FINANCIAL RESULTS BASED CONTROLS, BUDGETING AND ROLLING FORECASTING Teemu Malmi Accounting for Management Control -
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
METHODS FOR FINANCIAL CONTROL? • How can you control costs in an organization? Give few examples! – – – ……… • Financial control does not mean only control of costs, but also revenues and profitability! • If you control revenue and cost, do you ”by definition” control also profitability? • What can be a “result” in a results based financial control?
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
FOR WHAT PURPOSES ORGANIZATIONS DO BUDGETS FOR?
Budgetary control Set targets Prepare budgets Compare target to budgets Feedforward control Significant deviations? Accept and implement budgets No Yes Take control action Record actuals Action Compare actuals and budgets Forecast results Significant deviations? Compare forecasted and budgeted results No No need for action Feedback control Yes Take control action
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
ROLLING FORECASTING • Why do companies need rolling forecasts? • How to forecast? -
Why to forecast? • Investor relations • Measurement • Management Is the purpose to: a) get accurate view of the future? b) make better decisions?
Traditional vs. rolling forecasting Latest Estimate Ytd 1 Ytd 2 31 Dec 1 Jan Rolling forecasts Scenario Planning Ytd 1 Jan Ytd 3 31 Dec
Forecast period How long into the future to forecast? • How often the forecasts should be updated? Lead time between decision and the • impact (reaction time) How often revenues / costs change? • • How often environment changes? What is the longest reaction time in the business? • How often key assumptions change? Reaction time varies between industries and within a company • Is it reasonable to forecast everything in the same cycle? Calendar year (fiscal year) is hardly the best period…?
Different forecasts Freedom of choice increases Strategic planning Business forecasting Operative forecasting PROCESS ADAPTATION Degree of certainty increases PURPOSE ADAPTATION ”How to structure the business cost -effectively” Creation of options Alternative scenarios of the future environment Broad lines Freedom of choice ANSWER ”How to make the best use of resources” The most likely estimate of what is going to happen based on current assumptions Detailed enough Limited freedom of choice Decision-making REACTION ”How to satisfy demand effectively” Prediction of what will happen Very detailed Limited choice Implementation
How often and what to forecast? VARIABILITY Low IMPORTANCE High Low High Routine update on quarterly basis or as needed Routine monthly update Check on quarterly basis and update as needed Routine quarteraly update
Forecasting frequency – South West Airlines Economic significance Variability Importance of rapid response Update frequency Forecasting horizon Revenue High Daily Month Labor High Low Medium Twice a month 6 months Petrol High Medium Weekly Quarter Maintenance Medium Twice a month 6 months Marketing Medium High Monthly 6 months Depreciation Medium Low Qaurterly Year Airport fees Medium Low Weekly 6 months Other Medium Twice a month Quarter
Forecasting process Input Assumptions • Environment • Industry trends • Acitivites Processing Model • Judgement • Mathematics • Statistics What is forecasted? • Trends – Past patterns that will repeat themselves in the future – Without trends forecasting would be impossible – Discontinuities – Trend disturbances, surprises – Chaos (financial crisis 2008 ) – Novelty Output Forecasts • Momentum (direction) • Interventio (actions)
Judgement • Judgmental model – Commonly used – Based on experience – E. g. inflation • Benefits – Easy, inexpensive, rapid and accommodation of complexity (to the certain extent) • Weaknesses – – – Insufficient in large scale and scope (complexity) Difficult to reforecast (no scale benefits) Depends on the skills of the forecast producer Systematic bias (positive / negative) E. g. a manager is reponsible for a cost budget and the company seeks cost savings. What is the likelyhood that the manager will forecast cost reductions? How about cost increases?
Mathematical model • Basic idea is: – to address causal relationships between various factors and… – …model them mathematically A Volume B Material price • Methods Cost forecast Cost model A*((B*C*(1+D)) – Activity-based budgeting / forecasting – Driver-based forecasting • AMEX: building the model – Controllers to the business units • ”If you had to forecast each line of the P&L by using a driver and an algorithm, what would you use” – Results: 11 models in the web-based application C Usage D Waste
Driver-based forecasting Marketing activities Plan marketing resources and activities Call Center Response rate Incoming calls Plan call center resources and activities Production Success rate Sales volume Plan production resources and activities
Driver-based forecasting Traditional budget Gross sales -Discounts Net sales Driver-model: call center labor 5 300 000 Incoming calls per month 200 000 Modelling Days per month 20 Calls / person / day 75 Peak factor 500 000 Input from marketing 20% Cost / person / month 2 500€ Capacity/ person / month 75 x 20 = 1500 Required people (200’/1, 5’)*1, 2=160 Labor costs / month 160 * 2 500€ = 400 000 Success rate 16% 4 800 000 -COGS Product costs Call center labor Other Gross margin 1 950 000 400 000 50 000 2 400 000 -R&D 200 000 -Sales 200 000 Incoming calls per month 200 000 -Administration 300 000 Sales / month 16% * 200’ = 32 000 -STRATEX 500 000 Operating profit 1 200 000 Output to production
Statistical model • Complexity – Statistics is the only way to forecast complexity • Statistical model – – • Finds out patterns of the data Does not explain why some pattern occurs Is more simple than mathematical models Is based on the assumption that history repeats itself (adjustments of data) Pros – Rapid and inexpensive (once the model is built) – Free of motivational bias • Cons – Not actionable (relationships, no causal explanation) – Ignores surprises (trends, but no suprises)
A model or joint application? Base volume (S) Sales and marketing activity (J) Revenue model (M) Revenue forecast List price (J? ) Discounts (J) Profit forecast Material price (J) Processing (S) Cost model (M) Cost forecast Waste (J) S = statistical, J = judgemental, M = mathematical
Summary • What to forecast? – Fundamental business drivers – Variability + significance keep it simple! • When to forecast? – Issues change in different cycles horizons and frequencies – All costs are ultimately variable if the horizon is long enough • Who do the forecast? – Inputs from responsible managers – Modelling and updating by F&C
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
Budgets cause wrong behavior How to win the budget game • Negotiate lowest targets/highest rewards • Always make the bonus, whatever it takes • Never put customers above sales targets • Never share knowledge and resources • Always ask for more than you need • Always spend what’s in the budget • Always explain away adverse variances • Never provide accurate forecasts • Always meet, never beat the numbers • Never take risks
BB: Leadership vision Predictive & Centralised Adaptive & Devolved 1. Climate Performance contracts Competitive success 2. Motivation Plans & incentives Responsibility for outcomes 3. Devolution Constrained to plan Freedom to decide 4. Empowerment Bureaucratic ‘red tape’ Capability to act 5. Organisation Centralised hierarchy Customer focused teams 6. Information Closed & controlled Open & “one truth”
BB: Finance vision Predictive & Centralised Adaptive & Devolved 1. Targets Negotiating fixed targets Setting relative measures 2. Rewards Paying individual incentives Recognising team-based success 3. Strategy Centrally driven, annual event Devolved, inclusive & continuous 4. Resources Allocated annually thru budgets Free access with accountability 5. Coordination Predetermined by central plans Dynamic market-like processes 6. Control Top-down thru variances to plan Multi level, fast and open
Tools in use Borealis - Europe’s 2 nd largest petrochemical company. Financial planning Qtrly rolling forecasts, not linked with “performance management” Target setting Balanced scorecard to set targets and measure performance Budget Controlling fixed costs Trends, activity accounting, ABC and SAP Resource allocation Trends (s), Hurdle rates (m), Case by case (l)
Performance measures Competitive position Market value Few Aggregate Residual income Standardization Brand equity Market share ROCE Customer satisfaction Product reliability Number and nature of measures Outputs Process P&L + current assets P&L Sales revenue Many detailed Manufacturing costs Operating expenses Inputs narrow Wide Span of accountability
Dynamic resource allocation Do I have budget for this? Is this right thing to do? -Supports strategy? -Decision criteria? -Can I justify it? Bad thing! OK? Budget OK? OK OK? OK? 29
Dynamic resource allocation ABSOLUTE KPIs Traditional cost budget Absolute cost KPI RELATIVE KPIs Unit cost input/output Benchmarked unit cost NO KPIs Bottom line Strategic targets/ activities Cost efficient operations Xx Xx Xx 10. 000 € / unit € / customer € / employee ” 1 st quartile ” ”above average” EBIT ROCE (abs. /relative) Reduce the use of external services Monitoring of actuals, intervention only if needed Choose which fits best in your organization Increasing freedom and flexibility Increasing need for strong values and clear direction (strategy, objectives) 30
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
TRANSFER PRICING • In an international setting, questions regarding transfer pricing refer typically to tax issues • Arm’s length pricing required by OECD and local tax authorities • There also other problems than taxation related to transfer pricing -
THE PURPOSES OF TRANSFER PRICES FROM MANAGEMENT CONTROL PERSPESPECTIVE: 1) To motivate divisional managers to make optimal economic decisions from the viewpoint of a whole company 1) To determine the profit/loss of a division based on which the managerial and economic performance of the division can be evaluated (objectives and allocation of resources) 2) To ensure that divisional autonomy is not undermined Note! No single transfer price is likely to meet all of the set objectives
TRANSFER PRICING METHODS: • • Market-based transfer price Cost-based transfer price Negotiated transfer price Transfer price set by headquarters
MARKET PRICE • Theoretically superior, if perfectly competitive market exists • However: - market is seldom perfectly competitive market price is appropriate, if quality, delivery, discounts and back-up services are identical to other products in the market - market imperfections caused by distressed companies if market is not perfect, then the use of market prices may lead to incorrect decisions - marketing costs of supplier are not incurred
COST-BASED TRANSFER PRICE • Marginal costs, full costs or full cost plus a mark-up • According to economic theory, the optimal transfer price is the marginal cost of the supplying division, if market price cannot be applied • Seldom used in practice
MARGINAL COSTS: POSSIBLE PROBLEMS • Supplier does not receive profits and has no incentives to control overheads • Maximum overall company profits are not guaranteed, if supplier’s capacity is constrained and it is forced to sell internally • Supplier will sell externally, if it is able to receive a higher price from external sales • Receiving division may under-price the final products/services sold to end customers
FULL COSTS • ADVANTAGES: – Supplier recovers its costs – Receiving division emphasize cost efficiency – Receiving division has a picture of supplier’s full costs • DISADVANTAGES: – Supplier does not make any profit – Supplier may refuse to sell internally, if it can add a mark-up to external sales
FULL COST PLUS A MARK-UP • ADVANTAGES: – Supplier obtains profit • DISADVANTAGES: – Receiving division may pay more than what the actual value of product is, if it has no right to refuse and buy outside – In a long supply chain, the price paid by the end customer includes excess internal mark-up -> threat to competitiveness
NEGOTIATED TRANSFER PRICES • ADVANTAGES: – Often considered to be relatively fair • DISADVANTAGES: – Time consuming – Negotiating skills decisive, may lead to decisions less than optimal from the viewpoint of a company as a whole – In order to work, divisions should have equal bargaining power
TRANSFER PRICES SET BY HEADQUARTERS • E. g. market price – 10 % or full cost + 5 % • Neither based on economic logic as market- and costbased transfer prices, nor on responsibility logic as negotiated transfer prices • The aim is to simplify the situation, an ad hoc price is often set in practice • Sometimes, the aim might be to reach a fair distribution. E. g. if each division would have been able to acquire certain service at a certain price, but if the acquisition is centralized, the service is received at a lower price => the received benefit is shared fairly between divisions
TRANSFER PRICING IN PRACTICE Similar results are reported all over the world: - 35 -40 % of firms use market price/adjusted market price - 15 -20 % of firms use negotiated price - 40 -50 % of firms use cost-based transfer price - 5 -10 % of firms use marginal costs as a transfer price - There are differences in how domestic and international transfer prices are set. Domestic transfer prices are more commonly based on costs, whereas international transfer prices are market based due to more and more stringent tax regulation.
HOW TO SOLVE TRANSFER PRICING CONFLICTS IN PRACTICE? If no capacity constraints: a) Supplier’s marginal/variable cost + a fixed lump-sum charged from the receiving division benefits and disadvantages? b) Dual-rate transfer pricing system - supplier’s marginal/variable cost is charged from the receiving division, the supplier receives marginal cost + a mark-up, in other words, two transfer prices in practice benefits and disadvantages?
AGENDA • Methods for financial control • Purposes of budgets • Problems with traditional annual budgeting -> Case Handelsbanken • Rolling Forecasting • Beyond Budgeting • Transfer pricing • Managerially oriented research in management accounting
SEE REVIEW ARTICLE IN COURSE READINGS! • Many strands of management accounting research could be perceived as having managerialist aims • I my review I excluded analytical modelling, experiments in laboratory settings, contingency research relying on large data sets, interpretative and critical research • Included is case / field based research having managerial aims and non-empirical research aiming for managerial contributions • Case and field studies primarily aiming at explaining practices are excluded
CONSTRUCTIVE APPROACH • “The constructive approach means problem solving through the construction of models, diagrams, plans, organizations, etc. ” (Kasanen et al. 1993) • Two key criteria – Construct needs to be conceptually / theoretically novel – Practitioners need to use it = proof of concept • Case based - either construct is developed in interaction with practitioners or its “value” is demonstrated by showing that practitioners were willing to use it and found it beneficial = interventionist case studies
ACTION RESEARCH • Constructive approach is one strand of action research, or interventionist research • In this review all other types of interventionist studies are covered under the heading Action Research • Action research use change experiments to both solve real problems in practice and to contribute to the basic knowledge of social science (Lewin, K. , 1946) • Hence, from the scientific point of view the aim is to contribute to theory by drawing on learning during the interaction
ACTION RESEARCH • In other streams of action research, the novelty of a construct to the ”world” is not an issue like in constructive approach – the change is by definition new to the organization in question but is not, as such, interesting to broader audience • Four types of studies in Management Accounting – Researchers take part of change activities and theorize based on experiences and observations during the intervention – Studies demonstrating the value of existing frameworks or accounting concepts – Studies developing constructs but not showing its use or benefits – Field experiments
OTHER MANAGERIALIST STUDIES • Three main groups – Descriptive studies (empirical, non-interventionist) – Conceptual normative / prescriptive studies (no empirics) – Studies suggesting frameworks, models, algorithms, or like, but not providing evidence of practitioners using the construct (noninterventionist empirical and non-empirical)
SUMMARY • In case you will conduct your masters thesis as a commissioned work for an organization, you may use this review article as one source when you write your methods section to make clear the type of approach you use! -
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