An X-Bar/R chart is a specific member of a family of control charts. A control chart is a tool used in quality control, specifically SPC or statistical process control, as originally developed by Walter A. Shewhart at Western Electric in 1924 to improve the quality of telephones.
A control chart is a plot of measurements of a product on two special scales, usually located above and below each other and running horizontally. X-Bar/R charts consist of two chart, both with the same horizontal axis denoting the sample number.
The vertical axis on the top chart depicts the sample means (X-Bar) for a series of lots or subgroup samples. It has a centerline represented by Xdoublebar, which is simply the overall process average, as well as two horizontal lines, one above and one below the centerline, known as the upper control limit or UCL and lower control limit or LCL, respectively. These lines are drawn at a distance of plus and minus three standard deviations from the process average.
The bottom chart has the range (R) of each subgroup plotted on the vertical axis. Like an X-Bar chart, R charts have a centerline and two control limits. Unlike an X-Bar chart, the control limits on an R chart are not symetric about the centerline, and for small subgroups the LCL is zero.
The purpose of any control chart is to help determine if variations in measurements of a product are caused by small, normal variations that cannot be acted upon, or by some larger special cause that can be acted upon or fixed. The type of chart to be used is based on the nature of the data.
The Xbar/R chart is normally used for numerical data that is grouped in subgroups in some logical manner, for example 3 games of bowling that occur on one night. This allows the night to be considered as a unit, so a special cause such as a slippery floor or a sick bowler will be more obvious as a point on the chart.
Friday, August 03, 2007
APPLYING SPC TO PHARMACEUTICAL COMPANY
APPLYING SPC TO PHARMACEUTICAL COMPANY
Process Capability Index (“PCI”) is defined as ratio of the specification width to the natural tolerance of the process. Cp relates the natural variation of the process with the design specification in a single, qualitative measure,
Cp = UTL – LTL / 6s
Where
UTL = Upper tolerance limit
LTL = Lower tolerance limit
s = Standard deviation of the process
Process Capability Index is used to find out how well the process is centered within the specification limits. It is denoted by Cpk.
Cpk = Cp(1-K)Where,Cp = Process CapabilityK = 2(Design Target - Process Average) / (USL - LSL)Design target is the actual specification targetted without +/- allowance.
Here in this case, the PCI can be used for setting objectives and improving the process.
From the Table 14.5
UCL = 4.96679
LCL = 4.93541
µ = 4.95048
s = 0.008325841
Given the formula
Cp = UTL – LTL / 6s
Cp = 4.96679 - 4.93541 / 6*0.008325841
Cp = 0.62814
Now
Cpu = UTL - µ / 3s = 4.96679 – 4.95048 / 3*0.008325841 = 0.65298
Cpl = µ -LTL / 3s = 4.95048 - 4.93541/ 3*0.008325841 = 0.60336
Histogram:
4.93541
4.93667
4.93901
4.94294
4.94337
4.944487
4.94539
4.94626
4.9484
4.94904
4.9521
4.95252
4.95287
4.95311
4.95385
4.95422
4.95482
4.95533
4.9555
4.95603
4.9571
4.95775
4.95888
4.95941
4.95966
4.96014
4.96016
4.96114
4.96175
4.9623
4.96238
4.96255
4.96543
4.96633
4.96679
Bin
Frequency
Bin
Frequency
4.9350
0
4.9600
8
4.9400
3
4.9550
7
4.9450
3
4.9650
7
4.9500
4
4.9500
4
4.9550
7
4.9400
3
4.9600
8
4.9450
3
4.9650
7
4.9700
3
4.9700
3
4.9350
0
2. The reason why it is incorrect that the operators did not plot the initial data, find special causes, and compute the new control limit is that it led to subsequent modifications and correction in the centering of the process. When the maintenance technician set the length of the adjustment cap to where he was supposed to (lower), the worn-out threads made it impossible to hold the locknut in place, hence resulting in loosening of the locknut and thereby drifting of the center and producing syringes of erratic length. Here, the operators of the first shift who were not trained/familiar in SPC charting used only control limits they obtained to evaluate the future measurements, but did not plot the points. This led to plotting of the control limits with erroneous centricity, hence incorrect observations and adjustments. Therefore, though after the subsequent adjustments by the maintenance technician the syringes produces were of the desired and acceptable length, the variation has reduced dramatically, the string of 15 points of the x-bar chart were all above the center, hence resulting in the process being out of statistical control.
• 3. The learning and observations from this case that can be made out are that being familiarity with the SPC process and charting will be the most important for the process to be successful and quality-oriented. Erroneous data /input collection and analysis could lead to false assumption about the process quality. Also, a careful and out-of-box analysis of the various quality-determining factors such as x-bar chart or R-chart, histograms, SPC, etc. should be done before deriving any conclusion Only, a process that is operating with only chance causes of variation present is said to be in statistical control. It should always be kept in focus that the eventual goal of an SPC is the elimination of variability in the process
•
Process Capability Index (“PCI”) is defined as ratio of the specification width to the natural tolerance of the process. Cp relates the natural variation of the process with the design specification in a single, qualitative measure,
Cp = UTL – LTL / 6s
Where
UTL = Upper tolerance limit
LTL = Lower tolerance limit
s = Standard deviation of the process
Process Capability Index is used to find out how well the process is centered within the specification limits. It is denoted by Cpk.
Cpk = Cp(1-K)Where,Cp = Process CapabilityK = 2(Design Target - Process Average) / (USL - LSL)Design target is the actual specification targetted without +/- allowance.
Here in this case, the PCI can be used for setting objectives and improving the process.
From the Table 14.5
UCL = 4.96679
LCL = 4.93541
µ = 4.95048
s = 0.008325841
Given the formula
Cp = UTL – LTL / 6s
Cp = 4.96679 - 4.93541 / 6*0.008325841
Cp = 0.62814
Now
Cpu = UTL - µ / 3s = 4.96679 – 4.95048 / 3*0.008325841 = 0.65298
Cpl = µ -LTL / 3s = 4.95048 - 4.93541/ 3*0.008325841 = 0.60336
Histogram:
4.93541
4.93667
4.93901
4.94294
4.94337
4.944487
4.94539
4.94626
4.9484
4.94904
4.9521
4.95252
4.95287
4.95311
4.95385
4.95422
4.95482
4.95533
4.9555
4.95603
4.9571
4.95775
4.95888
4.95941
4.95966
4.96014
4.96016
4.96114
4.96175
4.9623
4.96238
4.96255
4.96543
4.96633
4.96679
Bin
Frequency
Bin
Frequency
4.9350
0
4.9600
8
4.9400
3
4.9550
7
4.9450
3
4.9650
7
4.9500
4
4.9500
4
4.9550
7
4.9400
3
4.9600
8
4.9450
3
4.9650
7
4.9700
3
4.9700
3
4.9350
0
2. The reason why it is incorrect that the operators did not plot the initial data, find special causes, and compute the new control limit is that it led to subsequent modifications and correction in the centering of the process. When the maintenance technician set the length of the adjustment cap to where he was supposed to (lower), the worn-out threads made it impossible to hold the locknut in place, hence resulting in loosening of the locknut and thereby drifting of the center and producing syringes of erratic length. Here, the operators of the first shift who were not trained/familiar in SPC charting used only control limits they obtained to evaluate the future measurements, but did not plot the points. This led to plotting of the control limits with erroneous centricity, hence incorrect observations and adjustments. Therefore, though after the subsequent adjustments by the maintenance technician the syringes produces were of the desired and acceptable length, the variation has reduced dramatically, the string of 15 points of the x-bar chart were all above the center, hence resulting in the process being out of statistical control.
• 3. The learning and observations from this case that can be made out are that being familiarity with the SPC process and charting will be the most important for the process to be successful and quality-oriented. Erroneous data /input collection and analysis could lead to false assumption about the process quality. Also, a careful and out-of-box analysis of the various quality-determining factors such as x-bar chart or R-chart, histograms, SPC, etc. should be done before deriving any conclusion Only, a process that is operating with only chance causes of variation present is said to be in statistical control. It should always be kept in focus that the eventual goal of an SPC is the elimination of variability in the process
•
Activity Based Costing!!!!The abc of ABC
Activity Based Costing
The abc of ABC
A study report
Table of Contents
Full absorption costing…a historical overview 3
Some of the important terms used in the absorption costing method 5
Advantages / Disadvantages of absorption costing 6
Activity Based Costing 7
Consumption of resources versus activities 11
Volume related allocation bases versus drivers at many levels 12
Example 16
Activity based management 21
Full absorption costing…a historical overview
Full absorption costing (also known as full costing and absorption costing) is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense however. Technically, full absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system. The full absorption method is also frequently used for internal reporting
The absorption approach is used by many firms and is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur.
Absorption Costing is a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overhead costs to cost units by means on one or a number of overhead absorption rates.
Generally accepted accounting principles require absorption costing for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.
[1]The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions.
Some of the important terms used in the Absorption Costing method
Overhead Absorption Rate
A means of attributing overhead to a product or service. For example, on direct labor hours, direct labor cost or machine hours.
Overhead Allocation Process
The various stages of the overhead absorption process are as follows:
Allocate overhead costs to cost centres that are directly identifiable to those centers.
Using appropriate basis apportion those overheads such as rent, heat and light, building insurance.
Apportion the indirect centres to the manufacturing centres such as the maintenance or research and development departments.
Absorb the cost of each direct cost centre in to the costs of production through that cost centre using a predetermined rate of absorption.
Common Rates of Absorption
v Direct labour hour
v % added onto the direct labour hour
v Machine hour rate
v Comparison of the two systems
v External vs. Internal
v Decision making
v Planning and control
v Variability of profit
Advantages / Disadvantaged of absorption costing
Advantages of Absorption Costing:
Disadvantages of Absorption Costing:
It recognizes the importance of fixed costs in production.
This method is used to prepare financial accounts.
When production remains constant but sales fluctuate, absorption costing will show less fluctuation in net profit.
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
As absorption costing emphasized on total cost namely both variable and fixed, therefore it is not so useful for management to use to make decision, planning, and control.
Since the decision maker’s emphasis is on total cost, the cost-volume-profit relationship is ignored. The decision makers needs to use the rule of thumb to make the decision.
Activity Based Costing
Activity Based Costing (“ABC”) can be defined as a subset of Activity-Based Management (“ABM”). The objective of ABC is to improve costing by tracing expenses (e.g., salaries, supplies, rent, insurance, etc.) to activities and tracing the activities to business processes, products, services, customers, distribution channels, etc.
Advocates of ABC believe that the major emphasis of a company such as continuous process improvement and simplification to boost productivity can only be attained if the real cost and time required to produce its goods and services is determined. This helps prevent arbitrary and indiscriminate cost-cutting measures (such as miscalculated downsizing) that may actually result in worse performance and profitability.
An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs. Allowing an organization or even every employee involved to better understand the cost of doing each activity gives a better chance to perform the activity better while minimizing costs. In fact, the cost attached to an activity may be used as a metric for organizational or personnel performance.
ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.' Value-added activities are activities that add value to the product or service that the customer is willing to pay for. Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities. On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for. Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible.
Activity-based costing consists of the following steps: 1) analysis of activities; 2) cost data gathering; 3) tracing of costs to activities; 4) establishment of output metrics; and 5) cost analysis.
Historically, cost accountants have arbitrarily added a broad percentage to the direct costs to allow for the indirect costs. However as the percentages of overhead costs had risen, this method became gradually inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
The reasons behind identifying the need of a new cost management system is to analyze the ‘true’ cost for a cost object (product, job service, or customer). More generally speaking, the knowledge of the ‘true’ cost a product will lead to identifying the money makers / money losers, to come up to an economic break-even point, and to compare different options of investments.
As is defined, the total cost of a cost object is the sum total of Direct Cost (Labor, Material) plus overhead costs.
The traditional cost accounting was based on arbitrarily allocating overheads to the cost objects. The assumption was the relationship between the overheads and the volume-based measures.
An example of traditional cost accounting is given below
TCA in Alpha Beta Omega Pvt. Ltd.
Product A
Product B
Labor hour
1/u
Labor hour
2/u
Direct labor cost
1*Rs. 20 = Rs. 20
Direct labor cost
2*Rs. 20 = Rs. 40
Demand of product A
100
Demand of product B
200
Total Overhead = Rs. 100,000
Total Direct Labor Hours = 2,000
Labor rate per hour = 100,000/2,000 = Rs. 50 per hour
TCA Overhead Allocation
Rs. 50/u
Rs. 100/u
Activity Based Costing on the other hand is a more accurate cost management methodology as it focuses on indirect costs (overhead), it traces costs on each expense category rather than merely allocating it to the particular cost object, and it makes the ‘indirect expense’ a ‘direct’.
The fundamental premises on which Activity Based Costing is performed are depicted in the following graphic.
Activity-Based Costing (ABC) gained momentum in the 1980s from the increasing lack of relevance and irreverence of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive. With very little or no automation, the product variety was relatively small and the fixed and variable overhead costs in companies were significantly low as compared to today. Nevertheless, gaining momentum from the 1960s and particularly in 1980s - this scenario changed rapidly.
The question, however, of course remains whether ABC has overcome these deficiencies or not? It has. In fact, ABC has been called one of the most important management innovations of the last hundred years.
So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:
In traditional cost accounting, it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
Traditional cost accounting mostly utilizes volume-related allocation bases while ABC uses drivers at various levels.
Traditional cost accounting is structure-oriented whereas ABC is process-oriented.
To be more specific, ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.
Consumption of resources versus activities
The fundamental assumption behind ABC is that it acknowledges you cannot manage costs, you can only manage what is being done and then costs will change as a consequence. In traditional cost accounting, however, the underlying assumption is that costs can be managed, but as most managers have found out the hard way - managing costs is almost impossible.
The advantages of the ABC approach is that it helps open up a wider array of measures when it comes to the matter of improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity more effectively than the traditional way.
Volume related allocation bases versus drivers at many levels
Due to the historic background of traditional cost accounting methods, the tendency was to use direct labor - or other volume-related allocation bases - for cost assignment purposes. But as overheads have grown and new technologies have emerged, it goes without saying that assigning costs based on only 5 – 15 percent (in most companies) of total costs is highly risky. In fact, the incurred errors are up to several hundred percent!
In ABC, however, costs are assigned according to the “cause and effect” relationship between activities (the actual happenings) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense, although they work the same way mathematically - drivers are estimates of actual cost behavior and can therefore also be used to identify the critical cost factors. Since the drivers are related to the actual processes, they occur at several levels. The four most common levels are;
Unit level. Unit level drivers are triggered for every unit that is being produced. For example, for a man and a machine that produces one unit at a time, the associated direct labor will be a unit level cost driver. This is therefore a volume related driver similar to the traditional allocation bases.
Batch level. Batch level drivers are triggered for every batch produced. A good example of that is production planning, because the planning is done for each and every batch regardless of the size of the batch. Here, number of batches can be a good driver.
Product level. Product level drivers are triggered for every product regardless of the number of units and batches produced. These drivers occur by the sole existence of a product. A good example of a driver is the number of product development hours per product so that the more product development hours a product triggers, the more product development costs should be assigned to that product.
Facility level. Facility level driver are drivers that are not related to the products at all. Costs that are traced by such drivers will therefore be allocated to products and not traced. The difference between allocation and tracing is that allocation is quite arbitrary whereas tracing is based on 'cause and effect' relations.
Hence, it can be seen that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all the costs are included. ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is a cost that exists due to the very existence of the activity whereas a variable activity cost changes as the output of the activity changes. This distinction is very helpful in various improvement efforts.
In discussing cost drivers, it is important to mention that in ABC there are two types of drivers with respect to cost assignment;
Activity drivers that keep track of how cost object behavior influences activity levels, i.e., the level of activity for each activity.
Resource drivers that keep track of how the subsequent activity level affects the resource consumption.
In early cost accounting terminology, drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'. But it is evident that the word 'cost driver' is misleading in this context because activity and resource drivers do not tell what drives costs in the general case.
Therefore, in Activity-Based Management (ABM) a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in a Balanced Scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify.
For example:
Traditional
ABC
Salaries Rs. 100
Clean door Rs. 40
Equipment Rs. 80
Paint door Rs. 75
Supplies Rs. 20
Inspect door Rs. 75
Overhead Rs. 45
Send door to assembly Rs. 55
TOTAL Rs. 245
TOTAL Rs. 245
In the above mentioned example, ABC doesn’t eliminate or change costs, but it provides data about how costs are actually consumed. In this example, if you want to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door.
Traditional accounting systems have been considered inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur somewhere from 50% to 200% LESS overhead than they are assigned. Small batch or low volume products and services typically incur 200% to 1000% MORE overhead than they are assigned.\
What does this mean???
This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies aim to move toward customer-defined products and services (which could often mean a batch size of one).
In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency.
Here
Resources are people and machines.
The resource drivers are the measure of the frequency and intensity of the demands placed on resources by activity
Activities are the processes performed by people and machines.
Activity drivers measure the frequency and intensity of the demands placed on activities by cost objects enabling costs to be assigned to cost objects.
Cost objects are the products and services produced.
Cost drivers are the factors that affect the cost of an activity, e.g., poor quality
A broader definition of a Cost Driver is that any activity that causes a cost to be incurred. The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred. In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output. With the change in business structures, technology and thereby cost structures, it was found that the volume of output was not the only cost driver. Some examples of indirect costs and their drivers are: maintenance costs are indirect costs and the possible driver of this cost may be the number of machine hours; or, handling raw-material cost is another indirect cost that may be driven by the number of orders received; or, inspection costs that are driven by the number of inspections or the hours of inspection or production runs.
Generally, the cost driver for short-term indirect variable costs may be the volume of output/ activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/ activity. According to John Shank and Vijay Govindarajan, cost drivers are listed into two categories:
1. Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations, complexity of products, use of technology, etc.
2. Executional cost drivers that are derived from the execution of the business activities such as capacity utilization, plant layout, work-force involvement, etc. To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools.
Example
Explained here is an example based on the fictitious Bainbridge University’s cost accounting systems. To make matter simple, only four service centers, three activity centers, and two cost objects are considered.
Bainbridge University has two professional management education programs: eMEP is a low volume program for working professionals (with 2,000 students and a faculty-student ratio of 1:10), and the regular PGP which is a high volume program (with 4,000 students and a faculty-student-faculty ratio of 1:20).
Costs for faculty remuneration average up to Rs. 30,000 in each department, and each department has approximately 200 faculty members; thus, the total salary cost in each department is Rs. 60 lakh.
The total overhead costs of providing these programs is Rs. 32 lakh per year (two and two-thirds the amount of salaries). Although each program has the same number of faculty members and PGP B has more students, eMEP requires more space for laboratories and classrooms than PGP Program.
So far, the University has not attempted to assign overhead costs to programs. Thus, the costs of operating each program were considered to be only the salaries of faculty members. The cost per student for each program was determined by dividing the faculty salaries by number of students. Using this method, the cost per student for eMEP is Rs. 3,000; for PGP Rs. 1,500.
This approach ignores the overhead costs of operating the programs. Last year, the college allocated overhead to programs based on the total number of students in each program (i.e., a volume-based costing method). The overhead application rate is computed as follows:
Total overhead costs/Total students = Rs. 32,000,000/6,000 = Rs. 5,333/per student
Using this rate, the cost per student of operating each program is given below:
eMEP
PGP
Salaries
Rs. 3,000
Rs. 1,500
Overhead rate
Rs. 5,333
Rs. 5,333
Total costs per student
Rs. 8,333
Rs. 6,833
The lacuna with the volume-based costing method is that it looks only at the number of students and disregards the impact of other factors, such as the space occupied or the number of computers used by the programs. Because other factors are being ignored, each program is assigned an equal amount of overhead costs per student. While this method is simple to apply, it is only relevant when other factors affecting overhead are not significant.
As it’s never too late, Bainbridge University has decided to design and implement an activity-based costing (ABC) system. With ABC, costs that were considered to be indirect costs (overhead) are traced directly to cost objects (programs). The first step in the design of the ABC system is to determine the activity centers. Bainbridge University analyzed its operations and identified three activity centers: course enrollment activities, student support activities, and academic activities. The second step in ABC system design is to assign costs to the activity centers. Bainbridge University has four service centers whose costs are assigned to activities--human resources, computing, duplicating, and maintenance services.
The determination of the costs per item for each of the service centers is presented in the following table.
Costs per Item
Service Center
Cost Driver
Traceable Costs
No. of Items
Cost per Item
Human resources
Number of employees
Rs. 1,000,000
1,000 employees
Rs. 1,000/employee
Computing
Number of computers
Rs. 2,000,000
200 computers
Rs. 1,000/computer
Duplicating
Number of copies
Rs. 100,000
100,000 copies
Rs. 1/copy
Maintenance
Square feet occupied
Rs. 5,000,000
50,000 square feet
Rs. 100/square foot
Total costs
Rs. 8,100,000
The number of items that are consumed by the activity centers (enrollment, student support, and academic activities) and the cost objects (eMEP and PGP) are given in the following table. These items are the first-stage cost drivers for the service centers.
First-Stage Cost Drivers
Service Centers
Activity/Object
Human Resources
Computing
Duplicating
Maintenance
Course enrollment activities
300 employees
150 computers
10,000 copies
2,000 square feet
Student support activities
200 employees
100 computers
7,000 copies
5,000 square feet
Academic activities
100 employees
50 computers
3,000 copies
3,000 square feet
eMEP
200 employees
1,100 computers
30,000 copies
25,000 square feet
PGP
200 employees
600 computers
50,000 copies
15,000 square feet
Total items
1,000 employees
2,000 computers
100,000 copies
50,000 square feet
The cost of each activity center is presented in the following table.
Cost of Activity Centers
Costs
Enrollment Activities
Student Support Activities
Academic Activities
Human resources
Rs. 300,000*
Rs. 200,000
Rs. 100,000
Computing
Rs. 150,000
Rs. 100,000
Rs. 50,000
Duplicating
Rs. 10,000
Rs. 7,000
Rs. 3,000
Maintenance
Rs. 200,000
Rs. 500,000
Rs. 300,000
Direct costs
Rs. 12,000,000
Rs. 8,000,000
Rs. 3,900,000
Total costs of activity
Rs. 12,660,000
Rs. 8,807,000
Rs. 4,353,000
Total of all activities
Rs. 25,820,000
*300 employees at a cost of Rs. 1,000 per employee
All the costs, except for direct costs, are computed by multiplying the number of events consumed by each activity center by the cost per event. For example, the human resources costs for enrollment activities is computed as the 300 employees in that activity center multiplied by Rs. 1,000 per employee. The direct costs are the costs specifically related to that activity. The salaries of employees in the enrollment activities area is an example of a direct cost. Direct costs usually make up a large part of the total costs of an activity.
The next step in the ABC is to define the cost objects. As explained previously, Bainbridge University has two programs that are considered cost objects, eMEP and PGP.
The final step in ABC system design is to link activity costs to cost objects. This is done in a similar fashion to assigning service center resource costs to activities. Before making this link, service department costs are assigned to cost objects. The number of service activities consumed by the two programs (as shown above) are repeated here.
Service Center
eMEP
PGP
Human resources
200 employees
200 employees
Computing
1,100 computers
600 computers
Duplicating
30,000 copies
50,000 copies
Maintenance
25,000 sq. ft.
15,000 sq. ft.
For activity centers, the costs per item are determined as shown in figure 6. The number of activities consumed by each cost object are:
Activity Center
eMEP
PGP
Enrollment activities
500 new students
1,000 new students
Student support
2,000 total students
4,000 total students
Academic activities
200 instructors
200 instructors
The total cost and cost per unit of each cost object are computed in the following figure.
Total Cost and Cost per Unit of Cost Objects
Costs
eMEP
PGP
Total
Human resources (Rs. 1,000/employee)
Rs. 200,000
Rs. 200,000
Rs. 400,000
Computing (Rs. 1,000/computer)
Rs. 1,100,000
Rs. 600,000
Rs. 1,700,000
Duplicating (Rs. 1/copy)
Rs. 30,000
Rs. 50,000
Rs. 80,000
Maintenance (Rs. 100/square foot)
Rs. 2,500,000
Rs. 1,500,000
Rs. 4,000,000
Subtotal (service costs)
Rs. 3,830,000
Rs. 2,350,000
Rs. 6,180,000*
Enrollment (Rs. 456/ per new student)
Rs. 4,220,000
Rs. 8,440,000
Rs. 12,660,000
Student support (Rs. 112/student)
Rs. 2,935,667
Rs. 5,871,333
Rs. 8,807,000
Academic (Rs. 440/lecturer)
Rs. 2,176,500
Rs. 2,176,500
Rs. 4,353,000
Subtotal (activity costs)
Rs. 9,332,167
Rs. 16,478,833
Rs. 25,820,000
Total (service + activity costs)
Rs. 13,162,167
Rs. 18,837,833
Rs. 32,000,000
Number of students
2,000
4,000
6,000
Costs per student
Rs. 6,581
Rs. 4,709
Rs. 5,333
*Rs. 6,180,000 service costs charged to the programs plus Rs. 1,920,000 charged to activities equals the total costs of service departments of Rs. 8,100,000
In the past using traditional absorption cost accounting, Bainbridge University was charging Rs. 5,333 in overhead cost per student in either program. The university should have been charging Rs. 6581 in overhead cost to each student in eMEP A, and only Rs. 4,709 to each student in PGP.
As a result of using the volume-based costing method, a relatively less overhead has been charged to eMEP eMEPnd too much has been charged to PGP program.
Through ABC, overhead costs that are traceable to each program have been identified, and thus cost data are more accurately determined.
ACTIVITY BASED MANAGEMENT
Definition
"A discipline that focuses on the management of activities as the route to continuously improving the value received by customers and the profit achieved by providing this value. This discipline includes cost driver analysis, activity analysis and performance analysis. Activity Based Management draws on activity based costing as a major source of information."
-- Peter B. B. Turney
Activity Based Management (ABM) focuses on managing activities/business processes to achieve organizational objectives. It helps reduce cost drivers and non-value and transfers resources to economic value-creating activities/business processes the customer wants and is willing to pay for. It also creates performance measures for cost, time, quality, and outcomes so everyone understands how their activities contribute to the mission and strategy. It aims to supports the Balanced Scorecard by creating performance measures. Some other feature of ABM is that it helps improve cash flow, quality, and cycle time reduction.
Activity Based Management adds optima value to an organization when it is used as the informational basis of managing and improving the business. Activity analysis leads to an Activity Based Management business model from which management can make decisions to improve the effectiveness of the organization. These improvements can take the form of incremental process improvement using Total Quality, Just-in-Time, or Reengineering.
Once these changes are made, the ABM model provides mechanisms to measure the relative success of the changes implemented and make business decisions leading to further analysis and improvement.
In order for a model to accomplish these ambitious goals, even in a limited department, division or strategic business unit, it must be, first, a clear and accurate representation of the actual business process. Care must be taken to insure that the model is not a representation of "what we think we are or should be doing". Second, costs must be attached to the resources from the financial accounting system. Finally, the model must be verified both operationally and financially to the satisfaction of the management who will be using it to make business decisions. Only then will the model have the credibility required for management to trust it and rely on it.
Nine Steps to Activity Based Management
1. Define the project scope.
2. Identify activities and their drivers.
3. Lay out the process flow.
4. Collect related date and rules.
5. Identify the ABC modeling tool to be used.
6. Build the model using the selected tool.
7. Test and validate the model.
8. Analyze the model results.
9. Take Action.
References:
http://maaw.info/5partsofcostsystem.htm#Full%20absorption
http://www.principlesofaccounting.com/chapter%2023.htm
http://www.emblemsvag.com/abc.htm
http://www.theacagroup.com/activitybasedcosting.htm
http://www.siliconfareast.com/abc.htm
http://en.wikipedia.org/wiki/Activity-based_costing
www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf
www.pitt.edu/~roztocki/abc/abctutor
[1] http://www.principlesofaccounting.com/chapter%2023.htm
The abc of ABC
A study report
Table of Contents
Full absorption costing…a historical overview 3
Some of the important terms used in the absorption costing method 5
Advantages / Disadvantages of absorption costing 6
Activity Based Costing 7
Consumption of resources versus activities 11
Volume related allocation bases versus drivers at many levels 12
Example 16
Activity based management 21
Full absorption costing…a historical overview
Full absorption costing (also known as full costing and absorption costing) is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense however. Technically, full absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system. The full absorption method is also frequently used for internal reporting
The absorption approach is used by many firms and is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur.
Absorption Costing is a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overhead costs to cost units by means on one or a number of overhead absorption rates.
Generally accepted accounting principles require absorption costing for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.
[1]The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions.
Some of the important terms used in the Absorption Costing method
Overhead Absorption Rate
A means of attributing overhead to a product or service. For example, on direct labor hours, direct labor cost or machine hours.
Overhead Allocation Process
The various stages of the overhead absorption process are as follows:
Allocate overhead costs to cost centres that are directly identifiable to those centers.
Using appropriate basis apportion those overheads such as rent, heat and light, building insurance.
Apportion the indirect centres to the manufacturing centres such as the maintenance or research and development departments.
Absorb the cost of each direct cost centre in to the costs of production through that cost centre using a predetermined rate of absorption.
Common Rates of Absorption
v Direct labour hour
v % added onto the direct labour hour
v Machine hour rate
v Comparison of the two systems
v External vs. Internal
v Decision making
v Planning and control
v Variability of profit
Advantages / Disadvantaged of absorption costing
Advantages of Absorption Costing:
Disadvantages of Absorption Costing:
It recognizes the importance of fixed costs in production.
This method is used to prepare financial accounts.
When production remains constant but sales fluctuate, absorption costing will show less fluctuation in net profit.
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
As absorption costing emphasized on total cost namely both variable and fixed, therefore it is not so useful for management to use to make decision, planning, and control.
Since the decision maker’s emphasis is on total cost, the cost-volume-profit relationship is ignored. The decision makers needs to use the rule of thumb to make the decision.
Activity Based Costing
Activity Based Costing (“ABC”) can be defined as a subset of Activity-Based Management (“ABM”). The objective of ABC is to improve costing by tracing expenses (e.g., salaries, supplies, rent, insurance, etc.) to activities and tracing the activities to business processes, products, services, customers, distribution channels, etc.
Advocates of ABC believe that the major emphasis of a company such as continuous process improvement and simplification to boost productivity can only be attained if the real cost and time required to produce its goods and services is determined. This helps prevent arbitrary and indiscriminate cost-cutting measures (such as miscalculated downsizing) that may actually result in worse performance and profitability.
An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs. Allowing an organization or even every employee involved to better understand the cost of doing each activity gives a better chance to perform the activity better while minimizing costs. In fact, the cost attached to an activity may be used as a metric for organizational or personnel performance.
ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.' Value-added activities are activities that add value to the product or service that the customer is willing to pay for. Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities. On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for. Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible.
Activity-based costing consists of the following steps: 1) analysis of activities; 2) cost data gathering; 3) tracing of costs to activities; 4) establishment of output metrics; and 5) cost analysis.
Historically, cost accountants have arbitrarily added a broad percentage to the direct costs to allow for the indirect costs. However as the percentages of overhead costs had risen, this method became gradually inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
The reasons behind identifying the need of a new cost management system is to analyze the ‘true’ cost for a cost object (product, job service, or customer). More generally speaking, the knowledge of the ‘true’ cost a product will lead to identifying the money makers / money losers, to come up to an economic break-even point, and to compare different options of investments.
As is defined, the total cost of a cost object is the sum total of Direct Cost (Labor, Material) plus overhead costs.
The traditional cost accounting was based on arbitrarily allocating overheads to the cost objects. The assumption was the relationship between the overheads and the volume-based measures.
An example of traditional cost accounting is given below
TCA in Alpha Beta Omega Pvt. Ltd.
Product A
Product B
Labor hour
1/u
Labor hour
2/u
Direct labor cost
1*Rs. 20 = Rs. 20
Direct labor cost
2*Rs. 20 = Rs. 40
Demand of product A
100
Demand of product B
200
Total Overhead = Rs. 100,000
Total Direct Labor Hours = 2,000
Labor rate per hour = 100,000/2,000 = Rs. 50 per hour
TCA Overhead Allocation
Rs. 50/u
Rs. 100/u
Activity Based Costing on the other hand is a more accurate cost management methodology as it focuses on indirect costs (overhead), it traces costs on each expense category rather than merely allocating it to the particular cost object, and it makes the ‘indirect expense’ a ‘direct’.
The fundamental premises on which Activity Based Costing is performed are depicted in the following graphic.
Activity-Based Costing (ABC) gained momentum in the 1980s from the increasing lack of relevance and irreverence of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive. With very little or no automation, the product variety was relatively small and the fixed and variable overhead costs in companies were significantly low as compared to today. Nevertheless, gaining momentum from the 1960s and particularly in 1980s - this scenario changed rapidly.
The question, however, of course remains whether ABC has overcome these deficiencies or not? It has. In fact, ABC has been called one of the most important management innovations of the last hundred years.
So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:
In traditional cost accounting, it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
Traditional cost accounting mostly utilizes volume-related allocation bases while ABC uses drivers at various levels.
Traditional cost accounting is structure-oriented whereas ABC is process-oriented.
To be more specific, ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.
Consumption of resources versus activities
The fundamental assumption behind ABC is that it acknowledges you cannot manage costs, you can only manage what is being done and then costs will change as a consequence. In traditional cost accounting, however, the underlying assumption is that costs can be managed, but as most managers have found out the hard way - managing costs is almost impossible.
The advantages of the ABC approach is that it helps open up a wider array of measures when it comes to the matter of improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity more effectively than the traditional way.
Volume related allocation bases versus drivers at many levels
Due to the historic background of traditional cost accounting methods, the tendency was to use direct labor - or other volume-related allocation bases - for cost assignment purposes. But as overheads have grown and new technologies have emerged, it goes without saying that assigning costs based on only 5 – 15 percent (in most companies) of total costs is highly risky. In fact, the incurred errors are up to several hundred percent!
In ABC, however, costs are assigned according to the “cause and effect” relationship between activities (the actual happenings) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense, although they work the same way mathematically - drivers are estimates of actual cost behavior and can therefore also be used to identify the critical cost factors. Since the drivers are related to the actual processes, they occur at several levels. The four most common levels are;
Unit level. Unit level drivers are triggered for every unit that is being produced. For example, for a man and a machine that produces one unit at a time, the associated direct labor will be a unit level cost driver. This is therefore a volume related driver similar to the traditional allocation bases.
Batch level. Batch level drivers are triggered for every batch produced. A good example of that is production planning, because the planning is done for each and every batch regardless of the size of the batch. Here, number of batches can be a good driver.
Product level. Product level drivers are triggered for every product regardless of the number of units and batches produced. These drivers occur by the sole existence of a product. A good example of a driver is the number of product development hours per product so that the more product development hours a product triggers, the more product development costs should be assigned to that product.
Facility level. Facility level driver are drivers that are not related to the products at all. Costs that are traced by such drivers will therefore be allocated to products and not traced. The difference between allocation and tracing is that allocation is quite arbitrary whereas tracing is based on 'cause and effect' relations.
Hence, it can be seen that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all the costs are included. ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is a cost that exists due to the very existence of the activity whereas a variable activity cost changes as the output of the activity changes. This distinction is very helpful in various improvement efforts.
In discussing cost drivers, it is important to mention that in ABC there are two types of drivers with respect to cost assignment;
Activity drivers that keep track of how cost object behavior influences activity levels, i.e., the level of activity for each activity.
Resource drivers that keep track of how the subsequent activity level affects the resource consumption.
In early cost accounting terminology, drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'. But it is evident that the word 'cost driver' is misleading in this context because activity and resource drivers do not tell what drives costs in the general case.
Therefore, in Activity-Based Management (ABM) a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in a Balanced Scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify.
For example:
Traditional
ABC
Salaries Rs. 100
Clean door Rs. 40
Equipment Rs. 80
Paint door Rs. 75
Supplies Rs. 20
Inspect door Rs. 75
Overhead Rs. 45
Send door to assembly Rs. 55
TOTAL Rs. 245
TOTAL Rs. 245
In the above mentioned example, ABC doesn’t eliminate or change costs, but it provides data about how costs are actually consumed. In this example, if you want to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door.
Traditional accounting systems have been considered inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur somewhere from 50% to 200% LESS overhead than they are assigned. Small batch or low volume products and services typically incur 200% to 1000% MORE overhead than they are assigned.\
What does this mean???
This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies aim to move toward customer-defined products and services (which could often mean a batch size of one).
In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency.
Here
Resources are people and machines.
The resource drivers are the measure of the frequency and intensity of the demands placed on resources by activity
Activities are the processes performed by people and machines.
Activity drivers measure the frequency and intensity of the demands placed on activities by cost objects enabling costs to be assigned to cost objects.
Cost objects are the products and services produced.
Cost drivers are the factors that affect the cost of an activity, e.g., poor quality
A broader definition of a Cost Driver is that any activity that causes a cost to be incurred. The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred. In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output. With the change in business structures, technology and thereby cost structures, it was found that the volume of output was not the only cost driver. Some examples of indirect costs and their drivers are: maintenance costs are indirect costs and the possible driver of this cost may be the number of machine hours; or, handling raw-material cost is another indirect cost that may be driven by the number of orders received; or, inspection costs that are driven by the number of inspections or the hours of inspection or production runs.
Generally, the cost driver for short-term indirect variable costs may be the volume of output/ activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/ activity. According to John Shank and Vijay Govindarajan, cost drivers are listed into two categories:
1. Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations, complexity of products, use of technology, etc.
2. Executional cost drivers that are derived from the execution of the business activities such as capacity utilization, plant layout, work-force involvement, etc. To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools.
Example
Explained here is an example based on the fictitious Bainbridge University’s cost accounting systems. To make matter simple, only four service centers, three activity centers, and two cost objects are considered.
Bainbridge University has two professional management education programs: eMEP is a low volume program for working professionals (with 2,000 students and a faculty-student ratio of 1:10), and the regular PGP which is a high volume program (with 4,000 students and a faculty-student-faculty ratio of 1:20).
Costs for faculty remuneration average up to Rs. 30,000 in each department, and each department has approximately 200 faculty members; thus, the total salary cost in each department is Rs. 60 lakh.
The total overhead costs of providing these programs is Rs. 32 lakh per year (two and two-thirds the amount of salaries). Although each program has the same number of faculty members and PGP B has more students, eMEP requires more space for laboratories and classrooms than PGP Program.
So far, the University has not attempted to assign overhead costs to programs. Thus, the costs of operating each program were considered to be only the salaries of faculty members. The cost per student for each program was determined by dividing the faculty salaries by number of students. Using this method, the cost per student for eMEP is Rs. 3,000; for PGP Rs. 1,500.
This approach ignores the overhead costs of operating the programs. Last year, the college allocated overhead to programs based on the total number of students in each program (i.e., a volume-based costing method). The overhead application rate is computed as follows:
Total overhead costs/Total students = Rs. 32,000,000/6,000 = Rs. 5,333/per student
Using this rate, the cost per student of operating each program is given below:
eMEP
PGP
Salaries
Rs. 3,000
Rs. 1,500
Overhead rate
Rs. 5,333
Rs. 5,333
Total costs per student
Rs. 8,333
Rs. 6,833
The lacuna with the volume-based costing method is that it looks only at the number of students and disregards the impact of other factors, such as the space occupied or the number of computers used by the programs. Because other factors are being ignored, each program is assigned an equal amount of overhead costs per student. While this method is simple to apply, it is only relevant when other factors affecting overhead are not significant.
As it’s never too late, Bainbridge University has decided to design and implement an activity-based costing (ABC) system. With ABC, costs that were considered to be indirect costs (overhead) are traced directly to cost objects (programs). The first step in the design of the ABC system is to determine the activity centers. Bainbridge University analyzed its operations and identified three activity centers: course enrollment activities, student support activities, and academic activities. The second step in ABC system design is to assign costs to the activity centers. Bainbridge University has four service centers whose costs are assigned to activities--human resources, computing, duplicating, and maintenance services.
The determination of the costs per item for each of the service centers is presented in the following table.
Costs per Item
Service Center
Cost Driver
Traceable Costs
No. of Items
Cost per Item
Human resources
Number of employees
Rs. 1,000,000
1,000 employees
Rs. 1,000/employee
Computing
Number of computers
Rs. 2,000,000
200 computers
Rs. 1,000/computer
Duplicating
Number of copies
Rs. 100,000
100,000 copies
Rs. 1/copy
Maintenance
Square feet occupied
Rs. 5,000,000
50,000 square feet
Rs. 100/square foot
Total costs
Rs. 8,100,000
The number of items that are consumed by the activity centers (enrollment, student support, and academic activities) and the cost objects (eMEP and PGP) are given in the following table. These items are the first-stage cost drivers for the service centers.
First-Stage Cost Drivers
Service Centers
Activity/Object
Human Resources
Computing
Duplicating
Maintenance
Course enrollment activities
300 employees
150 computers
10,000 copies
2,000 square feet
Student support activities
200 employees
100 computers
7,000 copies
5,000 square feet
Academic activities
100 employees
50 computers
3,000 copies
3,000 square feet
eMEP
200 employees
1,100 computers
30,000 copies
25,000 square feet
PGP
200 employees
600 computers
50,000 copies
15,000 square feet
Total items
1,000 employees
2,000 computers
100,000 copies
50,000 square feet
The cost of each activity center is presented in the following table.
Cost of Activity Centers
Costs
Enrollment Activities
Student Support Activities
Academic Activities
Human resources
Rs. 300,000*
Rs. 200,000
Rs. 100,000
Computing
Rs. 150,000
Rs. 100,000
Rs. 50,000
Duplicating
Rs. 10,000
Rs. 7,000
Rs. 3,000
Maintenance
Rs. 200,000
Rs. 500,000
Rs. 300,000
Direct costs
Rs. 12,000,000
Rs. 8,000,000
Rs. 3,900,000
Total costs of activity
Rs. 12,660,000
Rs. 8,807,000
Rs. 4,353,000
Total of all activities
Rs. 25,820,000
*300 employees at a cost of Rs. 1,000 per employee
All the costs, except for direct costs, are computed by multiplying the number of events consumed by each activity center by the cost per event. For example, the human resources costs for enrollment activities is computed as the 300 employees in that activity center multiplied by Rs. 1,000 per employee. The direct costs are the costs specifically related to that activity. The salaries of employees in the enrollment activities area is an example of a direct cost. Direct costs usually make up a large part of the total costs of an activity.
The next step in the ABC is to define the cost objects. As explained previously, Bainbridge University has two programs that are considered cost objects, eMEP and PGP.
The final step in ABC system design is to link activity costs to cost objects. This is done in a similar fashion to assigning service center resource costs to activities. Before making this link, service department costs are assigned to cost objects. The number of service activities consumed by the two programs (as shown above) are repeated here.
Service Center
eMEP
PGP
Human resources
200 employees
200 employees
Computing
1,100 computers
600 computers
Duplicating
30,000 copies
50,000 copies
Maintenance
25,000 sq. ft.
15,000 sq. ft.
For activity centers, the costs per item are determined as shown in figure 6. The number of activities consumed by each cost object are:
Activity Center
eMEP
PGP
Enrollment activities
500 new students
1,000 new students
Student support
2,000 total students
4,000 total students
Academic activities
200 instructors
200 instructors
The total cost and cost per unit of each cost object are computed in the following figure.
Total Cost and Cost per Unit of Cost Objects
Costs
eMEP
PGP
Total
Human resources (Rs. 1,000/employee)
Rs. 200,000
Rs. 200,000
Rs. 400,000
Computing (Rs. 1,000/computer)
Rs. 1,100,000
Rs. 600,000
Rs. 1,700,000
Duplicating (Rs. 1/copy)
Rs. 30,000
Rs. 50,000
Rs. 80,000
Maintenance (Rs. 100/square foot)
Rs. 2,500,000
Rs. 1,500,000
Rs. 4,000,000
Subtotal (service costs)
Rs. 3,830,000
Rs. 2,350,000
Rs. 6,180,000*
Enrollment (Rs. 456/ per new student)
Rs. 4,220,000
Rs. 8,440,000
Rs. 12,660,000
Student support (Rs. 112/student)
Rs. 2,935,667
Rs. 5,871,333
Rs. 8,807,000
Academic (Rs. 440/lecturer)
Rs. 2,176,500
Rs. 2,176,500
Rs. 4,353,000
Subtotal (activity costs)
Rs. 9,332,167
Rs. 16,478,833
Rs. 25,820,000
Total (service + activity costs)
Rs. 13,162,167
Rs. 18,837,833
Rs. 32,000,000
Number of students
2,000
4,000
6,000
Costs per student
Rs. 6,581
Rs. 4,709
Rs. 5,333
*Rs. 6,180,000 service costs charged to the programs plus Rs. 1,920,000 charged to activities equals the total costs of service departments of Rs. 8,100,000
In the past using traditional absorption cost accounting, Bainbridge University was charging Rs. 5,333 in overhead cost per student in either program. The university should have been charging Rs. 6581 in overhead cost to each student in eMEP A, and only Rs. 4,709 to each student in PGP.
As a result of using the volume-based costing method, a relatively less overhead has been charged to eMEP eMEPnd too much has been charged to PGP program.
Through ABC, overhead costs that are traceable to each program have been identified, and thus cost data are more accurately determined.
ACTIVITY BASED MANAGEMENT
Definition
"A discipline that focuses on the management of activities as the route to continuously improving the value received by customers and the profit achieved by providing this value. This discipline includes cost driver analysis, activity analysis and performance analysis. Activity Based Management draws on activity based costing as a major source of information."
-- Peter B. B. Turney
Activity Based Management (ABM) focuses on managing activities/business processes to achieve organizational objectives. It helps reduce cost drivers and non-value and transfers resources to economic value-creating activities/business processes the customer wants and is willing to pay for. It also creates performance measures for cost, time, quality, and outcomes so everyone understands how their activities contribute to the mission and strategy. It aims to supports the Balanced Scorecard by creating performance measures. Some other feature of ABM is that it helps improve cash flow, quality, and cycle time reduction.
Activity Based Management adds optima value to an organization when it is used as the informational basis of managing and improving the business. Activity analysis leads to an Activity Based Management business model from which management can make decisions to improve the effectiveness of the organization. These improvements can take the form of incremental process improvement using Total Quality, Just-in-Time, or Reengineering.
Once these changes are made, the ABM model provides mechanisms to measure the relative success of the changes implemented and make business decisions leading to further analysis and improvement.
In order for a model to accomplish these ambitious goals, even in a limited department, division or strategic business unit, it must be, first, a clear and accurate representation of the actual business process. Care must be taken to insure that the model is not a representation of "what we think we are or should be doing". Second, costs must be attached to the resources from the financial accounting system. Finally, the model must be verified both operationally and financially to the satisfaction of the management who will be using it to make business decisions. Only then will the model have the credibility required for management to trust it and rely on it.
Nine Steps to Activity Based Management
1. Define the project scope.
2. Identify activities and their drivers.
3. Lay out the process flow.
4. Collect related date and rules.
5. Identify the ABC modeling tool to be used.
6. Build the model using the selected tool.
7. Test and validate the model.
8. Analyze the model results.
9. Take Action.
References:
http://maaw.info/5partsofcostsystem.htm#Full%20absorption
http://www.principlesofaccounting.com/chapter%2023.htm
http://www.emblemsvag.com/abc.htm
http://www.theacagroup.com/activitybasedcosting.htm
http://www.siliconfareast.com/abc.htm
http://en.wikipedia.org/wiki/Activity-based_costing
www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf
www.pitt.edu/~roztocki/abc/abctutor
[1] http://www.principlesofaccounting.com/chapter%2023.htm
Indian Auto Supply Chain Management -
Quantification & Measurement.
Indian Auto Supply
“Any process that can be measured, can be improved”
Abstract
The Indian auto industry is small in size, compared to the world markets ($ 6.73 billion compared to a world market of $ 737 billion) but has experienced a growth rate of 20-25 % the past few years. Over 13Indian companies have won the Deming prize and quality has improved significantly. If we compare the Indian auto industry to the industry in China, it provides an interesting contrast. Some interesting insights regarding the future of the Indian auto and the way SCM is being measured in the same -
Introduction
A study of the evolution of the auto-ancillary supply chain in India using a combination of firm product specific data measures, firm level performance, industry performance, global best practice data and country comparisons with China. The goal is to assess the current state of the industry and identify both the potential and the management realities associated with developing globally competitive auto supply chains in India.
Some of the questions that need to be asked are :
- Will the future of the Indian automobile industry be that of a globally competitive car producer that can offer quality at a competitive price point?
- Will the industry mainly compete at the component level, focusing on design intensive and process intensive engineered products?
- Will the domestic car market provide sufficient incentives for foreign suppliers?
- How are these trends influenced by infrastructure investments in India, the impact of China, and world commodity price levels?
- How will the Indian government policies affect the development of these supply chains?
-
A quick summary of industry analysis suggests some intriguing and initially counter
intuitive results:
- The quality movement and the associated adoption of lean manufacturing techniques have been extremely successful in the Indian industry. 13 Indian companies that have
won the Deming prize. However, the analysis shows that none of these firms show any
improved financial benefits over the rest of the industry. Given this data, how do we interpret the impact of such quality improvement initiatives?
- Any understanding of the auto components industry has to focus on component type such as transmissions, engines, braking components etc. An analysis of the price pressure by segment shows that for many segments, margins have decreased in recent years. In addition, a total factor productivity analysis by segment shows decreasing productivity across the precise period that volumes have risen.
- Any focus on firm level growth has to consider firm size as we understand industry evolution. Analysis by firm size (large versus small segments), and by product segment, reveals that newer firms that have the benefit of size have shown the most improvement in recent years.
- Finally, despite higher raw material costs, higher energy costs and poorer infrastructure in India, multinational OEMs that have entered the Indian market have managed to produce cars that have high local content and are sold at competitive retail prices.
The Indian Automobile Industry – A quick survey
The Indian automotive components industry’s annual turnover (for FY 2003) was US$
6.73 billion. When compared to the global automotive components industry of US $737
billion, the Indian industry dwarfs in size. But, at a compounded growth rate of 20-25 %,
the growth in India’s auto components exports is much faster than that of the domestic
market (10-14%). Many consider this growth in exports as just the tip of the iceberg
similar to that witnessed by the information technology industry in the early 1990’s. The
auto ancillary industry caters to three broad categories of the market:
1) Original equipment manufacturers (OEM) or vehicle manufacturers, that
comprises of 25% total demand
2) Replacement market that comprises 65% of the total demand
3) Export Market, that comprises primarily of international Tier I suppliers and
constitutes 10% of total demand
Cost Structure
The cost structure in the auto ancillary sector is shown below. It is clear that any analysis
of the cost should focus on material cost, labor cost and other manufacturing costs.
It is evident from the from industry data that for the engine parts segment, the employee costs as a fraction of total cost are higher than for other segments, indicating the complexity of the activity. This plays an important role in explaining the total factor productivity trends, described later.
Quality
Firms in the auto sector have made significant advances in quality over the last 10 years.
This is the largest number of firms from any country outside Japan that have won this award.
According to conventional understanding, this rapid change should have resulted in better
bottom line performance. Senior quality managers in auto component companies reveal that one of the very first conditions that MNC OEMs set out for Indian auto component
companies in the late nineties was the need to conform to internationally recognized
standards within three years. A number of companies are also simultaneously embarking on a Six Sigma program in order to reduce defects and delays in their processes, drastically. All these initiatives have resulted in a perceptible increase in quality levels of auto component industry as a whole
The Supply Chain:
Delivery parameters are linked to Supply Chain (SC) metrics of an organization. It was,
again, the entry of the MNCs that heralded a paradigm shift in the way supply chain was
thought of and implemented in India (Refer Table 2.4). Today, all the automobile OEMs
demand (JIT) supplies and daily milk runs and the use of third party logistics (3PL) for
component supplies have now become commonplace. The result is that OEMs no longer
maintain large stocks of components / raw materials but instead leave it to their suppliers
to ensure that there is a smooth flow of parts in the logistics pipeline.
When the analysis was done at an industry level, it was found that new firms with lower overheads had high growth rates and that the small firms that are newer, larger and have lower overheads witness high growth rates and are more profitable. We also find that amongst large firms, new firms have better return on assets than old firms, i.e., traditional large companies perform poorly.
Methodology
The degree of development of the supply chain can be gauged by examining the extent to
which carmakers choose to buy in components, rather than manufacture in-house.
Supplier Quality
International best practices for carmakers in US, Japan and Europe currently aim to bring
the large majority of suppliers under 100 ppm. The distribution of defects observed confirm the view that first-tier suppliers to newly arrived carmakers in India and China are already operating close to world-class standards.
An ICRA report (ICRA, 2004), further, substantiates Suttons view that with regard to
quality there are not significant differences between India and China. Our initial
interviews with managers and Ramnath Consulting Ltd. reveals that China might be
slightly ahead in some areas and more importantly, both countries are behind world
standards.
A successful model that can be incorporated for robust measurement of Supply Chain is the SCOR model.
SCOR:
• Common Methodology
• Common Language
• Common Metrics
Partner Relationship Management
• Supply Chain Programs
• Innovative Product Developments
• Total Cost Reduction Programs
Procurement Excellence:
• Value Creation
• Low Cost Sourcing
• Operational Excellence
The Supply Chain Council (SCC) has developed The Supply Chain Council (SCC) has developed and endorsed the Supply Chain Operations Reference-model (SCOR)
as the cross-industry standard for supply chain management
The SCC is an independent, not-for-profit, global corporation with membership open to all companies and organizations interested in applying and advancing in state-of-the- art supply chain management systems and practices.
• Over 1000 Company Members
• Cross-industry representation
• Chapters in Australia/New Zealand, Brazil, Europe, Japan, North America, Southern Africa, and South East Asia with petitions for additional chapters pending.
SCOR: A Reference Model for a Supply Chain:
5 core processes:
PLAN
Source
Make
Delivery
Suppliers
Customers
Return
Return
Return
Process Best Practices
Metrics Technology
Ease of implementation
Solution portfolio
high
medium
low
SC reconfiguration
Direct Shipment
Transport Load optimization
Lead time reduction
Forecasting Process
VMI
Portfolio Strategic Development
SC Delivery Performance
high
medium
low
Impact/Benefits
Change management issues in a collaborative scenario
Typical barriers:
Shared vision feeding
mutual need & interest
Understanding about
business concepts &
opportunities
Trust & openness
between partners while
building reliable supply
chain operations
Change management
solutions:
Collaborative
workshops
Common definitions
(Reference model)
Commonly selected
& shared metrics
Conclusions
I
Enterprise
integration
II
Corporate
Excellence
III
Partner
Collaboration
IV
Value Chain
Constellation
V
Full Network
Connectivity
Enhancing partner collaboration is key
SCOR
Collaborative Commerce
Most Achieved level II
(today’s market)
SC Maturity Model
Functional
Process
Intra –
Enterprise
Inter-
Enterprise
External
Total Business
Systems
Everything here suggests that :
- Usage of simple tools leads to great improvements in SC management
- Automation is the buz word in the process control
- Implementation of SC management systems/tools require trust between partners.
- Continous coordination is a must for any model to work
- Continuous adaptation to the particular business & process improvements required.
A particular model is not guarantee for success in the Supply Chain. The auto supply chains in our Auto markets, are not yet tier zed and consolidated. Total factor productivity trends for the industry show a decline, suggesting a change in the product mix towards higher labor content, i.e., higher design content and engineering content products. In summary, the Indian auto ancillary supply chain presents a fascinating case study of firms at crossroads, that have to select whether to pursue business as it is, develop a global supply network, grow their demand globally or develop more complex products and design capabilities.
Quantification & Measurement.
Indian Auto Supply
“Any process that can be measured, can be improved”
Abstract
The Indian auto industry is small in size, compared to the world markets ($ 6.73 billion compared to a world market of $ 737 billion) but has experienced a growth rate of 20-25 % the past few years. Over 13Indian companies have won the Deming prize and quality has improved significantly. If we compare the Indian auto industry to the industry in China, it provides an interesting contrast. Some interesting insights regarding the future of the Indian auto and the way SCM is being measured in the same -
Introduction
A study of the evolution of the auto-ancillary supply chain in India using a combination of firm product specific data measures, firm level performance, industry performance, global best practice data and country comparisons with China. The goal is to assess the current state of the industry and identify both the potential and the management realities associated with developing globally competitive auto supply chains in India.
Some of the questions that need to be asked are :
- Will the future of the Indian automobile industry be that of a globally competitive car producer that can offer quality at a competitive price point?
- Will the industry mainly compete at the component level, focusing on design intensive and process intensive engineered products?
- Will the domestic car market provide sufficient incentives for foreign suppliers?
- How are these trends influenced by infrastructure investments in India, the impact of China, and world commodity price levels?
- How will the Indian government policies affect the development of these supply chains?
-
A quick summary of industry analysis suggests some intriguing and initially counter
intuitive results:
- The quality movement and the associated adoption of lean manufacturing techniques have been extremely successful in the Indian industry. 13 Indian companies that have
won the Deming prize. However, the analysis shows that none of these firms show any
improved financial benefits over the rest of the industry. Given this data, how do we interpret the impact of such quality improvement initiatives?
- Any understanding of the auto components industry has to focus on component type such as transmissions, engines, braking components etc. An analysis of the price pressure by segment shows that for many segments, margins have decreased in recent years. In addition, a total factor productivity analysis by segment shows decreasing productivity across the precise period that volumes have risen.
- Any focus on firm level growth has to consider firm size as we understand industry evolution. Analysis by firm size (large versus small segments), and by product segment, reveals that newer firms that have the benefit of size have shown the most improvement in recent years.
- Finally, despite higher raw material costs, higher energy costs and poorer infrastructure in India, multinational OEMs that have entered the Indian market have managed to produce cars that have high local content and are sold at competitive retail prices.
The Indian Automobile Industry – A quick survey
The Indian automotive components industry’s annual turnover (for FY 2003) was US$
6.73 billion. When compared to the global automotive components industry of US $737
billion, the Indian industry dwarfs in size. But, at a compounded growth rate of 20-25 %,
the growth in India’s auto components exports is much faster than that of the domestic
market (10-14%). Many consider this growth in exports as just the tip of the iceberg
similar to that witnessed by the information technology industry in the early 1990’s. The
auto ancillary industry caters to three broad categories of the market:
1) Original equipment manufacturers (OEM) or vehicle manufacturers, that
comprises of 25% total demand
2) Replacement market that comprises 65% of the total demand
3) Export Market, that comprises primarily of international Tier I suppliers and
constitutes 10% of total demand
Cost Structure
The cost structure in the auto ancillary sector is shown below. It is clear that any analysis
of the cost should focus on material cost, labor cost and other manufacturing costs.
It is evident from the from industry data that for the engine parts segment, the employee costs as a fraction of total cost are higher than for other segments, indicating the complexity of the activity. This plays an important role in explaining the total factor productivity trends, described later.
Quality
Firms in the auto sector have made significant advances in quality over the last 10 years.
This is the largest number of firms from any country outside Japan that have won this award.
According to conventional understanding, this rapid change should have resulted in better
bottom line performance. Senior quality managers in auto component companies reveal that one of the very first conditions that MNC OEMs set out for Indian auto component
companies in the late nineties was the need to conform to internationally recognized
standards within three years. A number of companies are also simultaneously embarking on a Six Sigma program in order to reduce defects and delays in their processes, drastically. All these initiatives have resulted in a perceptible increase in quality levels of auto component industry as a whole
The Supply Chain:
Delivery parameters are linked to Supply Chain (SC) metrics of an organization. It was,
again, the entry of the MNCs that heralded a paradigm shift in the way supply chain was
thought of and implemented in India (Refer Table 2.4). Today, all the automobile OEMs
demand (JIT) supplies and daily milk runs and the use of third party logistics (3PL) for
component supplies have now become commonplace. The result is that OEMs no longer
maintain large stocks of components / raw materials but instead leave it to their suppliers
to ensure that there is a smooth flow of parts in the logistics pipeline.
When the analysis was done at an industry level, it was found that new firms with lower overheads had high growth rates and that the small firms that are newer, larger and have lower overheads witness high growth rates and are more profitable. We also find that amongst large firms, new firms have better return on assets than old firms, i.e., traditional large companies perform poorly.
Methodology
The degree of development of the supply chain can be gauged by examining the extent to
which carmakers choose to buy in components, rather than manufacture in-house.
Supplier Quality
International best practices for carmakers in US, Japan and Europe currently aim to bring
the large majority of suppliers under 100 ppm. The distribution of defects observed confirm the view that first-tier suppliers to newly arrived carmakers in India and China are already operating close to world-class standards.
An ICRA report (ICRA, 2004), further, substantiates Suttons view that with regard to
quality there are not significant differences between India and China. Our initial
interviews with managers and Ramnath Consulting Ltd. reveals that China might be
slightly ahead in some areas and more importantly, both countries are behind world
standards.
A successful model that can be incorporated for robust measurement of Supply Chain is the SCOR model.
SCOR:
• Common Methodology
• Common Language
• Common Metrics
Partner Relationship Management
• Supply Chain Programs
• Innovative Product Developments
• Total Cost Reduction Programs
Procurement Excellence:
• Value Creation
• Low Cost Sourcing
• Operational Excellence
The Supply Chain Council (SCC) has developed The Supply Chain Council (SCC) has developed and endorsed the Supply Chain Operations Reference-model (SCOR)
as the cross-industry standard for supply chain management
The SCC is an independent, not-for-profit, global corporation with membership open to all companies and organizations interested in applying and advancing in state-of-the- art supply chain management systems and practices.
• Over 1000 Company Members
• Cross-industry representation
• Chapters in Australia/New Zealand, Brazil, Europe, Japan, North America, Southern Africa, and South East Asia with petitions for additional chapters pending.
SCOR: A Reference Model for a Supply Chain:
5 core processes:
PLAN
Source
Make
Delivery
Suppliers
Customers
Return
Return
Return
Process Best Practices
Metrics Technology
Ease of implementation
Solution portfolio
high
medium
low
SC reconfiguration
Direct Shipment
Transport Load optimization
Lead time reduction
Forecasting Process
VMI
Portfolio Strategic Development
SC Delivery Performance
high
medium
low
Impact/Benefits
Change management issues in a collaborative scenario
Typical barriers:
Shared vision feeding
mutual need & interest
Understanding about
business concepts &
opportunities
Trust & openness
between partners while
building reliable supply
chain operations
Change management
solutions:
Collaborative
workshops
Common definitions
(Reference model)
Commonly selected
& shared metrics
Conclusions
I
Enterprise
integration
II
Corporate
Excellence
III
Partner
Collaboration
IV
Value Chain
Constellation
V
Full Network
Connectivity
Enhancing partner collaboration is key
SCOR
Collaborative Commerce
Most Achieved level II
(today’s market)
SC Maturity Model
Functional
Process
Intra –
Enterprise
Inter-
Enterprise
External
Total Business
Systems
Everything here suggests that :
- Usage of simple tools leads to great improvements in SC management
- Automation is the buz word in the process control
- Implementation of SC management systems/tools require trust between partners.
- Continous coordination is a must for any model to work
- Continuous adaptation to the particular business & process improvements required.
A particular model is not guarantee for success in the Supply Chain. The auto supply chains in our Auto markets, are not yet tier zed and consolidated. Total factor productivity trends for the industry show a decline, suggesting a change in the product mix towards higher labor content, i.e., higher design content and engineering content products. In summary, the Indian auto ancillary supply chain presents a fascinating case study of firms at crossroads, that have to select whether to pursue business as it is, develop a global supply network, grow their demand globally or develop more complex products and design capabilities.
Performance Management and appraisal process in a professional services organization.
Performance Management and appraisal process in a professional services organization.
A twist in the tale.
Submitted by : Shailesh Dubey (eMEP 100)
Manoj Rajappan ( PM 04 175)
Venkat Kumar M (eMEP 121)
Contents
Abstract
What is performance management
What do organizations achieve by it
How does it work?
How does Performance Management work?
How do employees benefit from this change?
Performace management…the process
Where it can go wrong
Areas of improvement
Conclusion
Bibliography/References
Abstract
This study is a condensation of the readings on a variety of articles on Performance Management and appraisal process in different organizations. We have critically analyzed the various practices of these fields, how they affect an organization and its human resource development and management function, and the after-results of it.
For the purpose of exemplifying the topic, we have chosen a multinational Big Four professional services provider (name withheld to keep anonymity) and have examined the performance management review process, how it is done, the timelines and other factors, the various stakeholders involved in it, and how it has benefited/affected the various stakeholders involved in the process. We have also taken a case (rare, but not isolated), where the process went wrong, and the pitfalls of it. The effort has been directed towards critically examining the process as to see whether what is written and practiced is synergistic.
What is performance management?
Performance management is an interactive process where the management communicates the vision of the organization, I ts goals to every supervisor, subordinates, and employee who thereby develop group and individual goals, plan their future/expected accomplishment, and set standards to successfully achieve the firm’s vision and goals.
Being good at your own job is now no longer enough. You also have to encourage and support high performance standards from your team. You must inspire your team members to focus on a common goal and help them to use their mix of abilities to achieve it. Your team members need to know whether they are performing successfully, and you should reward their successful performance.The objectives of performance management process are to provide a foundation for professional development, a means to assess performance and an environment that facilitates effective coaching and counseling. As a result, this program focuses on both the skill development and performance evaluation. It is the responsibility of individuals to manage their own professional development. For this program to be successful, it is critical that both the Appraiser and the Appraisee to allocate time to use the available processes and applications. Performance management is not so much a set of single, independent processes; rather, it is a series of interrelated processes, the combination of which is critical to the achievement of organizational and individual performance.
Why is it important
Productivity Benefits
A growing body of research studies are identifying trends in effective performance management systems and pointing to the fact that performance management does impact organizational success.
In a survey by Developmental Dimensions International, the majority of CEO’s (67%) perceived that effective performance management systems directly influenced the following key outcomes:
· Financial Performance
· Productivity
· Product or Service Quality
· Customer Satisfaction
· Employee Job Satisfaction
What do organizations achieve by it?
Individual performance management is primarily the world of human resources management. This part of performance management is about cascading the strategic objectives of the organization down to goals for every individual, making sure that each person understands what he or she needs to do to achieve those goals, using pay for performance to keep people on track to achieve their goals and the organization’s objectives, providing frequent feedback to individuals about their performance, and analyzing data about the workforce to make human resource decisions. In brief, the employee performance management centers upon:
· Developing and communicating organization's point of view and vision on the "career experience" and navigating employees’ career
· Painting a picture of career success through current, relevant competency models
· Supplementing the existing short-term focus on performance management with a longer-term focus on career planning
· Providing tools and resources that help employees
· Let employees take more ownership of managing their careers
· Have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching
· Make the most of performance management and career planning processes (career planning to be developed)
· Better understand performance expectations and career paths
· Identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360° feedback
· Develop concrete actions to achieve short-term performance goals and long-term career goals through mentoring and coaching
· Simplifying and streamlining existing processes and tools to drive greater efficiency and a better experience for our people
· Building stronger ties to Coaching, Learning & Development, Resource Management, and Reward & Recognition; and analytics to identify potential needs in these areas
· Developing analytics that help us better understand our organization's bench strength
· In an effective performance management process, the organization’s strategic plan is “cascaded” down so that ultimately there is a clear path that connects individual employees to that plan. Employees know how their work contributes to the success of the organization. They also know what is expected of them, how they are doing, what is working well, and what needs improvement. Performance management done well increases satisfaction and productivity, and decreases turnover.
How does it work?
Performance management is a shared responsibility of employees and supervisors. Performance management is done best with employees, not to them. In any organization, employees are expected to be responsible for participating in all phases of the performance management process to the best of their abilities and for performing their work in a way that meets and exceeds performance expectations. Employees are also responsible for asking questions whenever necessary to understand what is expected of them and for communicating successes and problems to their supervisors to help their supervisor measure their progress or provide assistance when needed.
Effective performance management is crucial to the accomplishment of organizational goals and objectives. It is also a fundamental management responsibility. Employees need and want to know what is expected of them, how they are doing, what’s working well, and what needs improvement
Organization management should send a clear and unequivocal message to all employees that performance matters. Each employee at every level of the organization must be held responsible and accountable for their participation in this process. Management is also obligated to provide sufficient resources for the training and supporting of all supervisors and managers in the essential components of employee-level performance management. Successful implementation of performance management will lead the organizations to follow the path of creating and sustaining a performance-based, high-achieving culture.
Some of the most important, though not universally used, key components include:
1. The setting of clear performance expectations for each employee linked to the desired outcomes as set forth in the organization’s strategic plan. Performance expectations must be specific, measurable, and/or observable and must include the following:
Performance Expectations. “What” the employee is expected to do. These are expressed as results or outcomes the employee is expected to achieve in order to be fully successful; and
General Factors. “How” the employee is expected to behave. This consists of competencies that the employee is expected to demonstrate in order to be fully successful.
2. Individual training needed to support employee achievement of desired objectives.
3. Regular, ongoing coaching, feedback, and communication with employees.
4. Regular performance appraisal – the assessment of an employee’s actual performance relative to the performance expectations.
5. Timely, meaningful recognition of desired performance.
How do employees benefit from this change
The first benefit is that each employee will be able to identify his or her role in making the organization successful in achieving the goals and will have specific expectations and measurements for determining success. Another benefit will be professional development. Each supervisor and manager will be held accountable for a general factor “Staff/Team Development.” This will involve individual plans to provide the tools each employee needs to be successful.
Employees who meet or exceed expectations are recognized for those achievements under various compensation policies such as a New Pay for Performance program. Frontline employees who have earned an Overall Rating of Meets Expectations or Exceeds Expectations receive a pay increase or given a hierarchical promotion.
The motto is simple and unequivocal…employees should strive for excellence.
Recognizing excellence goes a long way toward encouraging individuals to reach higher and achieve their potential.
Performanc management…the process
The process….in my organization begins with developing and communicating our organization's point of view and vision on the "career experience" and navigating each personnel’s career. It involves painting a picture of career success through current, relevant competency models, supplementing the existing short-term focus on performance management with a longer-term focus on career planning
The employees are provided tools and resources that help them become better and more skilled professionals so as to enable them to take more ownership of managing their careers, have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching. Another objective of this exercise is to make the most of performance management and career planning processes (career planning to be developed) for employees to better understand the performance expectations and career paths, identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360 degree feedback.
Planning
Rewarding
Business Strategy/Goal Development
Employee Goal Setting
Development/Learning Plan
Reward & Recognition
Annual Compensation
Developing
Ongoing performance discussions
Training programs
Mentoring
Informal & Formal Discussions
Monthly, Mid-year, to
Year-end Reviews
Monitoring
The employees are provided tools and resources that help them become better and more skilled professionals so as to enable them to take more ownership of managing their careers, have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching. Another objective of this exercise is to make the most of performance management and career planning processes (career planning to be developed) for employees to better understand the performance expectations and career paths, identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360 degree feedback.
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Where it can go wrong
An analysis of the recruitment, retention, and turnover rate however gave startling insight into the reality behind the scene. For example, the average tenure of an employee (human resource/human capital!!!) was found to be 1.4 years. So much for the human resource development or so to say human resource management. The most common reason given in the exit interview was that of re-location/marriage/familial commitments. To accept this would be like an ostrich thinking it can hide from a problem by burying its head in the sand.
In summary, the human resource management, though in place, has sometimes little or no effect in helping the organization retain/sustain and groom its talent. In a survey conducted recently, an overwhelming majority of the respondents agreed that this organization is more of a stepping stone, not a career enhancer or career destination. Perhaps, the reasons lies behind the cultural, socioeconomic, and demographic factors when look into. With a burgeoning service industry and increasing demand for the best-of-breed talent, the temptation is much. Also, it’s again the proverbial organizational politics that wreaks many a career aspirations. To quote an example, an employee who was hired (in hurry) without giving him a clear picture of his role, job description/design, organizational structure, hierarchical positions, and as such. The induction, orientation, and transition for that employee, for whom it was a first MNC experience, did not go smoothly; the end result, miscommunication, ego clashes, groupism, and other evils. The employee wrote an anonymous e-mail to the Strategic level management, who in turn took their time to assess the situation. The end result, the manager/supervisor became vengeful towards this employee, ignored him by not giving him any work, or any credit for whatsoever work, castigating him in public, not providing any opportunity or advice as to plan his professional career, and in the end giving him the LOWEST POSSIBLE RATING in the performance appraisal. The result…the employee was put on a Performance Improvement Plan (PIP) which was a farce….after a couple of more months of humiliation, the employee decided to leave the organization. Again, the ugly face of the organization came in front, the employee was asked to stay and consider his decision (without any serious intention of retaining him). As it had to happen, the employee did speak his mind out to the HR Managers and other decision-makers. To anyone’s surprise, no action…just one more exit interview
Areas of improvement
What needs to be done or taken into consideration when recruiting a candidate is to look for the right attitude with that matches with the right skills. Skills can always be developed, but to develop the right attitude is often difficult or next to impossible. There should be a set of core values that needs to be defined and practiced at every level of the organization. While assessing an employee, equal consideration should be given to judge the employee on these core attributes. Some of these attributes are:
Conclusion
Performance Management is the process of analyzing the performance, goals, and accomplishment of the employees and finding areas of strengths and weakness to improve individual and team performance, based on the principles of measurement, appraisal, action, and monitoring. However, it can manifest in various forms depending on whether the aim is to further improve good performers, deal with underperformance, or to WEED OUT poor performers. Some other observations that are made during this study are:
There should be adequate senior management's leadership and support in articulating and achieving the personal/organisational goals in help ensuring alignment of objectives of performance management.
The stackholders must be discharged with clear and unambiguous responsibility for monitoring, mentoring, and improving performance of their respective teams/staff;
There should be keen focus continuous improvement in managers' skills on performance management, including objectives setting and measurement, coaching, appraising, and motivating staff;
Efforts should be made to engendering staff ownership of the performance management system by effective communication and regular feedback in the performance management processes.
Bibliography/References
sas.com magazine
Performance Management Dos and Don'ts
Management Today articleAugust 2004: Feature Straight Talk About JobAppraisals
http://performance-appraisals.org/appraisal-library/Measuring Performance - Performance Measurement
Harbard Business Review Articles
Motivating People for Improved Performance: The Results-Driven Manager Series
Performance Management That Drives ResultsLoren Gary
People and Performance: The Best of Peter Drucker on Management (Hardcover)Peter F. Drucker
Forced Ranking: Making Performance Management WorkDick Grote
A twist in the tale.
Submitted by : Shailesh Dubey (eMEP 100)
Manoj Rajappan ( PM 04 175)
Venkat Kumar M (eMEP 121)
Contents
Abstract
What is performance management
What do organizations achieve by it
How does it work?
How does Performance Management work?
How do employees benefit from this change?
Performace management…the process
Where it can go wrong
Areas of improvement
Conclusion
Bibliography/References
Abstract
This study is a condensation of the readings on a variety of articles on Performance Management and appraisal process in different organizations. We have critically analyzed the various practices of these fields, how they affect an organization and its human resource development and management function, and the after-results of it.
For the purpose of exemplifying the topic, we have chosen a multinational Big Four professional services provider (name withheld to keep anonymity) and have examined the performance management review process, how it is done, the timelines and other factors, the various stakeholders involved in it, and how it has benefited/affected the various stakeholders involved in the process. We have also taken a case (rare, but not isolated), where the process went wrong, and the pitfalls of it. The effort has been directed towards critically examining the process as to see whether what is written and practiced is synergistic.
What is performance management?
Performance management is an interactive process where the management communicates the vision of the organization, I ts goals to every supervisor, subordinates, and employee who thereby develop group and individual goals, plan their future/expected accomplishment, and set standards to successfully achieve the firm’s vision and goals.
Being good at your own job is now no longer enough. You also have to encourage and support high performance standards from your team. You must inspire your team members to focus on a common goal and help them to use their mix of abilities to achieve it. Your team members need to know whether they are performing successfully, and you should reward their successful performance.The objectives of performance management process are to provide a foundation for professional development, a means to assess performance and an environment that facilitates effective coaching and counseling. As a result, this program focuses on both the skill development and performance evaluation. It is the responsibility of individuals to manage their own professional development. For this program to be successful, it is critical that both the Appraiser and the Appraisee to allocate time to use the available processes and applications. Performance management is not so much a set of single, independent processes; rather, it is a series of interrelated processes, the combination of which is critical to the achievement of organizational and individual performance.
Why is it important
Productivity Benefits
A growing body of research studies are identifying trends in effective performance management systems and pointing to the fact that performance management does impact organizational success.
In a survey by Developmental Dimensions International, the majority of CEO’s (67%) perceived that effective performance management systems directly influenced the following key outcomes:
· Financial Performance
· Productivity
· Product or Service Quality
· Customer Satisfaction
· Employee Job Satisfaction
What do organizations achieve by it?
Individual performance management is primarily the world of human resources management. This part of performance management is about cascading the strategic objectives of the organization down to goals for every individual, making sure that each person understands what he or she needs to do to achieve those goals, using pay for performance to keep people on track to achieve their goals and the organization’s objectives, providing frequent feedback to individuals about their performance, and analyzing data about the workforce to make human resource decisions. In brief, the employee performance management centers upon:
· Developing and communicating organization's point of view and vision on the "career experience" and navigating employees’ career
· Painting a picture of career success through current, relevant competency models
· Supplementing the existing short-term focus on performance management with a longer-term focus on career planning
· Providing tools and resources that help employees
· Let employees take more ownership of managing their careers
· Have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching
· Make the most of performance management and career planning processes (career planning to be developed)
· Better understand performance expectations and career paths
· Identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360° feedback
· Develop concrete actions to achieve short-term performance goals and long-term career goals through mentoring and coaching
· Simplifying and streamlining existing processes and tools to drive greater efficiency and a better experience for our people
· Building stronger ties to Coaching, Learning & Development, Resource Management, and Reward & Recognition; and analytics to identify potential needs in these areas
· Developing analytics that help us better understand our organization's bench strength
· In an effective performance management process, the organization’s strategic plan is “cascaded” down so that ultimately there is a clear path that connects individual employees to that plan. Employees know how their work contributes to the success of the organization. They also know what is expected of them, how they are doing, what is working well, and what needs improvement. Performance management done well increases satisfaction and productivity, and decreases turnover.
How does it work?
Performance management is a shared responsibility of employees and supervisors. Performance management is done best with employees, not to them. In any organization, employees are expected to be responsible for participating in all phases of the performance management process to the best of their abilities and for performing their work in a way that meets and exceeds performance expectations. Employees are also responsible for asking questions whenever necessary to understand what is expected of them and for communicating successes and problems to their supervisors to help their supervisor measure their progress or provide assistance when needed.
Effective performance management is crucial to the accomplishment of organizational goals and objectives. It is also a fundamental management responsibility. Employees need and want to know what is expected of them, how they are doing, what’s working well, and what needs improvement
Organization management should send a clear and unequivocal message to all employees that performance matters. Each employee at every level of the organization must be held responsible and accountable for their participation in this process. Management is also obligated to provide sufficient resources for the training and supporting of all supervisors and managers in the essential components of employee-level performance management. Successful implementation of performance management will lead the organizations to follow the path of creating and sustaining a performance-based, high-achieving culture.
Some of the most important, though not universally used, key components include:
1. The setting of clear performance expectations for each employee linked to the desired outcomes as set forth in the organization’s strategic plan. Performance expectations must be specific, measurable, and/or observable and must include the following:
Performance Expectations. “What” the employee is expected to do. These are expressed as results or outcomes the employee is expected to achieve in order to be fully successful; and
General Factors. “How” the employee is expected to behave. This consists of competencies that the employee is expected to demonstrate in order to be fully successful.
2. Individual training needed to support employee achievement of desired objectives.
3. Regular, ongoing coaching, feedback, and communication with employees.
4. Regular performance appraisal – the assessment of an employee’s actual performance relative to the performance expectations.
5. Timely, meaningful recognition of desired performance.
How do employees benefit from this change
The first benefit is that each employee will be able to identify his or her role in making the organization successful in achieving the goals and will have specific expectations and measurements for determining success. Another benefit will be professional development. Each supervisor and manager will be held accountable for a general factor “Staff/Team Development.” This will involve individual plans to provide the tools each employee needs to be successful.
Employees who meet or exceed expectations are recognized for those achievements under various compensation policies such as a New Pay for Performance program. Frontline employees who have earned an Overall Rating of Meets Expectations or Exceeds Expectations receive a pay increase or given a hierarchical promotion.
The motto is simple and unequivocal…employees should strive for excellence.
Recognizing excellence goes a long way toward encouraging individuals to reach higher and achieve their potential.
Performanc management…the process
The process….in my organization begins with developing and communicating our organization's point of view and vision on the "career experience" and navigating each personnel’s career. It involves painting a picture of career success through current, relevant competency models, supplementing the existing short-term focus on performance management with a longer-term focus on career planning
The employees are provided tools and resources that help them become better and more skilled professionals so as to enable them to take more ownership of managing their careers, have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching. Another objective of this exercise is to make the most of performance management and career planning processes (career planning to be developed) for employees to better understand the performance expectations and career paths, identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360 degree feedback.
Planning
Rewarding
Business Strategy/Goal Development
Employee Goal Setting
Development/Learning Plan
Reward & Recognition
Annual Compensation
Developing
Ongoing performance discussions
Training programs
Mentoring
Informal & Formal Discussions
Monthly, Mid-year, to
Year-end Reviews
Monitoring
The employees are provided tools and resources that help them become better and more skilled professionals so as to enable them to take more ownership of managing their careers, have more meaningful career conversations by improving the skills and comfort level in giving and receiving feedback and coaching. Another objective of this exercise is to make the most of performance management and career planning processes (career planning to be developed) for employees to better understand the performance expectations and career paths, identify strengths, interests, and areas for improvement through self-assessment, evaluative feedback, and developmental 360 degree feedback.
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Where it can go wrong
An analysis of the recruitment, retention, and turnover rate however gave startling insight into the reality behind the scene. For example, the average tenure of an employee (human resource/human capital!!!) was found to be 1.4 years. So much for the human resource development or so to say human resource management. The most common reason given in the exit interview was that of re-location/marriage/familial commitments. To accept this would be like an ostrich thinking it can hide from a problem by burying its head in the sand.
In summary, the human resource management, though in place, has sometimes little or no effect in helping the organization retain/sustain and groom its talent. In a survey conducted recently, an overwhelming majority of the respondents agreed that this organization is more of a stepping stone, not a career enhancer or career destination. Perhaps, the reasons lies behind the cultural, socioeconomic, and demographic factors when look into. With a burgeoning service industry and increasing demand for the best-of-breed talent, the temptation is much. Also, it’s again the proverbial organizational politics that wreaks many a career aspirations. To quote an example, an employee who was hired (in hurry) without giving him a clear picture of his role, job description/design, organizational structure, hierarchical positions, and as such. The induction, orientation, and transition for that employee, for whom it was a first MNC experience, did not go smoothly; the end result, miscommunication, ego clashes, groupism, and other evils. The employee wrote an anonymous e-mail to the Strategic level management, who in turn took their time to assess the situation. The end result, the manager/supervisor became vengeful towards this employee, ignored him by not giving him any work, or any credit for whatsoever work, castigating him in public, not providing any opportunity or advice as to plan his professional career, and in the end giving him the LOWEST POSSIBLE RATING in the performance appraisal. The result…the employee was put on a Performance Improvement Plan (PIP) which was a farce….after a couple of more months of humiliation, the employee decided to leave the organization. Again, the ugly face of the organization came in front, the employee was asked to stay and consider his decision (without any serious intention of retaining him). As it had to happen, the employee did speak his mind out to the HR Managers and other decision-makers. To anyone’s surprise, no action…just one more exit interview
Areas of improvement
What needs to be done or taken into consideration when recruiting a candidate is to look for the right attitude with that matches with the right skills. Skills can always be developed, but to develop the right attitude is often difficult or next to impossible. There should be a set of core values that needs to be defined and practiced at every level of the organization. While assessing an employee, equal consideration should be given to judge the employee on these core attributes. Some of these attributes are:
Conclusion
Performance Management is the process of analyzing the performance, goals, and accomplishment of the employees and finding areas of strengths and weakness to improve individual and team performance, based on the principles of measurement, appraisal, action, and monitoring. However, it can manifest in various forms depending on whether the aim is to further improve good performers, deal with underperformance, or to WEED OUT poor performers. Some other observations that are made during this study are:
There should be adequate senior management's leadership and support in articulating and achieving the personal/organisational goals in help ensuring alignment of objectives of performance management.
The stackholders must be discharged with clear and unambiguous responsibility for monitoring, mentoring, and improving performance of their respective teams/staff;
There should be keen focus continuous improvement in managers' skills on performance management, including objectives setting and measurement, coaching, appraising, and motivating staff;
Efforts should be made to engendering staff ownership of the performance management system by effective communication and regular feedback in the performance management processes.
Bibliography/References
sas.com magazine
Performance Management Dos and Don'ts
Management Today articleAugust 2004: Feature Straight Talk About JobAppraisals
http://performance-appraisals.org/appraisal-library/Measuring Performance - Performance Measurement
Harbard Business Review Articles
Motivating People for Improved Performance: The Results-Driven Manager Series
Performance Management That Drives ResultsLoren Gary
People and Performance: The Best of Peter Drucker on Management (Hardcover)Peter F. Drucker
Forced Ranking: Making Performance Management WorkDick Grote
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