SIX SIGMA
Six Sigma was originally developed as a set of practices designed to improve business processes and eliminate defects.
In Six Sigma, a defect is defined as anything that could lead to customer dissatisfaction.
Six Sigma asserts that:
• Continuous efforts to achieve stable and predictable process results (i.e. reduce process variation) are of vital importance to business success.
• Manufacturing and business processes have characteristics that can be measured, analyzed, improved and controlled.
• Achieving sustained quality improvement requires commitment from the entire organization, particularly from top-level management.
Features that set Six Sigma apart from previous quality improvement initiatives include:
• A clear focus on achieving measurable and quantifiable financial returns from any Six Sigma project.
• An increased emphasis on strong and passionate management leadership and support.
• A special infrastructure of “Champions”, “Master Black Belts”, “Black Belts” etc. to lead and implement the Six Sigma approach.
• A clear commitment to making decisions on the basis of verifiable data, rather than assumptions and guesswork.
A key methodology of Six Sigma is DMAIC.
The basic methodology consists of the following five steps:
• Define process improvement goals that are consistent with customer demands and the enterprise strategy.
• Measure key aspects of the current process and collect relevant data.
• Analyze the data to verify cause-and-effect relationships. Determine what the relationships are, and attempt to ensure that all factors have been considered.
• Improve or optimize the process based upon data analysis using techniques like Design of Experiments.
• Control to ensure that any deviations from target are corrected before they result in defects. Set up pilot runs to establish process capability, move on to production, set up control mechanisms and continuously monitor the process.
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Sunday, July 31, 2011
Friday, July 29, 2011
Methods of Embedding Risk Awareness in Organisation
Risk embeddedness
Risk embeddedness refers to the way in which risk awareness and management are interwoven into the normality of systems and culture in an organisation. These two twin aspects (systems and culture) are both important because systems describe the way in which work is organised and undertaken, and culture describes the ‘taken-for-grantedness’ of risk awareness and risk management within the organisation.
The methods by which risk awareness and management can be embedded in organisations are as follows:
1. Aligning individual goals with those of the organisation and building these in as part of the culture. The need for alignment is important because risk awareness needs to be a part of the norms and unquestioned assumptions of the organisation.
2. Training of staff at all levels is essential to ensure risk is embedded throughout the organisation.
3. Including risk responsibilities with job descriptions. This means that employees at all levels have their risk responsibilities clearly and unambiguously defined.
4. Establishing reward systems that recognise that risks have to be taken (thus avoiding a ‘blame culture’). Those employees that are expected to take risks (such as those planning investments) should have the success of the projects included in their rewards.
5. Establishing metrics and performance indicators that monitor and feedback information on risks to management. This would ensure that accurate information is always available to the risk committee and/or board, and that there is no incentive to hide relevant information or fail to disclose risky behaviour or poor practice. A ‘suggestion box’ is one way of providing feedback to management.
6. Communicating risk awareness and risk management messages to staff and publishing success stories. Part of the dissemination of, and creating an incentive for, good practice, internal communications is important in developing culture and continually reminding staff of risk messages.
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Risk embeddedness refers to the way in which risk awareness and management are interwoven into the normality of systems and culture in an organisation. These two twin aspects (systems and culture) are both important because systems describe the way in which work is organised and undertaken, and culture describes the ‘taken-for-grantedness’ of risk awareness and risk management within the organisation.
The methods by which risk awareness and management can be embedded in organisations are as follows:
1. Aligning individual goals with those of the organisation and building these in as part of the culture. The need for alignment is important because risk awareness needs to be a part of the norms and unquestioned assumptions of the organisation.
2. Training of staff at all levels is essential to ensure risk is embedded throughout the organisation.
3. Including risk responsibilities with job descriptions. This means that employees at all levels have their risk responsibilities clearly and unambiguously defined.
4. Establishing reward systems that recognise that risks have to be taken (thus avoiding a ‘blame culture’). Those employees that are expected to take risks (such as those planning investments) should have the success of the projects included in their rewards.
5. Establishing metrics and performance indicators that monitor and feedback information on risks to management. This would ensure that accurate information is always available to the risk committee and/or board, and that there is no incentive to hide relevant information or fail to disclose risky behaviour or poor practice. A ‘suggestion box’ is one way of providing feedback to management.
6. Communicating risk awareness and risk management messages to staff and publishing success stories. Part of the dissemination of, and creating an incentive for, good practice, internal communications is important in developing culture and continually reminding staff of risk messages.
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Sustainability in the Context of Environment
Sustainability is ensuring that economic activities and development meet the needs of the present without compromising the ability of future generations to meet their own needs.
For businesses, sustainability means that:
• The business inputs and outputs should have no irredeemable effects on the environment. It involves developing strategies so that the organization only uses resources (inputs) at a rate that allows them to be replenished, in order to ensure that they will continue to be available.
• Emissions of waste should be confined to levels that do not exceed the capacity of the environment to absorb them.
• It also involves recycling to reduce the impact of product manufacturing on natural resources.
Sustainability can be assessed by measures such as triple bottom line reporting, measuring financial, social and environmental performance.
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For businesses, sustainability means that:
• The business inputs and outputs should have no irredeemable effects on the environment. It involves developing strategies so that the organization only uses resources (inputs) at a rate that allows them to be replenished, in order to ensure that they will continue to be available.
• Emissions of waste should be confined to levels that do not exceed the capacity of the environment to absorb them.
• It also involves recycling to reduce the impact of product manufacturing on natural resources.
Sustainability can be assessed by measures such as triple bottom line reporting, measuring financial, social and environmental performance.
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Saturday, July 23, 2011
Related and Correlated Risks
Related risks are risks that vary because of the presence of another risk. This means they do not exist independently and they are likely to rise and fall in importance along with the related one. Risk correlation is a particular example of related risk.
Risks are positively correlated if the two risks are positively related in that one will fall with the reduction of the other and increase with the rise of the other. They would be negatively correlated if one rose as the other fell.
In the case of environmental risks and reputation risk, they may be positively correlated for the following reasons:
***Environmental risks involve exposure to losses arising from an organisation’s consumption of resources or impacts through its emissions. Where an environmental risk affects a sensitive situation, (be it human, flora, fauna or other), this can cause negative publicity which can result in reputation damage.
***These two risks can have a shared cause, i.e. they can arise together and fall together because they depend upon the same activity. They are considered separate risks because losses can be incurred by either of both of the impacts (environmental or reputational).
***Positively correlated risk - Activities designed to reduce environmental risk, such as acquiring resources from less environmentally-sensitive sources or through the fitting of emission controls, will reduce the likelihood of the environmental risk being realised. This, in turn, will reduce the likelihood of the reputation risk being incurred. The opposite will also hold true: a reduction of attention to environmental risk will increase the likelihood of reputation loss.
***Negatively correlated risks are also present in some situations. If, for example, a company borrows money to reduce its environmental emissions then it might be that its environmental risks are reduced but, with its increased gearing, its financial risks are increased at the same time. This is because the higher gearing will increase the vulnerability to rising interest rates and put pressure on cash flow. In this case, then, there is a direct relationship between the environmental risk reducing and the financial risk increasing.
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Risks are positively correlated if the two risks are positively related in that one will fall with the reduction of the other and increase with the rise of the other. They would be negatively correlated if one rose as the other fell.
In the case of environmental risks and reputation risk, they may be positively correlated for the following reasons:
***Environmental risks involve exposure to losses arising from an organisation’s consumption of resources or impacts through its emissions. Where an environmental risk affects a sensitive situation, (be it human, flora, fauna or other), this can cause negative publicity which can result in reputation damage.
***These two risks can have a shared cause, i.e. they can arise together and fall together because they depend upon the same activity. They are considered separate risks because losses can be incurred by either of both of the impacts (environmental or reputational).
***Positively correlated risk - Activities designed to reduce environmental risk, such as acquiring resources from less environmentally-sensitive sources or through the fitting of emission controls, will reduce the likelihood of the environmental risk being realised. This, in turn, will reduce the likelihood of the reputation risk being incurred. The opposite will also hold true: a reduction of attention to environmental risk will increase the likelihood of reputation loss.
***Negatively correlated risks are also present in some situations. If, for example, a company borrows money to reduce its environmental emissions then it might be that its environmental risks are reduced but, with its increased gearing, its financial risks are increased at the same time. This is because the higher gearing will increase the vulnerability to rising interest rates and put pressure on cash flow. In this case, then, there is a direct relationship between the environmental risk reducing and the financial risk increasing.
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Why Manufacturing has a greater challenge with the management of Liquidity Risk
Manufacturing has historically had a greater challenge with the management of liquidity risk compared to some other sectors (especially low inventory businesses such as those in service industries)
There are two main reasons:
Firstly, manufacturing usually requires higher working capital levels because it buys in and sells physical inventory, both on credit. This means that both payables and receivables are relatively high. It also, by definition, requires inventory in the form of raw materials, work-in-progress and finished goods, and therefore the management of inventory turnover is one of the most important management tasks in manufacturing management. In addition, wages are paid throughout the manufacturing process, although it will take some time before finished goods are ready for sale.
Secondly, manufacturing has complex management systems resulting from a more complex business model. Whilst other business models create their own liquidity problems, the variability and availability of inventory at different stages and the need to manage inventories at different levels of completion raises liquidity issues not present in many other types of business (such as service based business).
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There are two main reasons:
Firstly, manufacturing usually requires higher working capital levels because it buys in and sells physical inventory, both on credit. This means that both payables and receivables are relatively high. It also, by definition, requires inventory in the form of raw materials, work-in-progress and finished goods, and therefore the management of inventory turnover is one of the most important management tasks in manufacturing management. In addition, wages are paid throughout the manufacturing process, although it will take some time before finished goods are ready for sale.
Secondly, manufacturing has complex management systems resulting from a more complex business model. Whilst other business models create their own liquidity problems, the variability and availability of inventory at different stages and the need to manage inventories at different levels of completion raises liquidity issues not present in many other types of business (such as service based business).
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Friday, July 22, 2011
Mandatory External Reporting of Internal Controls
The case for the mandatory external reporting of internal controls and risks
1. Disclosure allows for accountability. Had investors been aware of the internal control failures and business probity risks earlier, it may have been possible to replace the existing board before events deteriorated to the extent that they sadly did. In addition, however, the need to generate a report on internal controls annually will bring very welcome increased scrutiny from shareholders and others. It is only when things are made more transparent that effective scrutiny is possible.
2. Secondly, I am firmly of the belief that more information on internal controls would enhance shareholder confidence and satisfaction. It is vital that investors have confidence in the internal controls of companies they invest in and increased knowledge will encourage this.
3. Furthermore, compulsory external reporting on internal controls will encourage good practice inside the company. The knowledge that their work will be externally reported upon and scrutinised by investors will encourage greater rigour in the IC function and in the audit committee. This will further increase investor confidence.
4. Internal controls and risks are simply too important an issue to allow companies to decide for themselves or to interpret non-mandatory guidelines. It must be legislated for because otherwise those with poor internal controls will be able to avoid reporting on them. By specifying what should be disclosed on an annual basis, companies will need to make the audit of internal controls an integral and ongoing part of their operations.
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1. Disclosure allows for accountability. Had investors been aware of the internal control failures and business probity risks earlier, it may have been possible to replace the existing board before events deteriorated to the extent that they sadly did. In addition, however, the need to generate a report on internal controls annually will bring very welcome increased scrutiny from shareholders and others. It is only when things are made more transparent that effective scrutiny is possible.
2. Secondly, I am firmly of the belief that more information on internal controls would enhance shareholder confidence and satisfaction. It is vital that investors have confidence in the internal controls of companies they invest in and increased knowledge will encourage this.
3. Furthermore, compulsory external reporting on internal controls will encourage good practice inside the company. The knowledge that their work will be externally reported upon and scrutinised by investors will encourage greater rigour in the IC function and in the audit committee. This will further increase investor confidence.
4. Internal controls and risks are simply too important an issue to allow companies to decide for themselves or to interpret non-mandatory guidelines. It must be legislated for because otherwise those with poor internal controls will be able to avoid reporting on them. By specifying what should be disclosed on an annual basis, companies will need to make the audit of internal controls an integral and ongoing part of their operations.
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Stages in an Environmental Audit
Environmental auditing contains three stages.
1. The first stage is agreeing and establishing the metrics involved and deciding on what environmental measures will be included in the audit. This selection is important because it will determine what will be measured against, how costly the audit will be and how likely it is that the company will be criticised for ‘window dressing’ or ‘greenwashing’.
2. The second stage is measuring actual performance against the metrics set in the first stage. The means of measurement will usually depend upon the metric being measured. Whilst many items will be capable of numerical and/or financial measurement (such as energy consumption or waste production), others, such as public perception of employee environmental awareness, will be less so. Given the board’s stated aim of providing a robust audit and its need to demonstrate compliance, this stage is clearly of great importance.
3. The third stage is reporting the levels of compliance or variances. The issue here is how to report the information and how widely to distribute the report. The board’s stated aim is to provide as much information as possible ‘in the interests of transparency’. This would tend to signal the publication of a public document (rather than just a report for the board) although there will be issues on how to produce the report and at what level to structure it. The information demands of local communities and investors may well differ in their appetite for detail and the items being disclosed.
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1. The first stage is agreeing and establishing the metrics involved and deciding on what environmental measures will be included in the audit. This selection is important because it will determine what will be measured against, how costly the audit will be and how likely it is that the company will be criticised for ‘window dressing’ or ‘greenwashing’.
2. The second stage is measuring actual performance against the metrics set in the first stage. The means of measurement will usually depend upon the metric being measured. Whilst many items will be capable of numerical and/or financial measurement (such as energy consumption or waste production), others, such as public perception of employee environmental awareness, will be less so. Given the board’s stated aim of providing a robust audit and its need to demonstrate compliance, this stage is clearly of great importance.
3. The third stage is reporting the levels of compliance or variances. The issue here is how to report the information and how widely to distribute the report. The board’s stated aim is to provide as much information as possible ‘in the interests of transparency’. This would tend to signal the publication of a public document (rather than just a report for the board) although there will be issues on how to produce the report and at what level to structure it. The information demands of local communities and investors may well differ in their appetite for detail and the items being disclosed.
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Explain Environmental Footprint
The use of the term ‘footprint’ with regard to the environment is intended to convey a meaning similar to its use in everyday language. In the same way that humans and animals leave physical footprints that show where they have been, so organisations such as Chemco leave evidence of their operations in the environment. They operate at a net cost to the environment. The environmental footprint is an attempt to evaluate the size of Chemco’s impact on the environment in three respects.
Firstly, concerning the company’s resource consumption where resources are defined in terms of inputs such as energy, feedstock, water, land use, etc.
Second, concerning any harm to the environment brought about by pollution emissions. These include emissions of carbon and other chemicals, local emissions, spillages, etc. It is likely that as a chemical manufacturer, both of these impacts will be larger for Chemco than for some other types of business.
Thirdly, the environmental footprint includes a measurement of the resource consumption and pollution emissions in terms of harm to the environment in either qualitative, quantitative or replacement terms.
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Firstly, concerning the company’s resource consumption where resources are defined in terms of inputs such as energy, feedstock, water, land use, etc.
Second, concerning any harm to the environment brought about by pollution emissions. These include emissions of carbon and other chemicals, local emissions, spillages, etc. It is likely that as a chemical manufacturer, both of these impacts will be larger for Chemco than for some other types of business.
Thirdly, the environmental footprint includes a measurement of the resource consumption and pollution emissions in terms of harm to the environment in either qualitative, quantitative or replacement terms.
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Content of External Report on Internal Control
In common with corporate governance codes elsewhere, there are four broad themes that such a report should contain.
1. Firstly, the report should contain a statement of acknowledgement by the board that it is responsible for the company’s system of internal control and for reviewing its effectiveness. This might seem obvious but it has been shown to be an important starting point in recognising responsibility. It is only when the board accepts and acknowledges this responsibility that the impetus for the collection of data and the authority for changing internal systems is provided. The ‘tone from the top’ is very important in the development of my proposed reporting changes and so this is a very necessary component of the report.
2. Secondly, the report should summarise the processes the board (or where applicable, through its committees) has applied in reviewing the effectiveness of the system of internal control. These may or may not satisfy shareholders, of course, and weak systems and processes would be a matter of discussion at AGMs for non-executives to strengthen.
3. Thirdly, the report should provide meaningful, high level information that does not give a misleading impression. Clearly, internal auditing would greatly increase the reliability of this information but a robust and effective audit committee would also be very helpful.
4. Finally, the report should contain information about any weaknesses in internal control that have resulted in error or material losses. This would have been a highly material disclosure in the case of ZPT and the costs of non-disclosure of this was a major cause of the eventual collapse of the company
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The United States Securities and Exchange Commission (SEC) guidelines are to disclose in the annual report as follows:
1. A statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the company. This will always include the nature and extent of involvement by the chairman and chief executive, but may also specify the other members of the board involved in the internal controls over financial reporting. The purpose is for shareholders to be clear about who is accountable for the controls.
2. A statement identifying the framework used by management to evaluate the effectiveness of this internal control. This will usually involve a description of the key metrics, measurement methods (e.g. rates of compliance, fair value measures, etc) and tolerances allowed within these. Within a rules-based environment, these are likely to be underpinned by law.
3. Management’s assessment of the effectiveness of this internal control as at the end of the company’s most recent fiscal year. This may involve reporting on rates of compliance, failures, costs, resources committed and outputs (if measurable) achieved.
4. A statement that its auditor has issued an attestation report on management’s assessment. Any qualification to the attestation should be reported in this statement.
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1. Firstly, the report should contain a statement of acknowledgement by the board that it is responsible for the company’s system of internal control and for reviewing its effectiveness. This might seem obvious but it has been shown to be an important starting point in recognising responsibility. It is only when the board accepts and acknowledges this responsibility that the impetus for the collection of data and the authority for changing internal systems is provided. The ‘tone from the top’ is very important in the development of my proposed reporting changes and so this is a very necessary component of the report.
2. Secondly, the report should summarise the processes the board (or where applicable, through its committees) has applied in reviewing the effectiveness of the system of internal control. These may or may not satisfy shareholders, of course, and weak systems and processes would be a matter of discussion at AGMs for non-executives to strengthen.
3. Thirdly, the report should provide meaningful, high level information that does not give a misleading impression. Clearly, internal auditing would greatly increase the reliability of this information but a robust and effective audit committee would also be very helpful.
4. Finally, the report should contain information about any weaknesses in internal control that have resulted in error or material losses. This would have been a highly material disclosure in the case of ZPT and the costs of non-disclosure of this was a major cause of the eventual collapse of the company
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The United States Securities and Exchange Commission (SEC) guidelines are to disclose in the annual report as follows:
1. A statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the company. This will always include the nature and extent of involvement by the chairman and chief executive, but may also specify the other members of the board involved in the internal controls over financial reporting. The purpose is for shareholders to be clear about who is accountable for the controls.
2. A statement identifying the framework used by management to evaluate the effectiveness of this internal control. This will usually involve a description of the key metrics, measurement methods (e.g. rates of compliance, fair value measures, etc) and tolerances allowed within these. Within a rules-based environment, these are likely to be underpinned by law.
3. Management’s assessment of the effectiveness of this internal control as at the end of the company’s most recent fiscal year. This may involve reporting on rates of compliance, failures, costs, resources committed and outputs (if measurable) achieved.
4. A statement that its auditor has issued an attestation report on management’s assessment. Any qualification to the attestation should be reported in this statement.
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Roles of Risk Management Committee
1. To agree and approve the risk management strategy and policies. The design of risk policy will take into account the environment, the strategic posture towards risk, the product type and a range of other relevant factors.
2. Receiving and reviewing risk reports from affected departments. Some departments will file regular reports on key risks (such as liquidity assessments from the accounting department, legal risks from the company secretariat or product risks from the sales manager).
3. Monitoring overall exposure and specific risks. If the risk policy places limits on the total risk exposure for a given risk then this role ensures that limits are adhered to. In the case of certain strategic risks, monitoring could occur on a very frequent basis whereas for more operational risks, monitoring will more typically occur to coincide with risk management committee meetings.
4. Assessing the effectiveness of risk management systems. This involves getting feedback from departments and the internal audit function on the workings of current management and risk mitigation systems.
5. Providing general and explicit guidance to the main board on emerging risks and to report on existing risks. This will involve preparing reports on apparent risks and assessing their probability of being realised and their potential impact if they do
6. To work with the audit committee on designing and monitoring internal controls for the management and mitigation of risks. If the risk committee is part of the executive structure, it will likely have an advisory role in respect of its input into the audit committee. If it is non-executive, its input may be more directly influential.
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2. Receiving and reviewing risk reports from affected departments. Some departments will file regular reports on key risks (such as liquidity assessments from the accounting department, legal risks from the company secretariat or product risks from the sales manager).
3. Monitoring overall exposure and specific risks. If the risk policy places limits on the total risk exposure for a given risk then this role ensures that limits are adhered to. In the case of certain strategic risks, monitoring could occur on a very frequent basis whereas for more operational risks, monitoring will more typically occur to coincide with risk management committee meetings.
4. Assessing the effectiveness of risk management systems. This involves getting feedback from departments and the internal audit function on the workings of current management and risk mitigation systems.
5. Providing general and explicit guidance to the main board on emerging risks and to report on existing risks. This will involve preparing reports on apparent risks and assessing their probability of being realised and their potential impact if they do
6. To work with the audit committee on designing and monitoring internal controls for the management and mitigation of risks. If the risk committee is part of the executive structure, it will likely have an advisory role in respect of its input into the audit committee. If it is non-executive, its input may be more directly influential.
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Roles of A Risk Manager
Roles of a risk manager/risk department/risk management function
1. Providing overall leadership, vision and direction, involving the establishment of risk management (RM) policies, establishing RM systems etc. Seeking opportunities for improvement or tightening of systems.
2. Developing and promoting RM competences, systems, culture, procedures, protocols and patterns of behaviour. It is important to understand that risk management is as much about instituting and embedding risk systems as much as issuing written procedure. The systems must be capable of accurate risk assessment.
3. Reporting on the above to management and risk committee as appropriate. Reporting information should be in a form able to be used for the generation of external reporting as necessary.
4. Ensuring compliance with relevant codes, regulations, statutes, etc. This may be at national level (e.g. Sarbanes Oxley) or it may be industry specific. Banks, oil, mining and some parts of the tourism industry, for example, all have internal risk rules that risk managers are required to comply with.
5. Establishing a common risk management language including common measures around likelihood and impact and common risk categories.
6. Implement a set of risk indicators and reports including losses and incidents, key risk exposures and early warning indicators.
7. Primary champion of Risk Management at strategic and operational levels.
8. Developing risk responses including contingency and business continuity programs
1. Providing overall leadership, vision and direction, involving the establishment of risk management (RM) policies, establishing RM systems etc. Seeking opportunities for improvement or tightening of systems.
2. Developing and promoting RM competences, systems, culture, procedures, protocols and patterns of behaviour. It is important to understand that risk management is as much about instituting and embedding risk systems as much as issuing written procedure. The systems must be capable of accurate risk assessment.
3. Reporting on the above to management and risk committee as appropriate. Reporting information should be in a form able to be used for the generation of external reporting as necessary.
4. Ensuring compliance with relevant codes, regulations, statutes, etc. This may be at national level (e.g. Sarbanes Oxley) or it may be industry specific. Banks, oil, mining and some parts of the tourism industry, for example, all have internal risk rules that risk managers are required to comply with.
5. Establishing a common risk management language including common measures around likelihood and impact and common risk categories.
6. Implement a set of risk indicators and reports including losses and incidents, key risk exposures and early warning indicators.
7. Primary champion of Risk Management at strategic and operational levels.
8. Developing risk responses including contingency and business continuity programs
Risk Management Strategies - TARA
There are four strategies for managing risk and these can be undertaken in sequence. In the first instance, the organization should ask whether the risk, once recognised, can be transferred or avoided.
Transference means passing the risk on to another party which, in practice means an insurer or a business partner in another part of the supply chain (such as a supplier or a customer).
Avoidance means asking whether or not the organisation needs to engage in the activity or area in which the risk is incurred.
If it is decided that the risk cannot be transferred nor avoided, it might be asked whether or not something can be done to reduce or mitigate the risk. This might mean, for example, reducing the expected return in order to diversify the risk or re-engineer a process to bring about the reduction.
Risk sharing involves finding a party that is willing to enter into a partnership so that the risks of a venture might be spread between the two parties. For example an investor might be found to provide partial funding for an overseas investment in exchange for a share of the returns.
Finally, an organisation might accept or retain the risk, believing there to be no other feasible option. Such retention should be accepted when the risk characteristics are clearly known (the possible hazard, the probability of the risk materialising and the return expected as a consequence of bearing the risk).
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Transference means passing the risk on to another party which, in practice means an insurer or a business partner in another part of the supply chain (such as a supplier or a customer).
Avoidance means asking whether or not the organisation needs to engage in the activity or area in which the risk is incurred.
If it is decided that the risk cannot be transferred nor avoided, it might be asked whether or not something can be done to reduce or mitigate the risk. This might mean, for example, reducing the expected return in order to diversify the risk or re-engineer a process to bring about the reduction.
Risk sharing involves finding a party that is willing to enter into a partnership so that the risks of a venture might be spread between the two parties. For example an investor might be found to provide partial funding for an overseas investment in exchange for a share of the returns.
Finally, an organisation might accept or retain the risk, believing there to be no other feasible option. Such retention should be accepted when the risk characteristics are clearly known (the possible hazard, the probability of the risk materialising and the return expected as a consequence of bearing the risk).
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5 Typical Causes of Internal Control Failure
There are several possible causes of internal control failure. The UK Turnbull report (in paragraph 22) gives examples of causes of failure but this list is not exhaustive.
1. Poor judgement in decision-making. Internal control failures can sometimes arise from individual decisions being made based on inadequate information provision or by inexperienced staff.
2. Human error can cause failures although a well-designed internal control environment can help control this to a certain extent.
3. Control processes being deliberately circumvented by employees and others. It is very difficult to completely prevent deliberate circumvention, especially if an employee has a particular reason (in his or her opinion) to do so, such as the belief that higher bonuses will be earned.
4. Management overriding controls, presumably in the belief that the controls put in place are inconvenient or inappropriate and should not apply to them.
5. The occurrence of unforeseeable circumstances is the final cause referred to in the Turnbull Report. Control systems are designed to cope with a given range of variables and when an event happens outwith that range, the system may be unable to cope.
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1. Poor judgement in decision-making. Internal control failures can sometimes arise from individual decisions being made based on inadequate information provision or by inexperienced staff.
2. Human error can cause failures although a well-designed internal control environment can help control this to a certain extent.
3. Control processes being deliberately circumvented by employees and others. It is very difficult to completely prevent deliberate circumvention, especially if an employee has a particular reason (in his or her opinion) to do so, such as the belief that higher bonuses will be earned.
4. Management overriding controls, presumably in the belief that the controls put in place are inconvenient or inappropriate and should not apply to them.
5. The occurrence of unforeseeable circumstances is the final cause referred to in the Turnbull Report. Control systems are designed to cope with a given range of variables and when an event happens outwith that range, the system may be unable to cope.
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5 General Objectives of Internal Control
An internal control system comprises the whole network of systems established in an organisation to provide reasonable assurance that organisational objectives will be achieved.
Specifically, the general objectives of internal control are as follows:
1. To ensure the orderly and efficient conduct of business in respect of systems being in place and fully implemented. Controls mean that business processes and transactions take place without disruption with less risk or disturbance and this, in turn, adds value and creates shareholder value.
2. To safeguard the assets of the business. Assets include tangibles and intangibles, and controls are necessary to ensure they are optimally utilised and protected from misuse, fraud, misappropriation or theft.
3. To prevent and detect fraud. Controls are necessary to show up any operational or financial disagreements that might be the result of theft or fraud. This might include off-balance sheet financing or the use of unauthorised accounting policies, inventory controls, use of company property and similar.
4. To ensure the completeness and accuracy of accounting records. Ensuring that all accounting transactions are fully and accurately recorded, that assets and liabilities are correctly identified and valued, and that all costs and revenues can be fully accounted for.
5. To ensure the timely preparation of financial information which applies to statutory reporting (of year end accounts, for example) and also management accounts, if appropriate, for the facilitation of effective management decision-making.
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Specifically, the general objectives of internal control are as follows:
1. To ensure the orderly and efficient conduct of business in respect of systems being in place and fully implemented. Controls mean that business processes and transactions take place without disruption with less risk or disturbance and this, in turn, adds value and creates shareholder value.
2. To safeguard the assets of the business. Assets include tangibles and intangibles, and controls are necessary to ensure they are optimally utilised and protected from misuse, fraud, misappropriation or theft.
3. To prevent and detect fraud. Controls are necessary to show up any operational or financial disagreements that might be the result of theft or fraud. This might include off-balance sheet financing or the use of unauthorised accounting policies, inventory controls, use of company property and similar.
4. To ensure the completeness and accuracy of accounting records. Ensuring that all accounting transactions are fully and accurately recorded, that assets and liabilities are correctly identified and valued, and that all costs and revenues can be fully accounted for.
5. To ensure the timely preparation of financial information which applies to statutory reporting (of year end accounts, for example) and also management accounts, if appropriate, for the facilitation of effective management decision-making.
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Features of Sound Internal Control System
The Turnbull code employs the term ‘sound’ to indicate that it is insufficient to simply ‘have’ an internal control system. They can be :
**effective and serve the aim of corporate governance or
**ineffective and fail to support them.
In order to reinforce ‘soundness’ or effectiveness, systems need to possess a number of features. The Turnbull guidance described three features of a ‘sound’ internal control system.
1. Firstly, the principles of internal control should be embedded within the organisation’s structures, procedures and culture. Internal control should not be seen as a stand-alone set of activities and by embedding it into the fabric of the organisation’s infrastructure, awareness of internal control issues becomes everybody’s business and this contributes to effectiveness.
2. Secondly, internal control systems should be capable of responding quickly to evolving risks to the business arising from factors within the company and to changes in the business environment. The speed of reaction is an important feature of almost all control systems (for example a servo system for vehicle brakes or the thermostat on a heating system). Any change in the risk profile or environment of the organisation will necessitate a change in the system and a failure or slowness to respond may increase the vulnerability to internal or external trauma.
3. Thirdly, sound internal control systems include procedures for reporting immediately to appropriate levels of management any significant control failings or weaknesses that are identified, together with details of corrective action being undertaken. Information flows to relevant levels of management capable and empowered to act on the information are essential in internal control systems. Any failure, frustration, distortion or obfuscation of information flows can compromise the system. For this reason, formal and relatively rigorous information channels are often instituted in organisations seeking to maximise the effectiveness of their internal control systems.
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**effective and serve the aim of corporate governance or
**ineffective and fail to support them.
In order to reinforce ‘soundness’ or effectiveness, systems need to possess a number of features. The Turnbull guidance described three features of a ‘sound’ internal control system.
1. Firstly, the principles of internal control should be embedded within the organisation’s structures, procedures and culture. Internal control should not be seen as a stand-alone set of activities and by embedding it into the fabric of the organisation’s infrastructure, awareness of internal control issues becomes everybody’s business and this contributes to effectiveness.
2. Secondly, internal control systems should be capable of responding quickly to evolving risks to the business arising from factors within the company and to changes in the business environment. The speed of reaction is an important feature of almost all control systems (for example a servo system for vehicle brakes or the thermostat on a heating system). Any change in the risk profile or environment of the organisation will necessitate a change in the system and a failure or slowness to respond may increase the vulnerability to internal or external trauma.
3. Thirdly, sound internal control systems include procedures for reporting immediately to appropriate levels of management any significant control failings or weaknesses that are identified, together with details of corrective action being undertaken. Information flows to relevant levels of management capable and empowered to act on the information are essential in internal control systems. Any failure, frustration, distortion or obfuscation of information flows can compromise the system. For this reason, formal and relatively rigorous information channels are often instituted in organisations seeking to maximise the effectiveness of their internal control systems.
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Assessment of Risks
The assessment of the risk exposure of any organisation has five components.
1. Firstly, the identity (nature and extent) of the risks facing the company should be identified. This may involve consulting with relevant senior managers, consultants and other stakeholders.
2. Second, the company should decide on the categories of risk that are regarded as acceptable for the company to bear. Of course any decision to discontinue exposure to a given risk will have implications for the activities of the company and this cost will need to be considered against the benefit of the reduced risk.
3. Third, the assessment of risk should quantify, as far as possible, the likelihood (probability) of the identified risks materialising. Risks with a high probability of occurring will attract higher levels of management attention than those with lower probabilities.
4. Fourth, an assessment of risk will entail an examination of the company’s ability to reduce the impact on the business of risks that do materialise. Consultation with affected parties (e.g. departmental heads, stakeholders, etc.) is likely to be beneficial, as information on minimising negative impact may sometimes be a matter of technical detail.
5. Fifth and finally, risk assessment involves an understanding of the costs of operating particular controls to review and manage the related risks. These costs will include information gathering costs, management overhead, external consultancy where appropriate, etc.
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1. Firstly, the identity (nature and extent) of the risks facing the company should be identified. This may involve consulting with relevant senior managers, consultants and other stakeholders.
2. Second, the company should decide on the categories of risk that are regarded as acceptable for the company to bear. Of course any decision to discontinue exposure to a given risk will have implications for the activities of the company and this cost will need to be considered against the benefit of the reduced risk.
3. Third, the assessment of risk should quantify, as far as possible, the likelihood (probability) of the identified risks materialising. Risks with a high probability of occurring will attract higher levels of management attention than those with lower probabilities.
4. Fourth, an assessment of risk will entail an examination of the company’s ability to reduce the impact on the business of risks that do materialise. Consultation with affected parties (e.g. departmental heads, stakeholders, etc.) is likely to be beneficial, as information on minimising negative impact may sometimes be a matter of technical detail.
5. Fifth and finally, risk assessment involves an understanding of the costs of operating particular controls to review and manage the related risks. These costs will include information gathering costs, management overhead, external consultancy where appropriate, etc.
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Thursday, July 21, 2011
Embedding Risk Awareness
Good internal controls start with a full risk assessment and this control should be introduced and amended to respond to changes in the risk profile as appropriate on an ongoing basis. To have risk awareness and risk systems embedded implies a number of things.
It means that risk management is included within the control systems of an organisation. An example is the company’s budgetary control system which will need to reflect the risk metrics in the embedded system.
When risk is embedded, the budgetary control and reward systems would recognise the need for risk awareness in them by including risk-related metrics. When embedded, risk is interconnected with other systems so that risks must be taken into account before other internal controls will work effectively. So a given job description, for example, might have a particular risk check included in it which is then assessed annually in the job-holder’s appraisal. This would typically be a part of an operation manager’s job description where, for example, the accident rate could be a metric built into his annual appraisal.
In an embedded risk system, risk is not seen as a separate part of internal control but is ‘woven in’ to other internal controls and is a part of the organisation’s culture. The cultural norms in the IT department, for example, would be an implicit understanding that sensitive data is not transferred to portable laptops and that laptops are not left in unattended cars. This is a part of the taken-for-grantedness of embedded risk systems when woven into culture.
Finally, the management of risk is ‘normal’ behaviour at all levels. Behaviour concerned with risk management is never seen as ‘odd’ or ‘interfering’ but as much a part of the normal business activity as trading and adding shareholder value.
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It means that risk management is included within the control systems of an organisation. An example is the company’s budgetary control system which will need to reflect the risk metrics in the embedded system.
When risk is embedded, the budgetary control and reward systems would recognise the need for risk awareness in them by including risk-related metrics. When embedded, risk is interconnected with other systems so that risks must be taken into account before other internal controls will work effectively. So a given job description, for example, might have a particular risk check included in it which is then assessed annually in the job-holder’s appraisal. This would typically be a part of an operation manager’s job description where, for example, the accident rate could be a metric built into his annual appraisal.
In an embedded risk system, risk is not seen as a separate part of internal control but is ‘woven in’ to other internal controls and is a part of the organisation’s culture. The cultural norms in the IT department, for example, would be an implicit understanding that sensitive data is not transferred to portable laptops and that laptops are not left in unattended cars. This is a part of the taken-for-grantedness of embedded risk systems when woven into culture.
Finally, the management of risk is ‘normal’ behaviour at all levels. Behaviour concerned with risk management is never seen as ‘odd’ or ‘interfering’ but as much a part of the normal business activity as trading and adding shareholder value.
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Monday, July 18, 2011
Strategic Risk vs Operational Risk
Distinguish between Strategic Risks and Operational Risks
Strategic risks
These arise from the overall strategic positioning of the company in its environment. Some strategic positions give rise to greater risk exposures than others. Because strategic issues typically affect the whole of an organisation and not just one or more of its parts, strategic risks can potentially concern very high stakes – they can have very high hazards and high returns. Because of this, they are managed at board level in an organisation and form a key part of strategic management.
Operational risks
Operational risks refer to potential losses arising from the normal business operations. Accordingly, they affect the day-to-day running of operations and business systems in contrast to strategic risks that arise from the organisation’s strategic positioning. Operational risks are managed at risk management level (not necessarily board level) and can be managed and mitigated by internal control systems.
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Strategic risks
These arise from the overall strategic positioning of the company in its environment. Some strategic positions give rise to greater risk exposures than others. Because strategic issues typically affect the whole of an organisation and not just one or more of its parts, strategic risks can potentially concern very high stakes – they can have very high hazards and high returns. Because of this, they are managed at board level in an organisation and form a key part of strategic management.
Operational risks
Operational risks refer to potential losses arising from the normal business operations. Accordingly, they affect the day-to-day running of operations and business systems in contrast to strategic risks that arise from the organisation’s strategic positioning. Operational risks are managed at risk management level (not necessarily board level) and can be managed and mitigated by internal control systems.
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Entrepreneurial Risk
Define ‘entrepreneurial risk’
Entrepreneurial risk is the necessary risk associated with any new business venture or opportunity. It is most clearly seen in entrepreneurial business activity, hence its name. In ‘Ansoff’ terms, entrepreneurial risk is expressed in terms of the unknowns of the market/customer reception of a new venture or of product uncertainties, for example product design, construction, etc.
There is also entrepreneurial risk in uncertainties concerning the competences and skills of the entrepreneurs themselves.
Entrepreneurial risk is necessary because it is from taking these risks that business opportunities arise. The fact that the opportunity may not be as hoped does not mean it should not be pursued. Any new product, new market development or new activity is a potential source of entrepreneurial risk but these are also the sources of future revenue streams and hence growth in company value.
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Entrepreneurial risk is the necessary risk associated with any new business venture or opportunity. It is most clearly seen in entrepreneurial business activity, hence its name. In ‘Ansoff’ terms, entrepreneurial risk is expressed in terms of the unknowns of the market/customer reception of a new venture or of product uncertainties, for example product design, construction, etc.
There is also entrepreneurial risk in uncertainties concerning the competences and skills of the entrepreneurs themselves.
Entrepreneurial risk is necessary because it is from taking these risks that business opportunities arise. The fact that the opportunity may not be as hoped does not mean it should not be pursued. Any new product, new market development or new activity is a potential source of entrepreneurial risk but these are also the sources of future revenue streams and hence growth in company value.
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Market Risk
Definition of market risk
Market risks are those arising from any of the markets that a company operates in. Most common examples are those risks from resource markets (inputs), product markets (outputs) or capital markets (finance).
Why non-compliance increases market risk
The lack of a fully compliant committee structure (such as having a non-compliant audit committee) erodes investor confidence in the general governance of a company. This will, over time, affect share price and hence company value. Low company value will threaten existing management and make the company a possible takeover target. It will also adversely affect price-earnings and hence market confidence in the company’s shares. This will make it more difficult to raise funds from the stock market.
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Market risks are those arising from any of the markets that a company operates in. Most common examples are those risks from resource markets (inputs), product markets (outputs) or capital markets (finance).
Why non-compliance increases market risk
The lack of a fully compliant committee structure (such as having a non-compliant audit committee) erodes investor confidence in the general governance of a company. This will, over time, affect share price and hence company value. Low company value will threaten existing management and make the company a possible takeover target. It will also adversely affect price-earnings and hence market confidence in the company’s shares. This will make it more difficult to raise funds from the stock market.
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Liquidity Risk
Define Liquidity risk
Liquidity risk refers to the difficulties that can arise from an inability of the company to meet its short-term financing needs, i.e. its ratio of short-term assets to short-term liabilities. Specifically, this refers to the organisation’s working capital and meeting short-term cash flow needs.
The essential elements of managing liquidity risk are, therefore, the controls over receivables, payables, cash and inventories.
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Liquidity risk refers to the difficulties that can arise from an inability of the company to meet its short-term financing needs, i.e. its ratio of short-term assets to short-term liabilities. Specifically, this refers to the organisation’s working capital and meeting short-term cash flow needs.
The essential elements of managing liquidity risk are, therefore, the controls over receivables, payables, cash and inventories.
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Reputation Risk
Defining reputation risk
Reputation risk is one of the categories of risk used in organisations. It was identified as a risk category by Turnbull and a number of events in various parts of the world have highlighted the importance of this risk.
Reputation risk concerns any kind of deterioration in the way in which the organisation is perceived, usually, but not exclusively, from the point of view of external stakeholders. The cause of such deterioration may be due to irregular behaviour, compliance failure or similar, but in any event, the effect is an aspect of corporate behaviour below that expected by one or more stakeholder. When the ‘disappointed’ stakeholder has contractual power over the organisation, the cost of the reputation risk may be material.
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Reputation risk is one of the categories of risk used in organisations. It was identified as a risk category by Turnbull and a number of events in various parts of the world have highlighted the importance of this risk.
Reputation risk concerns any kind of deterioration in the way in which the organisation is perceived, usually, but not exclusively, from the point of view of external stakeholders. The cause of such deterioration may be due to irregular behaviour, compliance failure or similar, but in any event, the effect is an aspect of corporate behaviour below that expected by one or more stakeholder. When the ‘disappointed’ stakeholder has contractual power over the organisation, the cost of the reputation risk may be material.
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Environmental Risk
Define environmental risk
An environmental risk is an unrealised loss or liability arising from the effects on an organisation from the natural environment or the actions of that organisation upon the natural environment. Risk can thus arise from natural phenomena affecting the business such as the effects of climate change, adverse weather, resource depletion, and threats to water or energy supplies. Similarly, liabilities can result from emissions, pollution, waste or product liability.
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Why environmental risks are strategic?
1. Impact on primary stakeholders
• It affects the ways the company is viewed by its primary stakeholders, those without whose support the company will have difficulty continuing. These include the local community because it supplies the key resource of labour. Withdrawal of community support could mean the loss if key staff and problems filling vacancies.
• The other significant stakeholders are investors. Loss of their support may result in them selling their shares and affecting the company’s market price. They may also seek to engineer changes in objectives by, if necessary, forcing changes in company’s board.
2. Industry characteristics
Environmental risks are structural risks that underlie the entire industry in which the company is operation in:
• The method of processing used may result in consequences of the environmental risks materializing much higher than the other industries, leading to serious financial and reputational consequences.
• The useage of resources may have serious environmental implications, hence the company’s strategies may be affected by the need to change the resources it uses, a shortage of resources or significantly greater resource costs.
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An environmental risk is an unrealised loss or liability arising from the effects on an organisation from the natural environment or the actions of that organisation upon the natural environment. Risk can thus arise from natural phenomena affecting the business such as the effects of climate change, adverse weather, resource depletion, and threats to water or energy supplies. Similarly, liabilities can result from emissions, pollution, waste or product liability.
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Why environmental risks are strategic?
1. Impact on primary stakeholders
• It affects the ways the company is viewed by its primary stakeholders, those without whose support the company will have difficulty continuing. These include the local community because it supplies the key resource of labour. Withdrawal of community support could mean the loss if key staff and problems filling vacancies.
• The other significant stakeholders are investors. Loss of their support may result in them selling their shares and affecting the company’s market price. They may also seek to engineer changes in objectives by, if necessary, forcing changes in company’s board.
2. Industry characteristics
Environmental risks are structural risks that underlie the entire industry in which the company is operation in:
• The method of processing used may result in consequences of the environmental risks materializing much higher than the other industries, leading to serious financial and reputational consequences.
• The useage of resources may have serious environmental implications, hence the company’s strategies may be affected by the need to change the resources it uses, a shortage of resources or significantly greater resource costs.
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Tuesday, July 5, 2011
Behavioural Issues - performance monitoring, budgeting and transfer pricing
Explain the potential behavioural issues that may arise in the application of performance monitoring, budgeting and transfer pricing and suggest how problems may be overcome.
(1) Performance Monitoring
There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘good performance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves the organisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace. This approach has resulted in such terms and activities as performance monitoring, performance related pay, payment by results, bonus systems. The reward for the achievement of desired outcomes could be money, promotion, job security, preferred work activities, alternative work environments. Unfortunately this is a very complex task and problems are likely to arise in a number of areas:
It is very difficult in many work environments to measure individual performance – and if you resort to team performance, it is difficult to gauge the contribution from individual members.
It is difficult to ensure that individual targets are not inconsistent with other individuals or corporate objectives.
Current measured performance may discourage consideration of longer term issues that may have adverse repercussions.
Can a performance monitoring system comprehensively measure the key variables? For example, the desire to achieve greater volume/activity may be at the cost of quality that is more difficult to identify and appraise.
Measure fixation – concentrating on the measurement process and not on what needs to be achieved.
Misrepresentation – ‘creative’ responses that give a favourable view of activities.
Myopia – short sighted viewpoint with limited consideration to long term issues.
The problems highlighted above can be managed if the following points are considered:
Do not underestimate the scale of the task in designing a performance monitoring system.
Consider the expectations and likely responses of all the parties concerned – take a broad view.
Ensure that the people designing and operating the system have a comprehensive understanding of the organisation’s activities and the interrelationship between all of the stakeholders.
Ensure that all parties involved believe that they will be beneficiaries of the system.
Be prepared to reappraise and modify – it is unrealistic to believe that it can be perfected at the first attempt.
(2) Budgeting
Adverse behavioural consequences of budgeting can arise from insufficient consideration being given to the task during the planning stage. The targets set may be perceived as:
Imposed
Complicated
Unfair
Irrelevant
Easy
Unachievable.
This is likely to foster the ‘them and us’ syndrome and the consequential failure to achieve goal congruence.
These undesirable consequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, considering other people’s perception of the targets and anticipating their likely responses. On the other hand, if budget holders are given complete autonomy or are permitted to have a significant influence on budgetary targets, they may be tempted to build in ‘slack’ to give themselves an easy life which is not in the interests of their organisation.
Having implemented the planning stage, we need to turn our attention towards control.Behavioural problems can arise from:
A failure to distinguish between controllable and non-controllable factors for each particular budget holder – people will feel aggrieved for being accountable for what they do not control.
A failure to account for the changing circumstances that have arisen since the budget was determined – may require budget adjustments and/or a flexible budget approach.
Failure to reward favourable variances – budget under spending that automatically results in cuts in future budget provision merely encourages spending of the entire budget, not something that should be encouraged.
Budget constrained approach – a requirement to conform to budget may stifle attempts at improvement.
Insufficient participation in budgetary control and poor communication of the reasons for change decisions may alienate staff.
(3) Transfer Pricing
Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encourages divisional managers with autonomous decision making authority to pursue the interest of the corporation automatically whilst endeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interest as the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavour to harness selfish divisional behaviour to induce decisions that foster goal congruence. Problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non-optimal decisions being made:
Too high a price may result in unused capacity, lost contribution, reduced incentive to find external markets and unnecessary external sourcing from the buying division.
Too low a price may result in ‘excessive’ internal trading and a loss of valuable external business.
To avoid these pitfalls the transfer pricing determination should consider:
The cost behaviour (fixed and variable) of the different divisions.
The adequacy of the information available to the divisions concerning both internal and external prices.
Both the short and long run consequences of the prices set – internal and external markets and capacity levels.
The degree of autonomy given to the divisions.
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(1) Performance Monitoring
There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘good performance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves the organisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace. This approach has resulted in such terms and activities as performance monitoring, performance related pay, payment by results, bonus systems. The reward for the achievement of desired outcomes could be money, promotion, job security, preferred work activities, alternative work environments. Unfortunately this is a very complex task and problems are likely to arise in a number of areas:
It is very difficult in many work environments to measure individual performance – and if you resort to team performance, it is difficult to gauge the contribution from individual members.
It is difficult to ensure that individual targets are not inconsistent with other individuals or corporate objectives.
Current measured performance may discourage consideration of longer term issues that may have adverse repercussions.
Can a performance monitoring system comprehensively measure the key variables? For example, the desire to achieve greater volume/activity may be at the cost of quality that is more difficult to identify and appraise.
Measure fixation – concentrating on the measurement process and not on what needs to be achieved.
Misrepresentation – ‘creative’ responses that give a favourable view of activities.
Myopia – short sighted viewpoint with limited consideration to long term issues.
The problems highlighted above can be managed if the following points are considered:
Do not underestimate the scale of the task in designing a performance monitoring system.
Consider the expectations and likely responses of all the parties concerned – take a broad view.
Ensure that the people designing and operating the system have a comprehensive understanding of the organisation’s activities and the interrelationship between all of the stakeholders.
Ensure that all parties involved believe that they will be beneficiaries of the system.
Be prepared to reappraise and modify – it is unrealistic to believe that it can be perfected at the first attempt.
(2) Budgeting
Adverse behavioural consequences of budgeting can arise from insufficient consideration being given to the task during the planning stage. The targets set may be perceived as:
Imposed
Complicated
Unfair
Irrelevant
Easy
Unachievable.
This is likely to foster the ‘them and us’ syndrome and the consequential failure to achieve goal congruence.
These undesirable consequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, considering other people’s perception of the targets and anticipating their likely responses. On the other hand, if budget holders are given complete autonomy or are permitted to have a significant influence on budgetary targets, they may be tempted to build in ‘slack’ to give themselves an easy life which is not in the interests of their organisation.
Having implemented the planning stage, we need to turn our attention towards control.Behavioural problems can arise from:
A failure to distinguish between controllable and non-controllable factors for each particular budget holder – people will feel aggrieved for being accountable for what they do not control.
A failure to account for the changing circumstances that have arisen since the budget was determined – may require budget adjustments and/or a flexible budget approach.
Failure to reward favourable variances – budget under spending that automatically results in cuts in future budget provision merely encourages spending of the entire budget, not something that should be encouraged.
Budget constrained approach – a requirement to conform to budget may stifle attempts at improvement.
Insufficient participation in budgetary control and poor communication of the reasons for change decisions may alienate staff.
(3) Transfer Pricing
Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encourages divisional managers with autonomous decision making authority to pursue the interest of the corporation automatically whilst endeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interest as the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavour to harness selfish divisional behaviour to induce decisions that foster goal congruence. Problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non-optimal decisions being made:
Too high a price may result in unused capacity, lost contribution, reduced incentive to find external markets and unnecessary external sourcing from the buying division.
Too low a price may result in ‘excessive’ internal trading and a loss of valuable external business.
To avoid these pitfalls the transfer pricing determination should consider:
The cost behaviour (fixed and variable) of the different divisions.
The adequacy of the information available to the divisions concerning both internal and external prices.
Both the short and long run consequences of the prices set – internal and external markets and capacity levels.
The degree of autonomy given to the divisions.
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Behavioural Consequences
Explain why it is necessary when designing a management accounting system to consider the behavioural consequences of its application.
The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives.
The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved.
Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation.
The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities.
A management accountant who fails to consider these repercussions or denies responsibility for them is likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence between the interested parties.
The management accounting system will need to consider the particular culture of the organisation, whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.
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The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives.
The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved.
Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation.
The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities.
A management accountant who fails to consider these repercussions or denies responsibility for them is likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence between the interested parties.
The management accounting system will need to consider the particular culture of the organisation, whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.
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Limiting Factor Analysis (LFA) Concept
• For short-run product-mix, decisions with capacity constraints/bottlenecks and the assumed objective is to maximise short-run profits.
• If fixed costs remained unchanged, maximisation of total contribution will result in maximisation of short-run profits.
(A) Single limiting factor analysis - Two approaches:
• Using marginal costing principles
• Using throughput accounting principles – developed for a JIT environment
(B) Multi-limiting factor analysis
A Linear Programming Model using marginal costing principles can be used to determine the profit-maximisation product-mix.
(Key point: Always use marginal costing principles for decisions involving limiting factors. Throughput accounting principles is relevant only if specifically required in the question)
LFA Using Marginal Costing Principles
Decision rule: Rank products based on contribution per unit of the scarce resource/limiting factor.
Contribution = Sales – All Variable Costs
Contribution per unit of scarce resource
= Variable contribution per unit of output / Scarce resources required per unit of output
LFA Using Throughput Accounting Principles
Decision rule: rank products based on throughput accounting ratio (TA ratio)
TA ratio = Throughput contribution per bottleneck hour / Total factory cost per bottleneck hour
Throughput contribution or throughput return = Sales – Direct Material Costs
Total factory cost include all operating costs, except direct materials.
Note: Product ranking using TA ratios is identical to ranking products using throughput contribution per unit of the bottleneck.
TA ratios can be used to measure product profitability in the following context:
• As a relative measure of profitability for ranking products – the higher the ranking, the more profitable is the product.
• As an absolute measure – a product is profitable only if its TA ratio is more than one (1), otherwise not profitable.
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• If fixed costs remained unchanged, maximisation of total contribution will result in maximisation of short-run profits.
(A) Single limiting factor analysis - Two approaches:
• Using marginal costing principles
• Using throughput accounting principles – developed for a JIT environment
(B) Multi-limiting factor analysis
A Linear Programming Model using marginal costing principles can be used to determine the profit-maximisation product-mix.
(Key point: Always use marginal costing principles for decisions involving limiting factors. Throughput accounting principles is relevant only if specifically required in the question)
LFA Using Marginal Costing Principles
Decision rule: Rank products based on contribution per unit of the scarce resource/limiting factor.
Contribution = Sales – All Variable Costs
Contribution per unit of scarce resource
= Variable contribution per unit of output / Scarce resources required per unit of output
LFA Using Throughput Accounting Principles
Decision rule: rank products based on throughput accounting ratio (TA ratio)
TA ratio = Throughput contribution per bottleneck hour / Total factory cost per bottleneck hour
Throughput contribution or throughput return = Sales – Direct Material Costs
Total factory cost include all operating costs, except direct materials.
Note: Product ranking using TA ratios is identical to ranking products using throughput contribution per unit of the bottleneck.
TA ratios can be used to measure product profitability in the following context:
• As a relative measure of profitability for ranking products – the higher the ranking, the more profitable is the product.
• As an absolute measure – a product is profitable only if its TA ratio is more than one (1), otherwise not profitable.
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Information required at board level and to be published, on environmental and social policies
Information required to be supplied at board level would depend on the cmpany’s ongoing attitude to environmental and social issues
Type A Company
Company that the view that environmental and social issues are of no concern
1. The company would therefore only be interested in ensuring that current legal requirements were met and that the cost of adverse publicity was avoided.
2. An individual should become responsible for monitoring social and environmental developments and advise the board if or when the company was required to take additional steps.
3. Disclosure would be kept to a minimum, and would concentrate on practices that were of benefit to the community at large, rather than those that may be of interest to competitors.
Type B Company
Company who are environmental and socially responsible as there is a substantial interest amongst consumers and investment fund managers
1. The company may report on environmental and social issues as part of its competitive strategy.
2. Information required would then increase significantly.
3. A study would need to be conducted into what was considered to be best practice.
4. This would identify the investment requirements of the ethical investment funds and the current thinking on environmental and social issues by the various pressure groups, such as Amnesty International and Greenpeace.
5. The company then establish a formal code of challenging targets (such as 95% of packaging used should be made of recycled materials) to be achieved on these environmental and social issues and report on how these targets were being met.
6. This report could be included as part of the normal reporting package.
7. Areas in which the company was particularly successful and which were not commercially damaging (such as a change in product design) could then be included in the Annual Report.
*************
Type A Company
Company that the view that environmental and social issues are of no concern
1. The company would therefore only be interested in ensuring that current legal requirements were met and that the cost of adverse publicity was avoided.
2. An individual should become responsible for monitoring social and environmental developments and advise the board if or when the company was required to take additional steps.
3. Disclosure would be kept to a minimum, and would concentrate on practices that were of benefit to the community at large, rather than those that may be of interest to competitors.
Type B Company
Company who are environmental and socially responsible as there is a substantial interest amongst consumers and investment fund managers
1. The company may report on environmental and social issues as part of its competitive strategy.
2. Information required would then increase significantly.
3. A study would need to be conducted into what was considered to be best practice.
4. This would identify the investment requirements of the ethical investment funds and the current thinking on environmental and social issues by the various pressure groups, such as Amnesty International and Greenpeace.
5. The company then establish a formal code of challenging targets (such as 95% of packaging used should be made of recycled materials) to be achieved on these environmental and social issues and report on how these targets were being met.
6. This report could be included as part of the normal reporting package.
7. Areas in which the company was particularly successful and which were not commercially damaging (such as a change in product design) could then be included in the Annual Report.
*************
Friday, July 1, 2011
PRICING STRATEGY
Pricing strategy is a component of a firm’s product/market development strategy for that product and/or the business as a whole to achieve a competitive advantage.
A firm’s product/market strategy (inclusive of pricing strategy) must be developed in the context of the firm’s chosen generic strategy to maximize its competitive advantages (cost leadership, product differentiation and niche marketing/focus) and how the firm plans to develop the product over time (product-life cycle development)
1. Cost leadership
• Aim to produce the lowest cost and good quality product in the industry.
• Adopts a cost-conscious approach
• Competences - strong technical advantage and low-cost distribution system.
• A low-cost leader will have the ability to lower prices in time of severe competition and enjoy higher profit margins.
• A low-cost leader can defend itself in price wars, attack competitors on price to gain market share.
• Penetration pricing
2. Product differentiation
• Aim to produce products with special and unique attributes that are valued by customer and who is willing to pay for it.
• Strong marketing and promotion to develop customer/brand loyalty.
• Corporate reputation for quality or technological leadership.
• Adopts premium pricing or market skimming pricing
3. Focus/Niche Marketing
• Concentrates on a strategically identified target market segment (e.g. isolated geographical areas, small or medium-sized customers with unique demands)
• The target market segment will determine the choice between a low-cost base or a differentiation-base.
4. Product Life-cycle Development and Pricing
The price at which a product should be sold is not a one-time, once and for all decision. For example the price will need to be modified over time as the product passes through the various stages of its life-cycle:
• Introduction – high price skimming or penetration pricing
• Growth – gradual price reductions or gradual price increases
• Maturity / saturation – savage price cutting / price wars
• Decline – price decreases.
************
A firm’s product/market strategy (inclusive of pricing strategy) must be developed in the context of the firm’s chosen generic strategy to maximize its competitive advantages (cost leadership, product differentiation and niche marketing/focus) and how the firm plans to develop the product over time (product-life cycle development)
1. Cost leadership
• Aim to produce the lowest cost and good quality product in the industry.
• Adopts a cost-conscious approach
• Competences - strong technical advantage and low-cost distribution system.
• A low-cost leader will have the ability to lower prices in time of severe competition and enjoy higher profit margins.
• A low-cost leader can defend itself in price wars, attack competitors on price to gain market share.
• Penetration pricing
2. Product differentiation
• Aim to produce products with special and unique attributes that are valued by customer and who is willing to pay for it.
• Strong marketing and promotion to develop customer/brand loyalty.
• Corporate reputation for quality or technological leadership.
• Adopts premium pricing or market skimming pricing
3. Focus/Niche Marketing
• Concentrates on a strategically identified target market segment (e.g. isolated geographical areas, small or medium-sized customers with unique demands)
• The target market segment will determine the choice between a low-cost base or a differentiation-base.
4. Product Life-cycle Development and Pricing
The price at which a product should be sold is not a one-time, once and for all decision. For example the price will need to be modified over time as the product passes through the various stages of its life-cycle:
• Introduction – high price skimming or penetration pricing
• Growth – gradual price reductions or gradual price increases
• Maturity / saturation – savage price cutting / price wars
• Decline – price decreases.
************
PRICING POLICY FOR NEW PRODUCTS
A new product pricing strategy will depend largely on whether a company's product or service is the first of its kind on the market.
Totally new products create problems with pricing as there is no information on which to base the price.
If the product is the first of its kind, there will be no competition yet, and the company, for a time at least, will be a monopolist. Monopolists have more influence over price and are able to set a price at which they think they can maximise their profits. A monopolist's price is likely to be higher, and his profits bigger, than a company operating in a competitive market.
There are two basic strategies:
1. Penetration pricing.
2. Market skimming.
************
If the new product being launched by a company is following a competitor's product on to the market, the pricing strategy will be constrained by what the competitor is already doing.
The strategies available here are:
1. Penetration pricing.
2. Average or going rate pricing.
3. Discount pricing.
4. Premium pricing.
(1) Penetration Pricing
Market penetration – a policy of low prices when a product is initially launched in order to obtain a high penetration into the market i.e. to gain rapid acceptance of the product.
The circumstances that favour a penetration policy are as follows:
• If the firm wishes to discourage competitors from entering into the market.
• If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from high-volume output, and so a quick penetration into the market is desirable in order to gain those unit cost reductions.
• If demand is highly elastic and so would respond well to low prices.
•
For penetration pricing to be effective, the total market in which the firm is operating must be substantial, and the anticipated market share significant.
(2) Market Skimming
Market skimming involves high prices and high promotion costs when the product is launched to obtain sales.
Market skimming is an attempt to exploit those sections of the market that are relatively insensitive to price changes. Initially high prices may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic.
Conditions suitable for a market skimming policy are:
• Where the product is new and different, so that customers are prepared to pay high prices so as to be ‘one-up’ on other people who do not own one.
• Where the strength of demand and the sensitivity of demand to price are unknown. It is much easier to lower prices than to increase them. From a psychological point of view it is far better to begin with a high price, which can then be lowered if the demand for the product appears to be more price sensitive than at first thought.
• Where high prices in the early stages of a product's life might generate high initial cash flows. A firm with a liquidity problem may prefer market skimming for this reason.
• Where products have a short life cycle, and so need to recover their development costs and make a profit quickly.
With high prices being charged potential competitors will be tempted to enter the market. For skimming to be sustained, one or more significant barriers to entry must be present to deter these potential competitors. Examples include patent protection, prohibitively high capital investment, or unusually strong brand loyalty.
A skimming policy offers a safeguard against unexpected future increases in costs, or a large fall in demand after the novelty appeal has declined. Once the market becomes saturated the price can be reduced to attract that part of the market that has not been exploited.
(3) Average or Going-rate Pricing
In a competitive market, where there are many suppliers of homogeneous products, and the new product does not differ (and cannot be differentiated sufficiently by marketing means), in terms of quality or design, from existing products, then the firm has little choice but to charge the 'going-rate'. Departure from this price will lead to losses.
(4) Discount Pricing
Discount pricing is where products are priced lower than the market norm, but are put forward as being of comparable quality.
The aim is that the product will procure a larger share of the market than it might otherwise do, thereby counteracting the reduction in selling price.
However, care must be taken to ensure that potential customers' perceptions of the product are not prejudiced by the lower price. The consumer will often view with suspicion a branded product that is priced at even a small discount to the prevailing market rate.
(5) Premium Pricing
In most situations, the new product will either differ, or be made to appear different, in a way that will justify a premium over competing products thereby covering the additional production or marketing costs.
(6) Differential pricing – exists where it is possible to charge different prices for the same product to different customers. The bases on which price discrimination can operate are as follows:
• by product version
• by time
• by place (geographical location)
• by market segment (type of customer)
• by order size
• by age
***********
Totally new products create problems with pricing as there is no information on which to base the price.
If the product is the first of its kind, there will be no competition yet, and the company, for a time at least, will be a monopolist. Monopolists have more influence over price and are able to set a price at which they think they can maximise their profits. A monopolist's price is likely to be higher, and his profits bigger, than a company operating in a competitive market.
There are two basic strategies:
1. Penetration pricing.
2. Market skimming.
************
If the new product being launched by a company is following a competitor's product on to the market, the pricing strategy will be constrained by what the competitor is already doing.
The strategies available here are:
1. Penetration pricing.
2. Average or going rate pricing.
3. Discount pricing.
4. Premium pricing.
(1) Penetration Pricing
Market penetration – a policy of low prices when a product is initially launched in order to obtain a high penetration into the market i.e. to gain rapid acceptance of the product.
The circumstances that favour a penetration policy are as follows:
• If the firm wishes to discourage competitors from entering into the market.
• If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from high-volume output, and so a quick penetration into the market is desirable in order to gain those unit cost reductions.
• If demand is highly elastic and so would respond well to low prices.
•
For penetration pricing to be effective, the total market in which the firm is operating must be substantial, and the anticipated market share significant.
(2) Market Skimming
Market skimming involves high prices and high promotion costs when the product is launched to obtain sales.
Market skimming is an attempt to exploit those sections of the market that are relatively insensitive to price changes. Initially high prices may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic.
Conditions suitable for a market skimming policy are:
• Where the product is new and different, so that customers are prepared to pay high prices so as to be ‘one-up’ on other people who do not own one.
• Where the strength of demand and the sensitivity of demand to price are unknown. It is much easier to lower prices than to increase them. From a psychological point of view it is far better to begin with a high price, which can then be lowered if the demand for the product appears to be more price sensitive than at first thought.
• Where high prices in the early stages of a product's life might generate high initial cash flows. A firm with a liquidity problem may prefer market skimming for this reason.
• Where products have a short life cycle, and so need to recover their development costs and make a profit quickly.
With high prices being charged potential competitors will be tempted to enter the market. For skimming to be sustained, one or more significant barriers to entry must be present to deter these potential competitors. Examples include patent protection, prohibitively high capital investment, or unusually strong brand loyalty.
A skimming policy offers a safeguard against unexpected future increases in costs, or a large fall in demand after the novelty appeal has declined. Once the market becomes saturated the price can be reduced to attract that part of the market that has not been exploited.
(3) Average or Going-rate Pricing
In a competitive market, where there are many suppliers of homogeneous products, and the new product does not differ (and cannot be differentiated sufficiently by marketing means), in terms of quality or design, from existing products, then the firm has little choice but to charge the 'going-rate'. Departure from this price will lead to losses.
(4) Discount Pricing
Discount pricing is where products are priced lower than the market norm, but are put forward as being of comparable quality.
The aim is that the product will procure a larger share of the market than it might otherwise do, thereby counteracting the reduction in selling price.
However, care must be taken to ensure that potential customers' perceptions of the product are not prejudiced by the lower price. The consumer will often view with suspicion a branded product that is priced at even a small discount to the prevailing market rate.
(5) Premium Pricing
In most situations, the new product will either differ, or be made to appear different, in a way that will justify a premium over competing products thereby covering the additional production or marketing costs.
(6) Differential pricing – exists where it is possible to charge different prices for the same product to different customers. The bases on which price discrimination can operate are as follows:
• by product version
• by time
• by place (geographical location)
• by market segment (type of customer)
• by order size
• by age
***********
Different Types of Transfer Pricing Methods
For each of the under-noted transfer pricing methods, discuss the market conditions appropriate for their adoption and their limitations.
(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
____________________________________________________________________
Market-based Transfer Price
Market conditions which are appropriate for adoption
• Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.
• In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.
• TP=MC+OC = MP
• In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will be happy with a transfer price set as the market price.
• The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.
Limitations
(i) As a result of product differentiation, ther may be no comparable product or a single market price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors.
*****************************************************************
Full-cost based Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.
• The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.
• Full-cost based transfer price is widely used because managers require an estimate of long-run marginal cost for decision-making. However, traditional absorption costing systems tend to provide poor estimates of long-run marginal cost for decision-making. ABC will provide better estimates of long run MC.
Limitations
(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the transfer price (which includes the fixed costs) as a wholly variable cost.
**********************************************************
Negotiated Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market (different selling costs for internal and external sales, differential market prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not induce SD and BD to adopt optimal output level. Central/corporate management intervention is necessary in order to ensure that optimal output levels are set but this process may undermine divisional autonomy.
• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).
Limitations
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers
(iv) Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists as the SD will have a bargaining disadvantage)
**********
(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
____________________________________________________________________
Market-based Transfer Price
Market conditions which are appropriate for adoption
• Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.
• In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.
• TP=MC+OC = MP
• In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will be happy with a transfer price set as the market price.
• The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.
Limitations
(i) As a result of product differentiation, ther may be no comparable product or a single market price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors.
*****************************************************************
Full-cost based Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.
• The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.
• Full-cost based transfer price is widely used because managers require an estimate of long-run marginal cost for decision-making. However, traditional absorption costing systems tend to provide poor estimates of long-run marginal cost for decision-making. ABC will provide better estimates of long run MC.
Limitations
(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the transfer price (which includes the fixed costs) as a wholly variable cost.
**********************************************************
Negotiated Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market (different selling costs for internal and external sales, differential market prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not induce SD and BD to adopt optimal output level. Central/corporate management intervention is necessary in order to ensure that optimal output levels are set but this process may undermine divisional autonomy.
• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).
Limitations
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers
(iv) Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists as the SD will have a bargaining disadvantage)
**********
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