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ACCA F5
Performance Management
Lecture Notes (Revision)

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Contents

INTRODUCTION TO THE PAPER

CHAPTER 1 Absorption and marginal costing

CHAPTER 2 Activity Based Costing

CHAPTER 3 Target Costing

CHAPTER 4 Lifecycle Costing

CHAPTER 5 Throughput Accounting

CHAPTER 6 Environmental Management Accounting

CHAPTER 7 Cost Volume Profit Analysis

CHAPTER 8 Linear Programming

CHAPTER 9 Pricing

CHAPTER 10 Short term decisions

CHAPTER 11 Risk and Uncertainty

CHAPTER 12 Types of Budgets

CHAPTER 13 Quantitative methods in Budgeting

CHAPTER 14 Standard Costing

CHAPTER 15 Performance Measurement

CHAPTER 16 Divisional Performance Measurement

CHAPTER 17 Performance Measurement for Non Profit organisations

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The AIM of F5 paper

To develop knowledge and skills in the application of management accounting techniques

to quantitative and qualitative information for planning, decision making, performance
evaluation and control

MAIN CAPABILITIES :

On successful completion of this paper, candidates

should be able to:

A Explain and apply cost accounting techniques

Select and appropriately apply decision-making

B
techniques to facilitate business decisions and
promote efficient and effective use of scarce
business resources, appreciating the risks and
uncertainty inherent in business and controlling
those risks.

C Identify and apply appropriate budgeting

techniques and methods for planning and
control and use standard costing systems to
measure and control business performance and
to identify remedial action

Identify and discuss performance

D management information and measurement
systems and assess the performance of
an organisation from both a financial and non-
financial viewpoint, appreciating the problems
of controlling divisionalised businesses and
the importance of allowing for external
aspects

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FORMAT of the paper

Time Allowed: 3 hours and 20 minutes

The paper is divided into three sections

Section A 15 Compulsory OTs, 2 marks each. 30 marks

Section B 3 Compulsory Scenario based MTQs

Each MTQ has 5 tasks, 2 marks each. 30 marks

Section C 2 Questions worth 20 marks each. 40 marks

Constructed response questions

Total marks 100

What skills the students must develop to pass F5

Student attempting this paper must not only have the ability to understand the concepts and do
the computations regarding the syllabus topics, but In addition there is a need to understand
the scenario (Both in section Band C) and critically be able to ‘write commentary and analysis’
in relation to the scenario (in section C) and whatever the numbers you have already calculated.

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CHAPTER 1 Absorption andMarginal costing

TRADITIONAL ABSORPTION COSTING

1 Principles of absorption costing

1.1 A method whereby all production costs are included in the costing of a cost unit, ie. Direct materials, direct
labour, variable production overheads and fixed production overheads. IAS2 requires an element of fixed
production overhead to be ‘absorbed’ into product cost for inventory valuation purposes. All production
costs are charged to units of production.

2 Absorption costing Methodology:

1. Allocation: Overhead costs directly relating to particular cost centres,
for example, supervision, indirect materials.

2. Apportionment: Some overhead costs are common for all cost centres like rent, heating, Electricity,
they are incurred as a whole and therefore have to be distributed to cost centres
including service departments on some sharing bases like floor area for rent,
machine hours for machinery depreciation etc.

3. Re-apportionment: After allocated and apportioned overheads, the next step is to share the service
department cost into the production departments on a fair basis so that only
production coat centres overheads are determined, for which overhead absorption
rate can be calculated.

4. Overhead absorption.

Budgeted Overheads
i. Overhead Absorption Rate
* Budgeted Level of Activity

ii. Absorbed overheads = actual activity x OAR

* Activity levels can be labour hours, machine hours, and production volume etc.
These are VOLUME RELATED basis and absorption costing use a SINGLE rate to absorb overheads to
products, and assumes products that consumes more of the labour or machine hour would have consumed
more Overheads. ( later we will see this may not be true in Activity Based costing

iii. I Absorbed overheads are estimated overheads for the actual activity. They are later matched with
actual fixed overheads to identify and under or over estimated (absorbed) overheads.

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3 Under / over absorbed Overheads:

Amount of overhead absorbed X
Actual overhead expenditure (X)
--------------------------------------------- ---------
(Under)/over absorbed overheads (X)/X

IF IF

Absorbed Overheads > Actual overheads Actual Overheads > Absorbed overheads
Overheads are OVER-Absorbed overheads are UNDER-Absorbed

Treatment Treatment
Added back to gross profit Subtracted from gross profit

4 Advantages and disadvantages of absorption costing

Advantages of absorption costing.
- It recognizes that selling prices must cover all costs.
- It complies with IAS 2 on accounting for inventory, whereby the value of inventory must include an
appropriate amount of fixed production overhead.

Disadvantages of traditional Absorption Costing

- Absorption costing uses one universal OAR based on machine/labour hours and the Implication is
that overheads are volume related (more machine, labour hours, more overheads). (We will see in
ABC that all overheads do not incur on machine and labour hours).
- Because of the above there is risk of an unfair allocation of overheads cost to products.
- It can work only in traditional production environments where direct costs are a bigger part of the
production cost than overheads (which is not the case in modern environment where overhead
- Costs are much bigger proportion than direct material and labour costs).

5 Principles of marginal costing (variable costing)

(a) A principle whereby variable production costs only are charged to cost units and the fixed costs
attributable to the relevant period are written off in full against the contribution for the period.
(b) Inventory is valued at variable cost of production.

6 Contribution.
Contribution towards fixed costs is represented by:

a) Total contribution = Sales revenue Less ALL variable costs (even non production admin
selling distribution and marketing variable costs)

(b) Contribution per unit = Selling price per unit less all variable costs per unit (whether
production admin or selling etc).

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CHAPTER 2 Activity Based Costing (ABC)

1 Inadequacies of absorption costing

 Absorption costing uses one universal OAR based on machine/labour hours
 Implies all overheads are related to production volume
 Developed at a time when organizations produced only a narrow range of products and overheads
were only a small fraction of total costs.
 Tends to allocate too great a proportion of overheads to larger products

2 The Modern manufacturing environment:

- In the modern manufacturing environment, indirect costs constitute a relatively high proportion of total
product cost.
- Modern manufacturing is characterized by shorter and more frequent production runs rather than continuous or
high volume production runs. This increases the frequency of production line set-ups and therefore the total cost
arising from set-up activity.
- Widespread use of computer control and automation has decreased the importance and use of direct labour.
- Direct labour cost as a proportion of total cost has therefore declined.
- The products are made after an intense planning, designing, testing and prototyping ACTIVITIES.

The main CONCEPT is that products consume ACTIVITIES and they cause extensive amount of overheads.
So the products should be charged with overheads but for each activity (cost pool) separately using the related cost
driver i.e. basis.

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3 Activity Based Costing

Setup costs Number of

= OAR per setup
Setups

Testing Costs Number of

Tests = OAR per test

Designing cost No of Designing

hours = OAR per des. hr

General Labour or
Overheads Machine hours = OAR per Lab hr

4 Cost Pools and Cost Drivers

Activity (Cost Pools) Possible Cost Drivers
Ordering number of orders
Material handling number of production run
Setups number of production run (or setups)
Despatching number of despatches
Testing number of tests

Cost Pool is an activity that consumes resources and for which overhead costs are identified and
allocated. For each cost pool there should be a cost driver.

Cost Driver is any basis which causes a change in the activity and hence its cost.

5 The steps involved in ABC are:

1. Identify an organisation’s activities.
2. Collect the cost of each activity into cost pool (equivalent to cost centre under traditional costing).
3. Identify the appropriate cost drivers (basis) for each activity.
4. Divide the cost of activity over cost diver to determine Recovery rate (absorption rate) for each
activity.
5. Multiply actual cost driver consumed by products with OH rate for each cost pool to absorb OH cost
to products.

Cost of Activity

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= Recovery rate x Actual cost $ Overheads charged

Cost driver Driver consumed to products.

6 Advantages and Disadvantages of ABC

Advantages:
 More realistic, accurate and fair product cost per unit.
 More realistic sale price.
 Better information on product profitability since product cost information is more accurate, managers
have more accurate information on the relative profitability of individual products. This can lead to
better decisions on product promotion and pricing.
 Improved cost control Activity-based costing can lead to more detailed product cost information
because a larger number of ABC cost drivers are likely to be identified in a given manufacturing
organization.

Disadvantages:
 ABC system is very expensive to implement and operate.
 Difficult to find cost driver (basis) for all activities so some overheads are apportioned using single
cost driver.
 Because of the above it can again result in an unfair allocation of overheads to products because one
single basis cannot determine the change in multiple activities.
 Some arbitrary apportionment between products is still required

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CHAPTER 3 Target Costing

2 Traditional Costing:

STEPS: mark-up
(2nd)
1. Calculate the cost per unit. selling
2. Add a desired profit markup price
3. Determine the sale price. Cost (3rd)
(1st)
PROBLEMS with Traditional approach:

- It has an internal focus.

- It does not consider the market and
customer.
- Costs are not challenged.

3 Target costing:

STEPS: (detailed on next page)

1. Determine the sale price. Profit

2. Subtract a desired profit margin (2nd)
3. Calculate the target cost selling
price
Key Features: target (1st)
cost
- It has an External focus.
(3rd)
- It considers the market and customer.
- Costs are challenged.
- Cost per unit is lower in a target costing
environment

Slide 3

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4 Target costing steps:

• Determine product specifications for which an adequate sales volume is estimated.

• Set a selling price at which the company will be able to achieve a desired market share.

• Estimate the required profit margin based on return on investment.

• Calculate the target cost = estimated selling price – target profit margin.

• Compile a current cost estimate for the product based on anticipated design specification and
current cost levels.

• Calculate the target cost gap = estimated cost – target cost.

• Make strategies and efforts to close the gap. This is more likely to be successful if efforts are made
to ‘design out’ costs prior to production rather than ‘control out’ during production.

• Negotiate with the customer before making the decision to go ahead with the project.

Illustration 1:

Brisk ltd is making a new smart phone for the high end user market. The market price for the similar
featured phones is $700. The company wishes to charge a profit margin of 35% per unit. The current
estimated production cost based on current cost structure is $500 per unit.

Required:
Calculator the Target cost and the target cost gap that the company has to cover?

Solution:
Sale price – Profit Margin = Target cost
$700 – $245 (700x0.35) = $455

Estimated
Current cost – Target cost = Target cost Gap
$500 – $455 = $45

5 Implications and Benefits:

• The organisation has external focus to its product development. (competition)
• Only those features which are of value to customers will be included in product design

• Cost control will begin much earlier in the process. Traditionally cost control takes place at the
‘incurring stage’ which is far to late to make a significant impact on a product that is too expensive to
make.
• Cost per unit is often lower in a target costing environment. Target costing has been shown to
reduce product cost by between 20% and 40% depending on product and market conditions.

• It is often argued that target costing reduces the time taken to get a product to market. Under
traditional methodologies there are often lengthy delays whilst a team goes ‘back to the drawing

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board’. Target costing, because it has an early external focus, tends to help get things right first time
and this reduces the time to market.

6 STRATEGIES to close a Target cost Gap:

 Remove features from the product that add to cost but do not significantly add value to the product
when viewed by the customer.

 Use of technology can reduce the unit cost.

 Training workers with more efficient methodologies. Specialization where possible.

 Cost reduction works best when a team approach is adopted.

 Each step in the supply chain should be reviewed, possibly with the aid of staff questionnaires, to
identify areas of likely cost savings.

 New suppliers could be sought or different materials could be used. Care would be needed not to
damage the perceived value of the product.

 Efficiency improvements should also be possible by reducing waste or idle time that might exist.

 Productivity gains may be possible by changing working practices or by de-skilling the process.

 Automation is increasingly common in assembly and manufacturing.

 Productivity increases would also help here by spreading fixed overheads over a greater number of
units.

7 Target Coasting and Service Industries:

Services has some charecterictics which makes costing for services difficult than prodcucts.

 Simlutinuity
 Hetrogenity
 Intangibility
 Perishibility

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CHAPTER 4 Lifecycle Costing

1 Introduction
- Life cycle costing aims to track and accumulate the costs a product, service, customer or project over
its entire lifecycle, from inception to abandonment, with the aim of maximizing the return over the total
life while minimizing costs. (Cradle to Grave)
- 90% of costs to be incurred throughout its life cycle will have been determined before a product
reaches the market. (incurs at the design stage)
- Traditionally the costs and revenues of a product are assessed on a financial year or period by period
basis.
- In lifecycle costing profitability of each product (individually) can be assessed right from design stage
through development to market launch, production and sales, and finally to its eventual withdrawal
from the market. (i-e and considering the whole lifecycle costs)

2 Lifecycle cost per unit

Most of the product cost incur at the development and design stage which are not included in product cost
in traditional system and charged in other costs.

But in lifecycle costing the cost per unit is calculated based on costs incurred in a products entire lifecycle.

Total costs over Lifecycle

Lifecycle cost per unit =
Total volume over Lifecycle

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3 Product Lifecycle:

Product Lifecycle
volumes
$

Maturity
Growth Decline

Introduce Sales
revenue
Develop Profit

time

4 Product Lifecycle Features:

Illustration:

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5 Maximizing the return over the product life cycle:

There are a number of ways that return can be increased over the life cycle.

a) Design costs out of products.

Approximately 70% – 90% of a product's lifecycle costs are determined by decisions made early in the
lifecycle at the design and development stage. Thus design and production teams must work together
to ensure costs are minimized.

b) Minimize the time to market.

This is the time from the conception of the product to its launch. If a company can get a product to the
market place very quickly, it will give the product as long a span as possible without competitors' rival
products in the market place. This should mean that market share is increased in the long run.

c) Minimise breakeven time.

d) Maximize the length of the life span.
e) Manage the product’s cash flows

6 Implications and benefits:

 The visibility of ALL costs is increased, rather than just costs relating to one period. This
facilitates better decision-making.

 Individual profitability for products is more accurate because of this. This facilitates
performance appraisal and decision-making, and means that prices can be determined with better
knowledge of the true costs.

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 More accurate feedback can take place when assessing whether new products are a success or a
failure, since the costs of researching, developing and designing those products are also taken into
account.

 Price will change according to demand.

 Assess profitability over product life not by period.
 True costs of product are identified.

CHAPTER 5 Throughput Accounting

Key Concept:

Throughput = Sales – Direct material cost.

Throughput accounting is a concept which aims to maximize profit (in the short run) by maximizing the
‘THROUGHPUT’ contribution (sales – Direct material cost), as all other costs are considered fixed in the
short run including labour and all overheads.

Another important aspect to this concept is that throughput is maximized by increasing cash generation
from sales. The manager should try to generate as much sales revenue which will increase the throughput
(as material costs only incurs proportionate to sales) and ultimately will increase profit (all costs are fixed) in
the short run.

Another key aspect look at throughput is to ‘turn materials into sales as quickly as possible’, thereby
maximising the net cash generated from sales.

Throughput accounting concept is developed by Goldratt and Cox.

Marginal Costing Throughput Accounting

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Sales X Sales X

Less: Vareiable costs

Direct material (X) Less: Direct Material cost (X)

Direct labour (X)
Direct expenses (X)
Variable POHs (X)

Contribution XX Throughput Contribution XX

Less: Fixed costs: Less: Other fixed costs:

Sales Factory conversion costs

Admin Including Labour + POHs (X)
Marketing
Distribution (X) Sales, admin, marketing (X)

PROFIT XXX PROFIT XXX

2 Throughput Accounting ‘3’ Basis:

1. ALL costs except direct material are fixed including labour and overheads (conversion costs).

2. In a JIT environment, all inventory is a 'bad thing' and the ideal inventory level is zero. Products
should not be made unless a customer has ordered them.

3. Profitability is determined by the rate at which 'money comes in at the door' (that is,
when sales are made) and, in a JIT environment, this depends on how quickly goods can be
produced to satisfy customer orders.

3 Theory of Constraints (TOC):

Theory of constraints (TOC) is an approach to production management which aims to maximise sales
Revenue less material cost. It focuses on removing bottlenecks because as the company increases
throughput (and sales generation) it faces bottlenecks.

Bottleneck

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4. STEPS to Throughput Accounting and bottlenecks:

Illustration 1

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Here the bottleneck resource is clearly the “Recalling of patients’” activity

5 Production Management under TOC:

 One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput – this is
known as the binding constraint in TOC terminology. Steps should be taken to remove this by buying
more equipment, improving production flow and so on. But ultimately there will always be a binding
constraint, unless capacity is far greater than sales demand or all processes are totally in balance,
which is unlikely.

 Operations prior to the binding constraint should operate at the same speed as the binding constraint,
otherwise work in progress (other than the buffer inventory) will be built up.

 Since there is one bottleneck resource, it follows that all the other resources in production and
elsewhere are not bottlenecks. It means there will be idle capacity in other resources.

 To avoid the build-up of work in progress, production must be limited to the capacity of the
bottleneck resource but this capacity must be fully utilised.

6 Optimum product Mix (Ranking) Decision:

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If we have more than one product and fewer resources, we often need to make a decision about which
products to make. The Decision criteria is:

 Throughput accounting Ratio

 Return per factory hour (or Throughput per limiting factor)
Note: if conversion costs for products are same

7 Ratios

a) Throughput per unit = (sale price – direct material cost per unit)
Total throughput contribution = (sales revenue – total material cost)

b) Total Factory costs = (Production Overheads PLUS Labour)

(Conversion costs)

c) (Return per factory hour) = Throughput per unit (or total throughput)
Or TP per Bottleneck hour Bottleneck hours per unit (total Bott. hours)

d) Conversion costs per hour = Total Factory costs

Total Bottleneck hours

e) Throughput accounting Ratio= Return per factory hour (TP per hour)
Conversion cost per bottleneck hour

NOTE: Products with high TP per resource is Ranked (made) first and so on.

Illustration 2
A company makes two products A and B and has identified that there is a bottleneck during
machining.
Product A Product B
Sales price per unit $63 $40
Cost of materials per unit $12 $7
Machining time per unit 50 mins 40 mins

Which product should have priority in production?

Solution:
Product A Product B
$ $
Sale price 63 40
Less: direct material cost pu (12) (7)
Throughput $51 $33
Machining time per unit 50 mins 40 mins

Throughput per minute 1.02 0.825

Ranking 1st 2nd

7 Throughput Accounting Ratio (TPAR):

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TPAR = Return per factory hour

‘Conversion costs’ per factory hour

8 How to Interpret TPAR

TPAR > 1 Product earns more throughput per hour than cost per hour to the factory.

TPAR < 1 Loss maker. As product earns less throughput contribution per hours than cost per
hour to the factory

Illustration 3:

Hansel and Gretel ltd make two products H and G. Cost data is as follows:

H G
$ $
Sales price per unit 50 40
Direct materials per unit 12 20
Direct labour per unit 4 4
Bottleneck hours per unit 2 2.5

Total Fixed production overheads for the factory are $190,000 per month. Sales and marketing fixed costs
are $40,000 per month. The normal production level is 10,000 units per month. Factory capacity is identified
as a bottleneck and its capacity is 18,000 hours per month. Product H and G are made in the same division.

In April, the company makes and sells exactly 10,000 units of both H and G. Neither Will nor Grace has any
opening or closing inventory of raw materials or components.

Required:
a) Throughput accounting ratio for H and G
b) Calculate profit for the company for the month, if the company sell 9000 unit of each of the products.

Solution:
a) Throughput Ratio
Will and Grace ltd make two products W and G. Cost data is as follows:

W G
$ $ Production OH $190000
Sales price per unit 50 40 Labour W= 10000 x 4 $40,000
Direct materials per unit (12) (20) Labour G= 10000 x 4 $40,000

Troughput per unit / 38 20 Factory or Conversion costs $270,000

Bottleneck hours per unit 2 2.5
total conversion costs $270,000
Return per Factory hour 19 8 total bottleneck hours 18000
Conversion costs per hour $15 $15 =$15 per hour

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=
Throughput accounting ratio $1.27 $0.53
b) Profit
$
Total sales revenue 810,000
(9000x50)+(9000x40)
less: Material cost
(9000x12)+(9000x20) (288,000)

Total throughput contribution 522,000

less: All Fixed costs

fixed Labour (80,000)
Fixed POH (190,000)

Fixed sales, marketing (40,000)

PROFIT 212000

How to Improve TPAR:

• Speed up the bottleneck process. By increasing the speed of the bottleneck process the rate of
throughput will also increase.

• Increase the selling prices. It can be difficult to increase selling prices in what we are told is a
competitive market.

• Reduce the material prices. Reducing material prices will increase the net throughput rate. (Supplier
negotiations for discounts).

CHAPTER 6 Environmental Management Accounting

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1 What is Environmental Management Accounting:

Introduction
The rapid development of businesses, growth in world population and mass scale production has increased
harm to the environment, which is firstly, consumption of global resources, and secondly, the amount of
wasteful and hazardous output.

It has become such an important issue that business and political leaders have come to talk of the greener
and safer environment. Many organisations worldwide like Greenpeace, Environmental Protection Agency,
Kyoto Protocol are seeking to reduce emissions of greenhouse gases which are believed to be causing
global warming.

In order to comply with different local and global requirements, businesses and governments spend huge
amounts of money protecting environment in the name of environmental costs, eg improving production
process to reduce or eliminate pollutants and cleaning up contaminations in soil and water resources.

2 Important definitions:
The International Federation of Accountants (IFAC) in 1998 originally defined environmental
management accounting as:

‘The management of environmental and economic performance through the development and
implementation of appropriate environment-related accounting systems and practices. While this may
include reporting and auditing in some companies, environmental management accounting typically
involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for
environmental management.’

In 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their belief
that environmental management accounting systems generate information for internal decision making
rather than external decision making.

The UNDSD make what became a widely accepted distinction between two types of information: physical
information and monetary information. Hence, they broadly defined EMA to be the identification, collection,
analysis and use of two types of information for internal decision making:

 physical information on the use, flows and destinies

of energy, water and materials (including wastes)
 Monetary information on environment-related cost, earnings and savings.

To summarise, EMA is internally not externally focused and the Paper F5 syllabus should, therefore,
focus on information for internal decision making only. It should not be concerned with how
environmental information is reported to stakeholders (Environmental reporting).

EMA is the development of business strategies to manage the business performance and achieve
business objectives while keeping harm to the environment to the minimum.

3 Why to manage Environmental Costs:

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There are three main reasons why the management of environmental costs is becoming increasingly
important:

First, society as a whole has become more environmentally aware, with people becoming increasingly
aware about the ‘carbon footprint’ and recycling taking place now in many countries. A ‘carbon footprint’ (as
defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and indirectly
by a person, organisation, event or product.

Second, environmental costs are becoming huge for some companies, particularly those operating in highly
industrialised sectors such as oil production. In some cases, these costs can amount to more than 20% of
operating costs. Such significant costs need to be managed.

Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing
accordingly. In the largest ever seizure related to an environmental conviction in the UK, a plant hire firm,
John Craxford Plant Hire Ltd, had to not only pay £85,000 in costs and fines but also got £1.2m of its assets
seized. This was because it had illegally buried waste and also breached its waste and pollution permits.

And it’s not just the companies that need to worry. Officers of the company and even junior employees
could find themselves facing criminal prosecution for knowingly breaching environmental regulations.But the
management of environmental costs can be a difficult process. This is because first, just as EMA is difficult
to define, so too are the actual costs involved. Second, having defined them, some of the costs are difficult
to separate out and identify. Third, the costs can need to be controlled but this can only be done if they
have been correctly identified in the first place. Each of these issues is dealt with in turn below.

4 What are Environmental Costs:

Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to
consider all of the great range of definitions adopted. A useful cost categorisation, however, is that provided
by the US Environmental Protection Agency in 1998. They stated that the definition of environmental costs
depended on how an organisation intended on using the information. They made a distinction between four
types of costs:
 conventional costs: raw material and energy costs having environmental relevance
 potentially hidden costs: costs captured by accounting systems but then losing their identity in
‘general overheads’
 contingent costs: costs to be incurred at a future date, eg clean up costs
 Image and relationship costs: costs that, by their nature, are intangible, for example, the costs of
preparing environmental reports.

The UNDSD, on the other hand, described environmental costs as comprising of:

 costs incurred to protect the environment, eg measures taken to prevent pollution and
 costs of wasted material, capital and labour, ie inefficiencies in the production process.

5 Accounting for environmental costs:

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In the context of Paper F5, when the syllabus requires you to describe the different methods of accounting
for environmental costs, it aims to cover two areas:
 Internal reporting of environmental costs, which has already been discussed in the introduction.
 Management accounting techniques for the identification and allocation of environmental costs: the
most appropriate ones for the Paper F5 syllabus are those identified by the UNDSD, namely
input/outflow analysis, flow cost accounting, activity-based costing and lifecycle costing.

Input/outflow analysis

This technique records material inflows and balances this with outflows on the basis that, what comes in,
must go out. So, if 100kg of materials have been bought and only 80kg of materials have been produced,
for example, then the 20kg difference must be accounted for in some way. It may be, for example, that 10%
of it has been sold as scrap and 90% of it is waste. By accounting for outputs in this way, both in terms of
physical quantities and, at the end of the process, in monetary terms too, businesses are forced to focus on
environmental costs.

Flow cost accounting

This technique uses not only material flows but also the organisational structure. It makes material flows
transparent by looking at the physical quantities involved, their costs and their value. It divides the material
flows into three categories: material, system and delivery and disposal. The values and costs of each of
these three flows are then calculated. The aim of flow cost accounting is to reduce the quantity of materials
which, as well as having a positive effect on the environment, should have a positive effect on a business’
total costs in the long run.

Activity-based costing

ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to
the costs. In an environmental accounting context, it distinguishes between environment-related costs,
which can be attributed to joint cost centres, and environment-driven costs, which tend to be hidden on
general overheads.

Lifecycle costing

Within the context of environmental accounting, lifecycle costing is a technique which requires the full
environmental consequences, and, therefore, costs, arising from production of a product to be taken
account across its whole lifecycle, literally ‘from cradle to grave’.

CHAPTER 7
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CVP (cost, volume, profit) Analysis

1 CVP Analysis (Breakeven Analysis):
CVP analysis helps us understand the relationship between costs, revenue and profit with the level of
activity (sales volume). CVP analysis uses cost behaviour to identify the level of activity at which we have
no profit or loss (break-even point).

It can also be used to predict the profits or losses to be earned at varying activity levels (using the assumed
linearity of costs and revenues). CVP analysis assumes that selling prices and variable costs are constant
per unit regardless of the level of activity and that fixed costs are just that – fixed.

2 Simple Breakeven, single product (Revision):

Unit contribution = Selling price per unit – All Variable cost per unit

Total contribution = Unit contribution x volume

Break-even point = Fixed costs *minimum sales volume in order to

(Units)* Unit contribution cover the fixed costs (and v costs)

Volume needed to = Fixed costs + Target profit

Achieve target profit Unit contribution

Break-even point = Fixed costs *Revenue needed to cover fixed costs

(in Revenue)* C/S ratio (and v.costs)

Revenue required to = Fixed costs + target profit

achieve target profit C/S ratio

C/S ratio = Unit Contribution OR Total contribution

Sale price per unit Total revenue

Margin of safety = Actual sales units (revenue) - BE sales units (revenue)

(Units or Revenue) OR (budgeted sales)

Margin of safety = Actual sales units (rev) – BE sales units (rev)

(As a %) Actual Sales X 100

3 Breakeven Charts
Breakeven Chart

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Breakeven Chart with Contribution PV (Profit volume) chart

$ $ $

Profit
Profit

BE BE Profit
V costs Fixed BE
Costs Vol
Loss Rev
Fixed
Fixed costs
Costs V costs
MOS
Volume Volume

Margin of safety MOS

Example 1:
CV ltd makes a product P. The sale price of product P is $25. The company budgets to produce and sell
50,000 units. Other cost data is as follows:

$/unit

Material cost 7
Labour cost 5
Direct Expense 2
Variable OHs 3

Fixed cost in total is $240,000

Required:
I- Calculate the Breakeven point in units
II- Calculate the contribution/sales ratio
III- Calculate the breakeven in sales revenue
IV- Calculate the margin of safety (units, %)
V- Prepare the breakeven, contribution and P/V chart
VI- How much units CV ltd needs to sell in order to make a profit of $200,000.

4 Multi-Product Breakeven analysis:

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* Formulas to Remember

To do this analysis, a constant product sales mix must be assumed.

Breakeven point:
Breakeven point = Fixed costs
(in Units) for multiple products Weighted Average contribution per unit

Weighted Average Total contribution of product mix

Contribution per unit = Total units in product mix

Breakeven point: = Fixed costs

(In sales revenue) W.Average C/S ratio

W.Ave C/S ratio = Total contribution of product mix

Total sales revenue of product mix x 100

Target Profits:

Sales units to achieve TP= Fixed costs +Target profit

(in Units) for multiple products Weighted Average contribution per unit

Sales Rev$ to achieve TP= Fixed costs + Target Profit

(In sales revenue) W.Average C/S ratio

Margin of safety
Margin of safety = Actual sales units (revenue) - BE sales units (revenue)
(Units or Revenue) OR (budgeted sales)

Margin of safety = Actual sales units (rev) – BE sales units (rev)

(As a %) Actual Sales X 100

5 STEPS: Breakeven point in Units

1) Calculate the contribution per unit for each product

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2) Calculate the contribution of the product mix

3) Calculate W.Aevrage contribution per unit
4) Calculate the breakeven point
5) Using product mix volume ratio calculate Breakeven units for each product

6 STEPS: Breakeven point in Revenue

1) Calculate the revenue for product mix
2) Calculate the contribution for product mix
3) Calculate the average C/S ratio
4) Calculate the total breakeven point using formula
5) Calculate the revenue ratio of mix to calculate breakeven sales revenue for individual products

Example 2:
PL produces and sells two products, M and N. Product M sells for $7 per unit and has a total variable cost
of $2.94 per unit, while Product N sells for $15 per unit and has a total variable cost of $4.40 per unit. The
marketing department has estimated that for every five units of M sold, one unit of N will be sold. The
organisation's fixed costs per period total $123,600.

Required:
i- Calculate the breakeven point in units, for PL as sales volume of each product
ii- Calculate the Weighted average C/S ratio
iii- Calculate the Breakeven point in sales revenue for PL and sale revenue of each product

Example 3:
TIM produces and sells two products, the MK and the KL. The organisation expects to sell 1 MK for every
2 KLs and have monthly sales revenue of $150,000. The MK has a C/S ratio of 20% whereas the KL has a
C/S ratio of 40%. Budgeted monthly fixed costs are $30,000.

Required:
What is the budgeted breakeven sales revenue?

Example 4:
Beauty Co makes two products, nail polish and lipsticks. Nail polish sales make up 30% of total sales and
their variable costs are 45% as a percentage of sales value.
Lipsticks sales are 70% of the total sales and their variable costs are 40% as a percentage of sales value.
Total fixed costs are $400,000 for the company.

Required:
What is break-even level of sales revenues for the company?

Example 5:

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CCo ltd has budgeted sales, 2,000 units of X, 4,000 units of Y and 3,000 units of Z. The sales mix is 'fixed'
in these proportions. Sale price for product $8 for product X, $6 for product Y and $6 for product Z. variable
cost per unit is $3, $4, and $5 for product X,Y and Z respectively.

Budgeted fixed costs are $10,000 per annum.

Required:
i) Calculate the Breakeven point in units
ii) Calculate the breakeven point in revenue using C/S ratio
iii) Calculate the margin of safety in units, revenue and percentage
iv) What is the sales volume needed (in constant Mix) if CCo wants to earn a profit of $15,000
v) Prepare a Multi product Breakeven chart
vi) A PV chart (using constant mix and individual products)

7 Limitations of cost-volume-profit analysis

 Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in
volume (in particular), costs and selling prices, have on profit. However, its use is limited because it is
based on the following assumptions: Either a single product is being sold or, if there are multiple
products, these are sold in a constant mix. We have considered this above in Figure 3 and seen that if
the constance mix assumption changes, so does the break-even point.

 All other variables, apart from volume, remain constant, ie volume is the only factor that causes
revenues and costs to change. In reality, this assumption may not hold true as, for example, economies
of scale may be achieved as volumes increase. Similarly, if there is a change in sales mix, revenues will
change. Furthermore, it is often found that if sales volumes are to increase, sales price must fall. These
are only a few reasons why the assumption may not hold true; there are many others.

 The total cost and total revenue functions are linear. This is only likely to hold a short-run, restricted
level of activity.

 Costs can be divided into a component that is fixed and a component that is variable. In reality, some
costs may be semi-fixed, such as telephone charges, whereby there may be a fixed monthly rental
charge and a variable charge for calls made.

 Fixed costs remain constant over the 'relevant range' - levels in activity in which the business has
experience and can therefore perform a degree of accurate analysis. It will either have operated at
those activity levels before or studied them carefully so that it can, for example, make accurate
predictions of fixed costs in that range.

 Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that
production volumes are equal to sales volumes.

CH #7 CVP

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Answers to Examples

Answer example 1
Unit contribution = Selling price per unit – All Variable cost per unit
= $25 – 7 -5 -2 -3
= $8 per unit

i)
Break-even point = Fixed costs
(Units)* Unit contribution

= Fixed costs $240,000

Unit contribution $8
= 30,000 units

ii)
C/S ratio = Unit Contribution $8
Sale price per unit x100 $25 x100
= 32%

iii)
Break-even point = Fixed costs $240,000
(in Revenue)* C/S ratio 0.32
= $750,000

iv)

Margin of safety = Budgeted sales uits - Breakeven sales units

(Units) = 50,000 - 30,000
= 20,000 units

Margin of safety = Budgeted sales units – Breakeven sales units

(As a %) Budgeted Sales X 100

= 50,000 – 30,000
50,000 X100
= 40%

v)

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Breakeven chart

$000

1,250 Sales rev 1,250,000

Profit 160,000
Total costs 1,090,000

BE rev 750

$240

Fixed costs

30,000 50,000
BE units sales

Profit Volume (PV) chart

$000

profit 160k

BE

Volume
30,000 50,000
units

MOS

(240)
vi)
SalesVolume needed to= Fixed costs + Target profit

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Achieve target profit Unit contribution

= $240,000 + 200,000
$8
= 55,000units

Answer example 2
i) Breakeven in units
Calculate the contribution per unit and the weighted average contribution per unit.
M N
$ per unit $ per unit
Sales price 7.00 15.00
Variable cost 2.94 4.40
Contribution 4.06 10.60
$
Contribution from sale of 5 units of M (× $4.06) 20.30
Contribution from sale of 1 unit of N 10.60
Contribution from sale of 6 units in standard sales mix 30.90

Weighted average contribution per unit = $30.90/6 = $5.15 per unit.

BE point in units:

Fixed costs $123,600

Weighted average contribution per unit = $5.15 = 24,000 units.

Breakeven for products M and N.

These are in the ratio 5:1; therefore Volume for:
M (24,000 x 5/6) = 20,000 units
N (24,000 x 1/6) = 4,000 units

Note: you can also calculate the Breakeven sales revenue by multiplying the Breakeven volume with
sales prices:
M 20,000 units @ $7 = $140,000
N 4,000 units @ $15 = $60,000 total revenue = $200,000

ii)
Weighted average CS ratio

Total contribution = (5 x 4.06)+(1 x 10.60) = $30.90

Total sales Revenue x100 (5 x 7) + (1 x 15) x100 $50.00 x100 = 61.8%

iii)
Breakeven in revenue

Fixed costs $123,600

Weighted average CS ratio x100 0.618 x100 = $200,000

Calculate the sales revenue for each product

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M= ($200,000 x 35/50) = $140,000

N= ($200,000 x 15/50) = $60,000
It is important to note that the breakeven point is 24,000 units but not regardless of the sales mix. Rather, it
is when 20,000 units of M and 4,000 units of N are sold, assuming a sales mix of 5:1.

Answer example 3
Average C/S ratio = (20%×1)+(40%× 2)/3
= 331/3%

Breakeven point (rev) = Fixed costs $30,000/ C/S ratio 0.3333

= $90,000

Answer example 4
The formula needed for a multi product break-even point is:

Break-even point = Total fixed costs

Weighted average C/S ratio

Weighted average C/S:

Nail polish C/S ratio is 55% and proportion of its sales is 30%, therefore proportionate C/S ratio would be
55% x 30% = 16.5%

Lipstick C/S ratio is 60% and proportion of its sales is 70%, therefore proportionate C/S ratio would be 60%
x 70% = 42%
The combined weighted average C/S ratio, therefore will be: 16.5% + 42% = 58.5%

Break-even sales = $400,000

58.5%
= $683,761 (to the nearest dollar)

Answer example 5
Revenue
$
X (2,000 × $8) 16,000
Y (4,000 × $6) 24,000
Z (3,000 × $6) 18,000
Total Budgeted revenue 58,000

Variable costs of
X (2,000 × $3) 6,000
Y (4,000 × $4) 16,000
Z (3,000 × $5) 15,000
Total variable costs (37,000)

Contribution 21,000
Fixed costs (10,000)
Profit 11,000

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i)
Weighted Average Total contribution of product mix 21000
Contribution per unit = Total units in product mix 9,000

= $2.3333 per unit

BE point in units:
Fixed costs 10,000
Weighted average contribution per unit = $2.3333

= 4,286 units.
Volume for each product:

X (2000/9000 x 4286) = 952 units

Y (4000/9000 x 4286) = 1,905 units
Z (3000/9000 x 4286) = 1,429 units

ii)
Weighted average CS ratio=
Total contribution = 21,000 =
Total sales Revenue x100 58,000 x100

= 36.21%
Breakeven in revenue:
Fixed costs $10,000
Weighted average CS ratio x100 0.3621 x100

= $27,617
Calculate the sales revenue for each product
X= ($27,617 x 16,000/58,000) = $7,618
Y= ($27,617 x 24,000/58,000) = $11,428
Z= ($27,617 x 18,000/58,000) = $8,571
iii)
Margin of safety = Budgeted sales uits - Breakeven sales units
(Units) = 9000 - 4,286
= 4,714 units

Margin of safety = Budgeted sales revenue - Breakeven sales revenue

(Revenue) = $58,000 - $27,617
= $30,383

Margin of safety = Budgeted sales units – Breakeven sales units

(As a %) Budgeted Sales X 100
= 9,000 – 4,286
9,000 X100
= 52.38%
iv)
Target Profits:
SalesVolume needed to = Fixed costs + Target profit
Achieve target profit W. Ave Unit contribution
= $10,000 + 15,000
$2.3333
= 10,714 units
v) Breakeven chart

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Margin of safety
vi)Profit Volume chart

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An addition to the chart would show further information about the contribution earned by each
product individually, so that their performance and profitability can be compared.

Contribution Sales C/S ratio

$ $ %
Product X 10,000 16,000 62.50
Product Y 8,000 24,000 33.33
Product Z 3,000 18,000 16.67

Total 21,000 58,000 36.21

By convention, the products are shown individually on a P/V chart from left to right, in order of the size
of their C/S ratio. In this example, product X will be plotted first, then product Y and finally product Z. A
dotted line is used to show the cumulative profit/loss and the cumulative sales as each product's sales
and contribution in turn are added to the sales mix.

Cumulative Cumulative
Product sales profit
$ $
X 16,000 ($10,000 contribution – $10,000 fixed costs) 0
X and Y 40,000 8,000
X, Y and Z 58,000 11,000

You will see on the graph which follows that these three pairs of data are used to plot the dotted line, to
indicate the contribution from each product. The solid line which joins the two ends of this dotted line
indicates the average profit which will be earned from sales of the three products in this mix.

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The diagram highlights the following points.

(a) Since X is the most profitable in terms of C/S ratio, it might be worth considering an increase in the
sales of X, even if there is a consequent fall in the sales of Z.
(b) Alternatively, the pricing structure of the products should be reviewed and a decision made as to
whether the price of product Z should be raised so as to increase its C/S ratio (although an increase is
likely to result in some fall in sales volume).

The multi-product P/V chart therefore helps to identify the following.

(a) The overall company breakeven point.

(b) Which products should be expanded in output and which, if any, should be discontinued.
(c) What effect changes in selling price and sales volume will have on the company's breakeven point and
profit.

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CHAPTER 8
Limiting factor Analysis
(Linear Programming)
1 Determine the limiting factor

1 Single Limiting Factor Decision: factor decision

A Limiting Factor is a scare resource (or a constraint) which restricts the business activity (production,
sales) at any time. It can be any of the following:

1. Scarce raw materials.

2. Shortage of skilled (or rarely unskilled) labour hours.
3. Limited machine hours.

Objective:
“Maximise the Profit” by maximizing the contribution per unit of limiting factor

Steps:
1. Contribution per unit of sale.
2. Contribution per unit of scarce resource.
3. Rank in order of 2 - highest first.
4. Use up the resources in order of the ranking and determine the optimal product mix or profit maximizing
production plan

Assumption:

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 Fixed cost is assumed to be the same whatever the production mix is selected, so that the only
relevant cost is the variable cost.
 The unit variable cost is constant at all levels of production and sales
 The estimates of sales demand for each product are known with certainty

Illustration 1:
Prime ltd produces 4 products L, E, W and S. The sales demand, sales prices and costs data is given
below:

L E W S
$ $ $ $

Direct Material ($10 per kg) 15 10 12.5 20

Direct Labour ($12 per hour) 12 12 18 18
Variable OHs ($6 per hour) 12 6 9 9
Fixed OHs(per unit) 4 8 6 10

Total cost 43 36 45.5 57

Maximum Demand 3,000 2,000 1,500 2,500

Sales prices for product L, E, W and S are $49, $43, $51.5 and $67 respectively. There are 15,000 of direct
material available and 10,250 direct labour hours available.

What is the optimal production plan (in units) which will maximize profits for Prime ltd.

L E W S

A 3,000 2,000 1,500 2,500

B 2,250 2,000 1,500 2,500
C 3,000 2,000 1,500 1,500
D 3,000 2,000 1,000 2,500

Solution:

Determine the liming factor

L E W S Total Available shortfall

Demand 3,000 2,000 1,500 2,500 Req

Material kgs p.u 1.5 1 1.25 2

Kgs needed 4,500 2,000 1,875 5,000 11,575 15,000 nil

Labour hours p.u 1 1 1.5 1.5

Hours needed 3,000 2,000 2,250 3,750 11,000 10,250 yes

Labour hours is the limiting factor

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L E W S
$ $ $ $
Sale price 49 43 51.5 67
Less:
Direct Material cost 15 10 12.5 20
Direct Labour cost 12 12 18 18
Variable OHs 12 6 9 9

Contribution per unit 10 15 12 20

÷ ÷ ÷ ÷ ÷
Labour hours per unit 1 1 1.5 1.5

Contribution per limiting

Factor (lab hour) 10 15 8 13.33
Ranking 3rd 1st 4rth 2nd

Product Mix (Production Plan)

a b c d (c x d)
Units hours p.u Total hours contribution Profit
Per hour

1st E 2,000 1 2,000 10 2,000

2nd S 2,500 1.5 3,750 15 56,250
3rd L 3,000 1 3,000 8 24,000
4rth W 1,000 1.5 (1500/1.5) 1,500 Remaining 13.33 20,000
hours
Hours available 10,250 Total Profit 102,250

2 LINEAR PROGRAMMING – multiple limiting factors:

Objective:
“Maximise the Profit” with multiple factors by constructing mathematical
model.

The aim of decision making is to maximise profit, assuming that the fixed cost does not change, this would
mean that we must maximise contribution. Alternatively the aim may be minimise cost to subsequently
maximise profit.

3 Steps of a linear programming model

3.1 Define the problem (variables)
3.2 Establish Objective function
3.3 Establish Constraints
3.4 Draw the Graph by plotting the constraints.
3.5 Find the optimal solution i-e optimal product mix and profit using:
i- Graph
ii- Simultaneous equations

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Illustration 2
A company makes two products (R and S), with three Machines X, Y and Z. Production times per unit,
contribution per unit and the hours available in each department are shown below:

Products R S Capacity (hours)

Contribution/unit $4 $8

Hours/unit Hours/unit
Machine X 8 10 11,000
Machine Y 4 10 9,000
Machine Z 12 6 12,000

Required:
What is the optimum production plan in order to maximise contribution?

Solution:

3.1 Define the problem

Let R on X axis = number of units of R produced
Let S on Y axis = number of units of S produced

3.2 Objective Function is to maximize the contribution

4R + 8S

3.3 Establish constraints (called Inequalities in linear programming)

(Machine X) 8R + 10S ≤ 11000
(Machine Y) 4R + 10S ≤ 9000
(Machine Z) 12R + 6S ≤ 12000
(non-negativity) R,S ≥ 0
3.4 Plotting the constraints on the graph

If we know the constraints we are able to plot the limitations on a graph identifying feasible and non-feasible
regions. The linearity of the problem means that we need only identify two points on each constraint
boundary or line. The easiest to identify will be the intersections with the x and y-axes.

For example:
Machine X hrs – equating the formula 8R + 10S = 11,000

If R = 0 then S = 1,100 Co-ordinates (0, 11,00)

If S = 0 then R = 1,375 (1,375, 0)

And hence:
Machine Y hrs – 4R + 10S = 9,000 (0, 900) (2,250, 0)
Machine Z hrs – 12R + 6S = 12,000 (0, 2,000) (1,000, 0)

By plotting the individual constraints we build up an area of what is possible within all the constraints ie the
FEASIBLE REGION.

For Example plotting resource X 8R + 10S < 11,000

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Similarly plot the other two resources each will have its own feasible area

We will have a combined graph of all resources with a combined Feasible area as below:

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3.5 Identifying the optimal solution

i- The Graphical Method

i. The Iso-contribution (IC line) line is plotted identifying points of equal contribution. The linear nature of the
problem means that this line will be astraight line identifying an inverse relationship between the two
products.

The IC line is of importance because the relationship of the contribution earned by each product is
constant (ie $4 for R against $8 for S). This means that the gradient of the line will remain constant as
the total contribution figure gets larger or smaller.

If we ‘push out’ the IC line to the point where it leaves the feasible region (the last point of the feasible
area touched by the iso contribution line), that point will be the point of maximum contribution.

Steps
(i) Choose an arbitrary contribution figure (preferably one that can be easily plotted on the graph just
drawn). Example contribution = $2,400

(ii) What are the objective function values?

4R + 8S = 2400

(iii) Translate those values into co-ordinates for plotting on the graph
Co-ordinates (0, 300) and (600, 0)

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ii. The optimal solution can now be found by interrogating the point at which the IC line leaves the feasible
region to identify the co-ordinates and hence the product mix and maximum contribution.

The intersection or VERTEX identified is where two constraints meet, those constraints can be solved
simultaneously to identify the product mix.

a 8R + 10S = 11,000
b 4R + 10S = 9,000

(a – b) 4R = 2,000

R = 500
S = 700

 Therefore the optimal product mix is

Units Contribution/unit Total Contribution
R= 500 $4 2,000
S= 700 $8 5,600

Total Contribution (Max) 7,600

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This can be checked by seeing how much of the constraints are used up:

Machine hours used hours available

X 500 x 8 + 700 x 10 = 11,000 hours 11,000 hours
Y 500 x 4 + 700 x 10 = 9,000 hours 9,000 hours
Z 500 x 12 + 700 x 6 = 10,200 hours 12,000 hours

ii- The Simultaneous equations Method

Determine the product mix (units) of R and S on all of the joint feasible area points, A, B, C, and D. Then
calculate the contribution on all the points. The optimal product mix is the point at which the contribution is
the maximum.

Point A:
Point A is already on Y axis and not a crossing of the constraints. So we know at point A

Units Contribution/unit Total Contribution

R= 0 $4 0
S= 900 $8 7200
Total 7,200
Point B:
At Point B constraints X and Y are crossing.
a 8R + 10S = 11,000
b 4R + 10S = 9,000
(a – b) 4R = 2,000
R = 500

Substitute R=500 in equation a or b and we get S = 700

Units Contribution/unit Total Contribution

R= 500 $4 2,000
S= 700 $8 5,600

Total Contribution 7,600

Point C:
At point C constraints X and Z are crossing
a 8R + 10S = 11,000
b 12R + 6S = 12,000

(Multiply equation a with 1.5)

a1 12R + 15S = 16,500
b 12R + 6S = 12,000
(a1 - b) 9S = 4,500
S = 500

Substitute S=500 in equation a or b and we get R=750

Units Contribution/unit Total Contribution

R= 750 $4 3,000
S= 500 $8 4,000

Total Contribution 7,000

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Point D:
Point D is on X axis and againis not a crossing of the constraints. So we know at point D

Units Contribution/unit Total Contribution

R= 1,000 $4 4,000
S= 0 $8 0
Total 4,000
Conclusion
Optimal points Contribution
$
A 7,200
B 7,600 (MAX)
C 7,000
D 4,000

 Contribution is maximum ($7,200) at point B, so the optimal product mix is to make

500 units of R and 700 units of S.
(which is the same as the graphical method)

4 Slack and surplus

Machine X and Y are fully utilised or what are termed binding constraints (ie they bind the decision or
output). Machine Z has 1,800 hours un-utilised and is not binding on the decision, it is called a slack
constraint.

5 Shadow Price:
The SHADOW PRICE or dual price is the amount by which the total optimal contribution would rise
(incremental contribution) if ONE additional unit of a scarce resource (material kg or labour hour) was made
available at the optimal point.

Its an investigation to identify how the optimum solution will change with changes to individual variables.

Important points
-It is the maximum “incremental amount” that can be paid to acquire a resource.
-Shadow price can be determined only for resources on the optimal point.

Resources which are already in slack (with line above the optimal point on the graph) will have a shadow
price of NIL, as they are already in excess and providing more quantity of that resource will not increase
the output and contribution.

5.1 calculation of shadow price of a resource:

$
*Contribution earned at the revised optimal point:
Less: Contribution of the existing optimal point:
Shadow price
*when one extra unit of that resource is provided output and contribution will increase, so it’s the difference
between the revised contribution at the new optimal point and the existing contribution on existing optimal
point.

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5.1 Machine X – shadow price of one hour

If one more hour was available (ie 11,001 hours now), the constraint of department A will relax outward
slightly which should improve the overall optimum solution.

At Point B constraints X and Y are crossing.

a 8R + 10S = 11,001
b 4R + 10S = 9,000
(a – b) 4R = 2,001

R = 500.25

Substitute R=500.25 in equation a or b and we get S = 699.9

Units Contribution/unit Total Contribution

R= 500.25 $4 2,001
S= 699.9 $8 5,599.2

Total Contribution 7,600.2

$
Contribution earned at the revised optimal point: 7600.2
Less: Contribution of the existing optimal point: 7600
Shadow price 0.20

The shadow price of machine x is $0.20, means if we provide one more hour of machine x

5.3 shadow price and decision making

Shadow price is also the maximum incremental amount that can be paid to acquire a resource.
Say for example if one machine hour will cost $5 to acquire.

 We can pay $0.20 extra to obtain the extra machine X hour

Or
 We can pay a total amount of $5.20 to obtain one additional machine hour
So if the extra machine hour cost was say $6 it would not be worth having.

Example 1:
Calculate the shadow price for machine Y shadow and machine Z for Illustration 2 above.

6 Assumptions and limitations of linear programming:

 Linear programming may be used when relationships are assumed to be linear and where an
optimum solution does in fact exist.
 Assumes contribution per unit for each product is constant irrespective of the total quantities
produced and sold
 Assumes utilisation of resource per unit for each product is constant irrespective of the total
quantities produced and sold.
 Assumes that units produced and resources allocated are infinitely divisible.
 When there are a number of variables, it becomes too complex to solve manually and a computer is
required.

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CH #8 Limiting Factors
Answers to Examples

Answer example 1
If one more hour was available (ie 9,001 hours now), the constraint of department B will relax outward
slightly which should improve the overall optimum solution.

Solve the new constraint equations:

Machine X 8R + 10S = 11,000

Machine Y 4R + 10S = 9,001
4R + 0 = 1,999

Revised solution R = 499.75, S = 700.2

Revised contribution 499.75 x 4 + 700.2 x 8 = $7600.6
Shadow price $7,600.6 - £7,600.0 = $0.6/hour of dept Y

Effects – As Y increases by 1:
1 R decreases by 0.25
2 S increases by 0.2
3 Contribution increases by $0.6
Machine Z slack actually increases by 1.8 hours.

Machine Z – shadow price of one hour

Machine Z already has spare capacity, extra hours would not increase the contribution generated by the
optimum solution (they would not change the solution). The shadow price for machine Z is NIL.

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CHAPTER 9 Pricing Decisions

2 Factors affecting pricing decisions

o Organizational goals
o Price and demand relationship
o Competitors
o Cost
o Product mix
o Quality
o Inflation
o Product life cycle
o Income level
o Ethics

2.2 Demand:
Demand is the number of units of a commodity consumer want to buy.

2.2 Variables which influence demand

 Price of other goods
 Income
 Taste or Fashion
 Expectations
 Obsolescence

2.3 Markets
Perfect competition: many buyers and many sellers all dealing in an identical product. Neither
producer nor user has any market power and both must accept the prevailing market price.

Monopoly: one seller who dominates many buyers. The monopolist can use his market power to set a
profit-maximising price.

Monopolistic competition: a large number of suppliers offer similar, but not identical, products.
The similarities ensure elastic demand whereas the slight differences give some monopolistic power to
the supplier.

Oligopoly: where relatively few competitive companies dominate the market. Whilst each large firm
has the ability to influence market prices, the unpredictable reaction from the other giants makes the final
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3 Price elasticity of demand ():

The price elasticity of demand (PED) is a measure of the extent of change in demand for a good in
response to a change in its price.

% change in QD
PED =
% change in Price

IF
PED > 1: The good is price elastic. Demand is responsive to a change in price. If for example
a 15% fall in price leads to a 30% increase in quantity demanded, the price
elasticity = 2.0.

PED < 1: The good is inelastic. Demand is not very responsive to changes in price. If for
example a 20% increase in price leads to a 5% fall in quantity demanded, the price
elasticity = 0.25.

PED = 1: The good has unit elasticity. The percentage change in quantity demanded is equal
to the percentage change in price. Demand changes proportionately to a price
change.

PED = 0: The good is perfectly inelastic. A change in price will have no influence on quantity
demanded. The demand curve for such a product will be vertical.

PED= infinity The good is perfectly elastic. Any change in price will see quantity demanded fall to
zero. This demand curve is associated with firms operating in perfectly competitive
markets.

Illustration 1:
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research indicates that
an increase in price of 10 cents per unit will result in a fall in annual demand of 75,000 units. What is the
price elasticity of demand between prices of $1.20 and $1.20 per unit?

Solution:
Annual demand at $1.20 per unit is 800,000 units.
Annual demand at $1.30 per unit is 725,000 units.
% change in demand = (75,000/800,000) x100% = 9.375%
% change in price = (0.10/1.20) x100% = 8.333%

Price elasticity of demand = (–9.375/8.333) = –1.125

Ignoring the minus sign, price elasticity is =1.125.

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4 Demand Equation:
a
When demand is linear
The equation for the demand curve is:
b (slope)
P = a – bQ
P = the price
Q = the quantity demanded

a = the price at which demand would be nil

change in price Q
b =
change in quantity

Illustration 2:
Deriving the demand equation
The current price of a product is $30 and its the producers sell 100 items a week at this price. One week the
price is dropped by $3 as a special offer and the producers sell 150 items. Find an expression for the
demand curve, assuming that this is a linear equation.
Solution:
b= 3/50 = = 0.06

Derive a
P = a – 0.06Q
$30 = a – 0.06(100)
a = 36

Check
27 = 36 0.06Q
0.06Q = 36 – 27
Q = 9/0.06
Q = 150

5 The Total cost function

When determining price and output levels we need to bear in mind the cost and revenue behaviours. These
can be expressed as equations and graphed (as you will have seen in your earlier studies on cost
behaviours).

Most simply the costs of producing an item are expressed as y = a + bx

y= total cost
a= fixed cost
b= variable cost / unit
x= output

- However this assumes fixed costs remain unchanged and variable costs per unit are constant.
However, this will not always be the case.
- In the short term we may be able to assume that fixed costs stay the same but variable costs could
change due to economies of scale or bulk buying.

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6 The profit-maximising (optimum) price/output level:

Main concept
Profit is maximised
When
The Difference between total revenue (TR) and Total cost (TC) is maximum.

And

Marginal cost (MC) = marginal revenue (MR).

In economics, profit maximisation is the process by which a firm determines the price and output level that
returns the greatest profit. There are two common approaches to this problem.

6.1 The Total revenue (TR) – Total cost (TC) method is based on the fact that profit
equals revenue minus cost.

6.2 The Marginal revenue (MR) = Marginal cost (MC) method is based on the fact that
total profit in a perfect market reaches its maximum point where marginal revenue
equals marginal cost.

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Demand curve is P = a - bQ

MR curve is MR = a – 2bQ

(The slope of the MR curve is twice of the slope of the demand curve. If the Demand curve slope is 2 MR
curve slope will be 4. It is visible from the graph)

Illustration 3:
a b c =(a x b) d e= (a x c) (c - e)
Quantity Price TR MC TC MR Profit
0 50 0 35 0 0 0
1 49 49 35 35 49 14 Here MR > MC
2 48 96 35 70 47 26 Means each additional unit is
3 47 141 35 105 45 36 giving more revenue than cost and
4 46 184 35 140 43 44 will increase profit so continue to
5 45 225 35 175 41 50 produce until MC = MR
6 44 264 35 210 39 54
7 43 301 35 245 37 56
Here MC = MR
8 42 336 35 280 35 56
Where profit is the maximum
9 41 369 35 315 33 54
10 40 400 35 350 31 50
11 39 429 35 385 29 44 Here MR < MC
12 38 456 35 420 27 36 Means each additional unit is
13 37 481 35 455 25 26 making a loss
14 36 504 35 490 23 14

Conclusion: the company should produce and sell 8 units at a price of $42 which will
maximize profit

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Illustration 4:
When a firm charges $30 for its product, it can sell 40,000 units. It has been established that when price is
changed by $1, sales changed by 4,000 units. Variable cost per unit at all levels of production is $12.50.
The demand function is P = a – bQ and marginal revenue is MR = a – 2bQ.
Required:
(a) What is the demand function for this product?
(b) Determine the profit-maximising output level.
(c) What price should be charged in order to maximise profit?
(d) At what price will total revenue be maximised?

Solution:
(a)
P = a – bQ
b = $1/4,000 = 0.00025
$30 = a – (0.00025 x 40,000)
a = 40
P = 40 – 0.00025Q

(b)
Profits are maximised when MR = MC
$12.50 = 40 – 0.0005Q
Q = 55,000 units

(c)
P = 40 – (0.00025 x 55,000) = $26.25

(d)
MR = 40 – 0.0005Q
MR = 0 at maximum revenue

40 – 0.0005Q =0

Q = 80,000 units
P = 40 – (0.00025 x 80,000) = $20

5 Price strategies:
5.1 Cost Plus Pricing
i- Full cost plus pricing (absorption , ABC)
ii- Marginal cost plus pricing

2. Marginal
Advantages of full cost-plus pricing strategy:
- Easy to use.
- Ensures that all costs are covered.
- Ensures that firm can generate profits and survive in the future.
- Avoids costs of collecting market information on demand and competitor activity.
- It is believed to establish stable prices.

Disadvantages of full cost-plus pricing strategy:

- It does not consider the demand pattern of the product.

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- The absorption of overheads is a guess work therefore the strategy will produce different selling
prices using different bases.
- Takes no account of market conditions since its focus is entirely internal.
- By using a fixed mark up it does not permit the company to respond to the pricing decisions of its
competitors.
- It is not appropriate for making special decisions involving use of spare capacity.

5.1.2 Marginal cost-plus pricing

Pricing strategy in which a profit margin is added to the budgeted marginal or variable cost of the product.

Advantages of Marginal cost plus pricing

- This strategy ensures that fixed costs are covered.
- The size of the mark up can be adjusted to reflect demand.
- Maximum capacity utilisation.
- Efficient and most economic use of scarce resources.

Disadvantages of Marginal cost plus pricing

- Ignore profit maximisation.
- Ignores fixed overheads. The price may not be high enough to ensure that a profit is made after
fixed overheads are covered.
- Lack of consideration of overall market and customers.

5.2 Market skimming Prices

The price is set at a high level to generate maximum return per unit in the early units. The aim is to sell to
only that small part of the market which is not price sensitive. For market skimming to be effective the
company must have a barrier to entry in the form of a patent, brand, technological innovation or other.

Limitations of market skimming strategy

- It is only effective when the firm is facing an inelastic demand curve (market is not price sensitive).
- Price changes by any one firm will be matched by other firms resulting in a rapid growth in industry
volume.
- Skimming encourages the entry of competitors.
- Skimming results in a slow rate of diffusion and adaptation. This results in a high level of untapped
demand. This gives competitors time to either imitate the product or leap frog it with a new
innovation.

5.3 Market penetration pricing

The price is set at a level which should generate demand from the whole market and by so doing
encourage an acceleration of the life cycle quickly into growth and maturity phases. Necessary if the market
skimming approach is not possible because of a lack of barriers to entry or high initial development costs.

Penetration pricing strategy is appropriate when:

- Product demand is highly price elastic so that demand responds to price
changes.
- Substantial economies of scale are available.
- The product is suitable for a mass market and there is sufficient demand.
- The product will face competition soon after introduction.

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5.4 Going rate pricing or average pricing

Where the product is a leading brand (in market share terms) and any change in price made that company
will lead to a change by other competitors. Competition will continue in other forms.

5.5 Premium pricing

The product is able to command a premium due to specific and identifiable features of the product. The
premium may be payable for a number of differing reasons such as Prestige, Reliability, Longevity,
Technology, Style.
5.6 Complementary product pricing
Complementary products are products that are goods that tend to be bought and used together. For
example: computers and software. If sales of one increase, demand for the other will also increase. It is
also referred to as joint demand.

A loss leader is when a company sets a very low price for one product intending to make consumers buy
other products in the range which carry higher profit margins. Another example is selling razors at very low
prices whilst selling the blades for them at a higher profit margin. People will buy many of the high profit
items but only one of the low profit items – yet they are 'locked in' to the former by the latter. This can also
be described as captive product pricing.

5.7 Captive product pricing

Where products have complements, companies will charge a premium price where the consumer is
captured (family of brands).

5.8 Product line pricing

A product line is a group of products that are related to each other. Product line pricing strategies include
setting prices that are proportional to full or marginal cost with the same profit margin for all products in the
product line. Alternatively, prices can be set to reflect demand relationships between products in the line so
that an overall return is achieved.

5.9 Volume discounting

A volume discount is a reduction in price given for purchases of large volume. The objective is to increase
sales from large customers. The discount differentiates between wholesale and retail customers. The
reduced cost of a large order will compensate for the loss of revenues from offering the discount.

5.10 Price discrimination

This is the practice of selling the same product at different prices to different customers. Examples: off peak
travel bargains; theatre tickets sold at different prices based on location so that customers pay different
prices for the same performance.

CHAPTER 10 Short term Decisions

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1 Decision making scenarios

 Accept or reject (special order/contract)
 Minimum price of an order/job/contract
 Further processing decisions
 Make or buy
 Shutdown
2 Relevant costs:

“Relevant costs are costs that are incurred directly as a result of a decision.”
Or “Cost specifically incurred for (or attributable to) a decision.”

Relevant Costs

Future cash Incremental Avoidable Opportunity

flows (Differential) costs costs
costs

Relevant costs Irrelevant costs

o Variable costs incurred o Sunk costs (costs incurred in the past)

- Material o General Fixed costs (not specific,
- Labour unavoidable)
- Variable OHs
o Absorbed Overheads (arbitrary)
o Specific Fixed costs o Depreciation, Amortization (non cash flow)
o Any Incremental (Differential) costs paid o Committed cost (unavoidable)
o Opportunity costs

3 Opportunity cost:
The “Opportunity cost” of a decision is the (highest) contribution lost in another area (decision or option)
by forgoing it as a result of taking the current decision.

Illustration 1 (Opportunity cost):

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Daizy ltd is a furniture manufacturer and is offered an order which will require additional factory space. The
project will earn a net profit of $15,000. The additional factory space of Daizy was vacant but could be
rented out for $20,000.
Required:
i- Calculate the opportunity cost of the factory space for the order
ii- Should the order be accepted or not.

Solution:
$
Profit from the project 15,000
Less: Rent income forgone (opportunity cost) (20,000)
Loss (5,000)

It’s not financially feasible to accept the order as the rent income is more than the profit from the order. (The
opportunity cost is higher, or what we lost is higher than what we are earning)

4 Relevant costs of material and labour

Relevant cost of Material

1 Is the Material
already in stock?

YES NO

2 Is the Material Relevant cost

Replacement cost (current purchase price)
in regular use?

NO YES

Does it has a Relevant cost

Replacement cost
scrap value

YES NO

Relevant cost Relevant cost

Scrap Value NIL
(higher of all)

Relevant cost of Labour

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Relevant cost

1- If labour is to be hired wages to be paid

2- If labour is already hired and paid (surplus) NIL
3- If labour is in short supply(cant be hired) wages to be paid + any contribution lost
and existing labour is fully employed

5 Special order/contract Accept or Reject Decision

In this decision we calculate the relevant costs of an order or contact and compare or subtract with the
revenue. If revenue is higher than total relevant costs we accept the project.

The decision:
$
Revenue from the order/contract x
Less: Total relevant costs (x)
Profit or (loss) on decision x/(x)

“If the Revenue from the project exceeds the total relevant costs” the contract is
ACCEPTED

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Illustration 2 (Material Relevant cost):

Solution:
(a) Material A is not owned and would have to be bought in full at the replacement cost of $6 per unit.

(b) Material B is used regularly by the company. There is existing inventory (600 units) but if these are
used on the contract under review a further 600 units would be bought to replace them. Relevant
costs are therefore 1,000 units at the replacement cost of $5 per unit.

(c) Material C: 1,000 units are needed and 700 are already in inventory. If used for the contract, a further
300 units must be bought at $4 each. The existing inventory of 700 will not be replaced. If they are
used for the contract, they could not be sold at $2.50 each. The realisable value of these 700 units is
an opportunity cost of sales revenue forgone.

(d) Material D: these are already in inventory and will not be replaced. There is an opportunity cost of
using D in the contract because there are alternative opportunities either to sell the existing inventory
for $6 per unit ($1,200 in total) or avoid other purchases (of material E), which would cost 300 $5 =
$1,500. Since substitution for E is more beneficial, $1,500 is the opportunity cost.

(e) Summary of relevant costs

$
Material A (1,000 $6) 6,000
Material B (1,000 $5) 5,000
Material C (300 $4) plus (700 $2.50) 2,950
Material D 1,500
Total 15,450

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Illustration 2:

A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the company.
Costs incurred to date in manufacturing the machine are $50,000 and progress payments of $15,000 had
been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for $34,000 once it has been
completed.

To complete the work, the following costs would be incurred.

(a) Materials: these have been bought at a cost of $6,000. They have no other use, and if the machine is
not finished, they would be sold for scrap for $2,000.
(b) Further labour costs would be $8,000. Labour is in short supply, and if the machine is not finished, the
work force would be switched to another job, which would earn $30,000 in revenue, and incur direct
costs of $12,000 and absorbed (fixed) overhead of $8,000.
(c) Consultancy fees $4,000. If the work is not completed, the consultant's contract would be cancelled at
a cost of $1,500.
(d) General overheads of $8,000 would be added to the cost of the additional work.

Required:
Assess whether the new customer's offer should be accepted.

Solution:
(a) Costs incurred in the past, or revenue received in the past are not relevant because they cannot affect a
decision about what is best for the future. Costs incurred to date of $50,000 and revenue received of
$15,000 are 'water under the bridge' and should be ignored.

(b) Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of materials
affecting the decision is the opportunity cost of the revenue from scrap which would be forgone – $2,000.

(c) Labour costs

$
Labour costs required to complete work 8,000
Opportunity costs: contribution forgone by losing other work $(30,000 – 12,000) 18,000
Relevant cost of labour 26,000
(d) The incremental cost of consultancy from completing the work is $2,500.
$
Cost of completing work 4,000
Cost of cancelling contract 1,500
Incremental cost of completing work 2,500

(e) Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead incurred is the
only overhead cost to consider. General overhead costs (and the absorbed overhead of the alternative work
for the labour force) should be ignored.
(f) Relevant costs may be summarised as follows.
$ $
Revenue from completing work 34,000
Less: Relevant costs

Materials: opportunity cost 2,000

Labour: basic pay 8,000
Opportunity cost of labour 18,000
Incremental cost of consultant 2,500
(30,500)
Extra profit to be earned by accepting the order 3,500

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6 Minimum Price:
“Minimum Price = Total relevant costs”
It’s the minimum Price that can be accepted for a contract, a breakeven price.
(it’s the same relevant cost calculation with no markup)

6 Further processing decision

A further processing decision may arise in a manufacturing company that produces an item in a process or
a sequence of processes. The output from a process might have a market value, and a selling price.
However, there might also be an opportunity to further process the output to produce a finished item with a
higher selling price.

The decision:

Incremental revenue x
(extra revenue obtained by further processing)

Less: Incremental costs (x)

(of further processing)

further process the item “if the Incremental

The financial decision should be to
revenue exceeds the incremental costs”.

Illustration 3:
FP Ltd manufactures two Perfumes, P1 and P2. The two Perfumes are manufactured in a joint process.
Every 8,000 litres of materials input to the joint process produces 4,000 litre of P1 and 3,200 of P2. The
costs of processing are as follows:
$
Direct material 1,600
Direct labour 200
Variable production overheads 300
Fixed production overheads 2,000
Product P1 sells for $1.10 per litre and product P2 for $0.75 per litre.

FP Ltd could put product P1 through another production process, where there is spare production capacity.
The further processing would produce another cleaning product, Zplus. Every one litre of input to the further
process will produce 0.90 litres of Zplus.

The costs of further processing would be:

Product P1: 4,000 litres
$
Additional materials 400
Direct labour 40
Variable overheads 80
Fixed production overheads 400
920
Zplus would sell for $1.40 per litre
Required:
Using financial reasons only to justify the decision, should the company sell product P1 or should it further
process the product to make Z plus? Assume for the purpose of the analysis that direct labour is a variable
cost.

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Solution:
The joint processing costs are irrelevant to the decision. They will be incurred whether product P1 is sold for
$1.10 per litre or is processed further to make Zplus.
The analysis of relevant cash flow is as follows:
Every 4,000 litres of product P1 can be further processed to make 3,600 litres of Zplus.
$ $
Revenue from sale of 3,600 litres of Zplus @ $1.4 5,040
Revenue from sale of 4,000 litres of P1 @ $1.1 4,400

Incremental revenue from further processing 640

Incremental cost of further processing

Added materials 400
Direct labour 40
Variable production overheads 80
Total Incremental costs of further processing (520)

Incremental gain from further processing 120

7 Make or Buy/ Outsourcing Decision:

The decision is to make a component or product ‘in-house’ or to buy from an outside supplier. The
underlying assumption of this decision is that all fixed costs of manufacture are general to the organisation
as a whole and hence only the marginal cost of making the component is relevant.

The decision:

Total purchase cost x

Total cost of making x
(variable costs + specific Fixed costs)

*General fixed costs are not accounted for as they are unavoidable and will be incurred in any case

“The company will buy or make, whichever is cheaper”

“Practice Robber co”

8 Shut Down/Closure Decision:

This is a decision whether to shut down a product or a part or segment of a business. The avoidable costs
include variable costs and specific fixed costs. Specific fixed costs are those costs specific to the part or
segment of the business to be shutdown. General fixed costs will not be relevant.

The simplest way to consider such a problem is to re-draft any information in the form of a marginal costing
profit statement.

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General Rule:
A product should not be closed in the short run if it is earning a positive
contribution (after covering its own specific fixed costs)
Any product that produces a positive contribution is worth undertaking as it will contribute to profit, unless

 The company can use the capacity used by this product to produce another new product with a
higher contribution than that of this first product.
 The capacity used by this product can be used to produce more of the other existing product with
higher contribution.

Illustration 5:
Mike litd operates three divisions within a larger company. The CEO has been shown the latest profit
statements and is concerned that division Z is losing money.
You are required to advise her whether or not to close down division Z.

Division X Y Z
(000s) (000s) (000s)
Sales 100 80 40
Variable costs 60 50 30
Fixed costs 20 20 20

Profit/(loss) 20 10 (10)

You are also informed that 40% of the fixed cost is product specific, the remainder being allocated arbitrarily
to the divisions from head office.

Required:
Should division Z be shut down?

Solution:
If Division Z is shut down as per the CEO’s concerns, the following would be the financial impact on the
company.
$
Loss of Sale from closure (40,000)
Savings in variable cost 30,000
Fall in contribution (10,000)
Saving in Division specific fixed cost 8,000
Fall in divisional / company profits (2,000)

Decision: Division Z should not be closed down.

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CHAPTER 11
Decision Making under
Risk and Uncertainty

1 Risk and Uncertainty

Decision making, particularly long-term decisions, has to be taken under the conditions of risk and
uncertainty.

1.1 Uncertainty
Uncertainty simply reflects that there is more than one possible outcome for a given event but there is little
previous statistical evidence to enable the possible outcomes to be predicted. And we cannot establish
probabilities for the outcomes

1.2 Risk
Risk is where that uncertainty can be quantified in some way. It is normal to quantify the risk in terms of a
probability distribution, generally derived from statistical data in the past, or a situation in which we can
establish probabilities for all the outcomes.

2 Risk attitudes

Risk
Attitudes

Risk Averse Risk Seeker Risk Neutral

- Considers Risk in decision - Considers Risk in decision - DO NOT Considers Risk

- Select the worst outcomes - Select the Best outcomes - Calculate the average of all
- Accept Extra Risk only if - Accept Extra Risk even if extra options and select the one with
sufficient return is paid for return is uncertain or the higher average result (even if
taking that extra risk probability of it is very low that is the most risky option)

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3 Pay-off table (or matrix)

The pay-off table or matrix is a tabular layout which list the profit from all the possible outcomes from all the
decision options based on the state of the world over which the decision maker has no control.

”Important points”
 For each decision or option there will be more than one outcome. (One outcome means that one profit
or outcome that is 100% certain to occur so there is no uncertainty.
 It can be two, three, four or even more outcomes. For example worst, most likely, and best or poor,
average and good outcomes and they will be based on certain demand, weather, economic or some
other world conditions.
 the calculate the profit under each outcome for every option to complete the payoff table

4 Decision Rules
Choosing between mutually exclusive courses of action on the basis of worst, most likely or best possible
outcome can be stated as decision rules. The choice may be based on a maximax, maximin, or a minimax
regret decision rule, and expected value.

Maximax
 The decision maker will select or list the highest possible payoffs in all outcomes.
 Then will select the highest profit of the already selected higher outcomes (best among the best)
 The maximax decision rule is the decision rule for the risk seeker.

Criticisms of maximax
 Ignores the probability of each outcome occurring
 Is overly optimistic

Maximin
 The decision maker will select or list the Lowest possible payoffs in all outcomes.
 Then will select the highest profit of the already selected Lower outcomes (best among the best)
 This decision rule might be associated with a risk averse decision maker.

Criticisms of maximin
 Ignores the probability of each outcome occurring
 Is conservative (doesn’t try to maximise profit)

Minimax regret
Regret is the opportunity cost (profit lost of the best option) by making the wrong decision by selecting
another outcome instead of the best one within one world condition or state.

 The decision maker will calculate the regrets (opportunity costs) for each condition, decision wise.
 Then will list the highest regrets for all the decision options.
 And then will select the option or decision with lowest regret (opportunity cost or loss)
 It aims at minimising the regret from making the wrong decision.

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Expected Value
“Expected value is the average result of a decision or an option based on probabilities.”
 It’s the weighted mean of a decision
 The expected value ignores the degree of risk and focuses solely on the average return of the event.
 Expected values are used to support a risk-neutral decision maker.
 It is a long-term weighted average of all of the possible outcomes that will occur in the long run if
events occur many times over.

FORMULA:
EV (Expected Value) =  p(x)
Where P is the probability of the outcome
X is the value of the outcome

“NOTE: the sum of all probabilities of the outcomes of an even is always 1”

Maximin, Maximax and Minimax rules do not consider probabilities, only expected
value rule uses probabilities

Illustration 1 (EV):
Ex Ltd expects the following sales in the month of January based on demand conditions:

Demand conditions Profit Probability

Poor $80,000 70%

Good $30,000 30%

Required:
Calculate the Expected value (average sales) of sales in January.

Solution:

Sales (x) Probability P(x)

$
Poor $80,000 0.7 56,000
Good $30,000 0.3 9,000
Expected value EV =  p(x) 65,000

5 Limitations of expected values

- The expected value of a decision may be a value that will never occur
- Because an EV is an average value, it ignores the extreme outcomes. (it ignores the risky outcomes)

Illustration 2 (All Decision Rules):

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A company is trying to decide which of the three mutually exclusive projects to undertake. The profits of the
projects are subject to weather conditions which can be Poor, Normal and Good. The probability of Poor
normal and good conditions are 0.20, 0.50 and 0.30 respectively. The company has constructed the
following payoff table or matrix of the profits from the projects.

Net profit if outcome turns out to be Poor Normal Good

$,000 $,000 $,000
Project A 50 85 130
Project B 70 75 140
Project C 90 100 110

Required:
State which project would be selected using each of the:
(a) Maximin;
(b) Maximax criteria; and
(c) Minimax regret rule.
(d) Expected value

Solution:
A B C
Outcomes: $,000 $,000 $,000

Poor 50 70 90
Normal 85 75 100
Good 130 140 110

(a) Minimax
1. List Minimum profits 50 70 90
2. Select the maximum Profit 90
Decide Project C
(Best out of worst ones)

(b) Maximax
1. List Maximummum profits 130 140 110
2. Select the maximum Profit 140
Decide Project B
(Best out of best ones)

(c) Minimax Regret

1. Calculate the Regrets (Opportunity costs)
Regret = value of outcome selected – value of the best outcome
Regrets are calculated for each condition, decision wise.

A B C
Poor (40)*** (20)** 0*
Normal (15) (25) 0
Good (10) 0 (30)

2. List the maximum losses (40) (25) (30)

Select the minimum loss (25)
Decide project B

* In poor condition the best option would be C and if C is decided. Then (90 is earned – best is 90) so
opportunity cost is 0

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** In poor condition the best option is C but if B is chosen, then (70 is earned – best is 90 and lost) so
opportunity cost is (20)
*** In poor condition the best option is C but if A is chosen, then (50 is earned – best is 90 and lost) so
opportunity cost is (40)
Normal and good conditions have similar calculation

(c) Expected Value

Probability A B C
Outcomes: $,000 p(x) $,000 p(x) $,000 p(x)

Poor 0.20 50 10 70 14 90 18
Normal 0.50 85 42.5 75 37.5 100 50
Good 0.30 130 39 140 42 110 33

Expected value EV= 91.5 93.5 101

Decide project C as it has a higher average profits.

Maximin explanation: This is the decision criterion that management should play safe and either
minimises their losses or costs, or else go for the decision which gives the highest minimum profits. If the
company selects:
Project A the worst result is a net profit of 50.
Project B 70
Project C 90.
The best worst outcome is 90 and project C would be selected.

Maximax explanation: This is the decision to select the best possible result, by maximising the
maximum result (profit). The best possible outcomes are as follows:
Project A = 130
Project B = 140
Project C = 110.
As 140 is the highest of these three figures, project B would be selected using the maximax
criterion.

Minimax regret explanation: The minimax regret decision rule aims to minimise the maximum
regret (opportunity cost) from making the wrong decision. A table of regrets can be compiled as above.
The maximum regret for each decision is 40, 25 and 30 for projects A,B and C respectively.
The lowest of the maximum regrets is 25 with project B, and so project B would be selected if minimax
regret rule is used.

6 Decision Trees:
Decision tree is a diagram, which illustrate the choices and possible outcomes of a decision. The possible
outcomes are usually given associated probabilities of occurrence.

Decision Tree uses the Expected value criterion for a decision

Rollback analysis evaluates the EV of each decision option. You have to work from right to left and
calculate EVs at each outcome point.

Decision is represented by a square. The square from which the decision starts is called Root
Node

Circle represents outcomes. Outcomes are multiple possibilities in a decision.

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Illustration 3:
D ltd plans to invest $100,000 in a product DT. They have three Cities as options where they can launch
their product. Whichever City they launch, the product will face either Poor or Good demand conditions with
probability of 0.40 and 0.60 respectively. DT has sale price of $30 and a variable cost of $10 per unit. Data
for sales demand is as follows:

Demand
Poor Good
(Units) (Units)
Market A 5,000 10,000
B 6,000 9,000
C 3000 12,000

Solution:
A

($100,000)
B

Poor 0.40

Good 0.60

Poor 0.40

($100,000)
B

Good 0.60

Poor 0.40

Good 0.60

Contribution calculation:
Units x Contribution/unit = Total contribution
$
Market A Poor 5000 x (30-10) = 20 = 100,000
Good 10,000 x 20 = 200,000

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Market B Poor 6,000 x 20 = 120,000

Good 9,000 x 20 = 180,000

Market C Poor 3,000 x 20 = 60,000

Good 12,000 x 20 = 240,000

$
Poor 0.40 100,000

Good 0.60 200,000

Poor 0.40 120,000

($100,000)
B

Good 0.60 180,000

Poor 0.40 60,000

Good 0.40 240,000

Rollback:
Work from RIGHT To LEFT and Calculate the Expected Value at each circle.
Contribution(x) x probability = p(x)
$ $
First circle (Top) Poor 100,000 x 0.40 = 40,000
Good 200,000 x 0.60 = 120,000
 p(x) 160,000

Second circle (Mid) Poor 120,000 x 0.40 = 48,000

Good 180,000 x 0.60 = 108,000
 p(x) 156,000

Third circle (Bottom) Poor 60,000 x 0.40 = 24,000

Good 240,000 x 0.60 = 144,000
 p(x) 168,000

Expected Contribution - Investment = Profit

$ $ = $
Option A 160,000 - 100,000 = 60,000
Option B 156,000 - 100,000 = 56,000
Option C 168,000 - 100,000 = 68,000

Decision is to launch in Market C

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Illustration 4:
Beethoven Co has a new wonder product, the vylin, of which it expects great things. At the moment the
company has two courses of action open to it, to test market the product or abandon it.

If the company test markets it, the cost will be $100,000 and the market response could be positive or
negative with probabilities of 0.60 and 0.40.
If the response is positive the company could either abandon the product or market it full scale.

If it markets the vylin full scale, the outcome might be low, medium or high demand, and the respective net
gains/(losses)in sales units would be (200), 200 or 1,000. The contribution per unit is $1,000. These
outcomes have probabilities of 0.20, 0.50 and 0.30 respectively.

If the result of the test marketing is negative and the company goes ahead and markets the product,
estimated losses would be $600,000.

If, at any point, the company abandons the product, there would be a net gain of $50,000 from the sale of
scrap. All the financial values have been discounted to the present.

Required:
(a) Draw a decision tree and fully label it (Include figures for cost, loss or profit on the appropriate branches
of the tree)
(b) Decide whether the company should test market the product or abandon it.

Solution:

We start on the right hand side of the tree and work back towards the left hand side and the current
decision under consideration. This is known as the 'rollback' technique or 'rollback analysis'.

Outcome point E
The right-hand-most outcome point is point E, and the EV is as follows.

Profit(p) Probability px
$'000 $'000

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High 1,000 0.3 300

Medium 200 0.5 100
Low (200) 0.2 (40)
EV 360
This is the EV of the decision to market the product if the test shows positive response. It may help you to
write the EV on the decision tree itself, at the appropriate outcome point (point E).

At decision point C
The choice is to select the option with the highest EV of profit (or lowest EV of cost). Here the EV of the two
decision options, ‘market’ or ‘abandon’ are as follows.

(i) Market, EV = + 360 (the EV at point E)

(ii) Abandon, value = + 50
The choice would be to market the product, and so the EV at decision point C is +360.

At decision point D
The choice is again to select the option with the highest EV of profit (or lowest EV of cost). The two
decision options and their associated EVs are as follows.
(i) Market, value = – 600
(ii) Abandon, value = +50
The choice would be to abandon, and so the EV at decision point D is +50.

The second stage decisions have therefore been made. If the original decision is to test market, the
company will market the product if the test shows positive customer response, and will abandon the product
if the test results are negative.

The evaluation of the decision tree is completed as follows.

Calculate the EV at outcome point B.
0.6 360 (EV at C)
+ 0.4 50 (EV at D)
= 216 + 20
= 236.

Compare the options at point A, which are as follows.

(i) Test: EV = EV at B minus test marketing cost = 236 – 100 = 136
(ii) Abandon: Value = 50

The choice would be to test market the product, because it has a higher EV of profit.

7 Value of Perfect Information:

Perfect information is information that predicts with 100% accuracy what the outcome situation will be for
example for certain conditions or state of demand or the economy.
Having perfect information removes all doubt and uncertainty from a decision, and enables managers to
make decisions with complete confidence that they have selected the best decision option.

7.1 The value Perfect of information is:

$
The EV of the decision if Perfect information is made available x
Less: the EV of a decision if NO perfect information is available (x)

The value of Perfect Information xx

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“Important Point”
The value of perfect information is the incremental benefit (additional profit) obtained by
having additional information about certain conditions or state and taking an informed
decision.
And it is also the maximum amount that can be PAID to obtain that additional information.

Illustration 4:
WL must decide at what level to market a new product, the urk. The urk can be sold nationally, within a
single sales region (where demand is likely to be relatively strong) or within a single area. The decision is
complicated by uncertainty about the general strength of consumer demand for the product, and the
following conditional profit table has been constructed.

Demand
Weak Moderate Strong
$ $ $
Market nationally (A) (4,000) 2,000 10,000
in one region (B) 0 3,500 4,000
in one area (C) 1,000 1,500 2,000

Probability 0.3 0.5 0.2

Required:
a) Calculate the value of perfect information about the state of demand
b) A consultancy firm has researched the demand conditions and have perfect Information about what
state of demand will be, poor, moderate or strong (means can say with 100% certainty which one
will occur) and is asking for a fee of $2,000. Should the Fee be paid to obtain information from the
firm.

Solution:

a)
Step 1: First calculate the EV of each option and make the decision based on EV

Without perfect information, the option with the highest EV of profit will be chosen.

Option A (National) Option B (Regional) Option C (Area)

Demand Probability Profit EV Profit EV Profit EV
$ $ $ $ $ $
Weak 0.3 (4,000) (1,200) 0 0 1,000 300
Moderate 0.5 2,000 1,000 3,500 1,750 1,500 750
Strong 0.2 10,000 2,000 4,000 800 2,000 400
Expected Values 1,800 2,550 1,450

Marketing regionally (option B) has the highest EV of profit, and would be selected. Profit will be
2,550

Step 2: Calculate EV based on Perfect Information and compare with the EV without Perfect information

If perfect information about the state of consumer demand is available, option A would be preferred if the
forecast demand is strong and option C would be preferred if the forecast demand is weak.

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Demand Probability Choice Profit EV of profit

$ $
Weak 0.3 C 1,000 300
Moderate 0.5 B 3,500 1,750
Strong 0.2 A 10,000 2,000
EV of profit with perfect information 4,050

$
The EV of the decision with Perfect information available: 4,500
Less: the EV of a decision if NO perfect information is available: 2,550

The value of Perfect Information 1,500

b)
Additional benefit we can gain from obtaining Perfect information 1,500
Cost of information (2,000)
As the cost of information is higher than the benefits we should not obtain it.

8 SENSITIVITY ANALYSIS:

8.1 Introduction:
Sensitivity analysis is a method of risk or uncertainty analysis in which the effect on the expected outcome
of the change in values of key variables or key factors is tested. For example, in budget planning, the effect
on budgeted profit might be tested for changes in the budgeted sales volume, or the budgeted sale price,
material and labour costs, and so on.

There are several ways of using sensitivity analysis including:

 To estimate by how much costs and revenues would need to differ from their estimated values
before the decision would change.
 To estimate whether a decision would change if estimated sales were A% lower than estimated, or
estimated costs were B% higher than estimated. This is called ‘what if’ analysis. For example: what
if the sales volume is 5% less than the expected volume?

Illustration 6:
S Ltd has estimated the following sales and profit for a product which it may launch onto the market.

$ $
Sales (2,000 units) 4,000

Variable costs:
Materials 2,000
Labour 1,000
(3,000)
Contribution 1,000

Incremental fixed costs (800)

Profit 200

Required:
Analyse the sensitivity of the product. and Determine which of the variables is the product most sensitive.

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Solution:
(IF % change in each variable for profit to be zero or breakeven)
IF:
Sales revenue (or price) fell by 200/4,000 x 100 = 5% profit will be zero.
Costs rise by 200/3,800 x 100 = 5.3%
Materials rise by 200/2,000 x 100 = 10%
Labour will rise by 200/1,000 x 100 = 20%
Fixed costs rise by 200/800 x 100 = 25%
Sales volume fell by 200/1000 x 100 = 20%
Sales need to fall by least % so is most sensitive.

9.3 Advantages
1. It is easy to understand
2. It forces managers to identify the underlying key and sensitive variables, indicate where additional
information would be most useful, and helps to expose confused and inappropriate forecasts
3. An indication is provided of those variables to which profitability or value is most sensitive. And the
extent to which those variables may change before the investment break-even.
4. It provides an indication of why a project might fail. Once these critical variables have been identified,
management should review them to assess whether or not there is a strong possibility of events
occurring which will lead to a negative result.
5. It serves as an aid in the preparation of contingency plans, should key parameters show unfavourable
variations ex-post.

9.4 Disadvantages
1. The method requires that changes in each key variable are isolated. And looks at the effect of changes
in variables on final outcome individually, But management is often more interested in the combination of
the effects of changes in two or more variables. Looking at factors in isolation is unrealistic since they
are often inter-dependent.
2. It does not examine the probability that any particular variation in cost or revenue might occur.
3. It is not in itself a decision rule. Management must weigh the information provided by the analysis in
deciding whether the investment is worthwhile.

9 Simulation Models
Simulation models can be used to deal with decisions where there are a number of uncertain variables.
Simulation models can be created using computers and random numbers. These numbers are linked to
probability distributions so that the number chosen occurs with the same probability that the real life event
would occur.
Simulation can be used for estimating queues in shops as this depends on two uncertainties; arrival of
customers at the shop and service time. Two sets of probabilities and random numbers will be required.
Illustration 7:
Numbers
Daily demand Probability assigned
Units
17 0.15 00-14
18 0.45 15-59
19 0.40 60-99
1.00
Random numbers for a simulation over three days are 761301.
Random
Day number Demand
1 76 19
2 13 17
3 01 17

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CHAPTER 12
Budgetary Planning and Control
And Budgetary systems
A budget is a financial and/or quantitative plan of operations for a
forthcoming period.

3 Objectives of Budgetary control:

Objectives Explanation

To compel planning Budgeting makes sure that managers plan for the future,
producing detailed plans in order to ensure the implementation
of the company’s long term plan.

To co-ordinate activities Budgeting is a method of bringing together the activities of all the
different departments into a common plan. If an advertising
campaign is due to take place in a company in three months’
time, for example, it is important that the production department
know about the expected increase in sales so that they can
scale up production accordingly. Each different department may
have its own ideas about what is good for the organisation.

To communicate activities Through the budget, top management communicates its

expectations to lower level management

To motivate managers to The budget provides a basis for assessing how well managers
and employees are performing. In this sense, it can be
perform well motivational. However, if the budget is imposed from the top,
with little or no participation from lower level management and
employees, it can have a seriously demotivational effect.

To establish a system of control Expenditure within any organisation needs to be controlled and
the budget facilitates this. Actual results are compared to
expected results, and the reasons for any significant,
unexpected differences are investigated.

To evaluate performance Often, managers and employees will be awarded bonuses

based on achieving budgeted results.

To delegate authority to budget A formal budget permits budget holders to make financial
decisions within the specified limits agreed.
holders
To ensure achievement of the Objectives are set not only for the organisation as a whole but
also for individual targets. The budget helps to work out how
management’s objectives these objectives can be achieved.).

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6 Budget preparation:

Long-term plan
The starting point, this will show what the budget has to achieve (the introduction of new production, the
required return, and so on). The long-term policy needs to be communicated to all managers responsible
for preparing budgets so that they are aware of the context within which they are budgeting and how their
area of responsibility is expected to contribute.

Limiting factor
This is the factor in the budget that limits the scale of operations. Thelimiting factor is often sales demand,
but it may be production capacity, whensales demand is high or when a key production resource is in
short supply.

Budget manual
A budget manual is a guide or instruction document to assist functional managers with preparing their
functional budgets. It shows how figures and forecasts for the budget should be calculated, and gives
other practical information. It is likely to include proformas showing how the information is to be presented

Production capacity
The level of sales anticipated is matched against opening inventory and desired closing inventory to
establish the level of production. From this can be calculated the need for materials (again allowing for
opening and closing inventory), labour and machine hours.

Functional budgets
Functional budgets are budgets for the different departments or functions within the organisation

Consolidation and coordination

This can begin once all parts of the organisation have submitted their individual budgets. It is most
unlikely that all of the budgets will be in line with each other at the first attempt. Areas of incompatibility
must be identified and the budgets modified in consultation with individual managers.

Cash budget
This can only be prepared at this stage because it needs to take account of all of the plans of the
organisation and translate them into expected cash flows

Master budget
The final stage, once all of the necessary modifications have been made, is to prepare a summary of all
of the budgets in the form of a master budget, which generally comprises a budgeted income statement,
a budgeted balance sheet and a budgeted cash flow statement.

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7 Budgetary Planning and Control Process:

7.1 Preparing and implementing the budget:

A budget is a short-term plan formulated in financial terms and will show in detail the short-term actions the
organisation will take in working towards its long-term objectives. Once the budget has been formulated,
finalised and agreed it can be implemented.

7.2 Monitoring actual results:

In order to achieve the long-term objectives that are reflected in the budget, the organisation must ensure
that actual performance is proceeding according to plan. It will therefore need to monitor actual
performance and results.

7.3 Responding to divergences from plan:

Divergences from planned activity, as measured by variances from budget, can lead to action if they are
deemed to be significant. This action may be corrective in nature, in order to bring actual activity back into
line with planned activity, or may entail revision of the budget if one of its underlying assumptions is seen as
being in error.

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8 Feedback and feed-forward control:

8.1 Controllable vs uncontrollable costs
A controllable cost is a cost which can be influenced by the budget holder.
There may well be costs which cannot be changed by the budget holder or by management within a given
time period. These are uncontrollable costs.

Responsibility accounting associates costs and revenues with the managers that can control them. It
therefore distinguishes between controllable and uncontrollable costs.

8.3 Feedback control

Feedback control is defined as the measurement of differences between planned outputs and actual
outputs achieved, and the modification of subsequent action and/or plans to achieve future required results.
(CIMA).

Control through feedback is where actual result (output) are compared with those which were planned for
the budget period. Likewise, the input (cost) are compared with the budget, taking account of the actual
level of outputs. This comparison of actual with plan takes place after the event. The intention is to learn for
the future so that future deviations of actuals and plans are avoided or minimised. Feedback is a reactive
process. Budgetary control systems are feedback control systems.

8.3 Feed-forward control:

Feed-forward control is an alternative approach to control using feedback. Feed-forward control is defined
as the forecasting of differences between the actual and planned outcomes and the implementation of
actions before the event, to prevent such differences. (CIMA).

Control through feed-forward is where prediction is made of what output and inputs are expected for some
budget period. If these predictions are different from what was planned, then control actions are taken
which attempts to minimise the differences. The aim is for control to occur before the deviation is reported
hence feed-forward control is more proactive. Budget generation is a form of fed-forward in that various
outcomes are considered before one is selected.

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9 Behavioural aspects of budgeting:

General considerations
 Management must consider the impact of their budgeting systems on human behaviour.
- Budget pressure unites employees against management
- Pressure may lead to negative results
- Workers form into protective groups
- Accounting personnel equate success with finding fault in workers
- Workers feel victimised – loss of confidence and motivation results
- Supervisors use budgets as an expression of their position of superiority

 A good system of control must influence employees in the direction of the company’s best interests.
Motivation and budget setting
 Best performance is usually achieved when a budget is perceived as challenging but achievable.
 Hofstede's analysis suggested targets should be set at 'almost achievable' levels for maximum
motivation and performance.
 It is vital that the goals of management are in line with the goals of the organisation as a whole.
This is known as goal congruence.
 Management accountants should therefore try to ensure that management and employees have
positive attitudes towards setting and implementing budgets, and feedback of results.

10 Participation in budgeting
10.1 Top-down budgeting:
In this approach to budgeting, top management prepare a budget with little or no input from operating
personnel which is then imposed upon the employees who have to work to the budgeted figures. It is also
called “imposed” budget, or non-participative.

Situations where Top down Budgets Effective:

In newly-formed organisations
In very small businesses
During periods of economic hardship
When operational managers lack budgeting skills
When the organisation's different units require precise coordination

Advantages Disadvantages
- Strategic plans are likely to be incorporated into - Dissatisfaction, defensiveness and low morale
planned activities amongst employees
- They enhance the coordination between the - The feeling of team spirit may disappear
plans and objectives of divisions - The acceptance of organisational goals and
- They use senior management's awareness of objectives could be limited
total resource availability - The feeling of the budget as a punitive device
- They decrease the input from inexperienced or could arise
uninformed lower-level employees - Unachievable budgets for overseas divisions
- They decrease the period of time taken to draw could result if consideration is not given to local
up the budgets operating and political environments
- Lower-level management initiative may be
stifled

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10.2 Bottom-up budgeting:

In this approach to budgeting, budgets are developed by lower-level managers who then submit the
budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is
achievable and the associated necessary resources.

Participative budgets may be effective in the following circumstances.

In well-established organisations
In very large businesses
During periods of economic affluence
 When operational managers have strong budgeting skills
When the organisation's different units act autonomously

Advantages Disadvantages
- They are based on information from employees - They consume more time
most familiar with the department - When individuals are involved in negotiating their
- Knowledge spread among several levels of budget targets, they may want to set targets that
management is pulled together are easily-attainable rather than targets that are
- Morale and motivation is improved: employees challenging. In other words, an ability to
feel more involved and that their opinions matter negotiate targets may tempt managers to
to senior management introduce budgetary slack into their targets.
- They increase operational managers' - Individuals may not properly understand the
commitment to organisational objectives strategic and budget objectives of the
- In general they are more realistic organisation, and they may argue for targets that
- Co-ordination between units is improved are not in the best interests of the organisation as
- Specific resource requirements are included a whole
- Senior managers' overview is mixed with - Changes implemented by senior management
operational level details may cause dissatisfaction if they seem to ignore
the opinions of employees who have been
involved in negotiating targets
- Budgets may be unachievable if managers' are
not sufficiently experienced or knowledgeable to
contribute usefully
- They can support 'empire building' by
subordinates
- An earlier start to the budgeting process will be
required, compared with top-down budgeting and
target-setting.

10 Budget bias or budget slack:

Budget holders who are involved in the process from which the budget standards are set are more likely to
accept them as legitimate. However, they may also be tempted to seize the opportunity to manipulate the
desired performance standard in the favour. That is, they may make the performance easier to achieve and
hence be able to satisfy personal goals rather than organisational goals. This is referred to as incorporating
a slack into the budget. In this case there may be a relationship between the degree of emphasis placed on
the budget and tendency of the budget users to bias the budget content or circumvent its control.

12 Budgetary Systems

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12.1 Incremental budgeting:

With the ‘traditional’ approach to budgeting, known as incremental budgeting, is a method of budgeting in
which next year’s budget is prepared by using the current’s year’s actual results as a starting point, and
making adjustments for expected inflation, sales growth or decline and other known changes.

The main advantage of incremental budgeting is that it is a relatively straightforward way of preparing a
budget.
However, it is an inefficient form of budgeting as it encourages slack and wasteful spending to creep into
budgets. Past inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.

12.2 Fixed and Flexible Budgets:

Fixed Budget
A budget prepared at a single (budgeted) level of activity.

The term fixed budget means the following

1. that, the budget is prepared on the basis of an estimated volume of production and sales, but no plans
are made for the event that actual volume of production and sales may differ from budgeted volume
2. when actual volume of production and sales during a control period are achieved, a fixed budget is not
adjusted to the new levels of activity.

Advantage:
A fixed budget is likely to be useful in circumstances where the organizational environment is relatively
stable and can be predicted with a reasonable degree of certainty.

The major purpose of a fixed budget is for planning. It is prepared at the planning stage, when it is used to
define the objectives and targets of the organisation for the budget period (financial year).

Flexible Budget and Flexed Budget

Flexible Budget Flexed Budget

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- Used at the planning stage - Prepared At the end of each month (control
- Prepared at the start of the period for different period) or year.
volume of output and sales changes around the - For control purpose, to be compared with the
fixed budget. actual results.
- It shows changes in costs, revenues and profits
at volumes other than the fixed budget.

Illustration 1:
Flower budgeted to sell 200 units and produced the following budget.
$ $
Sales 71,400
Variable costs
Labour 31,600
Material 12,600
(44,200)
Contribution 27,200
Fixed costs (18,900)
Profit 8,300

Actual sales turned out to be 230 units, which were sold for $69,000. Actual expenditure on labour was
$27,000 and on material $24,000. Fixed costs totalled $10,000.

Required:
Prepare a flexed budget that will be useful for management control purposes.

Solution:
Budget Budget Flexed budget Actual
200 units per unit 230 units 230 units Variance
$ $ $ $ $

Sales 71,400 357 82,110 69,000 13,110 (A)

Variable costs
Labour (31,600) (158) (36,340) (27,000) 9,340 (F)
Material (12,600) (63) (14,490) (24,000) 9,510 (A)

Contribution 27,200 136 31,280 18,000 13,280 (A)

Fixed costs (18,900) (18,900) (10,000) 8,900 (F)

Profit 8,300 12,380 8,000 4,380 (A)

12.3 Zero Based Budgets (ZBB):

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Zero-based budgeting refers to a budgeting process which starts from a base of zero, with no
reference being made to the prior period’s budget or performance. “Budgeting From Scratch”

 Every department function is reviewed comprehensively, with all expenditure requiring approval,
rather than just the incremental expenditure requiring approval.

 Every activity has to be justified in its entirety, in terms of:

- Do we really need this activity
- If yes, how much activity
- And how much resources and cost to allocate to it

3 STEPS in ZBB:
STEP 1: Activities are identified by managers. These activities are then described in what is called a
‘decision package’. This decision package is prepared at the base level, representing the
minimum level of service or support needed to achieve the organisation’s objectives. Further
incremental packages may then be prepared to reflect a higher level of service or support.

STEP 2: Management will then rank all the packages in the order of decreasing benefits to the
organisation. This will help management decide what to spend and where to spend it.

STEP 3: The resources are then allocated based on order of priority up to the spending level.

Advantages and Disadvantages of zero based budgeting:

Advantages Disadvantages

- It is possible to identify and remove inefficient or - Departmental managers will not have the skills
obsolete operations. necessary to construct decision packages. They
- It forces employees to avoid wasteful will need training for this and training takes time
expenditure. and money.
- It can increase motivation of staff by promoting a - In a large organisation, the number of activities
culture of efficiency. will be so large that the amount of paperwork
- It responds to changes in the business generated from ZBB will be unmanageable.
environment. - Ranking the packages can be difficult, since many
- ZBB documentation provides an in-depth activities cannot be compared on the basis of
appraisal of an organisation's operations. purely quantitative measures. Qualitative factors
- It challenges the status quo. need to be incorporated but this is difficult.
- In summary, ZBB should result in a more efficient - The process of identifying decision packages,
allocation of resources. determining their purpose, costs and benefits is
massively time consuming and therefore costly.
- Since decisions are made at budget time,
managers may feel unable to react to changes
that occur during the year. This could have a
detrimental effect on the business if it fails to
react to emerging opportunities and threats.

12.4 Rolling Budgets (or Continuous Budgets):

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In a periodic budgeting system the budget is normally prepared for one year, a totally separate budget will
then be prepared for the following year. In continuous budgeting the budget from one period is ‘rolled on’
from one year to the next.
Typically the budget is prepared for one year, only the first quarter in detail, the remainder in outline. After
the first quarter is revised for the following three quarters based on the actual results and a further quarter is
budgeted for. This means that the budget will again be prepared for 12 months in advance. This process is
repeated each quarter (or month or half year).

“This budget helps in situations where conditions are dynamic.”

Advantages and Disadvantages of Rolling or Continuous budget:

Advantages Disadvantages

- They reduce the element of uncertainty in - They involve more time, effort and money in
budgeting because they concentrate detailed budget preparation.
planning and control on the near-term future, - Frequent budgeting might have an off-putting
where the degree of uncertainty is much smaller. effect on managers who doubt the value of
- They force managers to reassess the budget preparing one budget after another at regular
regularly, and to produce budgets which are up to intervals.
date in the light of current events and - Revisions to the budget might involve revisions to
expectations. standard costs too, which in turn would involve
- Planning and control will be based on a recent revisions to stock valuations. This could replace a
plan which is likely to be far more realistic than a large administrative effort from the accounts
fixed annual budget made many months ago. department every time a rolling budget is
- Realistic budgets are likely to have a better prepared.
motivational influence on managers. - The benefits of rolling budgets are limited, and so
- There is always a budget which extends for not worth the extra cost, when the rate of change
several months ahead. For example, if rolling in the business environment is not rapid and
- Budgets are prepared quarterly there will always continual.
be a budget extending for the next 9 to 12 months.
This is not the case when fixed annual budgets
are used.

12.5 Activity Based Budgeting (ABB):

ABB Main Principles

(a) It is activities which drive costs and the aim is to plan and control the causes (drivers) of costs rather
than the costs themselves, with the result that in the long term, costs will be better managed and better
understood.
(b) Not all activities add value, so activities must be examined and split up according to their ability to add
value.
(c) Most departmental activities are driven by demands and decisions beyond the immediate control of the
manager responsible for the department's budget.
(d) Traditional financial measures of performance are unable to fulfil the objective of continuous
improvement. Additional measures which focus on drivers of costs, the quality of activities undertaken,
the responsiveness to change and so on are needed.

CHAPTER 13

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Quantitative Techniques in Budgeting

1 Learning curve theory:
Introduction
A statistical relationship establishes this fact that labour time per unit falls as a complex task is repeated. As
workers become more familiar with the production of a new product or task, average time (and average
cost) will decline and exhibit a statistical relationship.

Theory
The theory of learning curves will only hold if the following conditions apply:
 There is a significant manual element in the task being considered.
 The task must be repetitive.
 Production must be at an early stage so that there is room for improvement.
 There must be consistency in the workforce.
 There must not be extensive breaks in production, or workers will 'forget' the skill.
 Workforce is motivated.

RULE
“As cumulative production doubles from the first unit, the cumulative average time per unit falls by
a constant percentage”

The cumulative average time per unit is the time per unit (each) for all the output units.

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3 Two Approaches
There are two methods for calculating the labour hours based on learning
1. Table
2. Algebraic Approach (Formula)

Illustrarion 1 (through Table):

Learning co makes a product Z. If the first unit requires 100 hours and the learning rate is 80%. Labour is
paid at $12 per hour.
Calculate the following cumulative and incremental data.

Cumulative Average time Cumulative Incremental Incremental

Units Per unit Total time Total time Time per unit
(average)
1 100 100 100 100

2* 80** (x 2) 160 60*** 60

(100x0.80) (160 – 100) Time on 2nd unit

4 64 (x 4) 256 96 (96 /2) 48****

(80x.80) (256 – 160) (time each 3rd and 4rth)

8 51.2 (x 8) 409.6 153.6 38.4

(64x.80) (409.6 – 256)

16 40.96 (x 16) 655.36 245.76 30.72

(51.2x.80) ( 655.36– 409.6)

32 32.768 (x 32)1,048.576 393.216 24.576

(40.96x.80) (1,048.576 – 655.36)

Important Points
* As cumulative output doubles, the cumulative average time per unit falls to a fixed percentage of the
previous average time.
** Column 2 is average time per unit if 2 units (or 4, or 8 units) are made
*** Incremental time is cumulative time on 2 units minus cumulative time on 1 unit and so on.
**** Incremental per unit time is incremental total time divided by Incremental units (2 to 4 = 2 units) for
that that incremental time.

Limitation of the table:

 The table assumes constant time for units in a group. For example units 4 to 8, all units take
same time per unit, that is 24 hours each with no learning
 If we want to find the incremental time for 9th and 10th units the table is not helpful
 Formula overcome these limitations

Algebraic approach (Formula):

The geometric formula can be used to establish the average time (or average cost) per unit.

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y = axb
Where:
y = average time (or average cost) per unit (for X output)
a = time (or cost) for first unit
b = Log LR
Log 2 (r = rate of learning)
x = cumulative output

4 Calculating Incremental time for incremental output:

For example we want to calculate the incremental time for 20 units, from output of 80 units in previous
month to output of 100 units in next month.
First we need to work out incremental output which is 20 units in this case. Then using formula calculate the
cumulative times

Cumulative time for total output (e.g 100 units): xx hrs

Less: Cumulative time for total Previous output (80 units): (x)
Incremental time for (20) incremental output x

Illustration 2:
Continuing with Illustration 1:
Learning co makes a product Z. If the first unit requires 100 hours and the learning rate is 80%. Labour is
paid at $12 per hour.
Required:
a) Use the formula to calculate the incremental time and labour cost of the 4rth unit alone.
b) Assume it’s the end of May and till now 20 units are made. Now the company is planning to make 12
additional units in June. What will be the budget for labour hours and labour cost in June?

Solution:
(a)
b = log LR/ log 2
= log 0.80 / log 2
= -0.09691 / 0.3010
= -0.3219

Cumulative time for 4 units Cumulative time for 3 units

y = a xb y = a xb
= (100) (4)-0.3219 = (100) (3) -0.3219
Average time per unit = 64 hours Average time per unit = 70.2125 hours
x 4 units x 3 units
Cumulative time for 4 units 256 hours Cumulative time for 3 units 210.6375 hours

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Cumulative time for total 4 units : 256 hours

Less: Cumulative time for 3 units: 210.6375 hours
Incremental time for the 4rth unit 45.3625 hours

Labour rate x $12 per hour

Labour cost of 4rth unit $544.35

NOTE: The table gives the same time of 48 hours for each 3rd and 4rth unit, which is not very
accurate.

“Alternatively we can calculate the cost directly by the formula if hours are not needed”

Cumulative cost for 4 units Cumulative cost for 3 units

y = a xb y = a xb
= (100 x $12) (4)-0.3219 = (100 x $12) (3) -0.3219
Average cost per unit = $768 Average cost per unit = $842.550
x 4 units x 3 units
Cumulative cost for 4 units $3,072 Cumulative cost for 3 units $2,527.65

Total cost for total 4 units : $3,072

Less: total cost for 3 units: $ 2,527.65
Incremental cost for the 4rth unit $544.35

(b)
In May output is 20 units, and in June additional 12 units are planned. It means the total output in June will
be 32 units.

Cumulative time for 32 units Cumulative time for 20 units

y = a xb y = a xb
= (100) (32)-0.3219 = (100) (20) -0.3219
Average time per unit = 32.77 hours Average time per unit = 38.12 hours
x 32 units x 20 units
Cumulative time for 32 units 1,048.64 hours Cumulative time for 3 units 762.4 hours

Cumulative time for total 32 units : 1,048.64 hours

Less: Cumulative time for 20 units: 762.4 hours
Incremental time for 12 units in June 286.24 hours

Labour rate x $12 per hour

Labour cost for June $3,434.88

5 Cessation of learning effect:

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Eventually, the time per unit will reach a steady state where no further
improvement can be made.

Practical reasons for the learning effect to cease are:

(a) When machine efficiency restricts any further improvement.
(b) The workforce reaches their physical limits.
(c) There is a ‘go-slow’ agreement among the workforce.

Important Point
The time per unit on the unit at which the learning stops will be the time per unit for all the units
after that. (We can calculate that through the formula)

Illustration 3:
Flogel Ltd has just produced the first full batch of a new product taking 200 hours. Flogel has a learning
curve effect of 85%.

Required:
(a) How long will it take to produce the next 15 batches?
(b) Flogel expects that after the 30th batch has been produced, the learning effect will cease. From the
31st batch onwards, each batch will take the same time as the 30th batch. What time per batch should
be budgeted?

Solution:
b = log 0.85/log 2 = –0.2345

(a)

Cumulative time on 16 batches Time on ONE batch = 200 hours

y = a xb
= (200) (16)-0.2345
Average time per batch = 104.40 hours
x 16 batches
Cumulative time for 16 batches 1,670.40 hours

Total time on 16 batches: 1,670.40 hours

Less: Time on 1 batch made: (200) hours
Time on 15 batches 1,470.40 hours

(b)

Cumulative time on 30 batches Cumulative time on 29 batches

y = a xb y = a xb

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= (200) (30)-0.2345 = (200) (29) -0.2345

Average time per batch = 90.08 hours Average time per batch = 90.80 hours
x 30 batches x 29 batches
Cumulative time on 30 batches 2,702 hours Cumulative time on 29 batches 2,633 hours

Total time on 30 batches: 2,702 hours

Less: Total time on 29 batches: 2,633 hours
Time on the 30th batch alone 69 hours

So this should be the budgeted hours once the steady state has been achieved. And this will be the time
per batch for all the batches after batch 30.

Illustration 4:
Cares ltd makes carpets. Each carpet sells for $1,000 and is hand made by skilled craftsmen. The company
started in January 2010 (current year) and the first carpet took 110 hours. Labour is paid at the rate of $20
per hour.

Till 31 March last month the total production was 150.The company budgets to make additional 100 units in
the month of April. It is observed that labour is working with 90% learning curve.

Required:
(a) Calculate the total labour hours and cost for the month of April.
(b) Calculate the labour hours and cost for month of April if the learning stops at 200th unit.

Solution:
(a)
In March total output is 150. 100 units in April will make the total output 250 units.
b = log 0.90/log 2 = –0.1520

Cumulative time for 250 units Cumulative time for 150 units

y = a xb y = a xb
= (110) (250)-0.1520 = (110) (150) -0.1520
Average time per unit = 47.52 hours Average time per unit = 51.36 hours
x 250 units x 150 units
Cumulative time for 250 units 11,880 hours Cumulative time for 150 units 7,704 hours

Cumulative time for total 250 units : 11,880 hours

Less: Cumulative time for 150 units: 7,704 hours
Incremental time for 100 units in April 4,176 hours

Labour rate x $20 per hour

Labour cost for April $83,520

(b)
1. First we need to calculate the incremental time between 150 to 200 units (with learning)

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2. Then calculate time on 200th unit and use that to calculate time from 200 to 250 units (No learning)

Incremental time for 50 units from 150 to 200

Cumulative time for 200 units Cumulative time for 150 units

y = a xb y = a xb
= (110) (200)-0.1520 = (110) (150) -0.1520
Average time per unit = 49.1627 hours Average time per unit = 51.36 hours
x 200 units x 150 units
Cumulative time for 200 units 9,832.54 hours Cumulative time for 150 units 7,704 hours

Total time for 200 units: 9,832.54 hours

Less: Total time for 150 units: 7,704 hours
Incremental time for 50 units 2,128.54 hours

Incremental time for the 200th unit alone

Cumulative time for 200 units Cumulative time for 199 units

y = a xb y = a xb
= (110) (200)-0.1520 = (110) (199) -0.1520
Average time per unit = 49.1627 hours Average time per unit = 49.20 hours
x 200 units x 199 units
Cumulative time for 200 units 9,832.54 hours Cumulative time for 199 units 9,790.8 hours

Total time for 200 units: 9,832.54 hours

Less: Total time for 199 units: 9,790.80 hours
Incremental time for 50 units 41.74 hours

Labour hours:
(150 – 200 units): = 2,128.54 hours
Add: (200 – 250 units) 50 units x 41.74 = 2,087.00 hour

Total hours required in April = 4,215.54

Rate per hour @ $12 per hour

Labour cost in April: $84,310.80

6 Derivation of the learning rate:

In exams sometimes you may be required to derive the learning rate

Illustration 4:
BL is planning to manufacture a new product, product A. Development tests suggest that 60% of the
variable manufacturing cost of product A will be affected by a learning and experience curve.
This learning effect will apply to each unit produced and continue at a constant rate of learning until
cumulative production reaches 4,000 units, when learning will stop.

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The unit variable manufacturing cost of the first unit is estimated to be $1,200 (of which 60% will be subject
to the effect of learning), while the average unit variable manufacturing cost of four units will be $405.

Required:
Calculate the rate of learning that is expected to apply.

Solution:
Let the rate of learning be r.
Cumulative production Cumulative average cost
$
1 720 (= 60% × $1,200)
2 720 r
4 720 r2

$720 r2 = $405
r2 = $405/$720 = 0.5625
r = 0.75
The rate of learning is 75%

7 Where learning curve theory can be used

- To calculate the marginal (incremental) cost of making extra units of a product
- To quote selling prices for a contract, where prices are calculated at a cost plus a percentage mark-
up for profit
- To prepare realistic production budgets and more efficient production schedules
- To prepare realistic standard costs for cost control purposes

8 Which costs are affected by the learning curve:

- As the learning effect is a function of labour, it affect labour costs.
- It also affects variable production overheads as they are estimated on labour hours basis.
- It can affect fixed overheads absorbed, if absorbed on the basis of labour hours.
- Any other costs that will be estimated on labour hours basis

9 Limitations of learning curve theory:

- It is only applicable in labour intensive operations which are repetitive and reasonably skilled.
- It assumes that employees are motivated to learn
- It assumes that there is a stable labour mix with a negligible turnover
- Difficulty in determining the learning rate accurately.
- Is the rate really constant? It assumes a constant learning rate.
- Difficulty in determining the level of production where the curve will be flat and no further learning
takes place.
- Breaks between production runs must be short or learning will be forgotten.
- It assumes stable conditions which allow learning to take place

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CHAPTER 14 Standard costing

Basic and advanced variances

1 STANDARD COSTING:
1.1 Introduction
Standard costing involves the establishment of predetermined estimates of the costs of a product
(Material, Labour, VOH, FOH) or service

1.2 Uses of standard costing:

 Prediction of costs and times for decision making, eg for allocating resources.
 Standard costing is used in setting budgets – an accurate standard will increase the accuracy of
the budget.
 Variance analysis is a control technique which compares actual with standard costs and revenues.
 Performance evaluation systems make use of standards as motivators and also as a basis for
assessment.
 Inventory valuation – this is often less time consuming than alternative valuations methods such
as FIFO or weighted average.

Important Note:
Standard costing is most suited to mass production and repetitive assembly work, where large
quantities of a standard product are manufactured.

1.3 Standard cost card

A standard cost card is a cost per unit statement based on predetermined standards. It is made at the start
of the period.

STANDARD COST CARD – WIDGET

$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40

Standard Full cost 14.00

Standard profit 6.00

Standing selling price 20.00

1.3 Types of standards:

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Ideal standard This standard that assumes perfect working conditions and does not
make allowance for any losses, waste and machine breakdown times. The
variances can only be adverse and it may have an adverse motivational
impact.

Attainable standard It is based upon efficient (but not perfect) levels of operation but will
include allowances for normal material losses, realistic allowances for
fatigue, machine breakdowns, etc. Attainable standards must be based on
a tough but realistic performance level so that its achievement is
possible.

Current Standard A current standard is standard based on current working conditions

(current wastage, current inefficiencies). This Will not motivate
employees to do anything more than they are currently doing.

Basic standard These are long-term standards which remain unchanged over a period of
years. Their sole use is to show trends over time for such items as
material prices, labour rates and efficiency and the effect of changing
methods.

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2 Basic variances and Operating statements

(Revision):
Illustration 1:

A company manufactures one product, and the entire product is sold as soon as it is produced.
There is no opening or closing inventory. The company operates a standard costing system and
analysis of variances is made every month.
Budgeted output for January was 5,100 units.

The standard cost card for the product, a widget, is as follows.

STANDARD COST CARD – WIDGET

$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40

Standard Full cost 14.00

Standard profit 6.00

Standing selling price 20.00

Actual results
Production of 4,850 units was sold for $95,600
Materials consumed in production amounted to 2,300 kilos at a total cost of $9,800
Labour hours paid for amounted to 8,500 hours at a cost of $16,800
Actual operating hours amounted to 8,000 hours
Variable overheads amounted to $2,600
Fixed overheads amounted to $42,300

Required:
Calculate all variances and prepare an operating statement for January.

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Solution:

2.1 Material Variances:

Material Total Variance

$
Actual production (4,850 units) should cost (0.5kg x $4) $2/unit= 9,700
Actual cost = 9,800
Variance = $100 A

Material Price Variance Material Usage Variance

$
2,300 kgs should cost (x $4/kg) = 9,200 4,850 units should use (x 0.5kgs) = 2,425 kgs
Actual cost = 9,800 Actual use = 2,300 kgs
Variance = $600 A Kgs variance 125 F kgs
x standard rate $4 per kg

Variance $500 F

2.2 Labour Variances:

Labour Total Variance

$
Actual production (4,850 units) should cost (2 hrs x $2) $4/unit= 19,400
Actual cost = 16,800
Variance = $2,600 F

Labour Rate Variance Labour Effiiency Variance

$
8,500 hrs should cost (x $2/hr) = 17,000 4,850 units should taje (x 2 hrs) = 9,700 hrs
Actual cost = 16,800 Actual hrs (8,500 – 8,000) = 8,000 kgs
Variance = $200 F Hours variance 1700 F hrs
x standard rate $2 per hr

Variance $3,400 F

Labour Idle time Variance

Idle hours 500 x rate $2 =

Variance = $1,000 A

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2.3 Variable Overheads Variances:

VOH Total Variance

$
Actual production (4,850 units) should cost (2 hrs x $0.30) $0.60= 2,910
Actual cost = 2,600
Variance = $310 F

VOH Expenditure Variance VOH Efficiency Variance

$
8,000 hrs should cost (x $0.30/hr) = 2,400 4,850 units should take (x 2 hrs) = 9,700 kgs
Actual cost = 2,600 Actual hrs = 8,000 kgs
Variance = $200 A Hours variance 1,700 F hrs
x standard rate $0.30 per hr

Variance $510 F

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2.4 Fixed Overheads Variances (absorption):

FOH Total Variance

$
Actual production (4,850 units) should cost (2 hrs x $3.7) $7.4= 35,890
Actual cost = 42,300
Variance = $6,410 A (under/over absorbed OH)

FOH Expenditure Variance FOH Volume Variance

$
Budgeted Fixed OH (5,100x $7.4) = 37,740 Budgeted Production volume = 5,100 units
Actual cost = 42,300 Actual Production volume = 4,850 units
Variance = $4,560 A Units variance 250 A units
x standard rate $7.4 per unit

Variance $1,850 A

FOH Vol Capacity Variance FOH Vol Efficiency Variance

Budgeted hours(5,100 x 2) = 10,200 4,850 units should take (2)= 9,700 hrs
Actual cost = 8,000 Actual hrs = 8,000 hrs
Hrs variance = 2,200 A hrs Hrs variance 1,700 F hrs
x standard rate $3.7 per hr x standard rate $3.7 per hr

Variance $8,140 A Variance $6,290 F

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2.5 Sales variances:

*Absorption based standard costing

Sales Price Variance Sales Volume Profit Variance
$
4,850 units standard revenue (x $20) = 97,000 Budgeted sales volume = 5,100 units
Actual sales revenue = 95,600 Actual sales volume = 4,850 kgs
Variance = 1,400 A Units variance 250 A units
x standard profit (20 – 14) $6 per unit

Variance $1,500 A

*Marginal based standard costing

Sales volume Contribution variance

Budgeted sales volume = 5,100 units

Actual sales volume = 4,850 kgs
Units variance 250 A units
x standard contribution(20 – 6.6) $13.4 per unit

Variance $3,350 A

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3 Operating statements:
3.1 Absorption costing based operating statement

OPERATING STATEMENT FOR JANUARY

$ $
Budgeted profit 30,600
Sales variances: Price 1,400 (A)
Volume profit 1,500 (A)
2,900 (A)
Actual sales minus the standard cost of sales 27,700

Cost variances
(F) (A)
$ $
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
Fixed overhead expenditure 4,560
Fixed overhead volume 1,850

4,610 F 8,210 A 3,600 (A)

Actual profit for January 24,100

Check
$ $
Sales 95,600
Materials 9,800
Labour 16,800
Variable overhead 2,600
Fixed overhead 42,300
(71,500)
Actual profit 24,100

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3.1 Marginal costing based operating statement

OPERATING STATEMENT FOR JANUARY

$ $
Budgeted profit 30,600
Add: Budgeted fixed production costs 37,740
Budgeted contribution 68,340

Sales variances: Price 1,400 (A)

Volume contribution 3,350 (A)
4,750 (A)
Actual sales minus the standard v.cost of sales (4,850 x $6.60) 63,590

Variable cost variances

(F) (A)
$ $
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510

4,610 F 1,800 A 2,810 F

Actual Contribution 66,400

Budgeted fixed production overhead 37,740

Expenditure variance 4,560 (A)
Actual fixed production overhead (42,300)

Actual profit 24,100

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4 Reason for variances:

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5 Investigating variances:
Materiality:
Small variations between actual and standard are bound to occur and are unlikely to be significant.
Obtaining an ‘explanation’ of the reasons why they occurred is likely to be time consuming and irritating for
the manager concerned. For such variations further investigation is not worthwhile since such variances are
not controllable and may not be cost beneficial.

Controllability:
Only controllable variances which occur due to the business own operational failures should be
investigated. Uncontrollable variances, which arises due to external factors like increase in market prices
call for a change in plan and revision to the standard, not an investigation into the past.

The type of standard being used:

The efficiency variance reported in any control period, whether for materials or labour, will depend on the
efficiency level set. If, for example, an ideal standard is used, variances will always be adverse. Similarly, if
basic standards are used, variances are likely to be favourable.

Variance trend:
Although small variations in a single period are unlikely to be significant, small variations that occur
consistently may need more attention. The trend provides an indication of whether the variance is
fluctuating within acceptable control limits or becoming out of control.

Interdependence between variances:

One variance might be inter-related with another, and much of it might have occurred only because the
other variance occurred too. When two variances are interdependent (interrelated) one will usually be
adverse and the other favourable. For example, an adverse selling price variance might be counterbalanced
by a favourable sales volume variance.

Costs of investigation:
The costs of an investigation should be weighed against the benefits of correcting the cause of a variance.

5.1 Variance investigation models

The rule-of-thumb and statistical significance variance investigation models and/or statistical control
charts can be used to determine whether a variance should be investigated.

The rule of thumb model:

This involves deciding a limit and if the size of a variance is within the limit, it should be considered
immaterial. Only if it exceeds the limit is it considered materially significant, and worthy of investigation.

Statistical significance model:

Historical data is used to calculate both a standard as an expected average and the expected standard
deviation around this average when the process is under control. By assuming that variances that occur are
normally distributed around this average, a variance will be investigated if it is more than a distance from
the expected average that theestimated normal distribution suggests is likely if the process is in control.

Statistical control charts. By marking variances and control limits on a control chart, investigation is
signalled not only when a particular variance exceeds the control limit but also when the trend of variances
shows a progressively worsening movement in actual results (even though the variance in any single
control period has not yet overstepped the control limit).

6 The principle of controllability:

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The principle of controllability is that managers of responsibility centres should only be held accountable for
costs over which they have some influence.

Controllable costs are items of expenditure which can be directly influenced by a given manager within a
given time span.

 Responsibility accounting system should be in place to control costs.

 A cost which is not controllable by a junior manager might be controllable by a senior manager.
 A cost which is not controllable by a manager in one department may be controllable by a manager in
another department.
 Some costs are non-controllable, such as increases in expenditure items due to inflation.

6.1 Controllability and dual responsibility:

Often a particular cost might be the responsibility of two or more managers. For example, raw materials
costs might be the responsibility of the purchasing manager (prices) and the production manager (usage). A
reporting system must allocate responsibility appropriately. The purchasing manager must be responsible
for any increase in raw materials prices whereas the production manager should be responsible for any
increase in raw materials usage.

7 Materials mix and yield variances:

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The materials usage variance can be sub-divided into a materials mix variance and a materials yield
variance when more than one type of material is used in the product.
However, calculating a mix and yield variance is only meaningful when:
1. For control purposes when management is in a position to control the mix of materials used in
production.
2. Two or material inputs go into to making the product (a mix).

What it means
 The mix variance represents the financial impact of using a different proportion of raw Materials.
 The yield variance represents the financial impact of the input yielding a different level of output to
the standard.

Pro forma for Material Mix and Yield variance:

7.1 Material Mix Variance:

Actual use Actual use Variance x Rate Variance

“Standard Mix” “Actual Mix” (Kgs/hrs) $ $

A xxxx xxxx xx x xxxx

B xxxx xxxx xx x xxxx

xxxx xxxx Total variance xxxx

7.2 Material Yield Variance (for individual material):

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“Standard use” “Actual use” Variance x Rate Variance

Standard Mix Standard Mix (Kgs/hrs) $ $

A xxxx xxxx xx x xxxx

B xxxx xxxx xx x xxxx

xxxx xxxx Total variance xxxx

NOTE: Yield Variance can be calculated for material in total than individual (see illustration 2)

Illustration 2:
A company manufactures a Product, Dynamite, using two compounds Flash and Bang. The standard
materials usage and cost of one unit of Dynamite are as follows.
$
Flash 5 kg at $2 per kg 10
Bang 10 kg at $3 per kg 30
40

In a particular period, 80 units of Dynamite were produced from 600 kg of Flash and 750 kg of Bang.

Required:
Calculate the materials usage, mix and yield variances.

Solution:
Standard usage for material F and B
80 units of D should use x 5 kg/unit = 400 kgs of Flash
80 units of D should use x 10 kg/unit = 800 kgs of Bang

Material usage variance:

Standard use Actual use Variance Rate/kg Variance

kgs kgs kgs $ $

F [400 - 600] = 200 A x 2 = 400 A

B [800 - 750] = 50 F x 3 = 150 F

Total Variance 250 A

Material mix variance:

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Actual use Actual use Variance x Rate Variance

“Standard Mix” “Actual Mix” (Kgs/hrs) $ $

F 450 (w1) 600 150 A 2 300 A

B 950 750 150 F 3 450 F

1,350 1,350 Total variance $150 F

The mix variance is Favourable since the material B which is expensive than F is actually used in
less proportion compared to standard mix.

[W1]
*Standard mix for actual use
Actual material used = 1,350 kgs
For Flash 1,350 x (5/15) = 450 kgs
Bang 1,350 x (10/15) = 900 kgs

Material Yield variance:

“Standard use” “Actual use” Variance x Rate Variance

Standard Mix Standard Mix (Kgs/hrs) $ $

F 400 450 50 A 2 100 A

B 800 900 100 A 3 300 A

1,200 1,350 Total variance 400 A

The yield variance can be calculated in total:

Method 1
The weighted average cost per kilogram of materials = $40/15 kg = $2.67 per kg.
kg
80 units of product should use in total (15 kg) 1,200
They did use (600 + 750) 1,350
Yield variance in kg 150 (A)
Weighted average price per kg x $2.67
Yield variance in $ $400 (A)

Method 2
units
1,350 kg of material should produce (15) 90
They did produce 80
Yield variance in units of output 10 (A)
Standard material cost per unit x $40
Yield variance in $400 (A)
Illustration 3:
Mix and Yield (with Losses):

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Micra and Mira Co make product D50 in a process. Data for standard and actual quantities in a month were
as follows.

Standard Actual
Quantity Price/kg Value Quantity price/kg usage
kg $ $ kg $ $

Material P 40,000 2.50 100,000 34,000 2.50 85,000

Material Q 20,000 4.00 80,000 22,000 4.00 88,000
Total 60,000 180,000 56,000 173,000

Losses occur at an even rate during the processing operation and are expected to be 10% of materials
input. So budgeted output for the month was 54,000 kg of D50 (= 60,000 kg × 90%). Actual output during
the month was 51,300 kg of T42.

Required:
Calculate material usage, mix and yield variances.

Solution:

Usage variance:

Std usage for

actual output of Actual Standard
51,300 kg usage Variance cost per kg Variance
kg kg kg $ $

Material P 38,000* 34,000 4,000 (F) 2.50 10,000 (F)

Material Q 19,000** 22,000 3,000 (A) 4 12,000 (A)

57,000 56,000 Total Variance 2,000 (A)

* (51,300/54,000) × 40,000 = 38,000 kg

** (51,300/54,000) × 20,000 = 19,000 kg

Mix variance:

Actual use Actual use standard

Std mix (2:1) Actual mix variance price/kg variance
kg kg kg $ $

Material P 37,333.3 34,000 3,333.33 (F) 2.50 8,333 (F)

Material Q 18,666.7 22,000 3,333.33 (A) 4 13,333 (A)

56,000 56,000.00 0 5,000 (A)

Yield variance:

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Std use Actual use standard

Std mix (2:1) Std mix variance price/kg variance
kg kg kg $ $

Material P 38,000 37,333.3 666.7 (F) 2.50 1,667 (F)

Material Q 19,000 18,666.7 333.33 (F) 4 1,333 (F)

57,000 56,000.00 0 3,000 (F)

Yield variance in total

The weighted average cost per kg of input materials = $180,000/60,000 = $3
kgs
51,300 kg of T34 should use (x 100/90) 57,000
They did use in total 56,000
Yield variance in units of T34 1,000 (F)
Standard material cost per kg of input material x $3 per kg
Yield variance in $3,000 (F)

7.3 Inter-relationship between mix and yield variance

A favourable mix variance occurs when the actual mix of materials is cheaper than the standard mix.
As a consequence of using a cheaper mix of materials, it is possible that the output/yield will be less than
the standard output. In other words, a favourable mix variance may result in an adverse yield variance.

For similar reasons, when there is an adverse mix variance because the actual mix of materials is more
expensive than the standard mix, there may possibly be an inter-related favourable yield variance.

Important Point
It would be totally inappropriate to calculate a mix variance where the materials in the 'mix' are discrete
items. A chair, for example, might consist of wood, covering material, stuffing and glue. These materials are
separate components, and it would not be possible to think in terms of controlling the proportions of each
material in the final product.

8 Sales mix and sales quantity variances:

Just as the material usage variance is sub-divided into mix and yield, similarly the sales volume variance
can be analysed further into a sales mix variance and a sales quantity variance.

This may be Meaninglful for control purposes ONLY where management is in a position to control the
sales mix (similar point to controlling mix of material), for example through the allocation of spending on
advertising and sales.

Sales volume Profit/contribution variance

Sales Mix variance Sales quantity variance

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Pro forma for sales mix and quantity variances:

8.1 Sales Mix Variance:
Actual sales vol Actual sales vol Variance x Profit/unit or Variance
“Standard Mix” “Actual Mix” (units) contribution $

A xxxx xxxx xx x xxxx

B xxxx xxxx xx x xxxx

xxxx xxxx Total variance xxxx

8.2 Sales quantity (Yield) Variance (for individual products):

“Budgeted sales” “Actual sales vol” Variance x Profit/unit or Variance

Standard Mix Standard Mix (units) contribution $

A xxxx xxxx xx x xxxx

B xxxx xxxx xx x xxxx

xxxx xxxx Total variance xxxx

Sales quantity variance can be calculated in total (see illustration 4 below)

Illustration 4:
Sales mix and quantity variances

Desserts Limited makes and sells two products, Chocolate Crunch and Strawberry Sundae. The budgeted
sales and profit are as follows.

Sales Revenue Costs Profit Profit per unit

Units $ $ $ $

Chocolate Crunch (CC) 400 8,000 6,000 2,000 5

Strawberry Sundae (SS) 300 12,000 11,100 900 3
2,900

Actual sales were 280 units of Chocolate Crunch and 630 units of Strawberry Sundae. The company
management is able to control the relative sales of each product through the allocation of sales effort,
advertising and sales promotion expenses.

Required:
Calculate the sales volume variance, the sales mix variance and the sales quantity variance.

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Solution:

Sales volume profit variance:

Budgeted Actual variance Profit/unit Variance

Sales volume sales volume units $ $

CC 400 280 120 A 5 600 A

SS 300 630 330 F 3 990 F

Total Variance 390 F

Sales Mix Variance:

Actual sales vol Actual sales vol Variance x Profit/unit or Variance

“Standard Mix” “Actual Mix” (units) contribution $

CC 520 (w1) 280 240 A 5 1,200 A

SS 390 620 240 F 3 720 F

910 910 Total variance 480 F

W1 CC = 910 x (400/700) = 520

SS = 910 x (300/700) = 390

Sales mix variance is adverse as product CC which has a higher profit per unit is sold less in mix.

Sales Quantity Variance (for Individual products):

“Budgeted sales” “Actual sales vol” Variance x Profit/unit or Variance

Standard Mix Standard Mix (units) contribution $

CC 400 520 120 F 5 600 F

SS 300 390 90 F 3 270 F

700 910 Total variance 870

Sales quantity variance in total:

The standard weighted average profit per unit of sale, taken from the budget, is $2,900/700 = $29/7

Units
Budgeted sales in total 700
Actual sales in total 910
Sales quantity variance in units 210 (F)
Standard weighted average profit per unit $29/7

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Sales quantity variance in $870 (F)

Sales mix variance $480 (A) + Sales quantity variance $870 (F) = Sales volume variance $390 (F).

The overall favourable sales volume variance was achieved by selling products in a cheaper sales mix, but
achieving a higher total quantity of sales units than budgeted.

9 Planning and Operational Variances:

The standard is set as part of the budgeting process which occurs before the period to which it relates, this
means that the difference between standard and actual may arise solely due to an unrealistic budget and
not due to operational factors.

The traditional variances we have seen so far can be investigated further to look at the elements driven by a
wrong standard (Planning variances) and the elements that were within the manager’s control
(Operational variances).

Traditional Variance

Original Revised Actual

standard standard Results

Planning Operational
Variance Variance
Occur due to setting wrong standard Occur as a result of problems in the
and also occurs due to external factors business performance itself. Occur
which are outside the control of the because of factors within
business like inflation, economic
management’s control. Control
conditions. The only thing that can be
actions needs to be taken to correct
done is to revise the standard.
it

Important point:
 It is the OPERATIONAL VARIANCE which highlights performance problems.
 Every tradition variance needs to be broken into planning and operational variances to know how
much of the variance has occurred due to a wrong standard and how much is because of problems
or underperformance within the business itself. A variance may occur entirely because of an
unrealistic standard and not because of the business underperformance. If we don’t do this
planning and operational break up we will never know this and business will be taking control
actions in various areas where none is required.

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Illustration 5:
A company expects to use 4kg per unit at a standard price of $5/kg. During the period it used 4,000 kilos at
a total cost of $25,000. After closer consideration of the market for the raw material it has been found that
the general market price of the material has risen by 50% due to exchange rate movements.

Required:
(a) Based on normal variance analysis, has the purchasing manager done a good or bad job?
(b) Is your conclusion changed as a result of sub-analysing the variance into planning and operational
elements?

Solution:

(a) Material Total Price Variance

$
Should pay (4,000kg x 5) = 20,000
Actual cost 25,000
Variance $5,000 Adv

Purchasing manager has done not a good job as the actual cost is more.

(b)
i- Material Planning Price Variance
$
Original standard (4,000kg x 5) = 20,000
Revised standard 4,000 x ($5 +50%)= 30,000
Variance $10,000 Adv
Standards were incorrect.

ii- Operational Price Variance $

Revised standard 4,000 x (£5 +50%) = 30,000

Actual Cost = 25,000
Variance $5,000 Fav

Purchasing manager did a good job.

Illustration 6:
The Standard cost of a product:
3hours/unit for $5/Hour

Actual results:
Actual Output 12,500 units
38,000 hours worked
Wages Cost $195,500

In retrospect it was decided the standard for labour should have been 3.5 hours and rate should be $5.5 per
hour.

Required:
Calculate labour rate variance, planning rate variance and operational rate variance.

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Solution:
Labour rate variance

38,000 hours shoud cost x $5 = 190,000

Actual 195,000
Variance $5,000 Adv

Labour planning rate variance:

38,000 hours original standard cost x5 = 190,000

Revised standard cost 38,000x5.5 = 209,000
Variance 19,000 ADV (revised std higher for cost)

Labour operational rate variance:

38,000 hours(revised std cost) x 5.5 = 209,000

Actual wages cost = 195,000
Variance $14,000 FAV

9.1 market size and market share variance

Important point
Market size variance is the sales volume planning variance
And
Market share variance is the sales volume operational variance

Illustration 5:
Dimsek ltd budgeted to make and sell 100 units per week of its product, the Role. In the four-week period
no 8, budget is as follows.
$
Budgeted sales (400 units per week) 40,000
Variable costs (24,000)
Contribution 16,000
Fixed costs (10,000)
Profit 6,000

At the beginning of the second week, production came to a halt because inventories of raw materials ran
out, and a new supply was not received until the beginning of week 3. As a consequence, the company lost
one week's production and sales. Actual results in period 8 were as follows.
$
Sales (320 units) 3 2,000
Variable costs (320 units x $60) (19,200)
Contribution 12,800
Fixed costs (10,000)
Actual profit 2,800
In retrospect, it is decided that the optimum budget, given the loss of production facilities in the third week,
would have been to sell only 300 units in the period.

Required:
Calculate appropriate planning and operational variances for sales volume.

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Solution:
The sales volume planning variance (may also be called a market size variance.

Revised sales volume = 300 units

Original budgeted sales volume = 400 units
Sales volume planning variance in units 100 units (A)
Standard contribution per unit × $40
Sales volume planning variance $4,000 (A)

Sales volume operational variance (may also be called a market share variance).
Actual sales volume 320 units
Revised sales volume 300 units
Operational sales volume variance in units 20 units (F)
Standard contribution per unit × $40
Operational sales volume variance in $ $800 (F)

(We can also calculate the original sale volume variance $3,200 to check the above two variances)
$ $
Operating statement, period 8
Budgeted profit 6,000
Planning variance: sales volume 4,000 (A)
Operational variance: sales volume 800 (F)
3,200 (A)
Actual profit in period 8 2,800

Example 6:
PG budgeted sales for 20X8 were 5,000 units. The standard contribution is $9.60 per unit. A recession in
20X8 meant that the market for PG's products declined by 5%. PG's market share also fell by 3%. Actual
sales were 4,500 units.

Required: Calculate planning and operational variances for sales volume.

10 Detailed breakup of planning and operational

variance (for Material and Labour)
Important point 1
For example a conventional total material is divided into price and usage variances.
Price variance can be further divided into planning price and operational price and usage variance
can be sub divided into planning usage and operational usage variances. All four variances should
reconcile to the conventional total variance.

Important point 2
There are 2 methods of reconciling all the four variances to the conventional
total variance. The next illustration 7 will explain both methods.

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Illustration 7 (method 1):

Product X has a standard material cost in the budget of: 4 kg of Material M at $5 per kg = $20 per unit.

Due to disruption of supply of materials to the market, the average market price for Material M during the
period was $7 per kg, and it was decided to revise the material standard to 3.2 kgs per unit of X. During the
period, 6,000 units of Product X were manufactured. They required 22,600 kg of Material M, which cost
$138,500.

Required: Calculate:
(a) Material Total variance
(b) Material Price variance and Material usage variance (without planning and operational)
(c) Divide the material price variance into planning price and operational price and material usage
variance into planning usage and operational usage variances.

Solution:
Material Variances:

Material Total Variance

$
Actual production (6,000 units) should cost (4kg x $5) $20= 120,000
Actual cost = 138,500
Variance 18,500 A

Material Price Variance Material usage Variance

$ $
Actual usage 22,600 AP (6,000) Std use x 4kgs = 24,000 kgs
Standard cost ($5/kg) = 113,000 Actual use = 22,600 kgs
Actual cost = 138,500 Variance in kgs = 1,400 F kgs
Variance 25,500 A x standard rate per kg x $5
Variance 7,000 F

Mat. Planning Price v Mat Operational Price v Mat Planning usage v Mat Operational usage v
Variance
Actual use (kgs) x Actual use x rev std price [Actual production x [Actual production x rev use
(old std price- Rev std price) 22,600 kgs x $7= $158,200 (old use – revised use)] 6000 units x 3.2= 19200 kgs
Actual cost = $138500 x standard rate/kg Actual use = 22,600 kgs
22,600 x ($5 - $7) =
6,000 x (4 – 3.2) = 4,800 kgs Variance Kgs = 3,400 kgs A
Std rate (old) = x $5 x Old std rate/kg = $5/kg

Variance $45,200 A Variance $19,700 F Variance $24,000 F Variance $17,000 A

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* Material price v can be calculated on actual material used and operational usage variance can be
calculated on OLD standard price. They will reconcile to material price and usage and all four variances
will reconcile to the total variance as well as above.
$
Material Total variance Material planning price variance 45,200 A
$18,500 Adv Material operational price variance 19,700 F
Material planning usage variance 24,000 F
Material operational usage variance 17,000 A

Illustration 7 (method 2): All data is same as above

Required: Calculate:
(a) Material Total variance
(b) Material Total planning variance and total operational variance
(c) Sub divide the total planning variance into planning price and planning usage and total operational
variance into operational price and operational usage variances.

Material Total Variance

$
Actual production (6,000 units) should cost (4kg x $5) $20= 120,000
Actual cost = 138,500
Variance 18,500 A

Material Total Planning Variance Material Total Operational Variance

$ $
Actual production (6,000) Actual production (6,000)
Old Std cost (4kgs x $5) x20 = 120,000 Rev Std cost (3.5kgs x $7) x22.40 = 134,400
Rev Std cost (3.2kgs x $7) x22.40 = 134,400 Actual cost = 138,500
Variance 14,400 A Variance 4,100 A

Mat. Planning Price v Mat Planning usage v Mat Operational Price v Mat Operational usage v
Variance
Revised Standard use (kgs) x [Actual production x Actual use x rev std price [Actual production x rev use
(old std price- Rev std price) (old use – revised use)] 22,600 kgs x $7= $158,200 6000 units x 3.2= 19200 kgs
x standard rate/kg Actual cost = $138500 Actual use = 22,600 kgs
*19,200 kgs x ($5 - $7) =
6,000 x (4 – 3.2) = 4,800 kgs Variance Kgs = 3,400 kgs A
Std rate (old) = x $5 x Rev std rate/kg = $7/kg

Variance $38,400 A Variance $24,000 F Variance $19,700 F Variance $23,800 A

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* The Material planning price variance is calculated on the basis of “Revised standard use” which is
calculated as:
Revised Use = Actual production x revised standard usage per unit.
= 6,000 x 3.2
= 19,200 kgs
$
Material Total variance Material planning price variance 38,400 A
$18,500 Adv Material operational price variance 19,700 F
Material planning usage variance 24,000 F
Material operational usage variance 23,800 A

11 Advantages and disadvantages of Planning and

operational variances:
Advantages Disadvantages

- Variances are more relevant, especially in an - The establishment of the revised standard is very
unpredictable environment. difficult
- The operational variances give fair reflection of - There is a considerable amount of administrative
the actual results achieved in the actual work
conditions that existed. - It may become too easy to justify all variances as
- Managers are more likely to accept and be being due to bad planning, so no operational
motivated by the variances reported which variances will be highlighted.
provide a better measure of their performance. - It is difficult to decide in hindsight what the
- It emphasises the importance of planning and the realistic standard should have been.
relationship between planning and control and a - It may become too easy to justify all the variances
better guide for cost control. as being due to bad planning, so no operational
- The analysis highlights those variances which variances will be highlighted.
are controllable (operational variances) and - Establishing realistic revised standards and
those which are non-controllable (planning analysing the total variance into planning and
variances). operational variances can be a time consuming
- Managers' acceptance of the use of variances for task, even if a spreadsheet package is devised.
performance measurement, and their - Even though the intention is to provide more
motivation, is likely to increase if they know they meaningful information, managers may be
will not be held responsible for poor planning and resistant to the very idea of variances and refuse
faulty standard setting. to see the virtues of the approach. Careful
- The planning and standard-setting processes presentation and explanation will be required
should improve; standards should be more until managers are used to the concepts.
accurate, relevant and appropriate.
- Operational variances will provide a more
realistic and 'fair' reflection of actual
performance.

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12 Behavioural aspect of standard costing

The modern business environment and world class manufacturing

Traditional production methods have centred around high volume, low unit cost outputs. However, in recent
years many changes have taken place in the nature of the world economy, technology, market demand and
manufacturing practices.

Features of the environment that businesses now have to operate in?

• Globalisation (internationally dispersed businesses)
• Multinational companies
• Changing attitudes to employment
• More companies competing to sell same products and services
• More demanding customers
• Increased emphasis on quality and reliability of output
• Increased importance of customisation of products and services
• Introduction of new technologies
• Cost is not the only competitive weapon nowadays

12.1 Total quality management

TQM is a business philosophy aimed at improving quality.

Get it right, first time

The cost of preventing mistakes is less than the cost of correcting them if they occur.

Continuous improvement
Never be satisfied with current achievement. It is always possible to improve performance.

Goals of TQM
(a) To gain competitive advantage via continuously improved quality
(b) To continuously reduce the cost of providing enhanced quality
(c) Innovation
(d) Provide first class customer service
(e) To involve all employees

12.2 Can standard costing and TQM co-exist?

Arguably, there is little point in running both a Total Quality Management programme and a standard
costing system simultaneously.

(a) Predetermined standards are at odds with the philosophy of continual improvement inherent in a total
quality management programme.
(b) Continual improvements are likely to alter methods of working, prices, quantities of inputs and so on,
whereas standard costing is most appropriate in a stable, standardised and repetitive environment.
(c) Material standard costs often incorporate a planned level of scrap. This is at odds with the TQM aim of
zero defects and there is no motivation to 'get it right first time'.
(d) Attainable standards, which make some allowance for wastage and inefficiencies are commonly set.
The use of such standards conflicts with the elimination of waste which is such a vital ingredient of a
TQM programme.
(e) Standard costing control systems make individual managers responsible for the variances relating to
their part of the organisation's activities. A TQM programme, on the other hand, aims to make all
personnel aware of, and responsible for, the importance of supplying the customer with a quality
product.

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12.4 Criticisms of standard costing

(a) Standard costing works best in a stable environment; the modern business environment is very fast
changing
(b) Regular revisions to the standard are required. This process is expensive and time consuming
(c) Meeting the standard should not necessarily be accepted as satisfactory if further improvements
could be made
(d) Techniques associated with standard costing (such as variance analysis) are less useful in a modern
environment of customised products

12.7 Behavioural impacts of standard costing in the modern

environment
Standard costing is often perceived as being at odds with the modern business environment.

Despite the criticisms and impacts, many businesses still operate with standard costing as it does
aid planning and control. Other non-financial measures should be used alongside it such as on time
deliveries, customer satisfaction measures and so on.

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CHAPTER 15 Performance Measurement

1 Performance Measurement
Performance measurement aims to establish how well something or somebody is doing in relation to a
plan.

Performance measures may be divided into two types.

Financial performance indicators
Non-financial performance indicators

Financial performance indicators analyse return on capital, profitability, liquidity and financial risk, often in
relation to a plan or budget, or in relation to performance in preceding time periods.

2 Financial Performance measurement

Analysing operating (trading) performance and Profitability:

In private sector organisations, the most important financial performance indicators are measurements of
profit.

Illustration 1:
A company has the following summarised income statements for two consecutive years.
Year 1 Year 2
$ $
Turnover 70,000 100,000
Less cost of sales (42,000) (55,000)
Gross profit 28,000 45,000
Less expenses (21,000) (35,000)
Net profit 7,000 10,000

Required:
Although the net profit margin (net profit/sales) is the same for both years at 10%, the gross profit margin is
not. Is this good or bad for the business?

Solution:
An increased profit margin must be good because this indicates a wider gap between selling price and cost
of sales. Given that the net profit ratio has stayed the same in the second year, however, expenses must be
rising. In year 1 expenses were 30% of turnover, whereas in year 2 they were 35% of turnover. This
indicates that administration, selling and distribution expenses or interest costs require tight control.

Percentage analysis of profit between year 1 and year 2

Year 1 Year 2
% %
Cost of sales as a % of sales 60 55
Gross profit as a % of sales 40 45
100 100
Expenses as a % of sales 30 35
Net profit as a % of sales 10 10
Gross profit as a % of sales 40 45

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3 Financial Ratios
3.1 Profitability ratios:
PBIT
Return on Capital Employed = x100
Capital employed

PBIT
Profit margin = x100
Sales (Turnover)

Sales (Turnover)
Asset Turnover = = No of times
Capital employed

3.2 Gearing ratios:

Financial Risk is measured by Financial Gearing. Financial Risk refers to the Risk that arises due to the use
of excessive long term debts in the company’s capital structure. Heavy long term debts mean high Financial
Risk, which may have the following implications:

 When a company is heavily in debt, and seems to be getting even more heavily into debt, banks and
other would-be lenders are very soon likely to refuse further borrowing and the company might well find
itself in trouble.
 When a company is earning only a modest profit before interest and tax, and has a heavy debt burden,
there will be very little profit left over for shareholders after the interest charges have been paid. And so
if interest rates were to go up or the company were to borrow even more, it might soon be incurring
interest charges in excess of PBIT. This might eventually lead to the liquidation of the company.
 If a company builds up debts that it cannot pay when they fall due, it will be forced into liquidation.

Financial Gearing:
(There are two ways to calculate financial gearing)

Long term Debt Debt

Financial Gearing = x100 OR *Financial Gearing = x100
Debt + equity Equity

*Also called Debt to Equity ratio

Operating gearing:
Financial risk, as we have seen above, can be measured by financial gearing. Business risk refers to the
risk of making only low profits, or even losses, due to the nature of the business that the company is
involved in.
Business risk is measured by a company's operating gearing or 'operational gearing'.

Contribution
Operating gearing =
Profit Before Interest and Tax (PBIT)
If contribution is high but PBIT is low, fixed costs will be high, and only just covered by contribution.

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Business risk, as measured by operating gearing, will be high. If contribution is not much bigger than PBIT,
fixed costs will be low, and fairly easily covered. Business risk, as measured by operating gearing, will be
low.

3.3 Liquidity ratios:

Current assets
Current ratio =
Current liabilities

Current assets inventory

Quick (acid test) ratio =
Current liabilities
Efficiency ratios

Days Ratios:

Inventory
Inventory days = x365
Cost of sales

Receivables
Receivable days = x 365
Credit sales (or Revenue)

Payables 365
Payable days = x365
Cost of sales

3.4 EPS (Earnings per share):

EPS is a measure that relates profitability to the shareholder. It is widely used as a measure of a company's
performance, especially in comparing results over a period of several years. A company must be able to
sustain its earnings in order to pay dividends and reinvest in the business so as to achieve future growth.
Investors also look for growth in the EPS from one year to the next.

Profit after Tax

EPS =
No of shares in issue

Illustration 2:

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Walter Wall Carpets made profits before tax in 20X8 of $9,320,000. Tax amounted to $2,800,000. The
company's share capital is as follows.
$
Ordinary share (10,000,000 shares of $1) 10,000,000
8% preference shares 2,000,000
12,000,000
Required:
Calculate the EPS for 20X8.
Answer
Solution:
Profits before tax 9,320,000
Less tax (2,800,000)
Profits after tax 6,520,000
Less preference dividend (8% of $2,000,000) (160,000)
Earnings 6,360,000

Number of ordinary shares 10,000,000

EPS 63.6c

Example 1:
ARH has the following results for the last two years of trading.
ARH
INCOME STATEMENT FOR THE YEAR ENDED
31.12.X4 31.12.X5
$'000 $'000
Sales 14,400 17,000
Less cost of sales 11,800 12,600
Gross profit 2,600 4,400

Less expenses 1,000 2,000

Less interest 200 –
Net profit for the year 1,400 2,400

Dividends paid 520 780

ARH
BALANCE SHEET
31 December 20X4 31 December 20X5
$'000 $'000 $'000 $'000
Non-current assets 2,500 4,000

Current assets
Inventories 1,300 2,000
Receivables 2,000 1,600
Bank balances 2,400 820
5,700 4,420

Total Assets 8,200 8,420

Financed by:

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2.4 million ordinary shares of

$1 each 2,400 2,400
Revaluation reserves 500 500
Retained profits 1,200 2,820
Equity 4,100 5,720

Long term liabilities

10% loan inventory 2,600 –

Current liabilities
Payables 1,500 2,700

Total Liabilities 8,200 8,420

Required:
Calculate for both years
(a) The gross profit margin
(b) The net profit margin
(c) The return on capital employed
(d) The acid test ratio
(e) The asset turnover
(f) The inventory turnover period in days
(g) The gearing ratio

5 Limitations and strengths of ratios

Limitations:
(a) Not useful on their own – need to be compared to yardstick.
(b) Must be carefully defined.
(c) Inflation needs to be adjusted for – often forgotten.
(d) Different basis of calculating between companies.
(e) Based on historical costs – accurate reflection of future?
Strengths:
(a) Easier to understand than absolute measures.
(b) Easier to look at changes over time.
(c) Puts performance into context.
(d) Can be used as targets.
(e) Summarise results.

Other problems with financial performance indicators

(a) Focus only on variables which can be expressed in monetary terms ignoring other important
variable which cannot be expressed in monetary terms
(b) Focus on past
(c) Do not convey the full picture of a company's performance in a modern business environment eg.
quality, customer satisfaction
(d) Focus on the short term

4 NON FINANCIAL performance Measurement:

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Changes in cost structures, the competitive environment and the manufacturing environment have led to an
increased use of non-financial performance indicators (NFPIs). Non-financial performance indicators can
also be a very useful guide to future financial performance.
There has been a growing emphasis on NFPIs for a number of reasons.
 Concentration on too few variables.
 Lack of information on quality.
 Changes in cost structures.
 Changes in competitive environment.
 Changes in manufacturing environment.
 NFPIs are a better indicator of future prospects.

4.1 Critical success factors (CSF) and KPIs:

Unlike financial performance measurement which has specific areas to measure like profitability, solvency
and liquidity, and which has standardized measures like ROCE, the Non financial measures has no specific
standardized areas and has no standardized ratios or indicators so any performance area can be measured
if it has any significance for the business with any ratio or measures the business develops for itself.
However there are some areas which in the modern world are important to almost every business and will
be measured by non financial measures. As a general guide, NFPIs may be measurements of the following
aspects of performance.

QUALITY OF SERVICE/PRODUCT - Number of customer complaints

- Rejections as a percentage of production or sales
- Number of account lost or gained

INNOVATION - Proportion of new products andservices to old ones

- New product or service sales level

CUSTOMER SATISFACTION - Speed of response to customer need

- Informal listening by calling a certain number of
customers each week
- Number of customer visit to the factory or workplace
- Number of managers visit to customers

COMPETITIVENESS - Sale growth by product or service

- Measures of customer base
- Relative market share and position

PRODUCTIVITY - Efficiency measurements of resources planned against

those consumed
- Production per person
- Production per hour
- Production per shift
Speed or efficiency - Output per hour; average time taken per unit of activity
Delivery - Average time between taking an order and delivery to
the customer
Reliability - Percentage of calls answered within a given target
time; number of equipment failures or amount of ‘down
time’

4.2 Value of NFPIs

Benefits

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(a) Information can be provided quickly for managers (eg. per shift, daily or hourly) unlike traditional
financial performance reports.
(b) Anything can be measured/compared if it is meaningful to do so.
(c) Easy to calculate and easier for non-financial managers to understand and use effectively.
(d) Less likely to be manipulated than traditional profit related measures (counteract short termism).
(e) Can be quantitative or qualitative.
(f) Provide better information about key areas such as quality, customer satisfaction, employees.
(g) Better indicator of future prospects than financial indicators which focus on the short term

Problems with NFPI's

(a) Too many measures can lead to information overload for managers, providing information which is
not truly useful.
(b) May lead managers to pursue detailed operational goals at the expense of overall corporate
strategy.
(c) Need to be developed and refined over time to ensure remain relevant.
(d) Need to be linked with financial measures.

5 The Balance Scorecard:

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The balanced scorecard approach to performance measurement focuses on four different perspectives of
performance, and uses both financial and non-financial indicators to set performance targets and monitor
performance.

The balanced scorecard forces managers to look at the business from four important perspectives.
It links performance measures by requiring firms to address four basic questions:
1. How do customers see us? – Customer perspective.
2. What must we excel at? – Internal perspective.
3. Can we continue to improve and create value? – Innovation & learning perspective.
4. How do we look to shareholders? – Financial perspective.

Financial perspective:
- This is concerned with the shareholders view of performance.
- Shareholders are concerned with many aspects of financial performance.
- Amongst the measures of success are:
- Market share.
- Profit ratio.
- Return on investment.
- Return on capital employed.
- Cash flow.
- Share price.

Customer perspective:
How do customers perceive the firm?
- This focuses on the analysis of different types of customers, their degree of satisfaction and the
processes used to deliver products and services to customers.
- Particular areas of focus would include:
- Customer service.
- New products.
- New markets.
- Customer retention.
- Customer satisfaction.

Internal business perspective:

How well the business is performing (internally)(Resource utilization)?
- Whether the products and services offered meet customer expectations.
- Activities in which the firm excels?
- And in what must it excel in the future?
- Quality performance.
- Quality.
- Motivated workforce.

Innovation and learning perspective:

Can we continue to improve and create value (New products and Processes)?
- In which areas must the organisation improve?
- Product diversification.
- % sales from new products.
- Amount of training.
- Number of employee suggestions.
- Extent of employee empowerment.
Illustration 3:

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6 Building Block model:

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Fitzgerald and Moon's building blocks for dimensions, standards and rewards attempt to overcome the
problems associated with performance measurement of service businesses. Performance measurement in
service businesses has sometimes been perceived as more difficult than in manufacturing businesses.
Fitzgerald and Moon (1996) suggested that a performance management system in a service organization
can be analysed as a combination of three building blocks:

 Dimensions of performance
 Standards
 Rewards.

1. Standards
This refers to the targets that are set within the organisation. These should be:
 High enough to motivate.
 Be owned by the employees (through participation in target-setting).
 Be seen to be equitable.

2. Rewards
This refers to what the organisation (and the employee) is trying to achieve.
 The organisation’s objectives should be clearly understood.
 Employees should be motivated to work towards these objectives.
 Employees should be able to control areas over which they will be held responsible.

3. Dimensions
This refers to how performance will be measured. The areas are:
 Financial
 Competitive performance
 Quality of service
 Flexibility. (the ability to deliver at the right time, response to customer requirements and changes in demand)
 Resource utilisation
 Innovation.

CH #15 Answers to Examples

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Answer example 1
(a) 20X4 20X5

The gross profit margin is

2,600/14,400 18.1%
4,400/17,000 25.9%

(b) The net profit margin is

1,400/14,400 9.7%
2,400/17,000 14.1%

(c) The return on capital employed is

(2,600 – 1,000)/6,700 23.9%
2,400/5,720 42.0%

(d) The acid test ratio is

(2,000 + 2,400)/1,500 2.9:1
(1,600 + 820)/2,700 0.9:1

(e) The asset turnover is

14,400/6,700 2.1 times
17,000/5,720 3.0 times

(f) The inventory turnover period in days is

1,300/11,800 × 365 40 days
2,000/12,600 × 365 58 days

(g) The gearing ratio is

2,600/6,700 × 100 38.9 % 0%

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CHAPTER 16
Divisional Performance Measurement

1 Responsibility centres:
Cost centre
A unit of a business where the manager is made accountable for all the cost.

Revenue centre
A unit of an organisation where the manager is accountable for the sales earned in the unit.

Profit centre
Where the manager is responsible for the profitability of the unit.

Investment centre
Where the manger is responsible for both the profitability and the capital investment of the unit. Note that
variance analysis alone will not work particularly well in the last two situations.

2 Divisionalisation: :
Divisionalisation is a term for the division of an organisation into divisions. Each divisional manager is
responsible for the performance of the division. A division may be a cost centre (responsible for its costs
only), a profit centre (responsible for revenues and profits) or an investment centre or Strategic Business
Unit (responsible for costs, revenues and assets).

Divisionalisation involves Delegating responsibilities to divisional managers or unit heads.

Advantages
 It increases motivation of the divisional managers as they feel involved in the decision making of the
organisation.
 It is a form of training for the divisional managers and it easy for them to rise through the ranks to
strategic positions.
 It should promote goal congruence (see later), as all decisions been taken are all geared towards
achieving the objectives of the whole organisation.I
 It drastically reduces the time taken to make decisions.

Disadvantages
 Divisional managers may make dysfunctional decisions (decisions that are not in the best interests of
the organisation).
 There is a need for a performance appraisal system to assess the performance of individual managers.
 Top management may lose control by delegating decision making to divisional managers, since they
are not aware of what is going on in the whole organisation.
 Lack of economies of scale. For example, efficient cash management can be achieved much more
effectively if all cash balances are centrally controlled.

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3. Ratios:
 ROI (Return on investment)
 RI (Residual Income)

3.1 Return on Investment (ROI):

Profit attributable to investment centre
ROI = x 100
Investment of the Investment centre

Return on investment (ROI) shows how much profit has been made in relation to the amount of capital
invested and is calculated as (profit/capital employed) 100%.

There is no generally agreed method of calculating ROI and it can have behavioural implications and lead
to dysfunctional decision making when used as a guide to investment decisions. It focuses attention on
short-run performance whereas investment decisions should be evaluated over their full life.

Advantages of ROI
1. It is easy to understand and easy to calculate.
2. ROI is still the commonest way in which business unit performance is measured and evaluated, and
is certainly the most visible to shareholders.
3. Managers may be happy in expressing project attractiveness in the same terms in which their
performance will be reported to shareholders, and according to which they will be evaluated and
rewarded.
4. The continuing use of the ROCE method can be explained largely by its utilisation of balance sheet
and income statement magnitudes familiar to managers, namely profit and capital employed.

Criticisms of ROI
1. It fails to take account of the project life or the timing of cash flows and time value of money within
that life.
2. The ratio will be distorted by the age of the assets. When assets are valued at net book value,
reported performance improves with time as the assets get old. In this case there is a disincentive to
invest in new assets.
3. It uses accounting profit and capital employed, hence subject to manipulation due to various
accounting conventions.
4. Performance measurement based on ROCE encourages short-termism in decision making. Failure to
invest in new assets could be harmful to the long term interest of the division and the organisation as
a whole.
5. It is difficult to assess the significance of ROI. There is no definite investment signal. The decision to
invest or not remains subjective in view of the lack of objectively set target ROI
6. Dysfunctional behaviour – only projects which increase ROI will be accepted, this could be at the
expense of growth in corporate profits.
7. The biggest disadvantage perhaps is its easy manipulation by managers.

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Illustration 1:
ROI and new investments:
For example, if investment centre A currently has assets of $1,000,000 and expects to earn a profit of
$400,000, how would the centre's manager view a new capital investment which would cost $250,000 and
yield a profit of $75,000 pa?
Without the new investment With the new investment
Profit $400,000 $475,000
Capital employed $1,000,000 $1,250,000
ROI 40% 38%
The new investment would reduce the investment centre's ROI from 40% to 38%, and so the investment
centre manager would probably decide not to undertake the new investment.
If the group of companies of which investment centre A is a part has a target ROI of, say, 25%, the new
investment would presumably be seen as beneficial for the group as a whole. But even though it promises
to yield a return of 75,000/250,000 = 30%, which is above the group's target ROI, it would still make
investment centre A's results look worse. The manager of investment centre A would, in these
circumstances, be motivated to do not what is best for the organisation as a whole, but what is best for his
division.

3.2 Residual income (RI):

RI = profit – (capital employed x the cost of capital)

RI can sometimes give results that avoid the behavioural problem of dysfunctionality. Its weakness is that it
does not facilitate comparisons between investment centres nor does it relate the size of a centre's income
to the size of the investment.

Advantages of residual income

Residual income overcomes many of the problems of ROI:
 It encourage investment centre managers to undertake new investments if they add to residual income.
 As a consequence it is more consistent with the objective of maximising the total profitability of the
company.
 It is possible to use different rates of interest for different types of asset.

Disadvantages of residual income

 Like ROI, residual income is also based on accounting profit and capital employed which can be
manipulated.
 It encourage investment centres managers to think in the short-term about how to increase next year’s
residual income for the centre, hence does not encourage decision making for long-term.
 Residual income is not as widely used as the ROI despite overcoming some of the problems in ROI.

3.3 RI versus ROI: marginally profitable investments:

Residual income will increase if a new investment is undertaken which earns a profit in excess of the
imputed interest charge on the value of the asset acquired. Residual income will go up even if the
investment only just exceeds the imputed interest charge, and this means that 'marginally profitable'
investments are likely to be undertaken by the investment centre manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be
undertaken because it would reduce the average ROI earned by the centre as a whole.

Illustration 2:

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ROI versus residual income

Suppose that Department H has the following profit, assets employed and an imputed interest charge of
12% on operating assets.
$ $
Operating profit 30,000
Operating assets 100,000
Imputed interest (12%) (12,000)
Return on investment 30%
Residual income 18,000

Suppose now that an additional investment of $10,000 is proposed, which will increase operating income in
Department H by $1,400. The effect of the investment would be:
$ $
Total operating income 31,400
Total operating assets 110,000
Imputed interest (12%) (13,200)
Return on investment 28.5%
Residual income 18,200

If the Department H manager is made responsible for the department's performance, he would resist the
new investment if he were to be judged on ROI, but would welcome the investment if he were judged
according to RI, since there would be a marginal increase of $200 in residual income from the investment,
but a fall of 1.5% in ROI.
The marginal investment offers a return of 14% ($1,400 on an investment of $10,000) which is above the
'cut-off rate' of 12%. Since the original return on investment was 30%, the marginal investment will reduce
the overall divisional performance. Indeed, any marginal investment offering an accounting rate of return of
less than 30% in the year would reduce the overall performance.

Illustration 3:
Tata is a division of Tatan group. Its manager has the authority to invest in new capital expenditure, within
limit set by head office. The senior management team of the division is considering an investment of £4.2
million. This would have a residual value of zero after four years. Net cash flows from the investment would
be £1.4 million for each of the next four years.
The cost of capital for the Tata division is 10%. It is the group’s policy to use straight-line depreciation when
measuring divisional profit. For measuring purpose and reporting purposes, capital is defined as the
opening net book value at the start of each year.

Required:
(a) Calculate residual income each year.
(b) Calculate the return on investment each year.

Solution:
(a)

YEAR 1 2 3 4
Profit 0.35 0.35 0.35 0.35
(1.4-1.05)

Asset Cost - 3.15 2.1 1.05 0

accumulated
depreciation
ROI 11.11% 16.67% 33.33% NIL

(b)
YEAR 1 2 3 4

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Profit 0.35 0.35 0.35 0.35

(1.4-1.05)
Imputed interest 0.315 0.21 0.105 0

Cost-accumulated
depreciation x
cost of capital
RI 0.035 0.14 0.245 0.35

4 Transfer Pricing:

Raw material Market

Supplying Buying
Division Division

When an organization is structured into profit centres or investment centres, authority is delegated to the
profit or investment centre managers. The performance of these managers will be assessed and rewarded,
on the basis of the results of their centres. Profit centre managers will therefore be motivated to
optimise the result of their own division, regardless of other profit centres and regardless of the organization
as a whole.

Transfer pricing is used when divisions of an organization need to charge other divisions of the same
organization for goods or services they provide to them.

1 Objectives:
Goal congruent decision making
Any decision by the management to improve the performance of either of the divisions must also improve
the performance of the company as a whole.

“Fair” performance measurement

The transfer price used will normally have a substantial effect on the distribution of profit between divisions,
it is important that this distribution is seen to be equitable to all parties.

Maintaining divisional autonomy

A key purpose of decentralisation is to provide greater autonomy at divisional level, there is little point in
granting autonomy and then imposing transfer prices that will materially affect the profitability of those
supposedly autonomous divisions.

2 Subsidiary objectives:

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Minimising global tax liability

If transactions occur within one tax regime little can be gained by manipulating transfer prices. A
multinational organisation can and will use transfer pricing to move profits “round the world” either to a low
tax regime or alternatively to the country of the holding company.

Recording the movement of goods and services

An important function of transfer pricing is simply to record movement of goods and services in financial
terms.

3 Decision-making:
In order to promote goal congruence we must ensure that the transfer price encourages the divisions to
trade with each other only when it is appropriate for the larger organisation. In order for this to take place we
follow a simple rule:
GENERAL RULE - All goods and services should be transferred at opportunity cost.

4 Performance measurement:
The aim is to set a transfer price that will give a “fair” measure of performance in each division, ie profit.
There is no formula for ensuring this and the result will always be an arbitrary allocation between the
divisions involved. We will see however that in some circumstances this will give a “better” result than
others. How do the transfer prices we have already calculated measure up?

5 Divisional autonomy:
Should the transfer prices be imposed on the divisions by Head Office, or should the divisions negotiate the
transfer price between themselves? The negotiation route seems more consistent with divisional autonomy.
There are however significant disadvantages:
1. Negotiation is time-consuming.
2. It leads to conflict between divisions.
3. Negotiated transfer prices are unlikely to reflect rational factors.
4. They will reflect Personality/Skill/Status/Training.
5. Senior management will need to spend substantial time overseeing the process.

Ideally a transfer price should be set at a level that overcomes these problems.
(a) The transfer price should provide an 'artificial' selling price that enables the transferring division to earn
a return for its efforts, and the receiving division to incur a cost for benefits received.
(b) The transfer price should be set at a level that enables profit centre performance to be measured
'commercially'. This means that the transfer price should be a fair commercial price.
(c) The transfer price, if possible, should encourage profit centre managers to agree on the amount of
goods and services to be transferred, which will also be at a level that is consistent with the aims ofthe
organisation as a whole such as maximising company profits.

In practice it is difficult to achieve all three aims.

6 General rules

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The limits within which transfer prices should fall are as follows.
 The minimum. The sum of the supplying division's marginal cost and opportunity cost of the item
transferred.
 The maximum. The lowest market price at which the receiving division could purchase the
goods or services externally, less any internal cost savings in packaging and delivery.

6.1 Opportunity cost

The opportunity cost included in determining the lower limit will be one of the following.
(a) The maximum contribution forgone by the supplying division in transferring internally rather than
selling goods externally.
(b) The contribution forgone by not using the same facilities in the producing division for their next
best alternative use.

If there is no external market for the item being transferred, and no alternative uses for the division's
facilities, the transfer price = standard variable cost of production.

If there is an external market for the item being transferred and no alternative, more profitable use for
the facilities in that division, the transfer price = the market price.

7 Basis for Transfer Prices:

There are three main bases for setting transfer price:
1. Cost-based prices.
2. Market-based prices.
3. Negotiated prices.

7.1. Cost based transfer price:

Non-existent market
Where there is no external market for the transferred product, the ideal transfer price should be based on
cost. A cost based transfer price could take the following forms:
 Transfer at full cost to the selling division of producing the product or services with or without profit
mark-up
 Transfer at marginal cost to the selling division of producing the product or services with or without
profit mark-up.

Illustration 4:
The following relates to two divisions of a company:

Division A Division B
Selling price - 20
Variable cost per unit 5 3
Fixed cost 40,000 80,000

The budgeted units for division B are 20,000 units transferred from division A. There is no external market
for the product from division A. The products of division A are required to produce product of division B.

Required:
Determine the ideal transfer price.

Solution:
Variable cost $5

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Fixed costs ($40,000 / 20,000 units) $2

Total cost per unit for Division A $7

As there is no external market price, therefore the ideal transfer price should be based on cost based
approach ($7) with or without any profit margins depending upon policy of the division / organisation.

Illustration 5:
The following relates to a selling division:
External market price 30
Variable cost of production 15

Total capacity of the division is 20,000 units.

The market demand for this product is 15,000.
A buying division requires 2000 unit of this product.

Required:
Determine the ideal transfer price.

Solution:
We have to see here that the division has extra capacity to produce and sell 2,000 units to the buying
division, therefore the selling division will not have to incur any additional fixed costs for this manufacture,
but also have to note a point that the division has an external market for this product.

So the ideal transfer may range from the variable costs per unit to the external selling price.
Transfer price ranges $15 ------ $30

7.2. Market-based transfer price:

Market-base transfer price might be used when there is an intermediate market for transferred goods or
services. An intermediate market is the external market for the goods or services of the selling division.
The market based transfer price could take the following forms:
 The transfer price is the price of the item in the external market, or
 The transfer price is at a discount to the external market price to allow for a saving in selling cost by
selling internally.

Illustration 6:
Division A of a company produces sigma which is needed as a component by division B of the same
company. Division B converts the sigma to form alpha which is sold externally.

The following is relevant:

Division A Division B
Selling price 30 50
Marginal cost of production 20 -
Further marginal cost 25
Fixed costs 300,000 400,000

Required:
Determine the ideal transfer price, if there is a perfect market for sigma.

Solution:

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There is a perfect external market for the product Sigma, therefore external market price ($30) should be an
ideal price for the selling division to maximise its profitability and hence its performance.

Illustration 7:
Assuming the same facts as in example above and that division A can sell in the external market at a
marginal selling cost of £4 per unit.

Required:
What will be the ideal transfer price?

Illustration 8:
In this situation selling division can deduct selling cost from the external selling price to revise its internal
transfer price for the buying division and it could be reduced to $26.

7.4 The use of market price as a basis for transfer prices:

If an external market price exists for transferred goods, profit centre managers will be aware of the price
they could obtain or the price they would have to pay for their goods on the external market, and they would
inevitably compare this price with the transfer price.

Illustration 9:

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7.3 Negotiated transfer price:

In some cases transfer price might be negotiated. If divisional managers are allowed to negotiate transfer
prices with each other, the agreed transfer price may be finalized from a combination of accounting
arithmetic, negotiation and compromise.

Dual transfer price

Dual transfer price is applied where the buying division pays one transfer price for unit purchased from the
selling division and the selling division receives a different, higher transfer price for each unit that it transfers
to the receiving division. The difference in the two transfer prices (the buying price and the selling price) is
subsidized by the head office, which charges the loss to head office costs.

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CHAPTER 17
Performance Measurement for
Non-Profit Organisations

1 Performance measurement for Non-Profit

organisations and the public sector
In simple terms the basic objective of a not for profit is to provide a service without making a loss, a profit or
surplus simply being either a timing issue or a means to an end.
The wider issue is that the organisation is providing a service of social or moral worth. We can attempt to
measure this service.

1.1 Objectives of a not for profit entity:

The objective for such an organisation will differ widely from one organisation to another. They may

Include one or more of the following:

 Client satisfaction
 Employee satisfaction (particularly when volunteers are a substantial part of the workforce)
 Maximisation of surplus (perhaps to assist in growth or protect against loss of future funding)
 Growth
 Usage of facilities (for example library services)
 Maintenance of capability (for example a fire service or army).

The key to remember in the exam is that for every not for profit organisation there will be multiple objectives
that have to be addressed as opposed to a profit making organisation where profit is the key aim in relation
to satisfying the owners or shareholders.

1.2 Problems of performance measurement of a not for profit

entity:
1. Multiple objectives
As seen above most organisations will have competing objectives. The difficulty arises when attempting to
identify the relative importance of the objectives.

2. Measurement of services provided

The nature of many services is that they are more qualitative than quantitative. When measuring such
outputs it is often very difficult to get meaningful aggregate measures of performance.

3. No profit motive
Measures such as ROI and RI cannot be used to gain an overall measure of performance.

4. Identification of cost unit

The cost unit is likely to be relatively complex and there is likely to be more than one cost unit. For example
what is a cost unit for a hospital/ there are likely to be multiple such cost units being used by a single
patient.

5. Key constraint

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For most organisations the key constraint is the level of finance available. A charity is limited to its
donations and a government department is limited to its allocation from the finance department. This
constraint is separate in most organisations to their end objective.

6. Political intervention
Unlike commercial entities not for profit entities are far more likely to be affected by political influence, either
directly in the form of elected official or indirectly by public sentiment.

7. Legal considerations
It is likely that adherence to restrictive legal rules are going to impact on a not for profit entity because of the
nature of the organisation or the links to government at a local or national level.
Performance measurement
1.3 Performance measurement:
In order to establish meaningful measures within such an environment we can employ the following
solutions:

1. Input measurement
In the absence of easily measured output then more consideration can be put into the costs and resourcing
of an organisation.

2. Independent scrutiny and target setting

There is need for fine judgement when setting qualitative targets. By use of independent experts then
measures can be set that reflect performance levels appropriate without introducing bias.

3. External comparison
A powerful assessment of the performance of an organisation is to benchmark that performance in relation
to similar organisations. This allows for both historical results to be used but also best practice measures to
be developed.

2 Value For Money (VFM):

Value for money is a framework by which not for profit organisations can be measured. It separates the
performance of the business into three areas – the three E’s:
1. Effectiveness
2. Efficiency
3. Economy

1. Effectiveness (an output measure)

This may be described as how well the organisation meets its objectives. Perhaps an easier way of
understanding it would be to see how well the output of services matches the client need.

2. Efficiency (the relationship between input and output)

This describes how well resources are utilised; it measures the output of services for a given level of
resource or input.

3. Economy (an input measure)

This considers the cost of sourcing the input resources. The aim being to minimize the costs of the input for
a given standard and level of resource.
The key to VFM
The key to VFM is to understand that performing in a single area is not sufficient, instead the organisation
must achieve in relation to all three aspects in order to provide value for money.

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