Cost-Volume-Profit Analysis (CVPA)

Concepts

CVPA provides a model of the relationships between volume sold, costs incurred and profit realized.

It is a basic business model that seeks to express the cost and revenue structures of a business in the form of mathematical equations.

It involves the identification and quantification of the following variables:

• Product mix
• Sales/demand
• Selling price
• Production efficiency (input and output relationships)
• Variable costs
• Total fixed costs


CVPA requires costs to be analyzed into variable cost and fixed cost to facilitate the prediction of costs and revenues at different activity levels for Decision Making purposes:

1. Variable costs vary in direct proportion with activity
2. Fixed costs remain constant over wide ranges of activity
3. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels.
4. Semi-variable costs include both a fixed and a variable component (eg telephone charges)
5. Note that the classification of costs depends on the time period involved. In the short term some costs are fixed but in the long term all costs are variable.


Usefulness of CVPA

(a) Facilitates the economic evaluation of short-run decisions.

(b) Facilitates strategic planning – CVPA can be used to determine what market share is needed to breakeven or to achieve a target return with a particular strategy.

(c) Facilitates cost planning in choosing between alternative cost structures – CVPA highlights the risk and returns of alternative fixed-cost/variable-cost structures. A strategy with a high proportion of fixed costs (eg in house manufacture) might be more risky although it promises a higher return. A strategy with a higher proportion of variable costs (eg outsource) can mean more flexibility.

(d) Sensitivity analysis, a what-if technique can be used to examine how the results of the CVPA will change if the original predicted data or if an underlying assumption changes. The sensitivity f operating income/profit to various possible outcomes broadens managers’ perspectives as to what might actually occur before they make cost commitments.


CVPA Equation Method

TR = Total revenue
TVC = Total variable costs
TFC = Total fixed costs
NP = Net profit
USP = Unit selling price
UVC = Unit variable cost
UCM = Unit contribution margin = USP-UVC

CM% (or C/S%) = contribution margin ratio (or contribution to sale ratio) = UCM/USP x 100

NP = TR – TVC – TFC
NP = (USP x Q) – (UVC x Q) – TFC
NP = (UCM x Q) – TFC

(a) Target profit, revenue and costs (NP, USP, Q, UVC, TFC) can be determined by manipulation of the net profit equation.

(b) At breakeven point, NP = 0 i.e. (UCM x Q) = TFC
Therefore, BEQ (units) = TFC/UCM
Breakeven Revenue = TFC / CM% or BEQ (units) x USP


CVPA : Risk and Return Measures

(a) Contribution Margin Ratio (CM%) is a return measure : the higher the CM %, the higher the expected payoff and vice versa.

(b) Breakeven (BE) sales is a risk measure: the lower the breakeven sales, the lower the risk of making losses (due to lower FC) and vice versa.

(c) Margin of safety (MOS) is a risk measure: the lower the MOS, the higher the risk as losses will occur when there is a small drop in sales.




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Economic Value Added (EVA)

EVA is an alternative absolute performance measure. It is similar to RI and is calculated as follows:


EVA = net operating profit after tax (NOPAT) less capital charge

(where capital charge = weighted average cost of capital x net assets)



Evaluation of EVA

The advantages of EVA include the followings:

(a) Real wealth for shareholders. Maximization of EVA will create real wealth for the shareholders.

(b) Less distortion of certain accounting policies. The adjustments within the calculation of EVA mean that the measure is based on figures that are closer to cash flows than accounting profits.

(c) An absolute value. The EVA measure is an absolute value, which is easily understood by non-financial managers.

(d) Treatment of certain costs as investments thereby encouraging expenditure. If management are assessed using performance measures based on traditional accounting policies they may be unwilling to invest in areas such as advertising and development for the future because such costs will immediately reduce the current year’s accounting profit. EVA recognizes such costs as investment for the future and thus they do not immediately reduce the EVA in the year of expenditure.



EVA does have some drawbacks:

(a) Focus on short-term performance. It is still a relatively short-term measure, which can encourage managers to focus on short-term performance.

(b) Dependency on historical data. EVA is based on historical accounts, which may be of limited use as a guide to the future. In practice the influences of accounting on the starting profit figure may not be completely negated by the adjustments made to it in he EVA model.

(c) Number of adjustments needed to measure EVA. Making the necessary adjustments can be problematic as sometimes a large number of adjustments are required.

(d) Comparison of like with like. Investment centres, which are larger in size, may have larger EVA figure for this reason. Allowance for relative size must be made when comparing the relative performance of investment centres.

(source : BPP Learning Media)



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Stock Market Ratios

Stock Market Ratios are ratios which help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of a company.


1. Dividend Yield = Dividend per Share / Market Price per Share


2. Interest Yield = Interest Payable / Market Value of Loan Stock


3. Earnings per Share = {Profit after tax, extraordinary items and preference dividends} / {Number of equity shares in issue and ranking for dividend}


4. Price/Earnings Ratio = Market Value per Share / Earning per Share


5. Dividend Cover = {Earnings available for distribution to ordinary shareholders} / {Actual dividend for ordinary shareholders}


Investors are interested in:

• The value (market price) of the securities that they hold
• The return that the security has obtained in the past
• Expected future returns
• Whether their investment is reasonably secure


(I) Dividend and Interest Yields

In practice, we usually find that dividend yield on shares is less than the interest yield on debentures and loan stock (and also less than the yield paid on gilt-edged securities)

The share price generally rises in most years, giving shareholder capital gain.

In the long run, shareholders will want the return on their shares, in terms of dividend received plus capital gains, to exceed the return that investors get from fixed interest securities.


(II) Earnings per Share (EPS)

EPS is widely used as a measure of a company’s performance and is of particular importance in comparing results over a period of several years.

A company must be able to sustain its earnings in order to pay dividends and re-invest in the business so as to achieve future growth.

Investors also look for growth in the EPS from one year to the next.

EPS must be seen in the context of several other matters:

(a) EPS is used for comparing the results of a company over time. Is its EPS growing? What is the rate of growth? Is the rate of growth increasing or decreasing?

(b) Is there likely to be a significant dilution of EPS in the future, perhaps due to the exercise of share options or warrants, or the conversion of convertible loan stock into equity?

(c) EPS should not be used blindly to compare the earnings of one company with another. When earnings are used to compare one company’s shares with another, this is done using the P/E ratio of perhaps the earning yield.

(d) If EPS is able to be a reliable basis for comparing results, it must be calculated consistently. The EPS of one company must be directly compared with the EPS of others, and the EPS of a company in one year must be directly comparable with its published EPS figures for previous years. Changes in the share capital of a company during the course of a year cause problems of comparability.

Note that EPS is a figure based on past data, and it is easily manipulated by changes in accounting policies and by mergers or acquisitions.



(III) Price/Earnings Ratio

P/E ratio is simply a measure of the relationship between the market value of a company’s shares and the earnings from those shares.

The value of the P/E ratio reflects the market’s appraisal of the shares’ future prospects. In other words, if one company has a higher P/E ratio than another, it is because investors either expect its earnings to increase faster than the other’s or consider that it is a less risky company or in a more secure industry.

(a) The relationship between the EPS and the share price is measured by the P/E ratio.

(b) There is no reason to suppose, in normal circumstances, that the P/E ratio will vary much over time.

(c) So if the EPS goes up or down, the share price should be expected to move up or down too, and the new share price will be the new EPS multiplied by the constant P/E ratio.


Changes in the P/E ratio of companies over time will depend on several factors:

(a) If interest rates go up, investors will be attracted away from shares and into debt capital. Share prices will fall, and so P/E ratio will fall.

(b) If prospects for company profits improve, share price will go up and P/E ratios will rise. Share prices depend on expectations of future earnings, not historical earnings, and so a change in prospects, perhaps caused by substantial rise in international trade, or an economic recession, will affect prices and P/E ratios.

(c) Investors’ confidence might be changed by a variety of circumstances, such as:

a. The prospect of a change in government
b. The prospect for greater exchange rates stability between currencies.



(IV) The Dividend Cover

The dividend cover is the number of times the actual dividend could be paid out of current profits and indicates:

(a) The proportion of distributable profits for the year that is being retained by the company

(b) The level of risk that the company will not be able to maintain the same dividend payments in future years, should earning fall.

A high dividend cover means that a high proportion of profits are being retained, which might indicate that the company is investing to achieve earnings growth in the future.


(source: BPP Learning Media)



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Liquidity Ratios: Cash and Working Capital

Profitability is of course an important aspect of a company’s performance, and Debt or Gearing is another.

However, none addresses the key issue of liquidity.

A company needs liquid assets so that it can meet its debts when they fall due.

Liquidity is the amount of cash a company can obtain quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds consist of:

(a) Cash
(b) Short-term investments for which there is a ready market, such as investments in shares of other companies. (Short-term investments are distinct from investments in shares in subsidiaries or associated companies).
(c) Fixed term deposits with a bank or building society, for example ix month deposits with a bank.
(d) Trade Receivables – they are not cash, but ought to be expected to pay what they owe within a reasonable short time.
(e) Bills of exchange receivable – like ordinary trade receivables, these represent amounts of cash due to be received soon.

Liquidity Ratios and Working Capital Turnover Ratios can give us some ideas of the company’s liquidity


Liquidity Ratios

(1) Current ratio = Current Assets / Current Liabilities

In practice a current ratio comfortably in excess of 1 should be expected, but what is comfortable varies between different types of businesses.


(2) Quick Ratio or Acid Test Ratio = (Current Assets less Inventory) / Current Liabilities

The ratio should ideally be at least 1 for companies with a slow inventory turnover For companies with a fast inventory turnover, a Quick Ratio can be less than 1 without suggesting that the company is in cash flow difficulties.

An excessive large current / quick ratio may indicate a company that is over-investing in working capital, suggesting poor management of debtors or stocks by the company.


Working Capital Turnover Ratios

Turnover Periods for Inventory, Receivables and Payables can be calculated.

If we add together the inventory days and the receivables days, this should give us an indication of how soon inventory is convertible into cash.

Both receivables days and inventory days therefore give us a further indication of the company’s liquidity.


(source: BPP Learning Media)



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Debt and Gearing Ratios

Debt ratios are concerned with how much the company owes in relation to its size and whether it is getting into heavier debt or improving its situation.

(a) When a company is heavily in debt and seems to be getting even more heavily into debt, banks and other would-be lenders are very soon likely to refuse further borrowing and the company might well find itself in trouble.

(b) When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid.


(1) Debt Ratio

Debt ratio is the ratio of a company’s total debts to its total assets.

(a) Assets consist of non-current assets at their balance sheet value, plus current assets.
(b) Debts consist of all payables, whether current or non-current.

(You can ignore long-term provisions and liabilities, such as deferred taxation)

There is no absolute rule on the maximum safe debt ratio, but as a very general guide, you might regard 50% as a safe limit to debt. In addition, if the debt ratio is over 50% and getting worse, the company’s debt position will be worth looking at more carefully.


(2) Capital Gearing

Capital gearing is concerned with the amount of debt in a company’s long-term capital structure. Gearing ratios provide a long-term measure of liquidity.


Gearing Ratio = Prior charge capital (long-term debt)/Prior charge capital + equity (shareholders’ funds)

Prior charge capital is a long-term loans and preferred shares (if any). It does not include loan repayable within one year and bank overdraft, unless overdraft finance is a permanent part of the business’s capital.



(3) Operating Gearing

Operating gearing measures the proportion of fixed costs to total costs. High operating gearing means that a high proportion of cost is fixed. This has implications for business risk in that if turnover alls, there is little automatic relief in the reduction of variable costs.


Operating gearing can be calculated as Contribution / PBIT


(4) Interest Cover

The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in profit before interest and tax (PBIT) would then have a significant effect on profits available for ordinary shareholders.


Interest Cover = PBIT/ Interest Charges


An interest cover of 2 times or less would below and it should really exceed 3 times before the company’s interest costs can be considered to be within acceptable limits. Note it is usual to exclude preference dividends from interest charges.


(5) Cash Flow Ratios

Cash flow ratio is ratio of a company’s net cash inflow to its total debts.


Net annual cash inflow/ Total debts


(a) Net annual cash inflow is the amount of cash which the company has coming into the business each year from its operations. This will be shown in a company’s statement of cash flows for the year.

(b) Total debts are short-term and long-term payables, together with provisions for liabilities and charges.

Obviously, a company needs to earn enough cash from operations to be able to meet its foreseeable debts and future commitments, and the cash flow ratio, and changes in the cash flow ratio from one year to the next, provides a useful indicator of a company’s cash position.

(source: BPP Learning Media)



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Financial Performance (11) - Market Strength Ratios

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Financial Performance (10) - Cash Flow Ratios

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Financial Performance (9) - Solvency Ratios

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Financial Performance (8) - Profitability Ratios

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Financial Performance (7) - Liquidity Ratios AP

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Financial Performance (6) - Liquidity Ratios Inventory

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Financial Performance (5) - Liquidity Ratios AR

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Financial Performance (4) - Liquidity Ratios

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Financial Performance (3) - Vertical Analysis

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Financial Performance (2) - Horizontal Analysis

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Financial Performance (1) - Overview

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Profitability and Return

(A) Profitability

A company ought of course to be profitable and obvious checks on profitability are:

• Whether there is profit or loss on its ordinary activities
• By how much this year’s profit or loss is bigger or smaller than last year’s profit or loss.

(B) Return on Capital

It is important to assess profits or profit growth by relating them to the amount of funds (the capital) employed in making the profits.

Return on Capital Employed (ROCE) is an important profitability ratio. It is a ratio which states the profit as a percentage of the amount of capital employed.

Profit is taken as profit on ordinary activities before interest and taxation (PBIT) and capital employed is shareholders’ capital plus long-term liabilities and debt capital (or total assets less current liabilities).

ROCE = PBIT/ Capital employed

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Evaluating ROCE

There are three comparisons that can be made:

(a) Change in ROCE from one year to the next

(b) ROCE being earned by other companies, if this information is available.

(c) A comparison of ROCE with current market borrowing rates:

a. If the company needs more loans, what would be the cost of extra borrowing to the company? Is it earning an ROCE that suggests it could make higher profits to make such borrowing worthwhile?
b. Is the company making an ROCE which suggests that it is making profitable use of the current borrowing?

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Analyzing Profitability and ROCE in more detail: the secondary ratios

We may analyze the ROCE to find out why it is high or low, or better or worse than last year.

(a) Profit margins

A company that makes a profit of 25c per $1 of sales is making a bigger return on its turnover than another company making a profit of only 10c per $1 of sales.

(b) Assets turnover

It is a measure of how well the assets of a business are used to generate sales. For example Company A & B each have a capital employed of $100,000. Company A makes sales of $400,000 a year whereas company B makes sales of only $200,000 a year, company A is making a higher turnover from the same amount of assets. This will help company to make a higher ROCE than company B.

Profit margin and Asset turnover together explain the ROCE. The relationship between the three ratios is as follows:

PBIT/Sales x Sales/Capital employed = PBIT/Capital employed

It is also worth commenting on the change in turnover from one year to the next. Strong sales growth will usually indicate volume growth as well as turnover increases due to price rises. Volume growth is one sign of a prosperous company.


(source: BPP Learning Media)



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Ratio Analysis

Ratios provide a means of systematically analyzing financial statements.

They can be grouped under the headings: Profitability, Liquidity, Gearing and Shareholders’ investment.

Broad Categories of Ratios

Ratios can be grouped into the following four categories:

• Profitability and return
• Debt and gearing
• Liquidity: Control of cash and other working capital items
• Shareholders’ Investment ratios (or stock market ratios)

Limitations of Ratio Analysis

Although ratio analysis can be a very useful technique, it is important to know its limitations:

(a) Availability of comparable information – difficult in identifying which companies are similar and in obtaining enough detailed information about these companies.

(b) Use of historical/out-of-date information – ratios based on published accounts were information which were filed some months after the end of the accounting period. Comparisons may also be distorted by inflation, leading to assets being stated at values that do not reflect replacement costs, and revenue increasing for reasons other than more sales being made.

(c) Ratios are not definitive – Ideal levels vary industry by industry, and even they are not definitive. Companies may be able to exist without any difficulty with ratios that are rather worse than the industry average.

(d) Need for careful interpretation – Business with high liquidity ratios may appear good, but further investigation might reveal that the higher ratios are a result of higher inventory and receivable levels which are a result of poor working capital management.

(e) Manipulation – any ratio including profit may be distorted by choice of accounting policies. For smaller companies, working capital ratios may be distorted depending on whether a big customer pays, or a large supplier is paid, before or after the year-end.

(f) Ratios lack standard form – for example, when calculating gearing some companies will include bank overdrafts, others exclude them.




(source: BPP Learning Media)



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Six Ways to Achieve Business & Environmental Benefits

(a) Integrating the environment into capital expenditure decisions (by considering environmental opposition to projects which could affect cas flows, for example)

(b) Understanding and managing environmental costs. Environmental costs are often hidden in overheads and environmental and energy cost ate often not allocated to the relevant budgets.

(c) Introducing waste minimization schemes.

(d) Understanding and managing life cycle costs. For many products, the greatest environmental impact occurs upstream (such as mining raw materials) or downstream from production (such as energy to operate equipment). This has led to producers being made responsible for dealing with the disposal of products such as cars, and government and third party measures to influence raw material choices. Organizations therefore need to identify, control and make provision for environmental life cycle costs and work with suppliers and customers to identify environmental cost reduction opportunities.

(e) Measuring environmental performance. Business is under increasing pressure to measure all aspects of environmental performance, both for statutory disclosure reasons and due to demands for more environmental data from customers.

(f) Involving management accountants in a strategic approach to environmental-related management accounting and performance evaluation.

a. To analyse the short-, medium- and long-term impact of possible changes in the followings:
i. Government policies, such as on transport
ii. Legislation and regulations
iii. Supply conditions, such as fewer landfill sites
iv. Market conditions, such as changing customer views
v. Social attitudes, such as to factory farming
vi. Competitor strategies


b. to identify possible actions:
i. Designating an “environmental champion” within the strategic planning or accounting function to ensure that environmental considerations are fully considered.
ii. Assessing whether new data sources are needed to collect more and better data.
iii. Making comparisons between sites/offices to highlight poor performance and generate peer pressure for action.
iv. Developing checklists for internal auditors.

(source: BPP Learning Media)



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EMA - Impact on Company's Performance

Ways in which a company’s concern for the environment can impact on its performance:


(a) Short-term savings through waste minimization and energy efficiency schemes can be substantial.

(b) Companies with poor environmental performance may face increased cost of capital because investors and lenders demand a higher risk premium.

(c) There are a number of energy and environmental taxes, such as the UK’s landfill tax.

(d) Pressure group campaigns can cause damage to reputation and/or additional costs.

(e) Environmental legislation may cause the “sunsetting” of products and opportunities for “sunrise” replacement.

(f) The cost of processing input which becomes waste is equivalent to 5-10% of some organization’s revenue.

(g) The phasing out of CFCs has led to markets for alternative products.


(source: BPP Learning Media)



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Strategic Management Video (7)

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Strategic Management Video (6)

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Strategic Management Video (5)

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Strategic Management Video (4)

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Strategic Management Video (3)

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Strategic Management Video (2)

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Strategic Management Video (1)

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Environmental Management Accounting (EMA)

EMA is the generation and analysis of both financial and non-financial information in order to support internal environmental management processes.

The main points made by Mr Shane Johnson in the January 2004 edition of Student Accounts are as follows:


(a) Major incidents like the Bhopal chemical leak and the Exxon Vaidez oil spill have significantly raised the profile of environmental issues over the last 20 years or so.

(b) Poor environmental behaviour can result in “fines, increased liability to environmental taxes, loss in value of land, destruction of brand values, loss of sales, consumer boycotts, inability to secure finance, loss of insurance cover, contingent liabilities, law suits and damage to corporate image”.

(c) Environmental issues need to be managed before they can be reported externally, and so changes are needed to management accounting systems.

(d) Management accounting techniques tend to underestimate the cost of poor environmental behaviour, underestimate the benefits of improvements and can distort and misrepresent environmental issues, leading managers to make decisions that are bad for business and bad for the environment.

(e) Most conventional accounting systems are unable to apportion environmental costs to products, processes and services and so they are simply classes as general overheads. Consequently, managers are unaware of these costs, have no information with which to manage them and have no incentive to reduce them. “Environmental management accounting (EMA)”, on the other hand, attempts to make all relevant, significant costs visible so that they can be considered when making business decisions.

(f) Management accounting techniques which are useful for the identification and management of environmental costs include:

(i) Input/output analysis (records material flows with the idea that what comes in must go out – or to be stored).
(ii) Flow cost accounting (aims to reduce the qualities of materials, which leads to increased ecological efficiency)
(iii) ABC (distinguishes between the environment-related and environment-driven costs)
(iv) Life cycle costing (used to advantage by Xerox Limited for its logistic chain)

(g) The major areas for the application of EMA are in the assessment of annual environmental costs/expenditures. Product pricing, budgeting, investment appraisal, calculating costs and savings of environmental projects, or setting quantified performance targets”

(h) Good environmental management can be seen as a key component of TQM (objectives such as zero waste).

(i) Although various classifications have been suggested, “the most significant problem of EMA lies in the absence of a clear definition of environmental costs. This means that organizations are not monitoring and controlling such costs”.


(source: BPP Learning Media)



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Building a Lean Cuture (Video)

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Lean Success Video

In a struggle for survival, a company found Lean Principles, abandoned ERP/MRP and adverted bankruptcy. This is a true success story with a Lean System using wirless Kanban that was implemented by Robert Krause, Lean Consultant. Inventory was established using Point Of Use Inventory (POUI) and material was only reordered using a pull system and obtaining incredible inventory turns over 15 times.



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What is Kaizen? (Video)

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Benefits of Continuous Improvement

(a) Better performance, which produces increased profits

(b) Improvements in customer satisfaction

(c) Increases in staff morale.

(d) Improvement on a continual, step-by-step basis is more prudent than changing things all at once.

(e) Better communication within organization.

(f) Improvements in relations with suppliers

(g) Better use of resources

(h) More efficient planning.


Case Study (1)

“Volex is committed to a program of Continuous Improvement across all its operations. All improvement projects have a specific customer focus and are based on measured progress against firm targets or industry benchmarks. We also encourage the active involvement of our employees. Many sites operate Kaizen schemes with cross-functional project teams applying working-level improvement actions on many topics including environmental, health and safety programs.

At Volex, Continuous Improvement is considered a crucial process to achieve competitive advantage for our customers and ourselves. We accord high management priority to key product and service-level improvement projects. Programs that integrate the results using international models of performance improvement are then used to set senior management performance targets for the subsequent years.

The process of improvement links closely with personal development. Volex is strongly committed to the training and development of his employees worldwide. Through our knowledge, skills and experience, we help ensure the success of our customers’ projects around the world everyday.”

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Case Study (2)


Chrysler ‘s Five Star Dealer Incentive Program is designed for improving or creating processes to quickly find what creates customer dissatisfaction and find ways to fix these issues.

The first step for dealers is to contact their customers to get feedback on their sales or service experience. The use of this feedback is mandatory, as getting information and not using it is seen to lower trust, increase frustration and cost money.

Dealers are required to put in place processes that not only resolve customer problems but also allow them to learn from the customers. This is the hallmark of continuous improvement: collecting information at every opportunity and putting it to use.


Dealers are also required to provide training for staff who deal with customers, as efforts to make change are seen to be constrained unless all staff understand not only that they can have an effect, but that they are expected to have an effect.


(source: BPP :Learning Media)



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Essential Factors for Continuous Improvement

(a) Total commitment from senior management.

(b) Opportunity for all employees to contribute to the process. The most successful continuous improvement programs are the one that have the highest staff involvement.

(c) Good, objective information about the organization’s environment so that its outcomes and its processes can be evaluated.

(d) Employees’ awareness of their role in the achievement of the organization’s strategy.

(e) Management of the performance and contribution of employees.

(f) Good communications throughout the organization.

(g) Implementation of recognized quality management systems and standards.

(h) Measurement and evaluation of progress against key performance indicators and benchmarks. By simply displaying productivity and quality data everyday or week raise production and quality because staff can tell when they are doing things right, and so find themselves in a personal continuous improvement cycle.

It is claimed that if these areas are regularly reviewed, change can be managed effectively and continuous improvement becomes a natural part of the organizational processes. It should create steady growth and development by keeping the organization focused on its aims, priorities and performance.


(source : BPP Learning Media)



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Continuous Improvement (Kaizen)

Continuous Improvement (where being popularized and it is known as Kaizen in Japan) is an ongoing process that involves a continuous search to reduce costs, eliminate waste and improve the quality and performance of activities that increase customer value or satisfaction.

The implementation of continuous improvement does not necessarily call for significant investment, but it does require a great deal of commitment and continuous effort.

Continuous improvement is often associated with incremental changes in the day-to-day process of work suggested by employees themselves.

Quantum leaps in performance can occur when cumulative improvements synergies, the sum of a number of small improvements causing a profound net effect greater than the sum of all the sum improvements.

Continuous improvement processes never stop and sustained success is more likely in organizations which regularly review their business methods and processes in the drive for improvement.

(source: BPP Learning Media)



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Performance Management & Evaluation - EVA

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Performance Management & Evaluation - Residual Income

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Performance Management & Evaluation - PM & AT

PM- Profit Margin
AT - Asset Turnover




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Performance Management & Evaluation - ROI

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Performance Management & Evaluation - Flexible Budgets

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Performance Management & Evaluation - Responsibility Accounting

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Performance Management & Evaluation - Balanced Scorecard

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Performance Management & Evaluation - Overview

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Cost Concepts - OH 4 Steps to Success

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Cost Concepts - OH 3 Approaches

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Cost Concepts - WIP and OH

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Cost Concepts - Three Manufacturing Inventories

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Cost Concepts - Manufacturing Income Statement

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Cost Concepts - Income Statements

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Cost Concepts - Terms

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Cost Concepts - OH Traditional vs ABC

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Transfer Pricing Video

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Benefits of TQM Video

The benefits of total quality management, which involves teaching all employees exactly what is expected of them, include getting everyone on the same page and helping customers more efficiently in the end.



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Total Quality Management Explained

TQM is the process of applying a zero defects philosophy to the management of all resources and relationships within an organization as a means of developing and sustaining a culture of continuous improvement which focuses on meeting customers expectations.


Characteristics of Total Quality Management Programs

(a) Organization wide there must be acceptance that the only thing that matters is the customer.

(b) There should be recognition of the all-pervasive nature of the customer-supplier relationship.

(c) Instead of relying on inspection to a predefined level of quality, the cause of the defect in the first place should be prevented.

(d) Each employee or a group of employees must be personally responsible for the defect-free production or service in their domain.

(e) There should be a move away from “acceptable” quality levels. Any level of defect must be unacceptable.

(f) All departments should try obsessively to get thing right first time, this applies to misdirected phone calls and typing errors as much as to production.

(g) Quality certification programs should be introduced.

(h) The cost of poor quality should be emphasized, good quality generates savings.

(source : BPP Learning Media)



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Lean Manufacturing Case Study - DELL

Lean Manufacturing Toyota Production System JIT Kaizen Kanban Value Stream 5S




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Lean Manufacturing Example - Toyota Plant

Lean Manufacturing Toyota Production System JIT Kaizen Kanban Value Stream 5S




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Target Costing (II)

Very often the management may decide to go ahead and manufacture a product whose target cost is well below the currently attainable cost (so that there is a cost gap).

To attain the Target cost, management will set benchmarks for improvement towards the target costs, by specified dates.

Options available to reduce costs:

(a) Training staff in more efficient techniques
(b) Using cheaper staff
(c) Acquiring new, more efficient technology
(d) Cutting out non-value-added activities

Cost savings must be actively sought and made continuously. Value analysis will be used to reduce costs if and when targets are missed.

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The following comments appeared in an article in the Financial Times


Mercedes-Benz, one of the world’s most prestigious and tradition-laden carmakers, has taken its time to wake up to the daunting dimensions of the challenges it faces in the rapidly-changing world car market of the 1990s.

The company has accepted that radical changes in the world car market mean that Mercedes-Benz will no longer be able to demand premium prices for its products based on an image of effortless superiority and a content of the ultimate in automotive engineering.

Instead of developing the ultimate car and then charging a correspondingly sky-high price as in the past, Mercedes-Benz is taking the dramatic and radical step of moving to target pricing. It will decide what the customer is willing to pay in a particular product category – priced against its competitors – it will add its profit margin and then the real work will begin to cost every part and component to bring in the vehicle at the target price.



The following extracts are from an article which appeared three months later.


The marketing motto for the Mercedes-Benz compact C-class is that it offers customers more car for their money.

It is the first practical example of a group’s new pricing policy. The range embodies a principle new to Mercedes which states that before any work starts, a new product will be priced according to what the market will bear and what the company considers an acceptable profit. Then each component and manufacturing process will be costed to ensure the final product is delivered at the target price.

Under the old system of building the car, adding up the costs and then fixing a price, the C-class would have been between 15 percent and 20 percent dearer than the 10-year-old outgoing 190 series, Mr Vohnringer said.

Explaining the practical workings of the new system, he explained that project groups for each component and construction process were instructed without exception to increase productivity by between 15 and 25 per cent. And they had to reach their targets in record time.

One result was that development time on the new models was cut to 40 months, about a third less than usual. But the most important effect, according to Mr Vohnringer, has been to reduce the company’s cost disadvantages vis-à-vis Japanese competitors in this class from 35 percent to only 15 percent.

(source: BPP Learning Media)



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Pricing - Target Costing

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Target Costing Explained

Target Cost is an estimate of a product cost which is derived by subtracting a desired profit margin from a competitive market price.

Target costing is a pro-active cost control system. Techniques such as value analysis are used to change production methods and/or reduce expected costs so that the target cost is met.

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Target cost management:

• It is effective in managing costs in new product design and development stages.

• It also enables the production cost of a proposed product to be identified so that when sold it generates the desired profit level.

• It also plays a useful role in enabling enterprise to set and support the attainment of cost levels.

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Target costing requires managers to change the way they think about the relationship between cost, price and profit.

(a) Traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price (probably based on cost) with a resulting profit or loss. Costs are controlled through variance analysis at monthly intervals.

(b) The target costing approach is to develop a product concept and the primary specifications for performance and design and then to determine the price the customers would be willing to pay for that concept. The desired profit margin is deducted from the price leaving a figure that represents total cost.
This is the target cost and the product must be capable of being produced for this amount otherwise the product will not be manufactured.
During the product’s life target cost will constantly be reduced so that the price can fall. Continuous cost reduction techniques must therefore be employed.

(source : BPP Learning Media)





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Essential Elements of JIT

(1) JIT Purchasing

• Parts and raw materials should be purchased as near as possible to the time they are needed, using small frequent deliveries against bulk contracts.

• Inventory levels are therefore minimized.


(2) Close Relationship with Suppliers

• In a JIT environment, the responsibility for the quality of goods lies with the supplier.

• A long-term commitment between supplier and customer should therefore be established.

• If an organization has confidence that suppliers will deliver material of 100% quality, on time, so that there will be no rejects, returns and hence no consequent production delays, usage of materials can be matched with delivery of materials and inventories can be kept at near zero levels.


(3) Uniform Loading

• All parts of the production process should be operated at a speed which matches the rate at which the final product is demanded by the customer.

• Production runs will therefore be shorter and there will be smaller inventories of finished goods because output is being matched more closely to demand (and so usage costs will be reduced).


(4) Set-up Time Reduction

• Machinery set-ups are non-value-added activities which should be reduced or even eliminated.


(5) Machine Cells

• Machines or workers should be grouped by product or component instead of by the type of work performed.

• Production can flow from machine to machine without having to wait for the next stage of processing or returning to the stores.

• Lead time and work in progress are thus reduced.


(6) Quality

• Production management should seek to eliminate scrap and defective units during production, and to avoid the need for reworking of units since this stops the flow of production and leads to late deliveries to customers.

• Product quality and production quality are important “drivers” in a JIT system.


(7) Pull system (Kanban)

• Products/components are only produced when needed by the next process.

• Nothing is produced in anticipation of need, to then remain in inventory, consuming resources.


(8) Preventive Maintenance

• Production systems must be reliable and prompt, without unforeseen delays and breakdowns.


(9) Employee Involvement

Workers within each machine cell should be trained to operate each machine within that cell and to be able to perform routine preventive maintenance on the cell machines (ie to be multi skilled and flexible).


(source: BPP Learning Media)



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Just-in-Time (JIT) Philosophy Explained

JIT is a system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for inventory.

JIT is a ‘pull’ system, which responds to demand, in contrast to a ‘push’ system, in which inventories act as buffers between the different elements of the system, such as purchasing, production and sales.

JIT aims to achieve (a) zero inventory and (b) perfect quality.

JIT operates by demand-pull.

JIT consists of JIT Purchasing and JIT Production:

• JIT Purchasing is a System in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide.

• JIT Production is a System which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage.

JIT results in lower investment requirements, space savings, greater customer satisfaction and increased flexibility.

JIT is often described as a technique, but it is more of a philosophy or approach to management since it encompasses a commitment to continuous improvement and the search for excellence in the design and operation of the production management system.


Problems associated with JIT

(a) It is not always easy to predict patterns of demand.
(b) JIT makes the organization far more vulnerable to disruptions in the supply chain.
(c) JIT, originated by Toyota, was designed at a time when all of Toyota’s manufacturing was done within a 50km radius of its headquarters. Wide geographical spread, however, make this difficult.


Costing implications of JIT

(a) Just-in-Time manufacturing enables purchasing, production, and sales to occur in quick succession with inventory being maintained at minimum levels.
(b) The absence of inventory renders decisions regarding cost-flow assumptions (such as weighted average or first-in, first-out) or inventory costing methods (such as absorption or marginal costing) unimportant. This is because all of the manufacturing cost attributable to a period flow directly into cost of goods sold.
(c) Job costing is simplified by the rapid conversion of direct materials into finished goods that are then sold immediately.


(source: BPP Learning Media)



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"Modern Chairs" - a TQM video

A Total Quality Management training video that the final year class at the University of Edinburgh made in the style of Charlie Chaplin's Modern Times. The intention was to teach, teamwork, production line processes, process optimisation, defects, quality, and continual improvement 'Kaizen'.







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TQM at QPL Ltd

QPL Ltd., a leader in total quality management, empowers emplyees to ensure uncompromising quality in the production process.








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6s Quality Process of Pharmanex (Video)

Pharmanex uses proprietary technology in its manufacturing processes to maintain tight quality controls through all stages of product development. The key to consistent quality is the Pharmanex® 6S® Quality Process, the basis of the company's pharmaceutical approach to product development.

The attention to detail, strict scientific testing, and commitment to quality ensures that every Pharmanex® product is absolutely safe and effective. The 6S® Quality Process has enabled Pharmanex to become an industry leader in quality and efficacy. (Intrinsic activity or efficacy refers to the ability of a drug-receptor complex to produce a functional response)


6s Quality Process: Selection, Sourcing, Structure, Standardisation, Safety, Substantiation Quality.






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Views on Quality Costs

Traditional View

• Cost of conformance is the cost of achieving specified quality standards.

• Cost of non-conformance is the cost of failure to deliver the required standards of quality.

• Cost of conformance is a discretionary cost which is incurred with the intention of eliminating the cost of internal and external failure.

• The cost of non-conformance on the other hand, can only be reduced by increasing the cost of conformance.


The traditional approach to quality management is that there is an optimal level of quality effort, that minimizes total quality costs, and there is an optimal level of quality effort, that minimizes total quality costs, and there is a point beyond which spending more on quality yield a benefit that is less than the additional cost incurred. Diminishing returns ser in beyond the optimal quality level.


The TQM philosophy is different.

(a) Failure and poor quality are unacceptable. It is inappropriate to think of an optimal level of quality at which some failures will occur, and the inevitability of errors is not something that an organization should accept. The target should be zero defect.

(b) Quality costs are difficult to measure, and failure costs are often seriously underestimated. The real costs of failure include not just the costs of scrapped items and re-working faulty items, but also the management time spent on sorting out problems and the loss of confidence between different parts of the organization whenever faults occur.

(c) A TQM approach does not accept that the prevention costs of achieving zero defects becomes unacceptably high as the quality standard improves and goes above a certain level. In other words, diminishing returns does not necessary set in. If everyone in the organization is involved in improving quality, the cost of continuous improvement need not be high.

(d) If an organization accepts an optimal quality level that it believes will minimize total quality costs, there will be no further challenge to management to improve quality further.


The TQM quality cost model is based on the view that:

(a) Prevention costs and appraisal costs are subject to management influence or control. It is better to spend money on prevention, before failures occur, than on inspection to detect failures after they have happened.

(b) Internal failure costs and external failure costs are the consequences of the efforts spent on prevention and appraisal. Extra effort on prevention will reduce internal failure costs and this in turn will have a knock-on effect, reducing external failure costs as well.


In other words, higher spending on prevention will eventually lead to lower total quality costs.

The emphasis is on “getting things right first time” and “designing in quality” to the product or service.


(source: BPP Learning Media)



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Costs of Quality & Quality Reports

“Concern for good quality saves money, Poor quality costs money”

Costs of quality can be analyzed into prevention, appraisal, internal failure and external failure costs and should be detailed in a cost of quality report.

Cost of quality is the difference between the actual cost of producing, selling and supporting products or services and the equivalent costs if there were no failures during production or usage.

Cost of quality can be analyzed into:

• Cost of prevention – the costs incurred prior to or during production in order to prevent substandard or defective products or services from being produced.

• Cost of appraisal – cost incurred in order to ensure that outputs produced meet required quality standards.

• Cost of internal failure – the cost arising from inadequate quality which are identified before the transfer of ownership from supplier to purchaser.

• Cost of external failure – the cost arising from inadequate quality discovered after the transfer of ownership from supplier to purchaser.

External failure costs are the costs of failing to deliver a quality product externally. The sum of internal failure costs, prevention and appraisal costs is the cost of failing to deliver a quality product internally.



Examples of Quality-related Cost

(1) Prevention costs
• Quality engineering,
• Design/development of quality control/inspection equipment,
• Maintenance of quality control/inspection equipment.
• Administration of quality control,
• Training in quality control


(2) Appraisal costs
• Acceptance testing,
• Inspection of goods inwards.
• Inspection costs of in-house processing.
• Performance testing

(3) Internal failure costs
• Failure analysis,
• Re-inspection costs.
• Losses from failure of purchased items.
• Losses due to lower selling prices for sub-quality goods.
• Costs of reviewing product specifications after failures

(4) External failure costs
• Administration of customer complaints section
• Costs of customer service section
• Product liability costs
• Costs of repairing products returned from customers
• Costs of replacing items due to sub-standard products/marketing errors


(source: BPP Learning Media)



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TEDxAtlanta Video

How to accelerate the journey to higher level leadership skills.









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Performance Prism

Overview

Performance Prism is a three dimensional model.

The model has Five Facets: The top and bottom facets are Stakeholder Satisfaction and Stakeholder Contribution respectively. The three side facets are Strategies, Processes and Capabilities.

These five facets are linked and have a sequential order starting with Stakeholder Satisfaction and finishing with Stakeholder Contribution.


Step 1 The model starts from the percept that successful organizations have a clear picture of who their key stakeholders are and what they want.

Step 2 These organizations then define what strategies they will pursue to ensure that value is delivered to these stakeholders.

Step 3 They understand what processes the enterprise requires if these strategies are to be delivered and they have defined what capabilities they need to execute these processes.

Step 4 Successful organizations have also thought carefully about what it is that the organization wants from its stakeholders. This includes employee loyalty, customer profitability, and long term investment, for instance.


In essence they have a clear business model and an explicit understanding of what constitutes and drives good performance.


(source : BPP Learning Module)





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