part of a Gantt chart is to plot all the activities in the correct positions. You'll use two rows for each activity – one being the earliest start/completion, and the second being the latest start/completion. The end result will look something like this:

The earliest start of an activity is the earliest arrival time at the event before
The earliest finish of an activity is the earliest start time + duration of the activity
The latest start time of an activity is the latest arrival at the destination event – duration of the event
The latest finish time of an activity is the latest start + duration of the activity
Therefore the completed table for the earliest start and earliest finishes is:

Activity Earliest Start Earliest Finish Latest Start Latest Finish
A 0 14 0 14
B 14 19 19 24
C 9 14 19 24
D 14 24 14 24
E 24 55 24 55
F 55 62 55 62
G 0 14 48 62
H 14 35 62 83
I 0 14 5 19
J 0 9 10 19
K 62 83 62 83



From this graph you can see the earliest and latest times that you can start activities. Each little block can be moved backwards and forwards as long as it's always after the earliest start time and before the latest start time. It is this fact that allows you to do the next part: scheduling.

Scheduling is where you shuffle all the little blocks around to form the most efficient way of completing the project. This is where it gets complicated. You must do it by eye, as mentioned: there is no algorithm to do it for you. There is often more than one possible arrangement, and you also have to take into consideration any skills based factors (can Bob actually do this task?). The first step is to redraw the Gantt chart so that you have people down the side (instead of activities). You can go about it two ways from here – either to use up all the available people, or try to arrange it so that you use as few people as possible (yet the few people you use are always busy). For this example we're going for the latter approach.

To get things started it's easiest to assign the first person to do all the critical activities. This person will then always have something to do, and it reduces the amount of juggling you have to do. The following diagram is one possible way of organising things:




It's a bit annoying organising the I-B and J-C pairs; both have to be completed before E (on the critical path) can be started, yet you can't arrange them so that only one person does them. You could (in a real world situation) have persons 1 and 2 full time team members, and make person 3 a temporary person – once they've done tasks J & C they go away again…

Conclusion

I hope this article has been of some use to you. As you've probably already noticed, this method has limited use for a one-person development team, and even with a multi-person team it still has its weaknesses. But ignoring those you can still get some very useful data from spending half an hour with this algorithm.

Decentralization, Segment Reporting and Transfer Pricing:

Decentralization and Segment Reporting:

When an organization grows beyond a few people, it becomes impossible for the top manager to make decisions about everything.
Managers have to delegate decisions to some degree to those who are at lower levels in the organization. However the degree to which decisions are delegated varies from organization to organization.

Decentralization in organizations:

A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity. At one extreme, a strongly decentralized organization is one in which even the lowest-level managers and employees are empowered to make decisions. At the other extreme, in a strongly decentralized organization, lower-level managers have little freedom to make decisions. Click here to read full article about definition, advantages and disadvantages of decentralization.

Traceable and common fixed costs:

The most puzzling aspect of segmented income statements is probably the treatment of fixed costs. While preparing segmented income statements the fixed cost is divided into tow parts on is traceable fixed cost and other is common fixed cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments. Click here to read full article for definition, examples and explanation of traceable and common fixed costs.

Segment reporting and profitability analysis-segmented income statements:

A different kind of income statement is required for evaluating the performance of a profit or investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin format income statement is used to evaluate the performance of different segments. In a contribution margin format income statement cost of goods sold consists only of the variable manufacturing costs. Click here to read full article.

Hindrances/Problems to Proper Cost Assignment in Segmented Reporting:

For segment reporting to accomplish its intended purposes, costs must be properly assigned to segments. If the purpose is to determine the profits being generated by particular segment or division, then all of the costs attributable to that division or segment--and only those costs--should be assigned to it. Unfortunately, three practices greatly hinder proper cost assignment:

Omission of some costs in the assignment process.
The use of inappropriate methods for allocating costs among segments of a company.
The assignment of costs to segments when they are really common costs. Click here to continue
Segmented Financial Information on External Reports:

The Financial Accounting Standards Board (FASB) now requires that companies in the united states include segmented financial and other data in their annual reports and that the segmented reports prepared for external users must use the same method and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions. This is a very usual requirement. Click here to continue reading.

Rate of Return (The Return on Investment-ROI) for Measuring Managerial Performance:

In a truly decentralized company, segment managers are given a great deal of autonomy. Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the "best" in the company. Competition between investment centers is particularly keen for investment funds. How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide which investment centers are most profitability using the funds that have already been entrusted to their care? One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI). Click here to read full article.

Controlling and Improving Rate of Return on Investment:

Return on investment is normally used to judge the managerial performance in an investment center. Managers therefore try to control and improve the ROI of their investment center. Click here to read full article.

Return on Investment (ROI) and Balanced Scorecard:

Simply exhorting managers to increase return on investment (ROI) is not sufficient. Managers who are told to increase return on investment (ROI) will naturedly wonder how this is to be accomplished. Generally speaking, ROI can be increased by increasing sales, decreasing costs, and/or decreasing investments in operating assets. However it may not be obvious to managers how they are supposed to increase sales, decrease costs, and decrease investments in a way that is consistent with the company's strategy. Click here to continue reading

Criticism, Disadvantages or Limitations of Return on Investment (ROI):

Although the return on investment is widely used in evaluating performance, it is not a perfect tool. It is not without criticism. Click here to continue reading.

Residual Income-Another Method to Measure Managerial Performance:

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income is another approach to measuring an investment center's performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA. Click here to read full article.

Limitations, Criticism or Disadvantage of Residual Income Method:

The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. You would expect larger divisions to have more residual income than smaller divisions, not necessarily because they are better managed but simply because they are bigger. Click here to continue.

Transfer Pricing:

Definition of Transfer pricing:

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. For example, most companies in the oil industry have a petroleum refining and retail sales divisions that are usually evaluated on the basis of return on investment (ROI) or residual income method.

The petroleum refining division processes crude oil into gasoline, kerosene, and other end products. The retail sales division takes gasoline and other products from the refining division and sells them through the company's chain of service stations. Each product has a price for transfers within the company. Suppose the transfer price for the gasoline is $0.80 a gallon. Then the refining division gets credit for $0.80 a gallon of revenue on its segment report and the retailing division must deduct $0.80 a gallon as an expense on its segment report. Clearly the refining division would like the transfer price as high as possible, whereas the retailing division would like the transfer price to be as low as possible. However, the transaction has no direct effect on the entire company's reported profit. It is like taking money out of one pocket and putting it into the other.

Managers are intensively interested in how transfer prices are set, since transfer prices can have a dramatic effect on the apartment profitability of a division. Three common approaches are used to set transfer prices.

Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
Set transfer prices at cost using variable or full (absorption) cost
Set transfer prices at the market price
Divisional Autonomy and Sub optimization:

How much autonomy should be granted to divisions in setting their own transfer prices and in making decisions concerning whether to sell internally or to sell outside? Should the divisional heads have complete authority to make these decisions, or should top corporate management step in if it appears that a decision is about to be made that would result in sub optimization? For example, if the selling division has idle capacity and divisional managers are unable to agree on a transfer price, should top corporate management step in and force a settlement? Click here to continue reading

International Aspects of Transfer Pricing:

The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders. The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company's competitive position and improving its relations with foreign governments.

International Aspects of Transfer Pricing:

The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders.

The objectives of international transfer pricing, as compared to domestic transfer pricing are summarized below:

Transfer Pricing Objectives

Domestic

Greater divisional autonomy
Greater motivation for managers
Better performance evaluation
Better goal congruence

International

Less taxes, duties and tariffs
Less foreign exchange risks
Better competitive position
Better governmental relations

The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company's competitive position and improving its relations with foreign governments. Although domestic objectives such as managerial motivation and divisional autonomy are always important, they often become secondary when international transfers are involved. Companies will focus instead on charging a transfer price that will slash its total tax bill or that will strengthen a foreign subsidiary.

For example, charging a low transfer price for parts shipped to a foreign subsidiary may reduce customs duty payments as the parts cross international borders or it may help the subsidiary to compete in foreign markets by keeping the subsidiary's costs low. On the other hand, charging charging a high transfer price may help a multinational corporation draw profits out of a country that has stringent controls on foreign remittances, or it may allow a multinational corporation to shift income from a country that has high income tax rates to a country that has low rates.

Cost Volume Profit Relationship - (CVP Analysis):

Cost Volume Profit Relationship - (CVP Analysis):

Learning Objectives:

What are the objectives of cost volume profit analysis (CVP Analysis)?
Define and explain contribution margin and contribution margin ratio.
Define, explain and calculate breakeven point?
What is operating leverage and operating leverage ratio?
What are the assumptions of CVP analysis?
What are the limitations of CVP analysis?
What are advantages and disadvantages of CVP Analysis?
Objectives of CVP Analysis:

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

Prices of products

Volume or level of activity

Per unit variable cost

Total fixed cost

Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Contribution Margin and Basics of CVP Analysis:

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Click here to read full article.

Difference Between Gross Margin and Contribution Margin:

Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses. Click here to read full article.

Cost Volume Profit (CVP) Relationship in Graphic Form:

The relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A CVP graph highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way. Click here to read full article.

Contribution Margin Ratio (CM Ratio):

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit calculations. Click here to read full article.

Applications of Cost Volume Profit (CVP) Concepts:

Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs, fixed costs, sales price, and sales volume effect contribution margin and profitability of companies in a variety of situations. For detailed study click on a link below.

Change in fixed cost and sales volume
Change in variable cost and sales volume
Change in fixed cost, sales price and sales volume
Change in variable cost, fixed cost, and sales volume
Change in regular sales price
Importance of Contribution Margin:

CVP analysis can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. Click here to read full article.

Break Even Analysis:

Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money." For detailed study about break even click on a link below:

Break even point analysis (calculation by contribution margin and equation method)
Target profit analysis
Margin of safety
Sales Mix and Break Even with Multiple Products
Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable cost that maximizes the ultimate objective i.e.; profit. Click here to read full article.

Operating Leverage and degree of operating leverage:

Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Click here to read full article.

Assumptions of Cost Volume Profit (CVP) Analysis:

A number of assumptions underlie cost volume profit analysis. Click here to read full article

Limitations of Cost Volume Profit Analysis:

Cost volume profit (CVP) is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting.

Activity Based Management (ABM)

•Activity Based Management is a cost reduction approach that first identifies the value added and non-value added activities
•Attempts to minimize non-value added activities by identifying the root cause(s) which are preventable and prevention is always cheaper.
•To improve customer value and overall profit.
Definitions
• Activity-Based Management:
A system wide , integrated approach that focuses management’s attention on activities.
Activity Management:
An assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value.

• Value-Added Activities Necessary, perfectly efficient activities. Example: Direct labor, Additional direct materials, and machining. The filing requirements of the IRS, reporting requirements of SEC, and preparing financial statements per GAAP requirements.
• Non-value-added Activities : Activities that are either unnecessary or necessary but inefficient and improvable. These activities cause non-value added costs.Example:Scheduling,moving,waiting,inspecting,and storing.
Dimensions of Activity Based management
• Cost Dimension Concerned with accurate assignment of costs to cost objects, such as products and customers.ABC is the focus of this dimension.
• Process Dimension Provides accurate information about why work is done and how well it is done.

Process Dimension Includes:
• Driver Analysis: Concerned with identifying the root cause(s) of activity costs. Knowing the root causes of activity cost is the key to improvement and innovation.
• Activity Analysis: The process of identifying, describing, and evaluating the activities an organization performs. It involves:
1. What activities are done.
2. How many people perform the activities.
3. The time and resources required to perform the activities.
4. An assessment of the value of activities to the organization, including
a recommendation to select and keep only those that add value.

Furthermore, activity analysis help management to select and keep- adding activities that brings about cost reduction and greater operating efficiency, thus providing support for the objective of continuous improvement. Moreover, activity analysis can reduce costs in four ways.
• Cost Reduction:
• Activity elimination: the identification and elimination of activities that fail to add value.
• Activity selection: the process of choosing among different sets of activities caused by competing strategies.
• Activity reduction: the process of decreasing the time and resources required by the activity.
• Activity sharing: Increasing the efficiency of necessary activities using economies of scale.
• Activity performance measurement: Assessing how well activities( and processes) are performed is the fundamental to management’s efforts to improve profitability. There are two types of measurement : Financial and non financial forms. These measures are designed to assess how well an activity was performed and the results achieved.

• Activity performance is evaluated on three dimensions:
• Efficiency :focuses on the relationship of activity inputs activity outputs. e.g.
producing the same output with lower costs for the inputs used.(financial and non financial)
• Quality: concerned with doing the activity right the first time it is performed. Otherwise the unnecessary costs will incur and will have adverse effect on efficiency.(financial and non financial)
• Time: the time it takes to develop and produce a product and delivering to customer.(non financial).

ABM STEPS
• Set a benchmark (standard) for value added activities.
• Identify activities
• Classify activities: Value added and Non-value added
• Search for the root causes for non-value added activities.
. Recommend how to improve non-value added activities by using:
1. activity selection
2. activity reduction
3. activity elimination
4. activity sharing

Illustration of ABM Application

• Setup time for a product is 5 hours. A firm that produces the same product and uses JIT has reduced setup time to 15 minutes. Setup labor is $10 per hour.
Value-added costs: (15/60)($10)=$2.50
Non value-added costs:(5-15/60)($10)=$47.50
15 minutes is considered to a benchmark .Root cause—product design—strategy—activity selection

• Warranty work costs the firm $1,000,000 per year. A competitor’s warranty costs are $200,000 per year.
• Value-added costs: $0.00
• Non-value added costs: $1,000,000
• With zero defects there should be no warranty costs.-- Root cause---.( Total Quality Management)—strategy: Activity elimination

• The company keeps 5 days of raw materials on hand to avoid shutdowns due to raw materials shortages. Carrying costs averages $1,000 per day.
• Value-added costs: $0.00
• Non-value-added costs: $1,000*5=$5,000.
• Delivery problem---Root Cause--(suppliers) Use JIT. Strategy: activity elimination

• By redesigning the plant layout, the time required to move materials can be reduced from 2 hours to 30 minutes. The labor cost is $12 per hour.
Value-added costs: (30/60)($12)=$6
Non-value added costs= (2-.5)($12)=$18
Root cause: plant layout…Strategy: Activity selection

Summary

• Activities are classified into: Value-added and non-value added costs.
• Identify the root causes for non-value added costs
• Recommend how to eliminate and / or improve inefficiency related to non-value-added activities.
• ABC and JIT are complimentary to ABM.
• To improve customer value and overall company’s profitability
• Identifying non-value added

The Problems of Transfer Pricing

The Problems of Transfer Pricing

EXECUTIVE SUMMARY
 WHEN A COMPANY adds facilities in another stateor even worse, when it goes internationalit suddenly must contend with the complex process of transfer pricing.
 A KEY ELEMENT of transfer pricing is the presence of a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit.
 A DANGER A COMPANY will want to avoid is being whipsawed between the taxing authorities of two jurisdictionsthat is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules.
 IN MOST STATES, companies compute taxable income by using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.
 THE TWO MOST COMMON approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.


Its hard enough for a company to do business when its situated in only one state, but consider the complexities when it adds facilities in another stateor, even worse, when it goes international. In addition to having to prepare multiple tax filings, a business with far-flung facilities suddenly must contend with another complication: transfer pricingin which local tax authorities view a company division in one political venue as a customer and/or a supplier of a related division in another political venue. The upshot is that the cost of any goods or services the two units exchange must be determined when the company calculates each units tax liability.
This article examines the processincluding its tax, accounting and corporate profit implications.
If you think transfer pricing affects only big companies, think again. Size is immaterial. The only condition that triggers transfer pricing is the existence of multiple facilities in more than one taxing jurisdiction. For example, a company with 45 employees in five locations in two states would activate transfer pricing concerns if one of its offices provides data processing, payroll or other services to the others. Similar situations arise in manufacturing, when one division ships parts or unfinished products for final assembly at another location in a different jurisdiction.
A key element is a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit. Companies establish transfer prices in a variety of ways. Two of the most popular are by estimating competitive market prices and by adding a markup to costs.
To illustrate, look at Example, Inc., a producer of telephones and related equipment at its Alpha division, which is situated in an urban U.S. community with high taxes on property and income. Competitive pressures combined with those high taxes prompted Alpha to look for lower tax jurisdictions for expansion. An opportunity arose when a supplier offered to sell its entire operation. The supplier has two facilities: one, Beta, is in a state with no income tax; and the other, Gamma, is in Canada, near the U.S. border.
Beta produces a variety of molded plastic parts, including the hard-plastic exteriors or shells of telephones, using raw plastic purchased in bulk. Excluding shells, much of Betas output is shipped to Gamma, where it is combined with purchased parts to create telephone subassemblies. As a result of the planned acquisition, Example will produce shells at Beta for sale to unaffiliated or outside entities and also will produce shells for its own use in final assembly at Alpha and for subassemblies at Gamma; some of these subassemblies will be shipped from Gamma to Alpha for final assembly. In addition, Alpha will provide marketing and administrative services for all three locations.

TAX CONSIDERATIONS

A danger that Example will want to avoid is being whipsawed between the taxing authorities of two jurisdictionsthat is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules. Further, because Alpha is in a high-tax state, any transfer pricing system that shifts taxable income away from Alpha will probably be challenged almost automatically by the state in which Alpha is situated.
In most states, companies compute taxable income using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.
Generally, its to the taxpayers advantage to establish high transfer prices for goods and services provided by a unit in a jurisdiction with low tax rates. The result is to have more revenue subjected to a lower rate and less to a higher rate. If the operating unit receiving the goods and services is in a high-rate jurisdiction, the high transfer price also produces a large expense deduction for that division. When goods and services must flow in the opposite directionfrom high- to low-tax jurisdiction, its better for the transfer price to be set as low as possible. Of course, tax authorities usually have a different interest: They want to maximize tax revenues.
In the illustration, suppose Beta produces plastic parts at a cost of $10,000 and ships them to Gamma, which processes them further at an additional cost of US$1,000 and then ships them to a nonaffiliated Canadian customer, which pays Alpha a total of US$20,000 for them. A transfer pricing mechanism will attribute some of the $9,000 profit to each unit and to the tax return for each country.
Now suppose Example assigns a transfer price of $17,000, resulting in Canadian taxable income equivalent to US$2,000 and taxable income from U.S. sources of $7,000. If the U.S. authorities reject Examples transfer prices, they may tax the entire $9,000 profit even though Canadian income tax also is paid on the Canadian portion. The result is double taxation on $2,000 of income.
A similar problem can arise if Example later changes its transfer pricing system. The prospective loss of tax revenue may lead one jurisdiction to reject the new system, while a prospective increase in taxes may lead the other jurisdiction to leave the new system in place. The key is not simply to set individual transfer prices at the right level but to have a defensible system in place for setting transfer prices and to make sure that that system wins government approval in all tax jurisdictions. CPAs should be aware that some national taxing authorities, including the IRS, will examine and may approve a taxpayers proposed transfer pricing method in advance, thus removing the uncertainty.
A business wishing to reduce the uncertainty concerning IRS approval of its transfer pricing method can participate in the IRS advance pricing agreement (APA) program, as set out in revenue procedure 96-53 (1996-2 CB 375). More than 100 businesses have secured protection under this program. In Notice 98-10 (1998-6 IRB), the IRS announced plans to institute special APA procedures for small businesses.
A critical issue is establishing a transfer price for marketing and administration services. Assuming Alpha charges Beta and Gamma a low price (in relation to what Alpha incurs to provide those services) for marketing and administration services, taxable income effectively would shift away from Alphas high-tax jurisdiction and to Betas and Gammas low-tax jurisdictions. Thus, if Alpha received a transfer price of $80,000 ($40,000 each from Beta and Gamma) for marketing and administration services that cost $100,000 to provide, Alphas income would be reduced by the $20,000 difference. Correspondingly, Betas and Gammas income would be $20,000 higher because they are paying only $80,000 as opposed to the full $100,000 that Alpha incurs to provide the services. To be sure, the company would have to justify that price.
Suppose Example faces effective income tax ratesstate, local and federal combinedof 52% in the Alpha location, 39.6% in Beta and 50% in Gamma. If Example successfully establishes an $80,000 transfer price for marketing and administration services, compared with using the actual costs of $100,000 incurred by Alpha to provide those services, it will save $1,440.

THE WRONG INCENTIVE

The two most common approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.
For example, suppose Betas manager wants to improve profits, including the profits that result from transfer pricing. Suppose also that Example sets transfer prices at cost-plus-10%. Then what happens if excessive amounts of scrap and rework raise the actual cost by $1,000 for some output transferred from Beta to Alpha? The result of Betas inefficiency is that a larger profit will be reported for Beta, whose costs increase by only the $1,000 inefficiency, while the transfer price increases by $1,100. The net effect is a $100 increase in Betas reported income.
Sample Calculation of Transfer Prices for a Dozen of Part #22
Competitive baseline cost of procurement $3.20

Adjustments:
• Lack of credit risk, risk of an uncollectible account (.01)
• Time value of money equivalent to value held in payment terms (.04)
• Procurement burden (.14)
• Purchase order management
• Supplier quality management
• Supplier delivery management
• Profit objective (1%) .03
__________
Betas local (hypothetical) transfer price $3.04

Geographical adjustment
For Canada: Gamma:
• Proportion 105%
• Price ($3.04 x 1.05) $3.19
For high-tax U.S. location: Alpha:
• Proportion 99%
• Price ($3.04 x .99) $3.01


Using the market-based approach, assume a division producing the transferred goods and services also sells some of the same outputs to unaffiliated entities in arms-length transactions: Those transactions can serve as a starting point in a system of market-based transfer prices.
The latter approach not only avoids the incentive drawbacks of a cost-plus system but in theory it also is the preferred way to value the output of each unit. Its weakness is that its difficult to defend the system as being truly market-based. For example, a single item may have different prices in different markets, depending on local supply and demand, regulation, shipping costs and many other factors. Transfer prices must reasonably reflect those differences, and when market conditions change significantly, the transfer prices must be revised.
For the transfer pricing system to be defensible, it must be treated consistently throughout the company. So, for example, if credit risk is considered in one situation, it must be considered in others, too.
$ [10,000 x (.52 - .396)]
+ [10,000 x (.52 - .500)] 1,240
+ 200 $ 1,440


Another consideration: Because only a book entry at headquarters is necessary to recognize the payment and collection of a transfer price, the transfer is the equivalent of an immediate cash payment. This should result in an adjustment representing the time value of money. When great distances or national borders separate the different business units, a company must make several adjustments to arrive at defensible market-based transfer prices. The exhibit above is a summary of the adjustments used to arrive at a market-based transfer price.
The business must make a similar calculation for each category of item shipped to each location. For a large, vertically integrated company with dozens of locations and hundreds of products, this could entail thousands of calculations and frequent revisions.

ACCOUNTING AND REPORTING

Any transfer pricing system creates internal revenues and expenses recorded for the goods and services transferred between units. The company must eliminate them to calculate the overall entitys income. If transfer prices exist between only two units of a company, the recordkeeping may be simple. It must create a structure to justify the many eliminations needed when transfer pricing is used at multiple levels of a company, such as in Examples production of plastic parts at Beta, the use of plastic parts in making subassemblies at Gamma and the use of subassemblies in making telephones at Alpha.
As business gets more complex, the likelihood grows that your company will eventually have to deal with transfer pricing issues. Its prudent to understand the subject nownot when the taxing authorities are breathing down your neck.