Implicancias del estudio

 Marketing costs are usually cut as the product is phased out

 Production economies may be lost as volumes fall

 Meanwhile, a replacement product will need to have been developed, incurring new levels of R&D and other product setup costs.

 Alternatively additional development costs may be incurred to refine the model to extend the life-cycle (this is typical with cars where 'product evolution' is the norm rather than 'product revolution'.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 50 - Illustration 2

Company X is considering whether to pursue Project A or Project B.

Project B has an initial cost of Rs.2, 000, while Project A has an initial cost of Rs.3, 000. Company X is more inclined to take on Project B because of the perceived lower cost. However, applying the life cycle cost formula will help Company X determine if Project B is truly more cost-effective than Project A.

Calculating life cycle cost

The formula for calculating life cycle cost is:

LIFE CYCLE COST = 
INITIAL COST + (ANNUAL COSTS x PROJECT LIFE x DISCOUNT FACTOR) PROJECT A PROJECT B Initial Cost Rs.3, 000 Rs. 2,000 Annual Costs Electricity Maintenance Rs. 150 Rs. 50 Rs. 250 Rs.150 Project Life (Years) 15 15 Discount Factor

(Based on an interest rate of 3%)

0.64 0.64

Calculations Rs. 3,000 + (Rs.200 x

15 x 0.64)

Rs.2, 000 + (Rs.400 x 15 x 0.64)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 51 - As the above comparison demonstrates, the lowest initial cost does not lead to the lowest cost overall. Project A is the more cost effective option to pursue.

When is life cycle costing useful?

When evaluating capital investment options, using Life Cycle Costing (LCC) can help you determine the option, which is most cost effective. Rather than evaluating projects solely on the basis of initial costs, LCC looks at the total cost of owning, operating and maintaining a project over its useful life (including its fuel, energy, labor and replacement components). Life cycle costing calculates operating and maintenance costs incurred during the lifetime of the project plus the initial capital costs.

Companies sometimes need to consider target prices and target costs for a product over a multi-year product life cycle. Product life cycle spans the time from initial R&D on a product to when customer service and support I s no longer offered for that product. For Automobile companies suggest Ford, Nissan, the product life cycle is from 12 to 15 years. In such high operations, life cycle costing is used in development period for R&D and design is long and costly. It is also being used for pricing the product, after all costs incurred for producing the product.

The decision making process involves a cross functional team, in which employees from various departments (Production, Engineering, R&D, Marketing, and Accounting) are given the responsibility of determining an acceptable market price and corresponding Return on Sales, as well as a feasible cost in which a given item may be produced. In order to minimize costs, team members focus on eliminating non-value-added costs of the process, improving product design and modifying process methods.

Achieving Full Cycle Cost management (SMR 153, Fall 2004) Case Toyota Motor Company: Target Costing (HBS/9-197-031)

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 52 - 11. Standard Cost and Budgets

When budgets are prepared, the costs are usually computed at two levels, in total dollars so an income statement can be prepared, and cost per unit. The cost per unit is referred to as a standard cost. A standard cost can also be developed and used for pricing decisions and cost control even if a budget is not prepared. A standard cost in a manufacturing company consists of per unit costs for direct materials, direct labor, and overhead.

The per unit costs can be further divided into the expected amount and cost of materials per unit, the expected number of hours and cost per hour for direct labor, and the expected total overhead costs and a method for assigning those costs to each unit. Within the expected amount of materials, waste or spoilage must be considered when determining the standard amount. For example, if a product, such as a chair, requires material, more material than is actually needed for the chair must be ordered because the shape of the seat and the fabric are usually not exactly the same. The scraps of material are called waste, which is not avoidable, given that the chair is being produced with this specific fabric. The cost of the full piece of material is used as the standard cost because the waste has no other use.

Similarly, when considering labor hours, downtime from production due to maintenance or start up and break time must be included in the number of hours it takes to make a product. Once standards are established, they are used to analyze and determine the reasons for actual cost variances from standards. The variances may be in quantity of materials or hours used to manufacture a product or in the cost of the materials or labor. Because overhead is normally applied on some basis, the variances in overhead will occur because the total overhead pool of dollars or the activity level (for example, direct labor dollars or hours) used to allocate the overhead is different from what was planned. Once standard costs are used in preparing budgets, analysis of variances can be used to provide management with information about whether a variance is caused by quantity or price so that appropriate action can be taken.

Standard Cost Variances

A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses.

There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances:

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 Rate variance. A rate variance (which is also known as a price variance) is the difference

between the actual price paid for something and the expected price, multiplied by the actual quantity purchased. The ―rate‖ variance designation is most commonly applied to the labor rate variance, which involves the actual cost of direct labor in comparison to the standard cost of direct labor. The rate variance uses a different designation when applied to the purchase of materials, and may be called the purchase price variance or the material price variance.

 Volume variance. A volume variance is the difference between the actual quantity sold

or consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of direct materials, it is called the material yield variance. If the variance relates to the use of direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of overhead, it is called the overhead efficiency variance.

Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the expected amount. The most common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these variances for revenue.

A budget usually refers to a department‗s or a company’s projected revenues, costs, or expenses. A standard usually refers to a projected amount per unit of product, per unit of input (such as direct materials, factory overhead), or per unit of output.

Budgeting may be defined as the process of preparing plans for future activities of the business enterprise after considering and involving the objectives of the said organisation. This also provides process/steps of collection and preparation of data, by which deviations from the plan can be measured. This analysis helps to measure performance, cost estimation, minimizing wastage and better utilisation of resources of the organisation. Thus, budgets are prepared on the basis of future estimated production and sales in order to find out the profit in a specified period. In other words Budget is an estimate and a quantified plan for future activities to coordinate and control the uses of resources for a specified period. According to Institute of Cost and Works Accountants, ―A budget is a financial and / or quantitative statement prepared prior to a defined period of time, of the Policy to be pursued during that period for the purpose of attaining a given objective.‖ Budgeting is a process which includes both the functions of budget and budgetory control. Budget is a planning function and budgetory control is a controlling system or a technique.

This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 54 - 12. Variance Analysis and Flexible Budgets

Meaning of Variance Analysis

Variance is the difference in the actual result and the standard result. It is a controlling technique in which the standard result is first set in the beginning of the month or year according to the accounting rules or company standards. Then the actual results are processed after the period. Then the actual results are compared with the expected or set standard results. When there is a difference in the result, this difference is known as variance. This difference is studied by the cost accountant to understand why this gap was formed and the reasons for it. This study or the reasons found out by the accountants on the basis of variance is known as variance analysis. If the actual result is better than the set result then it is known as a favourable result and if the actual result is worst then the standard result then it is unfavourable or adverse result. Taking revenue into consideration, if actual is more than expected than favourable and standard more than actual than unfavourable result.

Taking cost into consideration, if actual more than expected than unfavourable and standard more than actual than favourable result.

Definition

In accounting, a variance is defined as the difference between the expected amount and the actual amount of costs or revenues. Variance analysis uses this standard or expected amount versus the actual amount to judge performance. The analysis includes an explanation of the difference between actual and expected figures as well as an evaluation as to why the variance may have occurred. The purpose of this detailed information is to assist managers in determining what may have gone right or wrong and to help in future decision-making.

Favourable Variance

A variance can be put into the favorable category when the results are better than expected. This means that revenues were more than the expected amount or costs were below the budgeted amount. In accounting practice, a favorable variance is shown by noting a letter F in parenthesis on the reports. A favorable variance might earn a bonus for a manger, or perhaps a move up the corporate ladder.

Unfavourable Variance

In contrast, the variance can be judged as unfavorable if the results are worse than expected. If the revenues were below expectations or the costs were higher than standard, the variance would be termed unfavorable or adverse. This would be denoted on the reports with the letter A or U. Consistently creating an unfavourable variance might result in a manger being reprimanded or losing their job. However, the analysis is typically used to help mangers prevent a negative situation from recurring by providing information about what went wrong.

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Common Uses

Variance analysis is commonly used in several aspects of business accounting. One of the most common is in the purchase of manufacturing materials. The variance is the price paid for the materials less the expected cost and then multiplied by the actual number of units used in the process. Another commonly seen usage is the selling price variance or the actual sales price minus expected, times the number of units. The analysis is also used with overhead and labor

spending and efficiency.

Problems

Not all companies use variance analysis in their managerial process. There are several reasons for this, one of which is that it can be quite complex for the accountants to process all of the information necessary to discover why there may have been a problem or benefit that caused the variance. Finally, the standard figures used to calculate the variance may not be as accurate as the actual figures, thus the analysis may have little usefulness.

Many people think that adverse result is not good for the company but it is not true. Many a time what happens that the sales crosses the expected so in case of revenue there is a favourable result, and that time obviously the costs will be incurred more than expected i.e. adverse. So at this time you cannot say that the results were bad, the results eventually were better than expected. Therefore adverse effects are not always bad.

Item Budget Actual Variance Favourable

£'000 £'000 £'000 or Adverse