1.5performance Management
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Shanton Shaju1.5performance Management
Uploaded by
Shanton ShajuACCA – PM
PERFORMANCE MANAGEMENT
STUDY NOTES
Contents
Sr. # TOPIC Page #
1. Activity Based Costing(ABC) 01
2. Target Costing 12
3. Life Cycle Costing 16
4. Throughput Accounting 20
5. Environmental Accounting 27
6. Relevant costing & Short Term Decisions 31
7. CVP Analysis 43
8. Limiting Factor Analysis 56
9. Pricing Decisions 64
10. Risk & Uncertainty 75
11. Budgeting 91
12. Standard costing (Control) 114
13. Performance Measurement & Control 139
Study Notes Performance Management ‐ PM
• Introduction‐Recap‐absorption costing
• Need for ABC
Chapter 1 • Main concept
• comparison of ABC with traditional
Activity Based absorption costing
• Steps of ABC
Costing(ABC) • Advantages and disadvantages of ABC
Introduction:
Conventional costing distinguishes between variable and fixed costs. Typically, it is assumed that variable costs
vary with the number of units of output (and that these costs are proportional to the output level) whereas fixed
costs do not vary with output. This is often an over‐simplification of how costs actually behave. For example,
variable costs per unit often increase at high levels of production where overtime premiums might have to be paid
or when material becomes scarce. Fixed costs are usually fixed only over certain ranges of activity, often stepping
up as additional manufacturing resources are employed to allow high volumes to be produced.
Variable costs per unit can at least be measured, and the sum of the variable costs per unit is the marginal cost per
unit. The marginal cost is the additional costs caused when one more unit is produced. However, there has always
been a problem dealing with fixed production costs such as factory rent, heating, supervision and so on. Making a
unit does not cause more fixed costs, yet production cannot take place without these costs being incurred. To say
that the cost of producing a unit consists of marginal costs only will understate the true cost of production and this
can lead to problems. For example, if the selling price is based on a mark‐up on cost, then the company needs to
make sure that all production costs are covered by the selling price. Additionally, focusing exclusively on marginal
costs may cause companies to overlook important savings that might result from better controlled fixed costs.
Absorption costing:
The conventional approach to dealing with fixed overhead production costs is to assume that the various cost
types can be lumped together and a single overhead absorption rate derived. The absorption rate is usually
presented in terms of overhead cost per labour hour, or overhead cost per machine hour. This approach is likely to
be an over‐simplification, but it has the merit of being relatively quick and easy.
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Study Notes Performance Management ‐ PM
Example 1
In Table 1 in the spreadsheet above, we are given the budgeted marginal cost for two products. Labour is paid at
$12 per hour and total fixed overheads are $224,000. Fixed overheads are absorbed on a labour hour basis.
Based on Table 1 the budgeted labour hours must be 112,000 hours. This is derived from the budgeted outputs of
20,000 Ordinary units which each take five hours (100,000 hours) to produce, and 2,000 Deluxe units which each
take six hours (12,000 hours).
Therefore, the fixed overhead absorption rate per labour hour is $224,000/112,000 = $2/hour.
The costing of the two products can be continued by adding in fixed overhead costs to obtain the total absorption
cost for each of the products.
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Study Notes Performance Management ‐ PM
Table 1 has been amended to include the fixed overheads to be absorbed in both products.
Ordinary: (5 labour hours x $2 OAR) = $10
Deluxe: (6 labour hours x $2 OAR) = $12
This means we have arrived at the total production cost for both products under absorption costing. It also tell us
that if production goes according to budget then total costs will be (20,000 x $85) + (2,000 x $102) = $1,904,000.
The conventional approach outlined above is satisfactory if the following conditions apply:
1. Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing
environments which do not rely on sophisticated and expensive facilities and machinery.
2. Most fixed costs accrue with time.
3. There are long production runs of identical products with little customization.
However, much modern manufacturing relies on highly automated, expensive manufacturing plants – so much so
that some companies do not separately identify the cost of labour because there is so little used. Instead, factory
labour is simply regarded as a fixed overhead and added in to the fixed costs of running the factory, its machinery,
and the sophisticated information technology system which coordinates production.
Additionally, many companies rely on customization of products to differentiate themselves and to enable higher
margins to be made. Dell, for example, a PC manufacturer, has a website which lets customers specify their own
PC in terms of memory size, capacity, processor speed etc. That information is then fed into their automated
production system and the specified computer is built, more or less automatically.
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Study Notes Performance Management ‐ PM
Instead of offering customers the ability to specify products, many companies offer an extensive range of products,
hoping that one member of the range will match the requirements of a particular market segment. In Example 1,
the company offers two products: Ordinary and Deluxe. The company knows that demand for the Deluxe range
will be low, but hopes that the price premium it can charge will still allow it to make a good profit, even on a low
volume item. However, the Deluxe product could consume resources which are not properly reflected by the time
it takes to make those units.
These developments in manufacturing and marketing mean that the conventional way of treating fixed overheads
might not be good enough. Companies need to know the causes of overheads, and need to realize that many of
their ‘fixed costs’ might not be fixed at all. They need to try to assign costs to products or services on the basis of
the resources they consume.
Need for ABC:
1. Increase in proportion of overhead cost in total cost because of use of advance machinery and technology,
sometimes referred to as advanced manufacturing technology (AMT)
2. Complex production and increase in product range where all products are consuming different amount of
overheads
3. Falling cost of information processing
4. Increase in non‐volume related support activities e.g. Machine set up etc.
5. Absorption costing allocates a greater portion of overheads to high volume products and smaller portion of
overheads to low volume products
Activity based costing tries to overcome this problem by allocating overheads to products according to cost drivers.
NOTE: In activity based costing, the cost that seems to relate to volume of production, the cost drivers will be
volume related e.g. Number of production runs, Number of orders received.
Similarly, for products that are not volume related, the cost drivers will be non‐volume related e.g. Hours spent on
servicing.
ABC Vs. traditional absorption costing:
Traditional absorption costing:
Traditional absorption costing uses a single basis for absorbing all overheads into cost units for a particular
production department cost centre.
A business will choose the basis that best reflects the way in which overheads are being incurred, e.g. in an
automated business much of the overhead cost will be related to Maintenance and repair of the machinery. It is
likely that this will vary to some extent with machine hours worked so we would have used a machine hour
absorption rate.
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Study Notes Performance Management ‐ PM
PRODUCTION SET UP COSTS
Production OAR =
MACHINE OIL
Department Machine
SUPERVISOR SALARY
MACHINE REPAIRS A Hours
Activity based costing:
Production overheads are by no means all volume‐related and hence a single basis for absorption, e.g. labour
hours, would not adequately reflect the complexity of producing certain products/cost units as opposed to others.
ABC is an extension of absorption costing specifically considering what causes each type of overhead category to
occur, i.e. what the ‘cost drivers’ are. Each type of overhead is absorbed using a different basis depending on the
cost driver
Activities Cost Drivers
Number of production set
Production set up costs
up
Machine oil and machine
Total Machine Hours
repairs
Supervisor Salary Total Labour Hours
Steps of activity based costing:
1. Identify organizations major activities creating overheads and Collect cost related to each activity in a separate
cost pool.
2. Identify factor causing change in the cost of these activities. (cost drivers)
3. Calculate absorption rate per cost driver for each activity.
4. Charge cost to products on the basis of usage of these activities
Additional points (terms explained):
Cost driver: Cost pool:
Any factor, reason or base which generates The costs that accumulate for each activity
overheads cost. cost centre is called a cost pool.
Reason which increase or decrease Cost of each activity
overheads.
OAR =Cost pool
Cost driver
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Study Notes Performance Management ‐ PM
Examples‐Cost pool Suggested Cost drivers
Ordering costs: handling customer orders Number of orders
Materials handling costs Number of production runs
Machine set‐up costs Number of machine set‐ups
Production scheduling costs Number of production runs
Dispatching costs Number of orders dispatched
Example: how to calculate cost per unit under ABC
Let’s continue with our example from earlier; the total fixed overheads were $224,000. In the table below in
Example 2 the total overheads have been split into cost pools and cost driver data for the Ordinary and Deluxe
products has been collated.
Example 2
If we apply the ABC process we can see that Step 1 is complete as we know what the cost pools are.
For Step 2 we need to identify the cost driver for each cost pool.
Batch set‐up costs will be driven by the number of set‐ups required for production:
Ordinary: 20,000/2,000 = 10
Deluxe units: 2,000/100 = 20
Total set‐ups: 30
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Study Notes Performance Management ‐ PM
Stores/material handling costs will be driven by the number of components required for production:
Ordinary: (20,000 units x 20) = 400,000
Deluxe: (2,000 units x 30) = 60,000
Total components = 460,000
Other fixed overheads will have to be absorbed on a labour hour basis because there is no information provided
which would allow a better approach. We know from Example 1 that total labour hours required are 112,000.
In Step 3 we need to calculate a cost per unit of cost driver.
Batch set‐ups:
$90,000/30 = $3,000/set‐up
Stores/material handling:
$92,000/460,000 = $0.20/component
Other overheads:
$42,000/112,000 = $0.375/labour hour
Step 4 then requires us to use the costs per unit of cost driver to absorb costs into each product based on how
much the product uses of the driver.
Batch set‐ups:
Ordinary: ($3,000/2,000 units) = $1.50/unit
Deluxe: ($3,000/100 units) = $30/unit
Store/material handling:
Ordinary: ($0.20 x 20 components) = $4/unit
Deluxe: ($0.20 x 30 components) = $6/unit
Other overheads:
Ordinary: ($0.375 x 5 hours) = $1.875/unit
Deluxe: ($0.375 x 6 hours) = $2.25/unit
The ABC approach to costing therefore results in the figures shown in the spreadsheet below.
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Study Notes Performance Management ‐ PM
Check:
If production goes according to budget total costs will be (20,000 x $82.375) + (2,000 x $128.25) = $1,904,000 If
you look at the comparison of the full cost per unit in the spreadsheet above, you will see that the ABC approach
substantially increases the cost of making a Deluxe unit. This is primarily because the Deluxe units are made in
small batches. Each batch causes an expensive set‐up, but that cost is then spread over all the units produced in
that batch – whether few (Deluxe) or many (Ordinary). It can only be right that the effort and cost incurred in
producing small batches is reflected in the cost per unit produced. There would, for example, be little point in
producing Deluxe units at all if their higher selling price did not justify the higher costs incurred.
In addition to estimating more accurately the true cost of production, ABC will also give a better indication of
where cost savings can be made. Remember, the title of this exam is Performance Management, implying that
accountants should be proactive in improving performance rather than passively measuring costs. For example, it’s
clear that a substantial part of the cost of producing Deluxe units is set‐up costs (almost 25% of the Deluxe units’
total costs).
Working on the principle that large cost savings are likely to be found in large cost elements, management’s
attention will start to focus on how this cost could be reduced.
For example, is there any reason why Deluxe units have to be produced in batches of only 100? A batch size of 200
units would dramatically reduce those set‐up costs.
The traditional approach to fixed overhead absorption has the merit of being simple to calculate and apply.
However, simplicity does not justify the production and use of information that might be wrong or misleading.
ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur
costs, and then to use that detailed information for costing purposes. But understanding the drivers of costs
must be an essential part of good performance management.
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Study Notes Performance Management ‐ PM
Advantages of ABC:
1. Accurate cost calculation(Fair distribution of Overheads)
2. Accurate selling price(Better costing information)
3. Better cost control
4. Better decision making for the continuation/discontinuation of products if incurring losses
5. Better planning‐ activity based budgeting
6. Better performance measurement
Disadvantages of ABC:
1. ABC is time consuming and expensive.
2. Many judgmental decisions still required in the construction of an ABC system
3. Selection of cost driver may not be easy. A single cost driver may not explain the behavior of all items in a cost
pool. There may be more than one cost drivers for an activity
4. The cost of implementing and maintaining an ABC system can exceed the benefits of ‘improved accuracy’ in
product costs. ABC will be of limited benefit if overhead costs are primarily volume related
5. Reduced benefit if the company is producing only one product or a range of products with similar costs
6. Some arbitrary apportionment may still exist.
7. There must be a reason for using a system of ABC. ABC must provide meaningful product costs or extra
information that management will use. If management is not going to use ABC information for any practical
purpose, a traditional absorption costing system would be simpler to operate and just as good.
When ABC should be used:
a) When production overheads are high relative to prime costs (e.g. service sector)
b) When there is a whole diversity of product range
c) When there are considerable differences in the use of resources by products
d) Where consumption of resources is not driven by volume
Example objective test Question(OT)
A company manufactures two products, C and D, for which the following information is available:
Product C Product D Total
Budgeted production (units) 1,000 4,000 5,000
Labour hours per unit/in total 8 10 48,000
Number of production runs 13 15 28
required
Number of inspections during 5 3 8
production
Total production set up costs $140,000
Total inspection costs $80,000
Other overhead costs $96,000
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Study Notes Performance Management ‐ PM
Other overhead costs are absorbed on the basis of labour hours per unit. Using activity‐based costing, what is the
budgeted overhead cost per unit of product D?
a) $43∙84
b) $46∙25
c) $131∙00
d) $140∙64
Solution:
Correct option is B
Set‐up costs per production run = $140,000/28 = $5,000
Cost per inspection = $80,000/8 = $10,000
Other overhead costs per labour hour = $96,000/48,000 = $2
Overheads costs of product D:
$
Set‐up costs (15 x $5,000) 75,000
Inspection costs (3 x $10,000) 30,000
Other overheads (40,000 x $2) 80,000
––––––––
185,000
––––––––
Overhead cost per unit = 185,000/4,000 = $46∙2
Example objective test Question(OT)
A company makes two products using the same type of materials and skilled workers. The following information is
available:
Product A Product B
Budgeted volume (units) 1,000 2,000
Material per unit ($) 10 20
Labour per unit ($) 5 20
Fixed costs relating to material handling amount to $100,000. The cost driver for these costs is the volume of
material purchased.
General fixed costs, absorbed on the basis of labour hours, amount to $180,000.
Using activity‐based costing, what is the total fixed overhead amount to be absorbed into each unit of product B
(to the nearest whole $)?
A. $113
B. $120
C. $40
D. $105
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Study Notes Performance Management ‐ PM
Solution:
The correct option is B
Total material budget ((1,000 units x $10) + (2,000 units x $20)) = $50,000
Fixed costs related to material handling = $100,000
OAR = $2/$ of material
Product B = $2 x $20 = $40
Total labour budget ((1,000 units x $5) + (2,000 units x $20) = $45,000
General fixed costs = $180,000
OAR = $4/$ of labour
Product B = $4 x $20 = $80
Total fixed overhead cost per unit of Product B ($40 + $80) = $120
END OF CHAPTER
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Study Notes Performance Management ‐ PM
• What is target costing?
• Cost plus Pricing Vs Target Costing
• Steps of Target costing
Chapter 2 • Derive a target cost and cost gap
• How to close cost gap?
Target Costing • Target Costing in Service Industries
Introduction:
When a new product is launched, traditionally profit was added to cost i‐e cost plus pricing considering internal
factors to get to the selling price but, TARGET COSTING involves setting a target cost by subtracting a desired profit
margin from a target selling price.
In a modern environment with shortening product lifecycles, organistaions have to continually redesign their
products. It is essential that they try to achieve a target cost during the product’s development.
TARGET COST is the cost at which a product must be produced and sold in order to achieve the required amount
of profit at the target selling price. When a product is first planned, its estimated cost will often be higher than its
target cost. The aim of target costing is then to find ways of closing this target cost gap, and producing and selling
the product at the target cost.
Cost plus Pricing Vs. Target Costing
Cost plus pricing
Under traditional approaches to pricing, businesses calculate the cost of manufacturing and selling a product, and
then add mark up, to give the profit element. These methods are known as "cost plus pricing".
A major criticism of cost plus pricing techniques is that they do not consider any external factors (e.g. demand for
product; no. of competitors, etc.). They are therefore unlikely to
maximise the profits that a business will generate.
Target costing
As product life cycles have become much shorter, the planning, development and design stage of a product is
critical to an organisation's cost management process. Cost reduction must be considered at this stage of a
product’s life cycle, rather than during the production process.
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Study Notes Performance Management ‐ PM
Target costing involves setting a selling price for your product by reference to the market.
From this, your desired profit margin is deducted leaving you with a target cost.
Implementing Target Costing‐The Steps:
1. Determine a product specification of which an adequate sales volume is estimated
2. Decide a target selling price at which the organisation will be able to sell the product successfully and achieve
a desired market share.
3. Estimate the required profit, based on required profit margin or return on investment
4. Calculate: Target cost
Target cost = Target selling price – Target profit.
5. Prepare an estimated cost for the product, based on the initial design specification and current cost levels.
6. Calculate: Target cost gap = Estimated cost – Target cost.
7. Make 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 to 'control out' costs after ‘live’ production has started.
Derive a target cost and cost gap
Example:
A company manufactures digital watches and is in the process of introducing new watch into the market. Their
research shows the following;
Competitive Selling price $ 60
Cost Estimates $
Direct materialss 3.21
Direct labour 24.03
Machinery 1.12
Ordering and Receiving 0.23
Quality Assurance 4.60
Marketing 8.15
Distribution 3.25
After Sales Service 1.30
Target Profit Margin 30%
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Study Notes Performance Management ‐ PM
Requirement:
a) Calculate Target Cost
b) Calculate Cost gap
Solution:
$
competitive Selling price 60
Target profit margin(30% of selling price) 18
Target cost(60‐18) 42
Projected cost per unit(add all costs) (45.89)
COST GAP 3.89
The projected cost exceeds the target cost by $3.89. This is target cost gap. This company will have to find out
the ways to reduce this gap by controlling costs.
Possible Ways to close a Cost Gap:
Value analysis to determine which features are adding value to the product and which will not affect it at all.
Reducing the number of components.
Using cheap labour/staff.
Using standard components wherever possible.
Acquiring new more efficient technology.
Training staff in more efficient techniques
Cutting out non value added activities
Using different materials(identified using activity analysis)
The most effective stage to reduce non value added feature is the product design nd development stage and most
cots are determined at this stage.
Target Costing in Service Industries:
The target costing approach is a sensible basis for estimating / driving down costs regardless of the type of
business. However, due to the nature of service industries this process is more difficult in these businesses.
Unlike manufacturing, service industries have the following characteristics which make cost
and performance measurement more difficult:
1. Simultaneity – created at time consumed
2. Variability/Heterogeneity – quality / consistency varies
3. Intangibility – of what is provided
4. Perishability – cannot make in advance and store up.
5. No transfer of ownership
From the above ‘Intangibility and Variability/Heterogeneity’ make it difficult to use target costing
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Study Notes Performance Management ‐ PM
Example 1 objective test Question(OT)
Which of the following statements describes target costing?
a) It calculates the expected cost of a product and then adds a margin to it to arrive at the target selling price
b) It allocates overhead costs to products by collecting the costs into pools and sharing them out according to
each product’s usage of the cost driving activity
c) It identifies the market price of a product and then subtracts a desired profit margin to arrive at the target
cost
d) It identifies different markets for a product and then sells that same product at different prices in each market
Solution:
The correct option is C
A target cost is arrived at by identifying the market price of a product and then subtracting a desired profit margin
from it
Example 2 objective test Question(OT)
Which of the following techniques is NOT relevant to target costing?
A Value analysis
B Variance analysis
C Functional analysis
D Activity analysis
Solution:
The correct option is B
Variance analysis is not relevant to target costing as it is a technique used for cost control at the production phase
of the product life cycle. It is a feedback control tool by nature and target costing is feed forward.
Value analysis can be used to identify where small cost reductions can be applied to close a cost gap once
production commences.
Functional analysis can be used at the product design stage. It ensures that a cost gap is reached or to ensure that
the product design is one which includes only features which customers want.
Activity analysis identifies and describes activities in an organisation and evaluates their impact on operations to
assess where improvements can be made.
END OF CHAPTER
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Study Notes Performance Management ‐ PM
• Introduction
• Product life cycle
• Benefits of life cycle costing
Chapter 3 • How to maximize return over the product
life cycle
Life Cycle Costing
Introduction:
Life cycle costing aims to cost a product, service, customer or project over its entire lifecycle with the aim of
maximizing the return over the total life while minimizing costs.
Traditionally the costs and revenues of a product are assessed on a financial year or period by period basis.
Product life cycle costing considers all the costs that will be incurred from design to abandonment of a new
product and compares these to the revenues that can be generated from selling this product at different target
prices throughout the product's life.
Product Life cycle: there are 5 stages;
Stages Cost Demand Revenue Profit
R&D
Development Testing cost
Nil Nil Loss
stage Training cost
Sampling cost
Manufacturing cost
Distribution cost
Introduction Low Revenue Loss
High Marketing cost
Inventory
Manufacturing cost
Distribution cost
Growth Growing Growing Profit
Marketing cost
Inventory
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Study Notes Performance Management ‐ PM
Manufacturing cost
Distribution cost
High High
Maturity Inventory High profits
(Maximum) (maximum)
Marketing cost if long life
cycle product.
Manufacturing cost
Distribution cost
Decline Marketing cost Decreasing Decreasing Low profits
Inventory
Disposal
Extract from technical article:
The cost phases of a product can be identified as:
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Study Notes Performance Management ‐ PM
There are four principal lessons to be learned from lifecycle costing:
All costs should be taken into account when working out the cost of a unit and its profitability.
Attention to all costs will help to reduce the cost per unit and will help an organization achieve its target cost.
Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty
costs. More attention to training can machine maintenance costs. More attention to waste disposal during
manufacturing can reduce end‐of life costs.
Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in
the future because of decisions that have already been made. Costs are incurred only when a resource is used.
Benefits of life cycle costing:
1. It helps management to assess profitability over the full life of a product, which in turn helps management to
decide whether to develop the product, or to continue making the product.
2. It can be very useful for organizations that continually develop products with a relatively short life, where it
may be possible to estimate sales volumes and prices with reasonable accuracy.
3. The life cycle concept results in earlier actions to generate more revenue or to lower costs than otherwise
might be considered.
4. Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least
within a particular life cycle stage.
It encourages longer‐term thinking and forward planning, and may provide more useful information than
traditional reports of historical costs and profits in each accounting period.
How to maximize return over the product life cycle:
Careful design of product(can save design and manufacturing costs)
Take the product to market as soon as possible
Minimize breakeven time
Maximize the length of the life span
Through a heavy advertisement cost at the maturity
Minor changes in technology
Example 1 objective test Question(OT)
The following costs have arisen in relation to the production of a product:
(i) Planning and concept design costs
(ii) Testing costs
(iii) Production costs
(iv) Distribution and customer service costs In calculating the life cycle costs of a product, which of the above
items would be included?
A. (iii) only
B. (i), (ii) and (iii) only
C. (i), (ii) and (iv) only
D. All of the above
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Study Notes Performance Management ‐ PM
Solution:
The correct option is D
Example 2 objective test Question(OT)
A manufacturing company which produces a range of products has developed a budget for the life‐cycle of a new
product, P. The information in the following table relates exclusively to product P:
Lifetime total Per unit
Design costs $800,000
Direct manufacturing costs $20
Depreciation costs $500,000
Decommissioning costs $20,000
Machine hours 4
Production and sales units 300,000
The company’s total fixed production overheads are budgeted to be $72 million each year and total machine hours
are budgeted to be 96 million hours. The company absorbs overheads on a machine hour basis.
What is the budgeted life‐cycle cost per unit for product P?
A. $24∙40
B. $25∙73
C. $27∙40
D. $22∙73
Solution:
The correct option is C
OAR for fixed production overheads ($72 million/96 million hours) = $0∙75 per hour
Total manufacturing costs (300,000 units x $20) = $6,000,000
Total design, depreciation and decommissioning costs = $1,320,000
Total fixed production overheads (300,000 units x 4 hours x $0∙75) = $900,000
Total life‐cycle costs = $8,220,000
Life‐cycle cost per unit ($8,220,000/300,000 units) = $27∙40
END OF CHAPTER
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Study Notes Performance Management ‐ PM
• Introduction
• Theory of constraints
Chapter 4 • Throughput accounting‐Concepts
• Throughput accounting Vs Traditional
Throughput costing
• Throughput accounting Ratio
Accounting • Throughput & limiting Factor analysis
Introduction:
Throughput accounting is a production management system aiming to maximize return(throughput)
A JIT system is operated, with some buffer inventory kept only when there is a bottleneck resource
Theory of constraints (TOC):
The theory of constraints is a production system where the key financial concept is the maximization of throughput
while keeping conversion and investment costs to a minimum.
Throughput contribution = Sales revenue – Material cost
TOC focuses on bottlenecks in the production process which act as a barrier to throughput maximization.
Consider the following example of a production set up;
Bottlenecks
Raw Materials Component Final
Materials Sales
Preparation Preparation Assembly
100 units 50 units 100 units
per hour per hour per hour
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Study Notes Performance Management ‐ PM
Component preparation process will act as a bottleneck, known as a binding constraint. The other processes
(material preparation and final assembly) are non‐bottleneck resources
Steps‐Theory of constraints (TOC)
The theory of constraints is a production system where the key financial concept is the maximisation of throughput
while keeping conversion and investment costs to a minimum.
Goldratt’s five steps for dealing with a bottleneck activity are:
1. IDENTIFY the binding constraint
2. EXPLOIT. The highest possible output must be achieved from the binding constraint. This output must never
be delayed and as such a buffer inventory should be held immediately before the constraint
3. SUBORDINATE. Operations prior to the binding constraint should operate at the same speed as it so that WIP
does not build up
4. ELEVATE the systems bottleneck. Steps should be taken to increase resources or improve its efficiency
5. RETURN TO STEP 1. The removal of one bottleneck will create another elsewhere in the system
Throughput accounting (TA):
TA is an accounting system based on the theory of constraints. It is very similar to marginal costing but can be
used for longer‐term decision making about production capacity. It is an alternative system of cost and
management accounting in a JIT environment.
TA emphasizes throughput, inventory minimization and cost control.
Other important concepts:
a) In short term ONLY material cost is variable. ALL other factory costs are fixed.
b) In a JIT environment, producing for inventory is bad. Ideally inventory would be zero. Products should not be
made unless there is a customer for them.
c) This means accepting some idle time in non‐bottleneck operations.
d) WIP should be valued at material cost only, so that no value is added to profit until a sale is made.
e) Profit is determined by the rate at which throughput can be generated, i‐e how quickly raw materials can be
turned into sales to generate cash. Producing just to increase inventory creates no profit and so should not
be encouraged.
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Study Notes Performance Management ‐ PM
Throughput accounting vs. traditional costing:
Throughput Traditional
All costs other than materials are seen as fixed Labour costs and variable overheads are
in the short term. treated as variable costs.
Inventory is valued at material cost only. Inventory is valued at total production cost.
Value is added when an item is sold. Value is added when an item is produced.
Profitability is determined by the rate at which Product profitability can be determined by
money is earned. (Throughput) deducting a product cost from selling price.
Buffer inventory is allowed but only before
bottleneck process.
To avoid the buildup of work in progress,
production must be limited the the capacity of
the bottleneck resource but this capacity must
be fully utilized
Throughput accounting in service Industry: TA can be used in service sector as well
Example:
A Public sector eye clinic performs services in 3 stages:
Process Time/patient Total available hours/week
Test 0.5 hours 80
Interpret the result 0.2 hours 40
Re‐call patients 0.4 hours 60
Requirement: Identify the bottleneck process
Solution:
Test‐ 80/0.5 160 patients
Interpret‐40/0.2 200 patients
Recall‐60/0.4 150 patients
Recall is the bottleneck process and the service is most binding at this point(150 patients only)
The performance of this bottleneck process can be elevated as :
1. Increase the total duty time of the person making the calls
2. Increase efficiency by training
3. Try to reduce time it take to make one call
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Throughput accounting‐Ratios:
There are three main ratios that are calculated: (1) return per factory hour, (2) cost per factory hour and (3) the
throughput accounting ratio.
1. Return per factory hour = Throughput per unit / product time on bottleneck resource.
2. Cost per factory hour = Total factory costs / total time available on bottleneck resource.
The ‘total factory cost’ is simply the ‘operational expense’ of the organization .If the organisation was a service
organisation, we would simply call it ‘total operational expense’ or something similar. The cost per factory
hour is across the whole factory and therefore only needs to be calculated once.
3. Throughput accounting ratio (TPAR) = Return per factory hour/cost per factory hour.
In any organisation, you would expect the throughput accounting ratio to be greater than 1.
This means that the rate at which the organisation is generating cash from sales of this product is greater than
the rate at which it is incurring costs.
It follows on, then, that if the ratio is less than 1, this is not the case, and changes need to be made quickly.
How to improve throughput accounting ratio?
Increase the sales price to increase the throughput per unit
Reduce total operating expenses, to reduce the cost per hour
Improve productivity, reducing the time required to make each unit of product
Example 1 Objective test Question(OT)
X Co uses a throughput accounting system. Details of product A, per unit, are as follows:
Selling price $320
Material costs $80
Conversion costs $60
Time on bottleneck resource 6 minutes
What is the return per hour for product A?
a) $40
b) $2,400
c) $30
d) $1,800
Solution:
The correct option is B
$320 – $80/(6/60) = $2,400
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Example 2 Objective test Question(OT)
A company manufactures a product which requires four hours per unit of machine time. Machine time is a
bottleneck resource as there are only ten machines which are available for 12 hours per day, five days per week.
The product has a selling price of $130 per unit, direct material costs of $50 per unit, labour costs of $40 per unit
and factory overhead costs of $20 per unit. These costs are based on weekly production and sales of 150 units.
What is the throughput accounting ratio?
a) 1∙33
b) 2∙00
c) 0∙75
d) 0∙31
Solution:
The correct option is A
Return per factory hour = ($130 – $50)/4 hours = $20
Factory costs per hour = ($20 + $40)/4 = $15
TPAR = $20/$15 = 1∙33
Example 3 Objective test Question(OT)
A manufacturing company uses three processes to make its two products, X and Y. The time available on the three
processes is reduced because of the need for preventative maintenance and rest breaks.
The table below details the process times per product and daily time available:
Process Hours available Hours required Hours required
per day to make one unit to make one unit
of product X of product Y
1 22 1∙00 0∙75
2 22 0∙75 1∙00
3 18 1∙00 0∙50
Daily demand for product X and product Y is 10 units and 16 units respectively.
Which of the following will improve throughput?
A. Increasing the efficiency of the maintenance routine for Process 2
B. Increasing the demand for both products
C. Reducing the time taken for rest breaks on Process 3
D. Reducing the time product X requires for Process 1
Solution:
The correct option is A
Throughput is determined by the bottleneck resource. Process 2 is the bottleneck as it has insufficient time to
meet demand.
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The only option to improve Process 2 is to improve the efficiency of the maintenance routine. All the other three
options either increase the time available on non‐bottleneck resources or increase demand for an increase in
supply which cannot be achieved.
Performance measurement in Throughput Accounting:
If an organization is making more than one product, Production priority is given to products that generate the
highest throughput contribution per unit of bottleneck resource (in order to maximize throughput.
The calculations are same as those of ‘limiting factor Analysis’. The difference is that we use throughput
contribution(Sales minus direct material costs only) in TPA rather simple contribution(which is calculated as sales
minus all variable costs)
Example:
A company makes two products:
Product A B
$ $
Selling price 25 28
Material per unit 8 20
Labour per unit 5 2
Other variable overheads per unit 7 2
Fixed cost per unit 3 26
Machine hours per unit 2 1
Maximum demand 20000 units 10000 units
Total available machine hours 48000
Machine hours are the bottleneck factor.
Requirement:
Which product should be given priority using throughput accounting approach. Also calculate the production plan
and total profit.
Solution:
Step 1:
Identify the limiting factor (which is machine hours in this case)
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Step 2:
Calculate throughput contribution of each product:
A B
Selling price 25 28
Material cost per unit (8) (20)
Throughput contribution 17 8
Step 3:
Calculate throughput contribution per limiting factor & Rank: (to have a like with like comparison to know which
product is more profitable):
A B
17/2=8.5 per machine 8/1=8 per machine hour
hour
1st 2nd
Step 4:
optimal production plan:
Total Hours 48000
A (20000x2) (40000)
B(8000x1) (8000)
Nil
Step 5:
Total profit
$
Total TP contribution(340000+64000) 404000
Labour cost (120000) based on maximum demand
Variable overhead (160000) based on maximum demand
Fixed cost (80000) based on maximum demand
Profit 44000
*Note: all cost except for material is treated as operation expenses/factory cost in TP accounting.
END OF CHAPTER
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• Introduction
• Reasons/Advantages of environmental
Chapter 5 Accounting
• Limitations of EMA
Environmental • Environmental costs
• Methods for Environmental Costing
Accounting •
Introduction:
Environmental management accounting is:
’The generation and analysis of both financial and non‐financial information in order to support environment
management process.’
Example:
Activity‐based costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy
used to power the washing machine is an environmental cost; the cost driver is ‘washing’.
Once the costs have been identified and information accumulated on how many customers are using the gym, it may
actually be established that some customers are using more than one towel on a single visit to the gym. The gym
could drive forward change by informing customers that they need to pay for a second towel if they need one. Given
that this approach will be seen as ‘environmentally‐friendly’, most customers would not argue with its introduction.
Nor would most of them want to pay for the cost of a second towel. The costs to be saved by the company from this
new policy would include both the energy savings from having to run fewer washing machines all the time and the
staff costs of those people collecting the towels and operating the machines. Presumably, since the towels are being
washed less frequently, they will need to be replaced by new ones less often as well.
In addition to these savings to the company, however, are the all‐important savings to the environment since less
power and cotton (or whatever materials the towels are made from) is now being used, and the scarce resources of
our planet are therefore being conserved. Lastly, the gym is also seen as an environmentally friendly organisation and
this, in turn, may attract more customers and increase revenues. Just a little bit of management accounting (and
common sense!) can achieve all these things. While I always like to minimise the use of jargon, in order to be fully
versed on what environmental management accounting is really seen by the profession as encompassing today, it is
necessary to consider a couple of the most widely accepted definitions of it.
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Reason for Environmental accounting:
There are three main reasons why the management of environmental costs is becoming increasingly important in
organisations.
1. 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. Companies are finding that they
can increase their appeal to customers by portraying themselves as environmentally responsible.
2. 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.
3. 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.
Limitations of EMA:
But the management of environmental costs can be a difficult process.
1. This is because first, just as EMA is difficult to define, so too are the actual costs involved.
2. Second, having defined them, some of the costs are difficult to separate out and identify.
3. Third, the costs can need to be controlled but this can only be done if they have been correctly identified in the
first place.
Examples of Environmental Costs:
Consumable and raw materials
Transport and travel
Waste and effluent disposal
Water consumption
Energy
The majority of environmental costs are already captured within accounting system. It is often difficult to allocate
them to a particular product or service.
Accounting for Environmental Costs(Methods):
1. Input/output 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.
2. 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
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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.
3. 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.
4. Life Cycle 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’.
Example 1 objective test Question(OT)
Which of the following statements regarding environmental cost accounting are true?
(1) The majority of environmental costs are already captured within a typical organisation’s accounting system. The
difficulty lies in identifying them
(2) Input/output analysis divides material flows within an organisation into three categories: material flows; system
flows; and delivery and disposal flows
(3) One of the cost categories used in environmental activity‐based costing is environment‐driven costs which is used
for costs which can be directly traced to a cost centre
(4) Environmental life‐cycle costing enables environmental costs from the design stage of the product right through
to decommissioning at the end of its life to be considered
a) (1), (2) and (4)
b) (1) and (4) only
c) (1), (3) and (4)
d) (2) and (3) only
Solution:
The correct option is B
Most organizations do collect data about environmental costs but find it difficult to split them out and categories
them effectively.
Life‐cycle costing does allow the organisation to collect information about a product’s environmental costs
throughout its life cycle.
The technique which divides material flows into three categories is material flow cost accounting, not input/output
analysis.
ABC does categorise some costs as environment‐driven costs, however, these are costs which are normally hidden
within total overheads in a conventional costing system. It is environment‐related costs which can be allocated
directly to a cost centre.
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Example 2 Objective test Question(OT)
When activity‐based costing is used for environmental accounting, which statement is correct for environment‐
related costs and environment‐driven costs?
a) Environment‐related costs can be attributed to joint cost centres and environment‐driven costs cannot be
b) Environment‐driven costs can be attributed to joint cost centres and environment‐related costs cannot be
c) Both environment‐related costs and environment‐driven costs can be attributed to joint cost centres
d) Neither environment‐related costs nor environment‐driven costs can be attributed to joint cost centres
Solution:
The correct option is A
This is the correct option as environment‐driven costs are allocated to general overheads, not joint cost centres.
Example 3 Objective test Question(OT)
Different management accounting techniques can be used to account for environmental costs. One of these
techniques involves analysing costs under three distinct categories: material, system, and delivery and disposal.
What is this technique known as?
A. Activity‐based costing
B. Life‐cycle costing
C. Input‐output analysis
D. Flow cost accounting
Solution:
The correct option is D
Under a system of flow cost accounting material flows are divided into three categories – material, system, and
delivery and disposal.
END OF CHAPTER
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Study Notes Performance Management ‐ PM
• Relevant costing
• Make or buy decisions
Chapter 6 • Shut down decisions
Relevant costing • Further Processing decisions
• Outsoucing the service decision
& Short Term • One off contracts(minimum pricing
Decisions decisions)
•
Short Term Decisions
While performing the routine activities of the business, management faces different problems in choosing the
alternatives to make a decision. Management faces such problems like whether to make certain product more or
just stop it? It is more feasible to buy a product or make it by the company itself? Whether to add or drop a
certain production line?
The answer to all such questions is made by analyzing cost data. Cost data is the basis for profit calculations so it is
very important in decision making. But not all costs are relevant to decision making so managers must identify the
costs that are relevant to a decision.
A relevant cost is:
1) Future: Past costs are irrelevant, as they are not affected by current decisions and they are common to all
alternatives that management may choose.
2) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a certain decision.
Costs which would be incurred whether or not the decision is made are not considered to be incremental to
the decision(specifically related to the current decision)
3) Cash flow: Expenses like depreciation are not cash flows and are therefore not relevant.
Relevant Costs: Irrelevant Costs:
Generally Variable Costs General Fixed Costs(absorbed overheads)
Incremental Fixed Costs Uncontrollable Costs e.g. General fixed cost
Controllable costs e.g. material Unavoidable Costs
specifically bought for a building Lease
Avoidable Costs Profit or Mark‐up
Opportunity Costs Notional Cost (Assumed Cost)
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Relevant cost of materials:
The relevant cost of materials is usually their current replacement cost, beside that the materials have already
been in stock and would not be replaced once used.
The diagram below shows that how the relevant cost of materials can be identified if the materials are not in short
supply and so there is no internal opportunity cost.
is required material available in
stock?
if yes, is it regularly used? if no, puchase price will be
relavant(current market value)
if yes,relevant cost will be the if no, relavant cost will be higher of:
replacement cost (current a) scrap value
market value) b) alternative use
Note: if only scrap value OR alternative use are given in exam question, relevant cost will be the given values.
Example:
Zeneeth Co receives order from customers on special occasions like weddings and other parties of prepared food.
In the middle of the year Zeneeth just received an order of a wedding or preparing chicken vegetable stake and the
customer is ready to pay $19,000 for this order. This order would require the following materials
Material total kg kgs already book value realizable value replacement cost
required in stock of kgs in stock $/kg $/kg
Chicken 950 400 5 5.25 8
Vegetables 950 500 6 5.25 7
Herbs 150 150 7 9 12
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The following information is also available:
1) Vegetables and herbs have a lesser use in other orders so they are already in stock. There is no other use of
vegetables in any other dish but herbs can be used in another dish as an alternative for 200 kgs of dry
imported herbs, which currently cost $8 per kg but it is not present in stock currently.
2) Chicken is regularly used in most of the dishes prepared by Zeneeth and if chicken is required in this dish, they
would need to be replaced to meet other production of dishes.
Required:
What are the relevant costs of materials, in deciding whether or not to accept the order?
Solution:
Chicken: chicken is used in most of the dishes of the company regularly. There is existing stock of 400kg but if this
is used on the order under consideration then a further 400kg would be bought to replace it so relevant cost is
therefore 950kg at the replacement cost of $8 per unit.
Vegetables: 950kg are required but 500kgs are in stock. If kgs of stock are used in this dish then 450kg should
bought at $7 per kg. the kilograms in stock will not be replaced and if they are used in the current dish , they
cannot be sold at $5.25 each. The realizable value of 500kg is an opportunity cost of sales revenue forgone.
Herbs: herbs are in stock and will not be replaced. There is an opportunity cost of using herbs in the dish because
there are other alternatives either to sell the herbs in stock for $9 per kg or to avoid other purchases of dry
imported herbs, which would cost 200 x 8= $1600. Because the alternate or substitute for dry imported herbs is
more suitable, $1600 is the opportunity cost
Summary of relevant costs: $
Chicken (950 x 8) 7600
Vegetables (450 x 7) + (500 x 5.25) 5775
Herbs 1600
Total 14,975
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Relevant cost of labour:
Generally workforce is paid irrespective of the decisions made but Consider the following diagram for specific
scenarios:
is required labour available ?
if yes, do they have sprace
capacity or idle time? if no, relevant cost will be the hiring
cost ( or lower of training and hiring )
if yes,relevant cost will be the
lower of:
a) diversion cost(replacement cost
+lost contribution) if no, relavant cost will be 'zero'
b) overtime(basic+ premium)
Example including labour:
A company is considering whether or not to undertake an order from a customer, and to establish the minimum
price using relevant costing principles.
The order would require 3,000 kilos of material S. There are over 3,000 kilos already held in inventory. Material S is
no longer in regular use by the company and could be sold as scrap for $1.50 per kilo. It could also be used as a
substitute for material L, which is in regular use. Conversion costs of $1.60 per kilo would have to be spent on the
material S. One kilo of material S after conversion would be a substitute for one kilo of material L. The purchase
price of material L is $4/kg.
Skilled labour needed to fulfil the order would be specifically recruited for $50,000.
Unskilled labour needed to fulfil the order would be transferred from another department. The cost of the labour
time (3000 hours) would be $30,000 in wages. However, 1,500 of these hours would be idle time if the order is not
undertaken.
The other 1,500 hours would be spent on a work that would provide a contribution of $5,000.
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Required:
Calculate the relevant costs of material and labour for this customer order.
Solution:
Relevant cost $
Material S (3000 kilos × 2.4) 7,200
Skilled labour 50,000
Unskilled labour:
Use of idle time 0
Use of other time (50% × 30,000) + 5000 lost contribution 20,000
Total relevant cost 77,200
Notes:
‐ The relevant cost of material S is the benefit that would be obtained from the most profitable alternative use.
‐ The alternatives from using material S are
‐ To sell for scrap and earn $1.5 per kilo
‐ To use as a substitute for material L, and save $2.4 per kilo (4 ‐ 1.60)
‐ Therefore the relevant cost of material S is $2.4 per kilo (greater opportunity cost)
The full $50,000 will be the relevant cost of the skilled labour as all represent incremental cost.
The relevant cost of the unskilled labour, which will be paid wages of $30,000 anyway, is the loss of cash flow from
having to move the labour from other work. Contribution is calculated after deducting labour cost as a variable
cost, therefore 50% of the labour cost ‐ $15,000 must be included in the relevant cost along with the $5,000
contribution lost.
Opportunity Cost
Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by
choosing one opportunity instead of the next best alternative. Opportunity cost sometimes is used to refer to the
profit foregone from the next best alternative, and sometimes it is used to refer to the difference between the
profit from the action taken and the profit foregone from the next best alternative. A relevant (opportunity) cost is
one which changes with respect to a particular decision and the extant of its relevance is the extant of the change.
Opportunity Cost quantification:
To understand the concept of opportunity cost, consider the example of a contract. The contract requires material
a which is in stock now and you have to calculate the opportunity cost of material A. to find the opportunity cost
consider a simple question :what will be the result of decision to use material A on the special order?
There are three possible results and three relative concepts of cost.
The material will be replaced. The relative concept of cost is replacement cost.
If resources cannot be replaced then in this situation there are two further possibilities:
The material cannot be sold. The related concept of value is realizable value.
The material cannot be used anywhere else in the company then the relative concept of value or cost is called
economic value or value in use.
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In different situations the opportunity cost may be replacement cost or realizable value or economic value. But
before considering methods to decide which of the three is the opportunity cost in any situation it is considerable
that one very important concept of cost is notable by its omission from the alternatives identified above. This is
historic cost, it remains the basis of conventionally produced accounts but it cannot be the opportunity cost,
because it cannot change and therefore cannot be relevant.
Example
Ali has $7,000 to invest. He can invest the $7,000 in the bank account that earns 6% annually, for a first‐year return
of $420. Alternatively, he can pay off an auto loan on his car, which carries an interest rate of 8%. If he pays off the
auto loan, he will save $560 (8% of $7,000) in interest expense. (In this context, a dollar saved is as good as a dollar
earned.)
Required: What is Ali’s opportunity cost from investing in the bank account?
solution
The opportunity cost is the “profit foregone” from the best action not taken. The payoff from the action not taken
is clear: it is the $560 in interest expense avoided by paying off the loan. However, there is some ambiguity as to
whether the opportunity cost is this $560, or the difference between the $560, and the $420 that would be earned
on the bank account, which is $140.
This ambiguity is only a question of semantics with respect to the definition of opportunity cost; it does not create
any ambiguity with respect to the information provided by the concept of opportunity cost. Clearly, the
opportunity cost of paying off the auto loan implies that Ali is better off paying off the loan than investing in the
bank account.
When opportunity cost is defined in terms of the difference between the two profits (the $140 in the above
example), then the opportunity cost can be either positive or negative, and a negative opportunity cost implies
that the action taken is better than all alternatives.
Relevant cost of Non‐Current Assets (Machinery etc.):
A decision may involve using a non‐current asset like machine etc.
If NCA is specially purchased/ hired. (Relevant cost i‐e Cost of Purchase)
If the existing NCA is used for the new project (Irrelevant Cost because Depreciation is Non‐Cash)
Net Book Value is always irrelevant cost
Depreciation is always irrelevant cost
Historic Purchase Cost is irrelevant cost
Scrap Value of machine is relevant cost
Example objective test question(OT)
The Fruit Company (F Co) currently grows fruit which customers pick themselves from the fields before paying. F
Co is concerned that a large number of customers are eating some of the fruit whilst picking it and are
therefore not paying for all of it. As a result, it has to decide whether to hire staff to pick and package the fruit
instead. The following values and costs have been identified:
(i) The total sales value of the fruit currently picked and paid for by customers
(ii) The cost of growing the fruit
(iii) The cost of hiring staff to pick and package the fruit
(iv) The total sales value of the fruit if it is picked and packaged by staff instead
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Which of the above are relevant to the decision?
A All of the above
B (ii), (iii) and (iv) only
C (i), (ii) and (iv) only
D (i), (iii) and (iv) only
Solution:
The correct option is D
Option (ii) is not relevant since it is a common cost.
Short term decision making:
1. Make or buy decisions:
The suggested approach is to compare between the relevant costs of make or buy a product. If it cheaper to
make, the company should manufacture internally and if it cheaper to buy then the company should buy from
the outsiders.
In an exam questions you have to compare;
Relevant cost of making VS purchasing from outside supplier
Example
Jerry Ltd produces a number of components, two of which the production manager is considering buying in,
components X and Y:
Cost of making ($) X Y
Variable 14 28
Fixed 4 4
Total 18 32
Purchase price (from outside supplier) 17 25
Should Jerry Ltd make or buy in and discuss other factors (non‐financial)?
solution:
Variable cost (marginal cost) of making in‐house: 14 28
Variable cost of buying in: 17 25
Amount saved by making in‐house 3
Amount saved by buying in 3
Make in house
Decision? Buy in
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From this we can establish that it is cheaper by $3 to make X in‐house, there is no point in paying a supplier
$17 in order to save yourself $14 by making the product internally.
Similarly, it makes sense to buy in Y from the outside supplier, who can manufacture the product $3 cheaper
than Jerry.
Other factors:
Jerry would need to be confident that:
• The supplier can continue in the long term to supply at a competitive price;
• The supplier can meet Jerry’s needs in terms of flexibility of supply and quality;
• No extra costs will arise from the decision to stop making X in‐house. For example staff may have to be
made redundant or machinery may need to be scrapped.
Make or buy with limiting factor:
Which product to outsource (Buy) first?
The product with minimum cost will be bought first from the supplier
For rest of the products (expensive from supplier), Calculate extra buy in cost/limiting factor.
Rank the products which generates minimum extra buy in cost should be ranked first.
2. Shut Down Decision:
A decision related to shut down a:
a) department
b) product line
c) division
The decision should always be based on contribution. Profit won’t be able to give an appropriate decision.
RULE: As long as the product line/ department/ division generating contribution, it should not be closed down.
OR
Decision criteria: Shut down if avoidable costs > Revenues foregone
Other Factors(non‐financial):
The other product sales might be effected
Competitors can take advantage of your situation attracts customers.
Shutting down a department can adversely affect the rest the rest of employees reducing their morale.
Redundancy can lead to legal and reputation issues
Machine’s idle capacity can be generated as well (over capacity)
Over capacity of labour
Reputation issues
Adverse effect on suppliers causing loss of goodwill
Bulk purchase of discount might be lost
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Study Notes Performance Management ‐ PM
Example:
Jones Ltd operates three divisions within a larger company. The CEO has been shown the latest profit
statements and concerned that division C is losing money.
You are required to advise her whether or not to close down division C.
Division A ($000s) B($000s) C($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.
Should division C be shut down?
Solution:
Division C $'000 $'000
Revenue foregone (40)
Avoidable costs
Variable costs 30
Specific fixed costs
($20,000x40%) 8 38
Net cost of closure (2)
The decision should be to retain Division C. If closed, the business would lose $2,000 in overall profit. In
essence the contribution foregone of $10,000 ($40,000 revenue ‐ $30,000 variable costs) exceeds the specific
fixed costs saved.
Note: alternatively, calculations can be made for contribution being earned by division C.
3. Further Processing Decisions:
We can consider the relevant costing decision issue of whether or not it is worthwhile processing a product
further through a production system.
For example in a petroleum refining process, crude oil is refined in a ‘joint process’. Once refined, separate
products can be clearly identified such as; petrol, kerosene, lubricate oils etc. These are known as ‘joint
products’ and are usually identified at the split‐off point.
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The business needs to decide whether it is worthwhile selling unrefined products at this ‘split off’ point.
Alternatively the business can process/refine the product further and then sell the more refined product at a
higher sales price.
Rule:
If incremental Revenue is GREATER than incremental Cost then,
Decision : Process this further
If incremental Revenue is LESS than incremental Cost then,
Decision : Do not process further
FORMULA:
Incremental Revenue – Incremental Cost
Units x (New SP – Old SP) Further Processing Cost
NOTE: Joint costs are irrelevant because they are sunk costs and are incurred before the point of split.
Example:
Unrefined Product A can be sold at the separation point for $5 per unit. If it is further processed, at a cost of
$8 per unit, it can then be sold in its more refined state for $16 per unit. Should it be processed further?
Solution:
The word ‘incremental’ is important for relevant cost decisions because it identifies the extra cost, revenue or
cash flow that will occur as a result of a decision. Here, if Product A is processed further, incremental revenue
and costs will be earned/incurred:
$
Sales price if processed further (refined Product A) 16
Sales price if sold at split off point (unrefined Product A) 5
Incremental revenue 11
Incremental costs of processing further (8)
Extra profit by further processing 3
We can see that further processing is worthwhile because the incremental revenue of $11 outweighs the
incremental costs of $8.
If we altered the example so that only $12 is earned after further processing, then the decision would change
and it would no longer be worthwhile processing further and Product A should be sold at the split‐off point:
$
Sales price if processed further (refined Product A) 12
Sales price if sold at split off point (unrefined Product A) 5
Incremental revenue 7
Incremental costs of processing further (8)
Extra loss by further processing (1)
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4. Outsourcing a service to an External Party:
Decision Rule: If a company decides to outsource an internal service to an external party the decision will be
made by company.
Relevant cost of performing service in house VS Cost of out sourcing
5. Special one off contract and minimum pricing:
Minimum price equals to the relevant cost of the project
Example:
The Hi Life Co (HL Co) makes sofas. It has recently received a request from a customer to provide a one‐off
order of sofas, in excess of normal budgeted production. The order would need to be completed within two
weeks.
The following cost estimate has already been prepared:
Direct materials: Note $
Fabric 200 m2 at $17 per m2 1 3,400
Wood 50 m at $8‐20 per m2 2 410
Direct labour:
Skilled 200 hours at $16 per hour 3 3,200
Semi‐skilled 300 hours at $12 per hour 4 3,600
Factory overheads 500 hours at $3 per hour 5 1,500
Total production cost 12,110
Administration overheads at 10% of total production cost 6 1,211
Total cost 13,321
Notes
1. The fabric is regularly used by HL Co. There are currently 300 m2 in inventory, which cost $17 per m2. The
current purchase price of the fabric is Si7‐50 per m2.
2. This type of wood is regularly used by HL Co and usually costs S8‐20 per m2. However, the company's current
supplier's earliest delivery time for the wood is in three weeks' time. An alternative supplier could deliver
immediately but they would charge $8‐50 per m2. HL Co already has 500 m2 in inventory but 480 m2 of this is
needed to complete other existing orders in the next two weeks. The remaining 20 m2 is not going to be
needed until four weeks' time.
3. The skilled labour force is employed under permanent contracts of employment under which they must be
paid for 40 hours' per week's labour, even if their time is idle due to absence of orders. Their rate of pay is $16
per hour, although any overtime is paid at time and a half. In the next two weeks, there is spare capacity of
150 labour hours.
4. There is no spare capacity for semi‐skilled workers. They are currently paid $12 per hour or time and a half for
overtime. However, a local agency can provide additional semi‐skilled workers for $14 per hour.
5. The $3 absorption rate is HL Co's standard factory overhead absorption rate; $1‐50 per hour reflects the cost
of the factory supervisor's salary and the other $1 ‐50 per hour reflects general factory costs. The supervisor is
paid an annual salary and is also paid $15 per hour for any overtime he works. He will need to work 20 hours'
overtime if this order is accepted.
6. This is an apportionment of the general administration overheads incurred by HL Co.
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Required:
Prepare, on a relevant cost basis, the lowest cost estimate which could be used as the basis for the quotation.
Explain briefly your reasons for including or excluding each of the costs in your estimate.
Solution:
HI Lite Co
Direct materials: Note $
Fabric 200 m2 at $17‐50 per m2 1 3,500
Wood 20 m at $8‐20 per m 2 164
30 m at $8 50 per m 2 255
Direct labour:
Skilled 50 hours at $24 per hour 3 1.200
Semi‐skilled 300 hours at $14 per hour 4 4.200
Factory overheads 20 hours at $ 15 per hour 5 300
Administration overheads 6 ‐
Total cost 9.619
1. Since the material is in regular use by HL Co. it is replacement cost which is the relevant cost (or the contract.
2. 30 m will have to be ordered from the alternative supplier for immediate delivery but the remaining 20 m can
be used from inventory and replaced by an order from the usual supplier at a cost of $8‐20 per m.
3. There is no cost for the first 150 hours of labour because there is spare capacity. The remaining 50 hours will
be paid at time and a half, which is $16 x 1‐5. i.e. $24 per hour.
4. HL Co will choose to use the agency workers, who will cost $14 per hour, since this is cheaper than paying
existing semi‐skilled workers at $18 per hour ($12 x 1‐5) to work overtime.
5. None of the general factory costs are incremental, so they have all been excluded. However, the supervisor's
overtime pay is incremental, so has been included. The supervisor's normal salary, on the other hand, has
been excluded because it is not incremental.
6. These are general overheads and are not incremental, so no value should be included for them.
END OF CHAPTER
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• Objective of CVP analysis
• Single product CVP(breakeven points, C/S
ratio, target profits, margin of safety)
Chapter 7 • Single product breakeven ad P/V charts
• Multi product CVP(breakeven points,
CVP Analysis weighted average C/S ratio, target profits
,margin of safety)
• Multi product breakeven and P/V charts
• Limitations/Assumptions of CVP
Cost‐volume‐profit analysis looks primarily at the effects of differing levels of activity on the financial results of a
business
In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into a crystal ball
and find out exactly how many customers were going to buy our product, we would be able to make perfect
business decisions and maximize profits.
Take a restaurant, for example. If the owners knew exactly how many customers would come in each evening and
the number and type of meals that they would order, they could ensure that staffing levels were exactly accurate
and no waste occurred in the kitchen. The reality is, of course, that decisions such as staffing and food purchases
have to be made on the basis of estimates, with these estimates being based on past experience.
While management accounting information can’t really help much with the crystal ball, it can be of use in
providing the answers to questions about the consequences of different courses of action. One of the most
important decisions that need to be made before any business even starts is ‘how much do we need to sell in
order to break‐even?’ By ‘break‐even’ we mean simply covering all our costs without making a profit.
This type of analysis is known as ‘cost‐volume‐profit analysis’ (CVP analysis) and the purpose of this article is to
cover some of the straight forward calculations and graphs required for this part of the Performance Management
syllabus, while also considering the assumptions which underlie any such analysis.
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The Objective of CVP Analysis
CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The
reason for the particular focus on sales volume is because, in the short‐run, sales price, and the cost of materials
and labour, are usually known with a degree of accuracy. Sales volume, however, is not usually so predictable and
therefore, in the short‐run, profitability often hinges upon it.
For example, Company A may know that the sales price for product X in a particular year is going to be in the
region of $50 and its variable costs are approximately $30.
It can, therefore, say with some degree of certainty that the contribution per unit (sales price less variable costs) is
$20. Company A may also have fixed costs of $200,000 per annum, which again, are fairly easy to predict.
However, when we ask the question, ‘Will the company make a profit in that year?’ the answer is ‘We don’t know’.
We don’t know because we don’t know the sales volume for the year. However, we can work out how many sales
the business needs to achieve in order to make a profit and this is where CVP analysis begins.
CVP Analysis concepts and single Product Analysis:
Breakeven Point:
The breakeven point is when total revenue equals total costs
Contribution is calculated as sales revenue less variable costs and this contributes towards paying the fixed costs of
the organisation. Once the fixed costs have been paid any remaining contribution is profit.
Therefore when contribution is equal to fixed costs this is when the company is at its breakeven point as there is
no profit or loss made.
Example:
Contribution per unit = $15 per unit
Fixed costs = $30,000
If the company sold 3,000 units total contribution = $15 × 3,000 = $45,000.
After paying fixed costs of $30,000 there is $15,000 contribution remaining, which is profit.
If the company sold 2,000 units, total contribution = $15 × 2,000 = $30,000.
After paying fixed costs of $30,000 there is no profit made because contribution is equal to the fixed costs.
we know that;
Profit = Contribution ‐ Fixed costs
Rearranging this formula we can say that
Contribution = Fixed costs + Profit.
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Remember that contribution equals the number of sales units multiplied by contribution per unit. At the
breakeven point there is no profit and so the formula to calculate the breakeven point in units is as follows:
From the above example;
Breakeven units = $30,000/$15 = 2,000 units
Contribution to sales ratio
This ratio calculates just how much each $ sold contributes towards paying the fixed costs. It is calculated as:
It can also be calculated using total contribution and total sales revenue, it does not have to be calculated per unit.
Example:
Units sales price = $20
Unit variable costs = $8
Contribution per unit = $12
C/S ratio = $12/$20
This shows that for every $1 of sales revenue, $0.60 of contribution is generated and contributes towards the fixed
costs.
The C/S ratio can be used to calculate breakeven sales revenue
Target profits and Sales:
Calculating sales volume to achieve a target profit
We can use the formula Contribution = Fixed Costs + Profit to also calculate how many units we would need to sell
in order to achieve a desired profit. It is very similar to the breakeven units calculation, however this time we have
to bring profit into the calculation.
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Calculating sales Revenue to achieve a target profit
For this purpose C/S Ratio is used
Try this example now;
Example:
Unit sales price = $40
Unit variable costs = $24
Contribution per unit = $16
Fixed costs = $160,000
Calculate the C/S ratio, breakeven sales revenue and required revenue to achieve a profit of $56,000.
Solution:
C/S ratio = $16 / $40
= 0.4 or 40%
Breakeven sales revenue = $160,000/0.4
= $400,000
Required revenue = ($160,000 + $56,000)/0.4
= $216,000/0.4
= $540,000
Margin of safety:
This is a measure of sensitivity or riskiness of the budget. It measures how much that budgeted sales can decrease
before the business will fall into a loss making position, and therefore the excess of budgeted sales over the
breakeven sales.
It can be measured in terms of revenue, units or as a percentage:
Margin of safety (units) = Budgeted sales units – Breakeven sales units
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Example:
Sales price/unit = $50
Marginal cost/unit = $30
Contribution/unit = $20
Total fixed costs = $100,000
Budgeted sales = 16,000 units
Calculate the margin of safety in units, revenue and as a percentage.
Solution:
Firstly we need to calculate the breakeven point in units:
Breakeven (units) = $100,000/$20
= 5,000 units
Margin of safety (units) = 16,000 units ‐ 5,000 units
= 11,000 units
Margin of safety (revenue) = (16,000 units ‐ 5,000 units) x $50
= $550,000
Margin of safety (%) = (16,000 units ‐ 5,000 units)/16,000 units
= 0.6875 = 68.75%
Breakeven, contribution &profit volume(P/V) charts(single product):
Traditional breakeven chart
This chart plots total sales revenue, total cost and fixed cost and the breakeven point is where the total sales
revenue and total cost line intersect.
Contribution breakeven chart
The contribution breakeven chart is very similar to the traditional one however instead of having a fixed cost line
there is now a total variable cost line. The fixed costs is represented as the distance between the total cost and
the total variable cost line.
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Therefore on this chart it is clear to see contribution at different levels of activity as it is the distance between total
revenue and total variable cost.
Profit/volume chart
This chart emphasizes how different activity levels impacts on the level of profit and is an important chart for
paper PM.
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Multi‐product breakeven analysis
When carrying out breakeven analysis for organisations that sell more than one product we have to make an
assumption that those products are always sold in a constant sales mix. For example if an organisation makes
products P and Q then we assume that they are always sold together in a constant ratio such as 3:1. So that
whenever 3 units of P are sold 1 unit of Q is sold.
By assuming this ratio it enables us to calculate a weighted average contribution for each sales mix on the basis of
the proportion of each product in the mix. However this assumption will only allow an estimated analysis as it will
assume the products are always sold in a particular mix which may not always be the case. It could be that the
organisation will sell more units of one product or that it may choose to sell its most profitable product first. We
will examine the effects of selling the products in a different order when we look at multi‐product breakeven
charts.
Breakeven point
Multi‐product breakeven considerations
In multi‐product situation we can calculate a breakeven point as a number of product mixes by calculating the
contribution per sales mix.
Example:
Bat Pic produces two products, the ball and the racket. Below Is the sales and cost Information for the two
products:
Ball Racket
Sales price $3 $5
Variable cost $1.75 $2.30
Contribution per unit $1.25 $2.70
Bat pic have estimated that these products will always be sold In the ratio of 4:1. So for every 4 balls that are sold 1
racket Is also sold. Fixed costs are estimated to be $27,000.
Contribution per mix = ($1.25 x4) + ($2.70 x l)
= $7.70
Breakeven point (mixes) = $27,000/$7.70
= 3.507 mixes
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To determine how many units of each product need to be sold to reach this breakeven we need to multiply the
number of mixes by the proportion of units In the mix.
Breakeven (no. of units of each product) = (3,507 X 4) = 14,028 units of balls
= (3,507 X l) = 3,507 units of rackets
Please note that these two figures should never be added together to give a breakeven point In units as the
assumption Is that they are sold In this constant sales mix.
Weighted Average Contribution/Sales Ratio
Again assuming that the products are always sold in the same constant sales mix we can calculate a weighted
average
contribution to sales ratio, which will enable us to calculate a breakeven sales revenue:
Breakeven sales revenue = Fixed costs/Weighted average CS ratio
Following the above example(bat plc)
Sales revenue per mix = ($3 x 4) + ($5 x 1)
= $17
Contribution per mix (calculated previously) = $7.70
Weighted average C/S ratio = $7.70/$17
= 0.453 or 45.3%
Breakeven sales revenue = $27,000/0.453
= $59,603
In order to calculate the breakeven sales revenue for the Individual products we need to calculate the ratio of
revenue.
Revenue Ratio = ($3 x4 ) :( $5 x1)
= 12 :5
Therefore breakeven sales are: Ball $59,603 x 12/17 = $42,073
Bat $59,603 x 5/17 = $17,530
Margin of safety
Margin of safety in multi‐product breakeven analysis is exactly the same as in single product breakeven analysis;
however we use the breakeven sales in the standard mix.
Target profit calculations
This formula is very similar to that of single product breakeven analysis; however this time we will be calculating
the number of mixes of products in order to achieve the target profit.
It is calculated as:
No. of mixes to achieve target profit = (Fixed costs + Target profit)/Contribution per mix
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Example objective test question(OT):
A company makes and sells product X and product Y. Twice as many units of product Y are made and sold as that
of product X. Each unit of product X makes a contribution of $10 and each unit of product Y makes a contribution
of $4. Fixed costs are $90,000.
What is the total number of units which must be made and sold to make a profit of $45,000?
A. 7,500
B. 22,500
C. 15,000
D. 16,875
Solution:
The correct option is B
Two units of Y and one unit of X would give total contribution of $18.
Weighted average contribution per unit = $18/3 units = $6
Sales units to achieve target profit = ($90,000 + $45,000)/$6 = 22,500
Example objective test question(OT):
The following information is available for a manufacturing company which produces multiple products:
(i) The product mix ratio
(ii) Contribution to sales ratio for each product
(iii) General fixed costs
(iv) Method of apportioning general fixed costs
Which of the above are required in order to calculate the break‐even sales revenue for the company?
A All of the above
B (i), (ii) and (iii) only
C (i), (iii) and (iv) only
D (ii) and (iii) only
Solution:
The correct option is B
The method of apportioning general fixed costs is not required to calculate the break‐even sales revenue.
Breakeven charts (multi‐product )
You could be asked to draw a breakeven chart for a multi‐product situation and there are different approaches to
how we do this based on the assumptions we make.
A contribution chart is not specifically covered, however you could be asked to draw a traditional breakeven chart
or a profit volume chart. Due to the amount of lines drawn on a breakeven chart then a new one will need to be
drawn for each approach we use. However on a profit volume chart we can draw both approaches on the same
chart
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consider the following example to understand;
Walters PLC sells three products D, A and Z and they sell for $16, $12 and $12 respectively. Their variable costs are
$6, $8 and $10 respectively. Fixed cost for Walters Pic are $20,000 per annum.
Walters Pic predicts that sales for next year will be 4,000 units for 0,8,000 units for A and 6,000 units for Z. The three
products are always sold in the ratio of 2:4:3.
Breakeven chart ‐ assuming constant product mix
As we did when drawing a simple breakeven chart we need to establish the points for the three lines on the graph
and also for drawing the axis.
Fixed cost line ‐ this will be a horizontal line parallel to the x axis at $20,000.
Total revenue line the first point will be In the origin and the second point Is maximum sales revenue
calculated below.
D = 4,000 x $16 =$64,000
A = 8,000 x $12 = $96,000
Z = 6,000 x $12 =$72,000
Total = $232,000
Total cost ‐ the first point for this line will be when the x axis is equal to 0 and y axis is equal to
fixed costs line of $20,000.
The second point for this line will be the total cost of the three products calculated
below.
Variable Cost
D = 4,000 x $6 = $24,000
A = 8,000 x $8 = $64,000
Z = 6,000 x $10 =$60,000
Total variable cost =$148,000
Total fixed cost = $20,000
Total cost = $168,000
Now that we have the points for the lines and have establish the values for our axis we can now draw the
breakeven chart.
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The breakeven point Is approximately $55,000 of sales revenue. This can be shown by solving this
mathematically.
Contribution per mix = ($10 x 2) + ($4 x 4) + ($2 x 3)
= $42 per mix
Breakeven (mixes) = $20,000/$42
= 477 mixes (rounded)
Breakeven sales revenue
D (477 x 2) x $16 =$15,264
A (477 x 4) x $12 = $22,896
Z (477 x 3) x $12 = $17,172
Total = $55,332
P/V charts(Multi product)
Let discuss it with an example;
A company produces two products X and Y. the following information is relevant:
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The weighted average C/S ratio of 0.34375 or 34.375% has been calculated by calculating the total contribution
earned across both products and dividing that by the total revenue earned across both products.
When discussing graphical methods for establishing the break‐even point, we considered break‐even charts and
contribution graphs. These could also be drawn for a company selling multiple products, such as Company A in our
example.
The one type of graph that hasn’t yet been discussed is a profit–volume graph. This is slightly different from the
others in that it focuses purely on showing a profit/loss line and doesn’t separately show the cost and revenue
lines. In a multi‐product environment, it is common to actually show two lines on the graph: one straight line,
where a constant mix between the products is assumed; and one bow‐shaped line, where it is assumed that the
company sells its most profitable product first and then its next most profitable product, and so on.
In order to draw the graph, it is therefore necessary to work out the C/S ratio of each product being sold before
ranking the products in order of profitability. It is easy here for Company A, since only two products are being
produced, and so it is useful to draw a quick table as see on the spreadsheet below (prevents mistakes in the exam
hall) in order to ascertain each of the points that need to be plotted on the graph in order to show the profit/loss
lines.
The table should show the cumulative revenue, the contribution earned from each product and the cumulative
profit/(loss). It is the cumulative figures which are needed to draw the graph.
The graph can then be drawn (below) ,showing cumulative sales on the x axis and cumulative profit/loss on the y
axis. It can be observed from the graph that, when the company sells its most profitable product first (X) it breaks
even earlier than when it sells products in a constant mix. The break‐even point is the point where each line cuts
the x axis.
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Limitations /Assumptions of Cost‐Volume‐Profit Analysis:
Cost‐volume‐profit analysis is invaluable in demonstrating the effect on an organization 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 constant 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.
END OF CHAPTER
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• Single limiting factor and Optimal
Plan(steps)
Chapter 8 • Mutiple limiting factor‐linear
programming(step by step solved
example) shadow price‐how to calculate
Limiting Factor • Importance of Shadow price in Decision
Analysis Making
• Slack and calculation
• Surplus
•
Limiting factor is that resource which is in short supply and which limits the output of the business e.g. labour,
materials, machine capacity etc.
Single Limiting Factor:
This section looks at situations where there is only one factor limiting the company’s activities. This would typically
be a
Short term restriction on one of the following:
Limited availability of materials
Key staff shortages
Productive capacity etc.
In the long‐term, the business could rectify this by (for example) sourcing from different suppliers, recruiting new
workers (or re‐training existing workers), purchasing new machinery etc.
In the short‐term, we aim to maximize contribution by choosing production combinations of products which make
the ‘best use’ of the scarce resource. Again we assume that fixed costs in total will not change as a result of our
decision.
Decision criteria: Select and produce products which maximize the contribution per unit of the limiting factor
The steps involved in limiting factor decision questions are:
Step 1: Calculate the contribution per unit of sale (contribution of each product)
Step 2: Calculate the contribution per unit of scarce resource (contribution per unit of sale ÷ limiting factor per unit
of sale)
Step 3: Rank production schedule in order of step 2 – starting with the highest first;
Step 4: Use up the resource in order of the ranking(Optimal production plan)
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Example objective test Question(OT):
A company manufactures three products using different amounts of the same grade of labour, which is in short
supply.
The following budgeted data relates to the products:
Per unit: P1 P2 P3
$ $ $
Selling price 120 140 95
Materials ($2 per kg) (40) (32) (22)
Labour ($10 per hour) (10) (20) (11)
Variable overheads (20) (28) (24)
Fixed overheads (6) (9) (12)
–––– –––– ––––
Profit per unit 44 51 26
–––– –––– ––––
What order should the products be manufactured in to ensure that profit is maximised?
P1 P2 P3
A 2nd 1st 3rd
B 2nd 3rd 1st
C 1st 3rd 2nd
D 1st 2nd 3rd
Solution:
The correct option is C
Profit per unit 44 51 26
Add back fixed costs 6 9 12
Contribution per unit 50 60 38
Contribution per labour hour 50 30 34∙55
Ranking 1st 3rd 2nd
Multi Limiting Factor (The Linear Programming)
In the limiting factor analysis we have performed so far, we have considered just one limitation.
We now extend this analysis to consider situations where multiple restrictions or limiting factors exist. We only
consider two products in this situation.
We solve this problem by using linear programming. ‘Linear’ implies the use of straight line relationships and
‘programming’ involves formulating and solving the problem using mathematical techniques.
Let’s consider a simple example to understand linear programming:
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Example:
Suppose a profit‐seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited to
15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses three kgs of material
and four hours of labour, whereas to make Y, the firm uses five kgs of material and four hours of labour. The
contribution per unit made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg,
and the labour rate is $10 per hour.
Solution:
Linear programming is a multi‐part step by step approach:
Step 1: define variables
The first step in any linear programming problem is to define the variables and the objective function. Defining the
variables simply means stating what letter you are going to use to represent the products in the subsequent
equations as follows;
Let X = number of X to be produced
Let Y = number of Y to be produced
Step 2:define objective function
The objective function is essentially the contribution formula as the objective is to maximise contribution and
therefore profit.
Contribution = ($30 x units of X produced) + ($40 x units of Y produced), therefore: C = 30X + 40Y
Step 3:define constraints
The next step is to define the constraints. In our example;
the materials constraint will be 3X + 5Y ≤ 15,000,
and the labour constraint will be 4X + 4Y ≤ 16,000.
Note: You should not forget the non‐negativity constraint, if needed, of X,Y ≥ 0.
Step 4:Graph the constraints
In order to plot the graph you need to solve the constraints. This gives us the co‐ordinates for the constraint lines
on the graph.
Material:
If X = 0, Y = 3,000
If Y = 0, X = 5,000
Labour:
If X = 0, Y = 4,000
If Y = 0, X = 4,000
Step 5: Iso‐contribution Line:
In order to be able to plot the objective function (contribution) line you need to insert a figure to represent
contribution into the formula and solve in the same way as the constraints.
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Note: Select a figure for contribution which is easily divisible by your two contribution per unit figures – for
example:
Let C = $60,000
If X = 0, Y = 1,500
If Y = 0, X = 2,000
Figure 1: Optimal production plan
The area represented on the graph 0ABC is called the feasible region.
Plotting the resulting graph will show that by pushing out the objective function (iso contribution line‐dotted line
on the diagram) to the furthest vertex in the feasible region which is along the gradient of the objective function,
the optimal solution will be at point B (called as the optimal point) – the intersection of materials and labour
constraints. This is also the furthest vertex in the feasible region along the gradient of the objective function.
The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution. Check this for yourself
(Working 1). The ability to solve simultaneous equations is assumed in this article.
Working 1:
The optimal point is at point B, which is at the intersection of:
3X + 5Y = 15,000, and
4X + 4Y = 16,000
Multiplying the first equation by four and the second by three we get:
12X + 20Y = 60,000
12X + 12Y = 48,000
The difference in the two equations is:
8Y = 12,000, or Y = 1,500
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Substituting Y = 1,500 in any of the above equations will give us the X value:
3X + 5 (1,500) = 15,000
3X = 7,500
X = 2,500
The contribution gained is (2,500 x 30) + (1,500 x 40) = $135,000
The point of this calculation is to provide management with a target production plan in order to maximise
contribution and therefore profit. However, things can change and, in particular, constraints can relax or tighten.
Management needs to know the financial implications of such changes. For example, if new materials are offered,
how much should be paid for them? And how much should be bought? These dynamics are important.
Shadow Price/Dual Price:
Shadow price of limiting factor is the increase in contribution which would be created by having one additional unit
of the limiting factor(most binding constraint) at its original cost.
The shadow price is the maximum premium above the basic rate that an oganisation should be willing to pay for
one extra unit of a resource.
Shadow price indicates the effect of one unit change in constraint( provide a measure of the sensitivity of the
results)
The shadow price of a constraint that is not binding at the optimal solution is ‘zero’
Shadow prices are only valid for a small range before the constraint becomes a non‐binding if different resource
becomes critical.
Use of Shadow Price:
Shadow price helps management to make better informed decisions about:
Payment of overtime premiums
Bonuses
Premium for small orders i.e. Raw materials
Steps for Calculation of Shadow Price:
1. Take the equations of the constraints which falls at optimal point
2. Add 1 extra unit to the binding constraint for which the shadow price is to be calculated
3. Solve the equation simultaneously and get a new optimal plan, this optimal plan is with an assumption that
there is one extra unit of the binding constraints available
4. Calculate total contribution with this new optimal plan
5. Calculate shadow price by comparing Contribution with original optimal plan and Contribution with new
optimal plan
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Example:
From our linear programming example, let’s work out on calculation of shadow price for materials:
Shadow price of materials
To find this we relax the material constraint by 1kg and resolve as follows:
3X + 5Y = 15,001 and
4X + 4Y = 16,000
Again, multiplying by four for the first equation and by three for the second produces:
12X + 20Y = 60,004
12X + 12Y = 48,000
8Y = 12,004
Y = 1,500.5
Substituting Y = 1,500.5 in any of the above equations will give us X:
3X + 5 (1,500.5) = 15,001
3X = 7,498.5
X = 2,499.5
The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005
The increase in contribution from the original optimal is the shadow price: 135,005 – 135,000 = $5 per kg.
The shadow price of materials is $5 per kg .The important point is, what does this mean? If management is offered
more materials it should be prepared to pay no more than $5 per kg over the normal price. Paying less than $13
($5 + $8) per kg to obtain more materials will make the firm better off financially.
Paying more than $13 per kg would render it worse off in terms of contribution gained. Management needs to
understand this.
There may, of course, be a good reason to buy ‘expensive’ extra materials (those costing more than $13 per kg). It
might enable the business to satisfy the demands of an important customer who might, in turn, buy more products
later. The firm might have to meet a contractual obligation, and so paying ‘too much’ for more materials might be
justifiable if it will prevent a penalty on the contract. The cost of this is rarely included in shadow price calculations.
Equally, it might be that ‘cheap’ material, priced at under $13 per kg, is not attractive. Quality is a factor, as is
reliability of supply. Accountants should recognize that ‘price’ is not everything.How Many Materials To Buy?
Students need to realise that as you buy more materials, then that constraint relaxes and so its line on the graph
moves outwards and away from the origin. Eventually, the materials line will be totally outside the labour line on
the graph and the point at which this happens is the point at which the business will cease to find buying more
materials attractive (point D on the graph). Labour would then become the only constraint.
We need to find out how many materials are needed at point D on the graph, the point at which 4,000 units of Y
are produced. To make 4,000 units of Y we need 20,000kg of materials. Consequently, the maximum amount of
extra material required is 5,000kg (20,000 – 15,000).
Note: Although interpretation is important at this level, there will still be marks available for the basic calculations.
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Example‐Objective Tests Question:
C Co uses material B, which has a current market price of $0∙80 per kg. In a linear program, where the
objective is to maximise profit, the shadow price of material B is $2 per kg. The following statements have
been made:
(i) Contribution will be increased by $2 for each additional kg of material B purchased at the current
market price
(ii) The maximum price which should be paid for an additional kg of material B is $2
(iii) Contribution will be increased by $1∙20 for each additional kg of material B purchased a t the current
market price
(iv) The maximum price which should be paid for an additional kg of material B is $2∙80
Which of the above statements is/are correct?
A. (ii) only
B. (ii) and (iii)
C. (i) only
D. (i) and (iv)
Solution:
The correct option is D
Statement (ii) is wrong as it reflects the common misconception that the shadow price is the maximum price
which should be paid, rather than the maximum extra over the current purchase price.
Statement (iii) is wrong but could be thought to be correct if (ii) was wrongly assumed to be correct.
Slack & Surplus:
Slack:
At optimal point, the two constraints are the most binding constraints. Slack for binding constraint is always ‘zero’.
Slack occurs when maximum availability of resource is not used
Slack is the amount of unused resource.
Where the constraint is less than or equal to constraint
Surplus:
Surplus occurs when more than a minimum requirement is used.
Surplus is the excess over the minimum amount of constraint where the constraint is more than or equal to the
constraint.
Example‐objective Tests Question:
A jewellery company makes rings (R) and necklaces (N).
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The resources available to the company have been analyzed and two constraints have been identified:
Labour time 3R + 2N = 2,400 hours
Machine time 0∙5R + 0∙4N = 410 hours
The management accountant has used linear programming to determine that R = 500 and N = 400.
Which of the following is/are slack resources?
(1) Labour time available
(2) Machine time available
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2
Solution:
The correct option is A
If the values for R and N are substituted into the constraints:
Labour required = (3 x 500) + (2 x 400) = 2,300 hours which is less than what is available so there is slack.
Machine time required = (0∙5 x 500) + (0∙4 x 400) = 410 hours which is exactly what is available and so there is no
slack.
END OF CHAPTER
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•Factors affecting prices and types of markets
•Relationship between price & Demand
•Price elasticity of demand
•The Demand equation
•Profit maximizing quantity and Price (tabular
Chapter 9 and algebraic methods)
•Pricing Strategies for new products (skimming
Pricing Decisions & Penetration)
•Other pricing Strategies (complementary
pricing, volume discounting, product line
pricing, price discrimination, cost based and
minimum pricing (based on relevant costs)
The pricing of products or services is one of the more difficult and more important decisions for the organization.
The prices adopted by a company will have an immediate effect on the profitability of an organization and longer
term implications on the marketing of the product
Factors Affecting Price:
Inflation
Newness‐new or old product?
Incomes‐level of incomes of the community
Product range‐number and type of products being sold
Ethics‐sometimes it unethical to raise prices after a certain level
Product life cycle‐ life cycle stage effects price e.g. maturity stage means highest prices
Organizational goals‐ whether a profit making business? What is most important
Price sensitivity‐can a company passes on the burden of increased costs to customers?
Price perception –way customers react to prices
Quality of the product
Competitors pricing strategy
Suppliers‐what prices they are charging?
Types of Market:
1 Monopoly
Only one seller who dominates many buyers, so price can be set as high as possible
2 Oligopoly
Oligopoly is a market structure in which a small number of firms have the large majority of market share.
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3 Perfect competition
Selling the same product & there are a lot of buyers as well
4 Monopolistic competition
A large number of suppliers offer similar but not identical products e.g. Juices, detergents etc.
Relationship between price and demand:
Generally when price increases, demand decreases. The relationship is shown in diagram below;
Price Elasticity of demand:
Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes in price. Some products
are more responsive than others.
PED is calculated = % change in quantity /Demand (Q)
% change in price (p)
If the PED is greater than one, 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.
If the PED is less than one, 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.
If the PED is equal to one, 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.
If the PED is equal to zero, 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
factors affecting elasticity
Complementary products
Disposable income
Necessities
Tastes and fashions
Advertising and Marketing
Price
Local laws
Availability of substitutes
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Example:
The price of a good is $2 per unit and annual demand is 950,000 units. Research concludes that an increase in the
price of 20 cents per unit will result in a fall in annual demand of 86,000 units.
What is the price elasticity of demand?
Solution:
Annual demand at $2 per unit is 950,000 units.
And annual demand at $2.20 per unit is 864,000 units.
% change in demand = (86,000/950,000) x 100% = 9.053%
% change in price = (0.20/2) x 100% = 10 %
Price elasticity of demand = (9.053/10) = 0.9053
The demand for this commodity at a price of $2 per unit, would be referred to relatively inelastic because the price
elasticity of demand is lower than 1.
Interpretation of elasticity:
Perfectly Inelastic Demand Perfectly Elastic Demand
If the PED = 0 this means that the product is perfectly If the PED = infinity, this means that the product is
inelastic. This means that a change in price does not perfectly elastic. This means that demand is limitless at a
affect the quantity demanded. The quantity particular price. However, if price is increased by even a
demanded will always be the same, regardless of very small amount, demand will immediately drop to 0.
what price the company charges. The demand There is no incentive for the company to reduce the price
function for an inelastic product would be similar to as this would only reduce profits. The demand function for
the following: an inelastic product would be similar to the following:
In reality, it is highly unlikely that a product would be
perfectly inelastic. If the price of a product increases
by a high enough percentage, there will usually In a perfectly competitive market, a product with be
always be some customers who will stop buying the perfectly elastic. This is because if a company increased
product. the price very slightly, the customers with perfect
information would buy an identical product from another
Products which would be the closest to being company.
perfectly inelastic would include life‐saving
medicines, which people will be prepared to pay for
regardless of the price.
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Demand Equation:
Demand functions can be derived for a product or service.
A demand curve means a graph representing the quantity demanded at different sales prices. A straight line
demand curve has the following formula
P = a – bQ
Where;
p = the price
Q = the quantity demanded
a = the price at which the demand would be nil
b = change in price
Change in quantity
Constant (a) is calculated as follows
a = $(current price) + ( current quantity at current price x $ b)
Change in quantity when price is changed by $b
Example
Current price of a product AB is $11. The company sells at this price every month 55 units. Company decides to
increase the price to $14 one month, but just 44 units are sold at this price.
Determine the demand equation.
Solution:‐
1) First of all find the price at which demand would be nil. For demand to be nil, price needs to rise from its
current level by as many times as there are 16 units in 55 units (55/11 = 5) that is $11 + (5 x 3) = $26.
Using above formula, this is as follows:
= $11 + (55/11) x $3) = $26
2) Calculation of b:‐
b = change in price = $14 ‐ $11 = 3 = 0.27
change in quantity 55 – 44 11
demand equation is therefore P = $26 – 0.27 Q
3) Check the demand equation.
Check this by finding Q when P is $11.
11 = 26 – (0.27 Q)
0.27Q = 26 – 11
0.27Q = 15
Q = 55
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Profit‐maximizing price and quantity:
If price decreases, the quantity of units sold will increase. Given that this is the case, is it better for a given
company to sell fewer units at a high price or sell high volumes at a lower unit price? Presumably, a company
wishes to select the option that is going to maximise the total profits earned.
Before we look at how the profit‐maximising price and quantity are established, first we must understand a
number of concepts.
Traditionally, total revenue is viewed as linear i.e. if the selling price is $50/unit then total revenue will increase by
$50 every time one more unit is sold. However, we have now seen that for sales volumes to increase, the price per
unit would have to be reduced.
Price Quantity demanded Total revenue = P x Q
50 0 0
49.50 1 49.50
35 30 1.050
10 80 800
As we can see from the above, as quantity increases initially total revenue will also increase. However, if price is
reduced by too much, revenue will begin to decline as the increase in quantity is outweighed by the lost revenue
from price reductions.
Marginal revenue and marginal cost
Marginal revenue is the additional revenue earned from selling one more unit. As we have seen, the selling price
will decrease and quantity demanded increases, therefore marginal revenue decreases as Q increases.
Quantity demanded Price Total revenue Marginal revenue
1 $100 $100 $100
2 $90 $180 $80
3 $80 $240 $60
4 $70 $280 $40
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Marginal revenue can be shown graphically as follows:
Marginal revenue (MR) can be calculated as: MR = a ‐ 2bQ
Marginal cost is the additional cost incurred from making one extra unit. This is usually just the variable cost/unit
and for now, we will assume that this is constant. So if the variable cost/unit is $10 then it will always cost the
company $10 to produce one extra unit.
We can now show both marginal cost and marginal revenue on a graph:
We can see from this graph that profit will be maximised at the point where marginal revenue is equal to marginal
cost. In the graph above, point 1 therefore represents the profit‐maximising quantity.
This is because if quantity of units is below point 1, then the marginal revenue is greater than the marginal cost.
Therefore it would increase profits if quantity sold was increased by one unit.
However, once the quantity goes above point 1, the marginal revenue is less than the marginal cost. Therefore
selling further units above point 1 would actually reduce profits.
How to calculate profit maximizing price and quantity:
There are two ways;
1. Tabular approach
2. Algebraic/Equation method
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Tabular approach:
Multiple prices and quantities are considered and profit maximizing price is found by making calculations of
profits.
Example:
If we have a constant marginal cost of $8 per unit and the following revenue figures we can work out where
marginal cost equals marginal revenue (or is closest).
Units Price per unit ($) Total Revenue Marginal
Revenue
1 20 20 20
2 19 38 18
3 17 51 13
4 15 60 9
5 13 65 5
Mere we can see that marginal cost equals marginal revenue (or closest) where we sell 4 units. Does this make
sense? The profit at this level of activity Is $60 revenue less $32 cost (ie 4 units at $8 cost each), which equals $28.
Try yourself and you'll find that 3 units makes a profit of $27 (51‐24) and 5 units makes a profit of $25 (65‐40), so 4
units does maximise the profit.
Algebraic/equation Method:
Profits are maximized when, MC = MR
Where MR = a – 2bQ
Steps to calculate profit maximising price/quantity using Equation:
1 Establish the demand function (find the values for ‘a’ and ‘b’)
2 Obtain a value for MR from the demand curve. MR = a‐2bQ
3 Establish MC (the marginal cost)
4 To maximise profit, equate MC and MR to find Q
5 Substitute Q into the demand function and solve to find P (the optimium price)
Example:
A company estimates the following demand for the prices given:
Price = $7, demand = 100 units
Price = $8, demand = 60 units
The marginal cost of making each unit is $5
To work out the number of units and price we need to find the demand curve formula P=a‐bQ, work out the
marginal revenue function and then set it equal to marginal cost to find the optimal quantity to sell.
Demand curve
b = change in price/change in quantity = ‐1/40 = ‐0.025
a = 7 + 0.025 x 100 = 9.5 (using and rearranging P=a‐bQ,alternatively formula of ‘a’ can also be used )
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If marginal cost is $5 then to maximise profit;
MC = MR:
5=9.5 ‐ (2 x 0.025 Q)
so rearranging the equation, Q = 90 and P = $7.25 (from P=a‐bQ)
So we sell 90 units at $7.25 to maximise profit, giving a profit of $652.5 revenue less $450 costs = $202.50 profit.
We can see that this is higher than 100 units where we make $7 ‐ $5 profit on each, so $200 profit, or 60 units
where we make $180 profit
Different Pricing Strategies:
For New Products:
1. Skimming
2. Penetration
Price Skimming:
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.
A price skimming policy may be appropriate in the cases below:
a) The product is new and different, so that customers are prepared to pay high prices so as to be one up on
other people who do not own it.
b) The strength of demand and the sensitivity of demand to price are unknown. It is better from the point of view
of marketing to start by charging high prices and then reduce them if the demand for the product turns out to
be price elastic than to start by charging low prices and then attempt to raise them substantially if demand
appears to be insensitive to higher prices.
c) High prices in the early stages of a product's life might generate high initial cash flows. A firm with liquidity
problems may prefer market skimming for this reason.
d) The firm can identify different market segments for the product, each prepared to pay progressively lower
prices. It may therefore be possible to continue to sell at higher prices to some market segments when lower
prices are charged in others. This is discussed further below.
e) Products may have a short life cycle, and so need to recover their development costs and make a profit
relatively quickly.
Limitation of price skimming
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.
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Market Penetration pricing:
Penetration pricing is a policy of low prices when a product is first launched in order to obtain strong demand for
the product as soon as it is launched on the market. Low prices should encourage bigger demand.
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.
Other pricing Strategies:
1. Complementary products pricing:
Many businesses sell products where the main product is sold at a low margin but the accessories or after‐
sales service required, is sold subsequently at a high margin. Therefore over the life of the product a healthy
profit can be made. Examples of this might include shaving razors or electric toothbrushes where the handle is
sold at a very low margin but the tailor‐made replacement blades and brushes are sold at a healthy profit
margin.
2. Product line pricing
Some products may be sold in a range of items. For example if customers buy china crockery, then the
business may price each type of chinaware (e.g. plate, cup, vegetable dish etc.) at the same margin or mark‐
up. Alternatively different products in the range may be sold at different margins so that a reasonable profit is
made over time from an ‘average’ customer purchase. For example basic plates and bowls might be sold at a
low margin, but customers buying these products may tend to buy a salt and pepper pot in the same range
but at a much higher price and hence margin.
3. Price discrimination:
Using price discrimination a business may be able to sell what is essentially the same product or service to
different customer at different prices. In order to do this a business must recognize that it sells products to
customers with different price sensitivities. Some customers ‘tolerate’ paying much higher prices than others.
The key is identifying the circumstances where this happens and preventing customer from moving from a
high price to a lower price paying position.
4. Discount pricing/ Volume discounting
Some retailers may aim to be profitable by selling larger volumes of units at a lower than industry price. The
products sold will not necessarily be inferior, but perhaps there is less choice, not such a good perceived
quality or the products are bought and sold in bulk. Food retailers that possibly follow this strategy in the UK
could include Aldi, Lidl and Netto.
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5. Cost Based Pricing:
Full cost plus pricing: adding profit margin/markup to full cost
Advantages Disadvantages
Easy to use. It does not consider the demand pattern of the product.
Ensures that all costs are covered. The absorption of overheads is a guess work therefore the
Ensures that firm can generate strategy will produce different selling prices using different
profits and survive in the future. bases.
Avoids costs of collecting market Takes no account of market conditions since its focus is entirely
information on demand and internal.
competitor activity. By using a fixed markup it does not permit the company to
It is believed to establish stable respond to the pricing decisions of its competitors.
prices. It is not appropriate for making special decisions involving use of
spare capacity.
Marginal cost‐plus pricing: adding profit margin/markup to marginal (variable)costs
Advantages Disadvantages
This strategy ensures that fixed costs are Ignore profit maximization.
covered. Ignores fixed overheads. The price may not be high
The size of the mark up can be adjusted to enough to ensure that a profit is made after fixed
reflect demand. overheads are covered.
Maximum capacity utilization. Lack of consideration of overall market and
Efficient and most economic use of scarce customers.
resources.
Example:
Company wants to introduce a new product. The non‐current assets required for the production will cost
$7,000,000 and working capital is $1,500,000 required.
The sales estimated for the year is 75,000 units. Variable production cost is $55 per unit. Fixed production costs
will be $820,000 per year and annual fixed non‐production costs will be $280,000.
Required:
Calculate the selling price using (i) full cost plus 18% and (ii) on marginal cost plus 30%.
Solution
$
(i) Fixed cost 820,000
Annual non‐production cost 280,000
Total fixed cost 1,100,000
Per unit fixed cost ($1,100,000/75,000) 14.67
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Total budgeted cost per unit is as follows:‐
$
Variable cost 55
Fixed cost 14.67
Full cost 69.67
Total full cost 69.67
Mark‐up: 18% on cost 12.54
Selling price 82.20
Marginal cost:‐ $ per unit
(ii) Marginal cost plus 30%
Variable cost 55
Mark‐up = 30% on variable cost 16.50
Selling price 71.50
Relevant cost pricing/minimum pricing:
Discussed in previous chapter‐Relevant cost & short term decision making
END OF CHAPTER
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•Definitions Risk and Uncertainity
•Attitudes towards Risk
•MarketReaserach(a method to reduce
uncertainity)
Chapter 10 •Payoff tables
•methods to assess uncertainty(Expected
Risk & value,maximax,maximin,minimax regret
rule,simulation models,Sensitivity analysis
Uncertainty •Decision Trees
•Value of perfect information
•Value of imperfect information
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that
which was expected when the decision was taken.
We tend to distinguish between risk and uncertainty in terms of the availability of probabilities.
Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing a dice)
Uncertainty is where the randomness of outcomes cannot be expressed in terms of specific probabilities.
Attitudes towards Risk:
Risk seeker (optimistic) risk neutral (realistic) Risk‐averse (pessimistic)
A risk seeker is a decision‐ A decision‐maker is risk neutral if they A risk‐averse decision‐maker acts
maker who is interested in the are prepared to make a decision that on the assumption that the worst
best outcomes, no matter how balances risk and return. They are outcome might occur and will
small the chance that they may willing take on more risk, but only if the make a decision that limits or
occur. Focuses on maximum expected profit or return is higher. They minimizes the risk.
profit and ignore other factors. will also accept a lower return for lower
risk.
Market Research (A method to Reduce Uncertainty):
Marketing research can be undertaken to reduce uncertainty, and hopefully allow the possible outcomes of a
decision to be quantified (i.e. assess the risk of the project)
Marketing research techniques include techniques such as:
Questionnaires and interviews – potential customers could be asked questions in details about their likely
future buying requirements and needs.
Test marketing – prototype products are tried in small markets. For example a food retailer may trial a new
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product line in 5 shops and gauge customer feedback and buying patterns.
Online panel research – a group of individuals may have agreed to feedback on marketing research questions,
for example regularly providing details of their buying patterns.
Focus groups – a group of individuals who may meet to discuss the attributes and features of a new product.
How to construct a pay‐off table/Profit table?
Payoff table are normally required to apply a method to assess uncertainty(will be covered in later part of the
chapter)
It has 2 variables:
1. Options
2. Outcome
Pay‐off tables normally considers outcomes in the form of best, most likely, worst outcome estimates
Decisions will be about options
Example:
Gam Co sells electronic equipment and is about to launch a new product onto the market. It needs to prepare its
budget for the coming year and is trying to decide whether to launch the product at a price of $30 or $35 per unit.
The following information has been obtained from market research:
Price per unit $30 Price per unit $35
Probability Sales volume Probability Sales volume
0∙4 120,000 0∙3 108,000
0∙5 110,000 0∙3 100,000
0∙1 140,000 0∙4 94,000
Notes
Variable production costs would be $12 per unit for production volumes up to and including 100,000 units each
year. However, if production exceeds 100,000 units each year, the variable production cost per unit would fall to
$11 for all units produced.
Advertising costs would be $900,000 per annum at a selling price of $30 and $970,000 per annum at a price of $35.
3 Fixed production costs would be $450,000 per annum.
Required:
Calculate each of the six possible profit outcomes which could arise for Gam Co in the coming year OR construct a
payoff table for the two price options.
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Solution:
The options are prices and outcomes are different sales volumes:
Profit outcomes
Unit contribution Sales price per unit
$30 S3 5
Up to 100,000 units $18 $23
Above 100,000 units $19 $24
Sales price $30
Sales Unit Total Fixed Advertising Profit
volume contribution contribution costs costs
$ $'000 $'000 S'OOO $'000
120,000 19 2,280 450 900 930
110,000 19 2,090 450 900 740
140,000 19 2,660 450 900 1,310
Sales price $35
Sales Unit Total Fixed Advertising Profit
volume contribution contribution costs costs
$ $'000 $'000 S'000 $'000
108,000 24 2,592 450 970 1,172
100,000 23 2,300 450 970 880
94,000 23 2,162 450 970 742
Note: Once the profit table is made, different methods can be applied which we are now going to discuss
Methods to Assess Uncertainty and Decision Making:
Expected Values
Using the information regarding the potential outcomes and their associated probabilities, the expected value of
the outcome can be calculated simply by multiplying the value associated with each potential outcome by its
probability. Consider the following example regarding the sales forecast.
It is the weighted average of all possible outcomes
A real world example could be that of a company forecasting potential future sales from the introduction of a new
product in year one:
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The expected value of the sales for year one is given by:
Expected value
= ($500,000 x 0.1) + ($700,000 x 0.2) + ($1,000,000 x 0.4) + ($1,250,000 x 0.2) + ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000
= $990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily always
the case.
Moreover, it is likely that the expected value does not correspond to any of the individual potential outcomes.
For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family
(in the UK) supposedly has 2.4 children.
A further point regarding the use of expected values is that the probabilities are based upon the event
occurring repeatedly, whereas, in reality, most events only occur once.
This methods is used by Risk neutral Decision makers
Expected value is used for decision making. If two or more options are considered the selected option is the one
which has the highest expected value.
Decision‐Making Criteria’s:
As an extension of EVs, we can consider other techniques which particularly focus on different attitudes towards
risk that investors may have
The decision outcome resulting from the same information may vary from manager to manager as a result of their
individual attitude to risk. We generally distinguish between individuals who are risk averse (dislike risk) and
individuals who are risk seeking (content with risk). Similarly, the appropriate decision‐making criteria used to
make decisions are often determined by the individual’s attitude to risk.
To illustrate this, we shall discuss and illustrate the following criteria:
1. Maximin
2. Maximax
3. Minimax regret
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes into
consideration the weather forecast (cold, warm, or hot). There are nine possible combinations of order size and
weather, and the payoffs for each are shown in Table 4.
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The highest payoffs for each order size occur when the order size is most appropriate for the weather, i.e. small
order/cold weather, medium order/warm weather, large order/hot weather. Otherwise, profits are lost from
either unsold ice cream or lost potential sales. We shall consider the decisions the ice cream seller has to make
using each of the decision criteria previously noted (note the absence of probabilities regarding the weather
outcomes).
1. Maximin
This criterion is based upon a risk‐averse (cautious) approach and bases the order decision upon maximizing
the minimum payoff. The ice cream seller will therefore decide upon a medium order, as the lowest payoff is
£200, whereas the lowest payoffs for the small and large orders are £150 and $100 respectively.
2. Maximax
This criterion is based upon a risk‐seeking (optimistic) approach and bases the order decision upon maximizing
the maximum payoff. The ice cream seller will therefore decide upon a large order, as the highest payoff is
$750, whereas the highest payoffs for the small and medium orders are $250 and $500 respectively.
3. Minimax regret
This approach attempts to minimize the regret from making the wrong decision and is based upon first
identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the small order
yields the highest payoff, and the regret from the medium and large orders is $50 and $150 respectively. The
same calculations are then performed for warm and hot weather and a table of regrets constructed (Table 5).
The decision is then made on the basis of the lowest regret, which in this case is the large order with the maximum
regret of $200, as opposed to $600 and $450 for the small and medium orders.
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Example‐Objective Test Question (OT)
The Mobile Sandwich Co prepares sandwiches which it delivers and sells to employees at local businesses
each day.
Demand varies between 325 a n d 400 s a n d w i c h e s each day. As the day progresses, the price of the
sandwiches is reduced and, at the end of the day, any sandwiches n o t sold are thrown away. The company
has prepared a regret table to show the amount of profit which would be foregone each day at each supply
level, given the varying daily levels of demand.
Regret table
Daily supply of sandwiches (units)
325 350 375 400
325 $0 $21 $82 $120
Daily demand 350 $36 $0 $44 $78
for sandwiches (units) 375 $82 $40 $0 $34
400 $142 $90 $52 $0
Applying the decision criterion of minimax regret, how many sandwiches should the company decide to
supply each day?
A 325
B 350
C 375
D 400
Solution
4 the correct option is C
The maximum regret at each supply level is as follows:
A At 325: $142
B At 350: $90
C At 375: $82
D At 400: $120
The minimum of these is $82 at 375, therefore the answer is C.
Simulation techniques
Elaborate computer software exists which can help a business model complex problems involving probabilities. For
example a programme could be run which assigns random numbers to the particular outcomes of a project
weighted by the probabilities of those outcomes. The computer can then simulate the possible outcome of that
project many times over so that the management team can identify the patterns of returns they could expect on
that project
Decision Trees and Multi‐Stage Decision Problems:
A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of action that
we can take in a particular situation and all possible outcomes for each possible course of action. It is particularly
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useful where there are a series of decisions to be made and/or several outcomes arising at each stage of the
decision‐making process. For example, we may be deciding whether to expand our business or not. The decision
may be dependent on more than one uncertain variable.
For example, sales may be uncertain but costs may be uncertain too. The value of some variables may also be
dependent on the value of other variables too: maybe if sales are 100,000 units, costs are $4 per unit, but if sales
are 120,000 units costs fall to $3.80 per unit. Many outcomes may therefore be possible and some outcomes may
also be dependent on previous outcomes. Decision trees provide a useful method of breaking down a complex
problem into smaller, more manageable pieces.
There are two stages to making decisions using decision trees:
1. The first stage is the construction stage, where the decision tree is drawn and all of the probabilities and
financial outcome values are put on the tree. The principles of relevant costing are applied throughout – i.e.
only relevant costs and revenues are considered.
2. The second stage is the evaluation and recommendation stage. Here, the decision is ‘rolled back’ by calculating
all the expected values at each of the outcome points and using these to make decisions while working back
across the decision tree. A course of action is then recommended for management.
Constructing the Tree
A decision tree is always drawn starting on the left hand side of the page and moving across to the right. Above, I
have mentioned decisions and outcomes. Decision points represent the alternative courses of action that are
available to you. These are within your control – it is your choice. You either take one course of action or you take
another. Outcomes, on the other hand, are not within your control. They are dependent on the external
environment – for example, customers, suppliers and the economy. Both decision points and outcome points on a
decision tree are always followed by branches. If there are two possible courses of action – for example, there will
be two branches coming off the decision point; and if there are two possible outcomes – for example, one good
and one bad, there will be two branches coming off the outcome point. It makes sense to say that, given that
decision trees facilitate the evaluation of different courses of actions, all decision trees must start with a decision,
as represented by a □ (small square).
There is no universal set of symbols used when drawing a decision tree but the most common ones that we tend to
come across in accountancy education are squares (□), which are used to represent ‘decisions’ and circles (○),
which are used to represent ‘outcomes.’ Therefore, I shall use these symbols in this article and in any suggested
solutions for exam questions where decision trees are examined.
A simple decision tree is shown below. It can be seen from the tree that there are two choices available to the
decision maker since there are two branches coming off the decision point. The outcome for one of these choices,
shown by the top branch off the decision point, is clearly known with certainty, since there is no outcome point
further along this top branch. The lower branch, however, has an outcome point on it, showing that there are two
possible outcomes if this choice is made. Then, since each of the subsidiary branches off this outcome point also
has a further outcome point on with two branches coming off it, there are clearly two more sets of outcomes for
each of these initial outcomes. It could be, for example, that the first two outcomes were showing different
income levels if some kind of investment is undertaken and the second set of outcomes are different sets of
possible variable costs for each different income level.
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Once the basic tree has been drawn, like above, the probabilities and expected values must be written on it.
Remember, the probabilities shown on the branches coming off the outcome points must always add up to 100%,
otherwise there must be an outcome missing or a mistake with the numbers being used. As well as showing the
probabilities on the branches of the tree, the relevant cash inflows/outflows must also be written on there too.
This is shown in the example later on in the article.
Once the decision tree has been drawn, the decision must then be evaluated.
Evaluating the Decision
When a decision tree is evaluated, the evaluation starts on the right‐hand side of the page and moves across to the
left – i.e. in the opposite direction to when the tree was drawn. The steps to be followed are as follows:
1. Label all of the decision and outcome points – i.e. all the squares and circles. Start with the ones closest to the
right‐hand side of the page, labelling the top and then the bottom ones, and then move left again to the next
closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate the expected value of the
cash flows by applying the probabilities to the cash flows. If there is room, write these expected values on the
tree next to the relevant outcome point, although be sure to show all of your workings for them clearly
beneath the tree too.
Finally, the recommendation is made to management, based on the option that gives the highest expected value.
It is worth remembering that using expected values as the basis for making decisions is not without its limitations.
Expected values give us a long run average of the outcome that would be expected if a decision was to be repeated
many times. So, if we are in fact making a one‐off decision, the actual outcome may not be very close to the
expected value calculated and the technique is therefore not very accurate. Also, estimating accurate probabilities
is difficult because the exact situation that is being considered may not well have arisen before.
The expected value criterion for decision making is useful where the attitude of the investor is risk neutral. They
are neither a risk seeker nor a risk avoider. If the decision maker’s attitude to risk is not known, it difficult to say
whether the expected value criterion is a good one to use. It may in fact be more useful to see what the worst‐case
scenario and best‐case scenario results would be too, in order to assist decision making.
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Let me now take you through a simple decision tree example. For the purposes of simplicity, you should assume
that all of the figures given are stated in net present value terms.
Example 1:
A company is deciding whether to develop and launch a new product. Research and development costs are
expected to be $400,000 and there is a 70% chance that the product launch will be successful, and a 30% chance
that it will fail. If it is successful, the levels of expected profits and the probability of each occurring have been
estimated as follows, depending on whether the product’s popularity is high, medium or low:
If it is a failure, there is a 0.6 probability that the research and development work can be sold for $50,000 and a 0.4
probability that it will be worth nothing at all.
The basic structure of the decision tree must be drawn, as shown below:
Next, the probabilities and the profit figures must be put on, not forgetting that the profits from a successful
launch last for two years, so they must be doubled.
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Now, the decision points and outcome points must be labelled, starting from the right‐hand side and moving
across the page to the left.
Now, calculate the expected values at each of the outcome points, by applying the probabilities to the profit
figures. An expected value will be calculated for outcome point A and another one will be calculated for outcome
point B. Once these have been calculated, a third expected value will need to be calculated at outcome point C.
This will be done by applying the probabilities for the two branches off C to the two expected values that have
already been calculated for A and B.
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EV at A = (0.2 x $1,000,000) + (0.5 x $800,000) + (0.3 x $600,000) = $780,000.
EV at B = (0.6 x $50,000) + (0.4 x $0) = $30,000.
EV at C = (0.7 x $780,000) + (0.3 x $30,000) = $555,000
These expected values can then be put on the tree if there is enough room.
Once this has been done, the decision maker can then move left again to decision point D. At D, the decision
maker compares the value of the top branch of the decision tree (which, given there were no outcome points, had
a certain outcome and therefore needs no probabilities to be applied to it) to the expected value of the bottom
branch. Costs will then need to be deducted. So, at decision point D compare the EV of not developing the product,
which is $0, with the EV of developing the product once the costs of $400,000 have been taken off – ie $155,000.
Finally, the recommendation can be made to management. Develop the product because the expected value of
the profits is $155,000.
Often, there is more than one way that a decision tree could be drawn. In my example, there are actually five
outcomes if the product is developed:
1. It will succeed and generate high profits of $1,000,000.
2. It will succeed and generate medium profits of $800,000.
3. It will succeed and generate low profits of $600,000.
4. It will fail but the work will be sold generating a profit of $50,000.
5. It will fail and generate no profits at all.
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Therefore, instead of decision point C having only two branches on it, and each of those branches in turn having a
further outcome point with two branches on, we could have drawn the tree as follows:
You can see that the probabilities on the branches of the tree coming off outcome point A are now new. This is
because they are joint probabilities and they have been by combining the probabilities of success and failure (0.7
and 0.3) with the probabilities of high, medium and low profits (0.2, 0.5, 0.3). The joint probabilities are found
easily simply by multiplying the two variables together each time:
Success and high profits: 0.7 x 0.2 = 0.14
Success and medium profits: 0.7 x 0.5 = 0.35
Success and low profits: 0.7 x 0.3 = 0.21
Fail and sell works: 0.3 x 0.6 = 0.18
Fail and don’t sell work: 0.3 x 0.4 = 0.12
All of the joint probabilities above must, of course, add up to 1, otherwise a mistake has been made.
Whether you use my initial method, which I always think is far easier to follow, or the second method, your
outcome will always be the same.
The decision tree example above is quite a simple one but the principles to be grasped from it apply equally to a
more complex decision resulting in a tree with far more decision points, outcomes and branches on.
Finally, I always cross off the branch or branches after a decision point that show the alternative I haven’t chosen,
in this case being the ‘do not develop product’ branch. Not everyone does it this way but I think it makes the tree
easy to follow. Remember, outcomes are not within your control, so branches off outcome points are never
crossed off. I have shown this crossing off of the branches below on my original, preferred tree:
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The Value of Perfect and Imperfect Information
Perfect information is said to be available when a 100% accurate prediction can be made about the future.
Imperfect information, on the other hand, is not 100% accurate but provides more knowledge than no
information. Imperfect information is far more difficult to calculate and you would only ever need to do this in the
exam if the numbers were extremely straightforward to start with. In this article, we are only going to deal with
perfect information in any detail. This is because the calculations involved in calculating the value of imperfect
information from my example are more complex than Performance Management syllabus would require you to
calculate.
Perfect information
The value of perfect information is the difference between the expected value of profit with perfect information
and the expected value of profit without perfect information. So, in our example, let us say that an agency can
provide information on whether the launch is going to be successful and produce high, medium or low profits or
whether it is simply going to fail. The expected value with perfect information can be calculated using a small table.
At this point, it is useful to have calculated the joint probabilities mentioned in the second decision tree method
above because the answer can then be shown like this.
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However, it could also be done by using the probabilities from our original tree in the table below and then
multiplying them by the success and failure probabilities of 0.7 and 0.3:
EV of success with perfect information = 0.7 x $380,000 = $266,000
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EV of failure with perfect information = 0.3 x $0 = $0.
Therefore, total expected value with perfect information = $266,000.
Whichever method is used, the value of the information can then be calculated by deducting the expected value of
the decision without perfect information from the expected value of the decision with perfect information – i.e.
$266,000 – $155,000 = $111,000.
This would represent the absolute maximum that should be paid to obtain such information.
Imperfect information:
In reality, information obtained is rarely perfect and is merely likely to give us more information about the
likelihood of different outcomes rather than perfect information about them. However, the numbers involved in
calculating the values of imperfect information are rather complex and at this level, any numerical question would
need to be relatively simple. It is suffice here to say that the value of imperfect information will always be less than
the value of perfect information unless both are zero. This would occur when the additional information would not
change the decision. Note that the principles that are applied for calculating the value of imperfect information are
the same as those applied for calculating the value of perfect information
Sensitivity analysis:
Sensitivity analysis is a method of analyzing the uncertainty in a situation or decision. It measures the effect of
changes in the estimated value of an item ('key factor') on the future outcome. It can therefore be used to assess
the sensitivity of the expected outcome to variations or changes in the value of the item ('key factor').
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Example objective test question(OT)
Berraq runs a cafeteria in an accountancy college and is now considering investing in a specialty coffee. She has
estimated the following daily results for the new machine:
$
Sales (650 units) 1,300
Variable
(845)
costs
Contribution 455
Incremental fixed costs (70)
Profit 385
Which of the following statements is/ are true regarding the sensitivity of this investment?
1. The investment is more sensitive to a change in sales volume than selling price
2. If variable costs increase by 44% the investment will make a loss
3. The investment’s sensitivity to incremental fixed costs is 550%
4. The margin of safety is 84∙6%
A. 1, 2 and 3
B. 2 and 4
C. 1, 3 and 4
D. 3 and 4 only
Solution:
The correct option is D
The investment’s sensitivity to fixed costs is 550% ((385/70) x 100), so Statement 3 is correct.
The margin of safety is 84∙6%. Budgeted sales are 650 units and BEP sales are 100 units (70/0∙7), therefore
the margin of safety is 550 units which equates to 84∙6% of the budgeted sales, so Statement 4 is therefore
correct.
The investment is more sensitive to a change in sales price of 29∙6%, so Statement 1 is incorrect.
If variable costs increased by 44%, it would still make a very small profit, so Statement 2 is incorrect
END OF CHAPTER
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• Introduction & objective of budgeting
• Planning and control cycle
Chapter 11 • Fixed, flexible and flexed budgets
• Participation in budgeting, behavioural
implications, changing budgetary system etc.
• Budgeting techniques (includes incremental,
Budgeting ZBB, ABB, rolling budgets, beyond budgeting)
• Quantitative analysis (learning curve)
• Spreadsheets in budgeting
Introduction:
The budgeting process is an essential component of management control systems, as it provides a system of
planning, coordination and control for management. It is often an arduous process, however, and often strikes
dread in the hearts of those involved in budget preparation.
In the public sector, the budgeting process can be even more difficult, since the objectives of the organisation are
more difficult to define in a quantifiable way than the objectives of a private company. For example, a private
company's objectives may be to maximise profit. The meeting of this objective can then be set out in the budget by
aiming for a percentage increase in sales and perhaps the cutting of various costs. If, on the other hand, you are
budgeting for a public sector organisation such as a hospital, then the objectives may be largely qualitative, such as
ensuring that all outpatients are given an appointment within eight weeks of being referred to the hospital. This is
difficult to define in a quantifiable way, and how it is actually achieved is even more difficult to define.
This leads onto the next reason why budgeting is particularly difficult in the public sector. Just as objectives are
difficult to define quantifiably, so too are the organisation's outputs. In a private company the output can be
measured in terms of sales revenue, for example. There is a direct relationship between the expenditure that
needs to be input in order to achieve the desired level of output. In a hospital, on the other hand, it is difficult to
define a quantifiable relationship between inputs and outputs. What is easier to compare is the relationship
between how much cash is available for a particular area and how much cash is actually needed. Therefore,
budgeting naturally focuses on inputs alone, rather than the relationship between inputs and outputs.
Objectives of Budgeting:
1. Ensure the achievement of the organization’s objectives
2. Helps in Planning
3. Co‐ordinate activities
4. Provides a system of Control
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5. Authorizing and delegating
6. Evaluation of performance(Provide a framework for responsibility accounting)
7. Communicating of ideas and plans
8. Motivate employees to improve their performance(budgets are targets)
The planning and control cycle:
Step 1. Identify objectives (e.g. the objective is to increase market share)
Step 2. Identify alternative strategies (market share can be improved using multiple strategies e.g. increase in
advertisement, decrease in price etc.)
Step 3. Evaluate each strategy (benefits and limitations of each strategy considering financial and non‐financial
aspects)
Step 4. Choose the best strategy (best suitable for the current position of business)
Step 5. Plan for the chosen strategy and implement (budgeting is the part of detailed planning)
Step 6. Measure actual results and compare with the plan(variance analysis)
Step 7. Respond to variances from the plan(control actions)
Control can be;
1. Feedback
After the results are achieved. For planning better for the next time
Actual results are compared with planned results for control purpose
Negative feedback: Activities are deviating from the plan
Positive Feedback: Results are going according to the plan and no corrective action is required.
Single loop Feedback: Like the thermostat which regulates the output of a system. The plan target
itself is not changed even though the resources needed to achieve might have to be required.
Double loop Feedback: Information used to change the plan itself(revision of budgets)
2. Feed forward: Before results are achieved, if you foresee any material variance taking a corrective action
there and then.
Important Terms:
Budgetary Slack
The difference between the minimum required costs and the built into the budget or actually incurred.
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Managers might deliberately over estimate cost and under estimate sales so that they will not be blamed for over
spending and poor results
Goal Congruence
It exists when managers working in their own best interest also act in harmony with co‐operate or organizational
objective.
Fixed and flexible budgets
Fixed Budgets :
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.
3. used for planning at the beginning of the year
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.
Flexible / Flexed Budgets :
A budget prepared with the costs classified as either fixed or variable. The budget may be prepared at any activity
level and can be ‘flexed’ or changed to the actual level of activity for budgetary control purposes.
Flexible budget recognises the difference in behaviour between fixed and variable cost in relation to fluctuations in
output, turnover or other variable factors and is designed to change appropriately with such fluctuations.
Steps in flexible budgeting:
1. A fixed budget is set at the beginning of the period based on estimated production. This is the original budget.
2. This is then flexed to correspond with actual level of activity. Variable costs and sales revenue are adjusted to
reflect the actual level of activity.
3. The result is compared with actual cost and differences (variances) are reported to the managers responsible.
Separating fixed and variable cost
One problem normally faced in examinations is how to divide cost into its fixed and variable elements. One
possible way of separating fixed and variable cost is through the use of high‐low method.
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Applying the high low method, the following steps must be applied:
Step 1
Variable cost/unit = (Total cost at the high level of activity – total cost at the low level of activity)/(Volume at the
high level of activity – volume at the low level of activity)
Step 2
Fixed costs = Total cost ‐ variable cost/unit x number of units
Note: Fixed costs can be calculated by using either the information at the low level of activity or the information
at the high level of activity.
Example:
A company has prepared the following fixed budget for the coming year.
Sales 10,000 units
Production 10,000 units
$
Direct materials 50,000
Direct labour 25,000
Variable overheads 12,500
Fixed overheads 10,000
97,500
Budgeted selling price $10 per unit.
At the end of the year, the following costs had been incurred for the actual production of 12,000 units.
$
Direct materials 60,000
Direct labour 28,500
Variable overheads 15,000
Fixed overheads 11,000
114,500
The actual sales were 12,000 units for $122,000
(a) Prepare a flexed budget for the actual activity for the year, and calculate the variances.
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Solution:
Flexed Actual Variances
Sales 12,000 u 12,000 u
Production 12,000 u 12,000 u
Sales 120,000 122,000 2,000 (F)
Materials 60,000 60,000 ‐
Labour 30,000 28,500 1,500 (F)
Variable o/h 15,000 15,000 ‐
105,000 103,500
Contribution 15,000 18,500
Fixed o/h 10,000 11,000 1,000 (A)
Profit $5,000 $7,500 $2,500 (F)
Budget preparation‐Top down and bottom up approaches
A non‐participatory (top down) approach to budgeting is where junior management do not participate in the
budgeting process. Senior management prepares the budget and distributes the final budget to the relevant
departments. This will usually only be appropriate in smaller organisations or if junior management lack the skill to
prepare budgets.
A participatory (bottom up) approach to management is also called participatory budgeting. This is where junior
management prepare the budget for their area of responsibility and submit to senior management for approval
Bottom up approach Advantages
1. More motivating for junior management as they have been involved in the process.
2. Targets will be more realistic as departmental managers have a more in depth understanding of the issues
within that area.
3. Co‐ordination between the different departments is improved.
Bottom up Approach Disadvantages
1. It is more time consuming than a top down approach.
2. Junior management may introduce budgetary slack.
3. The quality of departmental budgets will vary based on the skill of individual managers.
Target setting and motivation
Targets can assist motivation and appraisal if they are set at the right level.
if they are too difficult then they will demotivate
if they are too easy then managers are less likely to strive for optimal performance
ideally they should be slightly above the anticipated performance level
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Good targets should be:
agreed in advance
dependent on factors controllable by the individual
measurable
linked to appropriate rewards and penalties
chosen carefully to ensure goal congruence
'Aspirations' budgets can be used as targets to motivate higher levels of performance but a budget for planning
and decision‐making should be based on reasonable expectations.
Types of budgeting techniques:
1. Incremental Budgeting:
Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the
current period's budget or actual performance as a base, with incremental amounts then being added for the
new budget period. These incremental amounts will include adjustments for things such as inflation, or
planned increases in sales prices and costs. It is a common misapprehension of students that one of the
biggest disadvantages of incremental budgeting is that it doesn't allow for inflation. Of course it does; by
definition, an 'increment' is an increase of some kind. The current year's budget or actual performance is a
starting point only.
Example:
A school will have a sizeable amount in its budget for staff salaries. Let's say that in one particular year, staff
salaries were $1.5m. When the budget is being prepared for the next year, the head teacher thinks that he will
need to employ two new members of staff to teach languages, who will be paid a salary of $30,000 each
(before any pay rises) and also, that he will need to give all staff members a pay increase of 5%. Therefore,
assuming that the two new staff will receive the increased pay levels, his budget for staff will be $1.638m
[($1.5m +$30k + $30k) x 1.05]
It immediately becomes apparent when using this method in an example like this that, while being quick and
easy, no detailed examination of the salaries already included in the existing $1.5m has been carried out. This
$1.5m has been taken as a given starting point without questioning it. This brings us onto the reasons why
incremental budgeting is not always seen as a good thing and why, in the 1960s, alternative methods of
budgeting developed. Since I thoroughly believe that Performance Management students should always go
into the exam with their metaphorical Performance Management toolbox in their hand, pulling tools out of
the box as and when they need them in order to answer questions, I am going to list the benefits and
drawbacks of both budgeting methods in a easy‐to‐learn format that should take up less room in the 'box'. The
problem I often find with Performance Management students is that they think they can go into the exam
without any need for such a toolbox, and while they may be able to get through some of the numerical
questions simply from remembering techniques that they have learnt in the past, when it comes to written
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questions, they simply do not have the depth of knowledge required to answer them properly.
2. Benefits of incremental budgeting
1. It is easy to prepare and is therefore quick. Since it is easy to prepare, it is also easily allocated to more
junior members of staff.
2. As well as being easy to prepare, it is easy to understand.
3. Less preparation time leads to lower preparation costs.
4. Prevents conflict between departmental managers since a consistent approach is adopted throughout the
organisation.
5. The impact of change can be seen quickly. For example, the increase of $138k in staff costs for the
aforesaid school can quickly be traced back to the employment of two new staff members and a 5% pay
increase because everything else in the staff salaries budget remained unchanged.
3. Drawbacks of incremental budgeting
1. It assumes that all current activities and costs are still needed, without examining them in detail. In our
school example above, we know that the head teacher has budgeted for two new language teachers. How
carefully has he looked into whether both of these new teachers are actually needed? It may be that, with
some timetable changes, the school could manage with only one new teacher, but there is no incentive
for the head teacher to actually critically assess the current costs of $1.5m (provided, of course, that the
funding is available for the two new teachers).
2. With incremental budgeting, the head teacher does not have to justify the existing costs at all. If he can
simply prove that there is an increase in the number of language lessons equivalent to two new staff's
teaching hours, he can justify the cost of two new teachers. By its very nature, incremental budgeting
looks backwards rather than forwards. While this is not such a problem is fairly stable businesses, it will
cause problems in rapidly changing business environments.
3. There is no incentive for departmental managers to try and reduce costs and in fact, they may end up
spending money just for the sake of it, knowing that if they don't spend it this year; they won't be
allocated the cash next year, since they will be deemed not to need it.
4. Performance targets are often unchallenging, since they are largely based on past performance with some
kind of token increase. Therefore, managers are not encouraged to challenge themselves and
inefficiencies from previous periods are carried forward into future periods. In our school example above,
the head teacher may have hired an extra cook for the school kitchen when he thought that there was
going to be greater demand for school dinners than there actually turned out to be. One of the cooks may
be sitting idle in the kitchen most of the time but, with no‐one looking at the existing costs, it is unlikely to
change.
Zero based Budgeting:
With zero‐based budgeting, the budgeting process starts from a base of zero, with no reference being made to the
prior period's budget or actual performance. All of the budget headings, therefore, literally start with a balance of
zero, rather than under incremental budgeting, when they all start with a balance at least equal to last year's
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budget or spend. Every department function is then reviewed comprehensively, with all expenditure requiring
approval, rather than just the incremental expenditure requiring approval.
Zero‐based budgeting tries to achieve an optimal allocation of resources to the parts of the business where they
are most needed. It does this by forcing managers to justify every activity in their department as they know that,
until they do this, the budget for their department is zero. If they are unable to do this, they aren't allocated any
resources and their work therefore stops (as does their employment within the organisation, at this point,
presumably). In this way, all unjustifiable expenditure theoretically ceases. A questioning attitude is developed by
management, who are constantly forced to ask themselves questions such as:
Is the activity really necessary at all?
What happens if the activity ceases?
Is the current level of provision adequate?
What other ways are there of carrying out the activity?
How much should the activity cost?
Do the benefits to be gained from the activity at least match the costs?
All of these questions are largely answered by breaking the budgeting process down into three distinct stages, as
detailed below.
Stages In Zero‐Based Budgeting (important)
1. Activities are identified by managers. Managers are then forced to consider different ways of performing the
activities. These activities are then described in what is called a 'decision package', which:
analyses the cost of the activity
states its purpose
identifies alternative methods of achieving the same purpose
establishes performance measures for the activity
Assesses the consequence of not performing the activity at all or of performing it at different levels.
As regards this last point, the decision package may be 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.
For example, if ZBB was used by our head teacher in our example above, one of the activities that would have
to be performed would be the provision or facilitation of school lunches. The school catering manager may
consider three options. Option 1: providing an area where students can bring their own cold food to, with
some sandwiches and other cold food and drinks being prepared and sold by catering staff. Option 2:
providing a self‐service cafeteria with hot and cold food and drinks available. Option 3: providing a full, hot
food, catered service for pupils. The base level of service would be option 1, with options 2 and 3 being higher
level service options. The school may, on the other hand, consider two mutually exclusive decision packages ‐
providing a service internally or outsourcing the whole catering activity to an external provider.
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While some form of cost‐benefit analysis may be useful at this stage, a degree of quantitative analysis must
also be incorporated. For example, cost‐benefit analysis may show that the minimal level of provision for the
school (option 1) is the most cost‐effective. However, this would present the school in a negative light to
parents of potential pupils and would deter some parents from sending their children to that school.
Consequently, more able students may be discouraged from applying, thus leading to poorer results which, in
turn, could have a negative impact on the school's future funding. Simple cost‐benefit analysis would find it
difficult to incorporate the financial effect of such considerations.
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. This ranking of the decision packages happens
at numerous levels of the organisation. For example, in the case of the school, the catering manager will rank
the numerous decision packages that he prepares. Then, the headmaster will rank the catering packages
amongst all the packages prepared for the rest of the school.
3. The resources are then allocated based on order of priority up to the spending level.
Benefits of ZBB
The benefits of ZBB are substantial. They would have to be otherwise no organisation would ever go to the lengths
detailed above in order to implement it. These benefits are set out below:
Since ZBB does not assume that last year's allocation of resources is necessarily appropriate for the current
year, all of the activities of the organisation are re‐evaluated annually from a zero base. Most importantly
therefore, inefficient and obsolete activities are removed, and wasteful spending is curbed. This has got to be
the biggest benefit of zero‐based budgeting compared to incremental budgeting and was the main reason why
it was developed in the first place.
By its nature, it encourages a bottom‐up approach to budgeting in order for ZBB to be used in practice. This
should encourage motivation of employees.
It challenges the status quo and encourages a questioning attitude among managers.
It responds to changes in the business environment from one year to the next.
Overall, it should result in a more efficient allocation of resources.
Drawbacks of ZBB
Departmental managers may not have the necessary skills to construct decision packages. They will need
training for this and training takes time and money.
In a large organisation, the number of activities will be so large that the amount of paperwork generated from
ZBB will be unmanageable.
Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely
quantitative measures. Qualitative factors need to be incorporated but this is difficult. Top level management
may not have the time or knowledge to rank what could be thousands of packages. This problem can be
somewhat alleviated by having a hierarchical ranking process, whereby each level of managers rank the
packages of the managers who report to them.
The process of identifying decision packages and determining their purpose, costs and benefits is massively
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time consuming and costly. One solution to this problem is to use incremental budgeting every year and then
use ZBB every three to five years, or when major change occurs. This means that an organisation can benefit
from some of the advantages of ZBB without an annual time and cost implication. Another option is to use ZBB
for some departments but not for others. Certain costs are essential rather than discretionary and it could be
argued that it is pointless to carry out ZBB in relation to these. For example, heating and lighting costs in a
school or hospital are expenses that will have to be paid, irrespective of the budget amount allocated to them.
Incremental budgeting would seem to be more suitable for costs like these, as with building repair costs.
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.
The organization’s management information systems might be unable to provide the necessary information.
It could be argued that ZBB is far more suitable for public sector than for private sector organizations. This is
because, firstly, it is far easier to put activities into decision packages in organizations which undertake set
definable activities. Local government,for example, have set activities including the provision of housing,
schools and local transport. Secondly, it is far more suited to costs that are discretionary in nature or for
support activities. Such costs can be found mostly in not for profit organizations or the public sector, or in the
service department of commercial operations.
Using zero based budgeting
ZBB is useful for budgeting for discretionary costs and for rationalisation purposes, in areas of operations where efficiency
standards are not properly established, such as administration work.
ZBB is not particularly suitable for direct manufacturing costs, which are usually budgeted using standard costing, work study and
other management planning and control techniques. It is best applied to support expenses; that is, expenditure incurred in
departments which exist to support the essential production function. These support areas include marketing, finance, quality
control, personnel, data processing, accounting, sales and distribution. In many organisations, these expenses make up a large
proportion of the total expenditure. These activities are less easily quantifiable by conventional methods and are more
discretionary in nature.
ZBB can also be successfully applied to service industries and non profit making organizations, such as local and central
government departments, educational establishments and hospitals, and in any organisation where alternative levels of
provision for each activity are possible and where the costs and benefits are separately identifiable.
Rolling budgets
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
period to the next.
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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).
Benefits (as opposed to periodic budgeting)
1. The budgeting process should be more accurate.
2. Much better information upon which to appraise the performance of management.
3. The budget will be much more ‘relevant’ by the end of the traditional budgeting period.
4. It forces management to take the budgeting process more seriously.
Drawbacks:
1. More costly and time consuming.
2. An increase in budgeting work may lead to less control of the actual results.
Example‐Rolling Budgets:
A company uses rolling budgeting and has a sales budget as follows:
Q1 ($) Q2 ($) Q3 ($) Q4 ($) Total ($)
Sales 125,750 132,038 138,640 145,572 542,000
Actual sales for Quarter 1 were $123,450. The adverse variance is fully explained by competition being more intens
e than expected and growth being lower than anticipated. The budget committee has proposed that the revised as
sumption for sales growth should be 3% per quarter for Quarters 2, 3 and 4.
Required: Update the budget figures for Quarters 2–4 as appropriate
Solution:
The revised budget should incorporate 3% growth starting from the actual sales figure of Q1.
Q2 ($) Q3 ($) Q4 ($)
Sales 127,154 130,969 134,898
Workings
Q2: Budget = $123,450 × 103%
Q3: Budget = $127,154 × 103%
Q4: Budget = $130,969 × 103%
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Activity based budgeting
Use of activity based costing principles to provide better overhead cost data for budgeting purposes.
The advantages of using such a technique accrue from better cost allocation.
Exam questions will be closely related to the ABC questions we looked at earlier on
in the course
ABB is used in an environment with the following criteria:
1. Complex manufacturing environment.
2. Wide range of products.
3. High proportion of overhead costs.
4. Competitive market.
Benefits of ABB:
1. Better understanding of overhead costs.
2. Identifies the accurate relationship between product and activity.
3. Each activity more accurately describes where costs are incurred.
Each and every benefit allows for better control of costs together with the opportunity to reduce the costs using
other management accounting techniques.
Disadvantages of ABB:
1. Identifying appropriate cost drivers may be subjective and therefore accuracy depends on the judgment of
management.
2. The implementation and maintenance of an ABB system will be expensive and time consuming.
Beyond Budgeting :
Beyond Budgeting is a budgeting model which proposes that traditional budgeting should be abandoned.
Adaptive management processes should be used rather than fixed annual budgets
Problems with budgetary systems:
Annual budgeting adds little value and takes up too much valuable management time.
Too heavy reliance on budgetary control in managing performance has an adverse impact on management
behavior.
The use of budgeting as a base for communicating corporate goals, setting objectives, assisting continuous
improvement, etc. is seen as contrary to its original purpose as a financial control mechanism.
Most budgets are not based on a rational causal model of resource consumption and are, therefore, of little
use in determining strategy.
The process has insufficient external focus from which to derive targets or benchmarks.
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The argument may be put that increased focus on knowledge or intellectual capital through competent
managers, skilled workforce, effective systems, loyal customers and strong brands is more likely to yield
improved business effectiveness.
They argue that using rolling budgets and non‐financial performance indicators should:
Create a culture based on beating the competition (since goals are related to external benchmarks) rather
than simply gaining more internal resources.
Rewards can be team‐based increasing the amount of motivation.
It is easier to judge the performance of people lower down the organization (who are closer to the customers).
It empowers more junior managers meaning they can respond more quickly to changes in the external
environment
The main principles of beyond budgeting
Bind people to a common cause.
Govern through shared values and sound judgment not detailed rules & regulations.
Make information transparent don’t restrict and control it.
Have a network of accountable teams and not centralized functions.
Trust teams to regulate their own performance.
Base accountability on holistic criteria.
Set ambitious medium term goals not short term.
Reward on relative performance not meeting fixed targets.
Continuous and inclusive planning not top down.
Co‐ordinate interactions within the organization but not through annual budgets.
Make resources available just in time not just in case.
Base controls on frequent feedback not variances.
Changing a budgetary system and the types of budget used
For many organizations, a budget is a regular, routine, labour intensive exercise in which sales, production and
other departments are all involved. All submit their plans and requirements according to the agreed timetable.
Information is gathered in standard formats, there are negotiations to and fro, and there is a set timetable. These
budgets may be communicated outside the organization, e.g. to bankers.
A budgeting system provides a common language for running the business. A large organisation’s accounting data
is also structured by a chart of accounts, which sets up coding systems, cost centers. In many systems, standard
reports are produced.
Moving from one type of budget or budgetary system to another can cause some problems, depending on the
nature of the change.
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(a) If this involves changing the chart of accounts or standard reports, then many legacy IT systems will not be
able to cope.
(b) Reclassifying and reformatting information can create errors or anomalies.
(c) The old classifications of costs and revenues may not be suitable for the new system. It will therefore be hard
to make comparisons or budget to prior year unless ‘actuals’ are modified also to the new format. Comparing
budget performance with prior year, when the budget is being prepared, actual will not be comparing like
with like. New reports and cost classifications may be needed. For example, an organization moving to Activity
Based Budgeting, will need to identify cost pools, and classify transactions costs accordingly.
(d) A lot of organizational learning will be necessary, not just in the finance department
(e) A radical change to a budgeting system – eg to Zero Based Budgeting in which every activity (and job) has to
be justified from the ground up, has to have a significant disruptive effect, and may be a significant
organizational change. The costs of change may not be warranted by the budgetary improvements delivered.
Not all changes are quite so radical. Moving from an annual exercise to a 12‐month rolling budget may spread the
effort over the year and provide more stability
Budget systems and uncertainty
Uncertainty can be allowed for in budgeting by means of flexible budgeting, rolling budgets, probabilistic
budgeting and sensitivity analysis.
Causes of uncertainty in the budgeting process include:
Customers. They may decide to buy less than forecast, or they may buy more.
Products/services. In the modern business environment, organisations need to respond to customers' rapidly
changing requirements.
Inflation and movements in interest and exchange rates. Exchange rate fluctuations can affect the cost of
imported materials, and the price that foreign customers will have to pay, which is likely to affect demand.
Materials. The cost of raw materials may change unexpectedly.
Competitors. They may steal some of an organisation's expected customers, or some competitors' customers
may change their buying allegiance.
Employees. They may not work as hard as was hoped, or they may work harder.
Machines. They may break down unexpectedly.
Unrest or disaster. There may be political unrest (terrorist activity), social unrest (public transport strikes) or
minor or major natural disasters (storms, floods).
Rolling budgets are a way of trying to reduce the element of uncertainty in the plan. There are other planning
methods which try to analyse the uncertainty, such as probabilistic budgeting and sensitivity analysis. These
methods are suitable when the degree of uncertainty is quantifiable from the start of the budget period and actual
results are not expected to go outside the range of these expectations.
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Behavioural aspects of budgeting
It is important to appreciate that budgeting is largely a human exercise and many exam questions are based
around areas where a manager’s performance may be assessed against unfair or unreasonable budgets. We not
only need to consider why the budget is unreasonable, but also to consider what the effect is likely to be on the
manager’s behaviour and attitudes.
It is very easy for the budgetary process to cause dysfunctional activity. For example, if junior management believe
that a budget imposed upon them is unattainable, their aim may well be to ensure that the budget is not achieved,
thereby proving themselves to be correct. This behaviour is unlikely to motivate the manager and will certainly not
contribute towards the business meeting its aims and goals.
Budgets need to be set at a level that is tough enough to challenge the manager, but be attainable so that the
manager will feel motivated to achieve it (particularly if the budget is linked to the business’s reward schemes)
Spreadsheets in budgeting
Spreadsheets are used as modelling and decision making tools and are very versatile. In a budgeting process, the
finance department might typically send out a ‘budget pack’ showing the required format for submissions.
Benefits of using spreadsheets in budgets
Most managers know how to use spreadsheets at a basic level
Spreadsheets offer high‐level modelling tools which some accounting processing systems do not possess:
using spreadsheets makes it easier to do sensitivity and another analyses on budget figures.
It is easy to aggregate spreadsheet submissions if in a common format.
The accounting system may be organised on a functional basis, eg most companies have a common payroll
system.
Spreadsheets may be easier to use for budget submission by staff who do not use the accounting software.
Spreadsheets enable data to be organised in different ways.
If the transaction processing system is primitive or inflexible, spreadsheets may be used routinely in
management reporting anyway, and it is therefore natural to extend their use to budgeting.
Some limitations are:
Error in a formula can affect the validity of data. The more complex the spreadsheet model, the riskier it is to
error or manipulation. Even one mistake in a formula, or a shift in a decimal point, can affect many other cells
in a spreadsheet.
Many people can use them at a basic, but not sophisticated level.
Risk of over dependence
Cannot take account of qualitative and non‐financial factors
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The way to deal with risks is through control over the formats used and proper training.
Quantitative Analysis in budgeting:
Learning Curve:
In practice, it is often found that the resources required to make a product decrease as production volumes
increase. It costs more to produce the first unit of a product than it does to produce the one hundredth unit. In
part, this is due to economies of scale since costs usually fall when products are made on a larger scale. This may
be due to bulk quantity discounts received from suppliers, for example.
The learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon
that occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing
them for a while. The first time a new process is performed, the workers are unfamiliar with it since the process is
untried. As the process is repeated, however, the workers become more familiar with it and better at performing
it. This means that it takes them less time to complete it.
The specific learning curve effect is that the cumulative average time per unit decreased by a fixed percentage
each time cumulative output doubled.
The learning process starts as soon as the first unit or batch comes off the production line. Since a doubling of
cumulative production is required in order for the cumulative average time per unit to decrease, it is clearly the
case that the effect of the learning rate on labour time will become much less significant as production increases.
Eventually, the learning effect will come to an end altogether. You can see this in Figure 1 below. When output is
low, the learning curve is really steep but the curve becomes flatter as cumulative output increases, with the curve
eventually becoming a straight line when the learning effect ends.
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Figure 1
The learning curve effect will not always apply, of course. It flourishes where certain conditions are present. It is
necessary for the process to be a repetitive one, for example. Also, there needs to be a continuity of workers and
they mustn’t be taking prolonged breaks during the production process.
The Importance Of The Learning Curve Effect
Learning curve models enable users to predict how long it will take to complete a future task. Management
accountants must therefore be sure to take into account any learning rate when they are carrying out planning,
control and decision‐making. If they fail to do this, serious consequences will result
1. As regards its importance in decision‐making, let us look at the example of a company that is introducing a
new product onto the market. The company wants to make its price as attractive as possible to customers but
still wants to make a profit, so it prices it based on the full absorption cost plus a small 5% mark‐up for profit.
The first unit of that product may take one hour to make. If the labour cost is $15 per hour, then the price of
the product will be based on the inclusion of that cost of $15 per hour. Other costs may total $45. The product
is therefore released onto the market at a price of $63. Subsequently, it becomes apparent that the learning
effect has been ignored and the correct labour time per unit should is actually 0.5 hours. Without crunching
through the numbers again, it is obvious that the product will have been launched onto the market at a price
which is far too high. This may mean that initial sales are much lower than they otherwise would have been
and the product launch may fail. Worse still, the company may have decided not to launch it in the first place
as it believed it could not offer a competitive price.
2. let us now consider its importance in planning and control. If standard costing is to be used, it is important
that standard costs provide an accurate basis for the calculation of variances. If standard costs have been
calculated without taking into account the learning effect, then all the labour usage variances will be
favourable because the standard labour hours that they are based on will be too high. This will make their use
for control purposes pointless.
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3. Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is
traditionally associated with. It is also used in other less traditional sectors such as professional practice,
financial services, publishing and travel. In fact, research has shown that just under half of users are in the
service sector.
When learning curve theory can be applied:
1. When Product is made largely by labour effort
2. Brand new product
3. Short life products (will have more effect of learning curve)
4. Complex products made in small quantities for special orders (modern business environment)
5. Applied on homogenous products
Learning Curve‐Methods:
1. Tabular approach
2. Formula Approach
Tabular Approach:
*The learning curve applies when output is doubled
Let take an example to understand how tabular approach works;
Example:
Time to make first unit=50 hours and learning curve is 90%
Cumulative Cumulative average Total time (hours) Incremental total Hours/unit
output(units) time per unit time
1 50 50(50x1)
2* 45 (50x90%) 90(45x2) 40(90‐50) 40(40/1)
4* 40.50(45x90%) 162(40.50x4) 72(162‐90) 36(72/2)
8* 36.45(40.50x90%) 291.6(36.45x8) 129.6(291.6‐162) 32.4(129.6/4)
So for example if you want to calculate time it took to make 8th unit, it will be 32.4 from above table
And time it took to make 8 units, it will be 291.6
4. Formula Approach
The learning curve formula, as shown below, is always given on the formula sheet in the exam:
Where Y = cumulative average time per unit to produce x units
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a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log2)
LR = the learning rate as a decimal
While a value for ‘b’ has usually been given in past exams there is no reason why this should always be the case. All
candidates should know how to use a scientific calculator and should be sure to take one into the exam hall.
Example:
A firm's workforce experiences a 75% learning rate.
The budgeted cost for the first batch is 100 Hours
Required
Using the formula Y= aXb , calculate the cost of producing:
(a) the first 10 batches in total
(b) the 10th batch only
Solution:
a) Steps
- First calculate ‘Cumulative Average time per Unit’ (Y)
- Calculate Total time (Hours) by multiplying total no. of units with ‘Y’
Y = 100 x 10 – 0.415 = 38.459 hrs
Total time taken to produce 10 batches: 10 × 38.459 = 384.59 hrs
b) Steps
- Calculate Total time (Hours) of which you have to find (i.e. 10 batches) as calculated above
- Calculate Total time (Hours) of which you have to find less 1 (i.e. 10 – 1 = 9 batches)
- Difference of step 2 and step 1 is the tome taken to produce a specific unit (i.e. 10th batch)
Total time taken to produce 10 batches: 384.59 hrs (from part ‘a’)
Total time taken to produce 9 batches: 361.60 hrs (Working)
Time to produce the 10th batch only(total cost of 10 batches minus total cost of 9 batches) =384.59‐
361.60
=22.99 hrs
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Working
Y = 100 x 9 – 0.415
= 40.1781 hrs
Total time to produce 9 batches = 9 x 40.1781 = 361.60 hrs
Cessation of learning:
A time will be reached when the learning effect no longer applies and steady state of production will reach for a
product.
When a steady state point is reached a standard time and labour cost for the product can be established (most of
the time it is the time it takes to make the last unit with learning.
For example if learning ceases at 30 units. The time it takes to make 30th unit will be time required to make the rest
of the units(hint: use learning curve formula to calculate time for 30th unit as shown in detailed example above)
Calculating The Learning Rate
The learning effect can continue to be examined with candidates being asked to calculate the time taken to
produce an individual unit or a number of units of a product either when the learning curve is still in effect or when
it has ended. In most questions ‘b’ has usually been given, however candidates can also be expected to calculate
the learning rate itself. Here, the tabular method is the simplest way to answer the question.
Example 1
P Co Operates a standard costing system. The standard labour time per batch for its newest product was estimated
to be 200 hours, and resource allocation and cost data were prepared on this basis.
The actual number of batches produced during the first six months and the actual time taken to produce them is
shown below:
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Required
(a) Calculate the monthly learning rate that arose during the period.
(b) Identify when the learning period ended and briefly discuss the implications of this for P Co.
Solution:
(a) Monthly rates of learning
Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
Therefore the monthly rate of learning was 88%.
(b) End of learning rate and implications
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The learning period ended at the end of September. This meant that from October onwards the time taken to
produce each batch of the product was constant. Therefore, in future, when P Co makes decisions about allocating
its resources and costing the product, it should base these decisions on the time taken to produce the eighth
batch, which was the last batch produced before the learning period came to an end. The resource allocations and
cost data prepared for the last six months will have been inaccurate since they were based on a standard time per
batch of 200 hours.
P Co could try and improve its production process so that the learning period could be extended. It may be able to
do this by increasing the level of staff training provided. Alternatively, it could try to incentivize staff to work
harder through payment of bonuses, although the quality of production would need to be maintained.
Example 2
The first batch of a new product took six hours to make and the total time for the first 16 units was 42.8 hours, at
which point the learning effect came to an end.
Required:
(a) Calculate the rate of learning.
Solution:
Again, the easiest way to solve this problem and find the actual learning rate is to use a combination of the tabular
approach plus, in this case, a little bit of math. There is an alternative method that can be used that would involve
some more difficult math and use of the inverse log button on the calculator, but this can be quite tricky and
candidates would not be expected to use this method. Should they choose to do so, however, full marks would be
awarded, of course.
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Using algebra:
Step 1: Write out the equation:
42.8 = 16 x (6 x r4)
Step 2: Divide each side by 16 in order to get rid of the ’16 x’ on the right hand side of the equation:
2.675 = (6 x r4)
Step 3: Divide each side by 6 in order to get rid of the ‘6 x’ on the right hand side of the equation:
0.4458333 = r4
Step 4: take the fourth root of each side in order to get rid of the r4 on the right hand side of the equation. You
should have a button on your calculator that says r4 or x1/y. Either of these can be used to find the fourth root (or
any root, in fact) of a number. The key is to make sure that you can use your calculator properly before you enter
the exam hall rather than trying to work it out under exam pressure. You then get the answer:
r = 0.8171
This means that the learning rate = 81.71%.
Uses of learning curve(summary):
Learning curve provides useful information to management accountant since it helps with:
setting realistic labour standards
planning manpower needs
formulating budgets
calculation of incentive rates in bonus wages
setting delivery date
Pricing for successive units, where prices are established, or quotations are made, on a cost plus basis.
Limitations of learning curve:
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 curve effect accurately.
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.
END OF CHAPTER
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•Costing & Introduction, uses and limitation of
standard costing
•Types of standard and effect on motivation
Chapter 12 •Flexible budgets and variance analysis
•Variance analysis (mix and yield variances,
sales mix and quantity variances, planning and
operational variances)
Standard costing •Investigation of variances
•Principle of controllability
(Control) •Performance measurement using variances
•Standard Modern environment (JIT & TQM)
Standard costs are budgeted cost of one unit
Standard costing is a system of accounting based on pre‐determined costs and revenue per unit which are used as
a benchmark to assess actual performance and therefore provide useful feedback information to management.
Example:
Standard cost card for Product X
$ per unit
Sales price 100
Materials (2 kg @ $20/kg ) 40
Labour (1.5 hrs @ $2/hr ) 3
Variable o/h (1.5 hrs @ $6/hr) 9
Fixed o/h (1.5 hrs @ $10/hr) 15
Standard cost of production 67
Standard profit per unit 33
Uses of standard costing
inventory valuation (for internal and/or external use)
as a basis for pricing decisions
for budget preparation
for budgetary control
for performance measurement
for motivating staff using standards as targets
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Limitations of standard costing
Accurate preparation of standards can be difficult
It may be necessary to use different standards for different purposes (see next section)
Less useful if not mass production of standard units
Traditional standards are based on companys own costs – a more modern approach is benchmarking, where
the practices of other organisations are taken into account
The use of standard costing can lead to an over‐emphasis on quantitative measures of performance at the
expense of qualitative measures (e.g. customer satisfaction, employee morale)
Types of standards:
1. Ideal standard
Calculated assuming that perfect conditions apply. E.g. 100% efficiency from men and from machines.
Could form the basis for long‐term aims, but not useful for variance analysis because unattainable.
Demotivation for employees
2. Basic standard
This is a long‐run underlying average standard.
It is only really of use in very stable situations where there are unlikely to be fluctuations in prices, rates
etc.
3. Attainable standard
This is a standard expected to apply to a specific budget period and is based on normal efficient operating
conditions.
This is used for variance analysis routine reporting. However, it may be too ‘easy’ to be used as a target.
It is Motivating for employees
4. Current standard
This is the current attainable standard which reflects conditions actually applying in the period under
review.
This should be used for performance appraisal, but the calculation of a ‘fair’ current standard can be
complicated and time‐consuming.
Flexed budgets and Variance Analysis:
In the chapter on budgeting, we looked at the comparison between the actual results for a period and the flexed
budget. The differences between the two are known as the variances.
In this section we will repeat the exercise, and then analyse them into their different components. If we are to
investigate variances properly and use them for control, then it is important that we should analyse the reasons for
their occurrence.
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Example:
A company has prepared the following standard cost card:
$ per unit
Materials (4 kg at $4.50 per kg) 18
Labour (5 hrs at $5 per hr) 25
Variable overheads (5 hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
68
Budgeted selling price $75 per unit.
Budgeted production 8,700 units
Budgeted sales 8,000 units
There is no opening inventory
The actual results are as follows:
Sales: 8,400 units for $613,200
Production: 8,900 units with the following costs:
Materials (35,464 kg) 163,455
Labour (45,400 hrs paid, 44,100 hrs worked) 224,515
Variable overheads 87,348
Fixed overheads 134,074
Required: Prepare a flexed budget and calculate the total variances
Solution:
Original Flexed Actual Variances
Fixed Budget Budget $
$ $
Sales (units) 8,000 8,400 8,400
Production (units) 8,700 8,900 8,900
Sales 600,000 630,000 613,200 16,800 (A)
Materials 156,600 160,200 163,455 3,255 (A)
Labour 217,500 222,500 224,515 2,015 (A)
Variable O/H 87,000 89,000 87,348 1,652 (F)
Fixed O/H 130,500 133,500 134,074 574 (F)
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591,600 605,200 609,392
Closing Inventory (47,600) (34,000) (34,000)
544,000 571,200 575,392 ‐‐‐‐‐‐‐‐‐‐‐
Profit 56,000 58,800 37,808 20,992 (A)
Deriving standards:
The responsibility for deriving standards costs should be shared between managers able to provide the necessary
information about levels of expected efficiency, prices and overhead costs
Allowance for idle time / wastage should be built in to standards
Performance Measurement‐Principle of controllability:
Managers should only be held accountable for the items within their control while measuring the performance
using variance analysis
Variance Analysis:
1. Mix & Yield Variances:
The materials usage variance can be subdivided into a materials mix variance and a materials yield variance
when more than one material is used in the product.
However, calculating a mix and yield variance is only meaningful for control purposes when management is in
a position to control the mix of materials used in production
A mix variance occurs when the materials are not mixed or blended in standard proportions and it is a measure
of whether the actual mix is cheaper or more expensive than the standard mix.
A yield variance arises because there is a difference between what the input should have been for the output
achieved and the actual input.
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When to calculate mix and yield variances:
a. Reporting a mix and yield variance is an alternative to reporting the usage variance of each material
separately. If mix and yield variances are reported, usage variances are not reported.
b. A mix variance has no practical meaning unless management is able to control the mix of materials used in
production. For example, management may be able to use a cheaper mix of materials (= favourable mix
variance) by including a larger proportion of the cheapest material in the production mix.
c. A yield variance is a total usage variance for all the materials combined. If a mix variance is calculated, there
must also be a yield variance.
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. The usage of each material must be controlled separately.
Example (with mix and yield variances formulas):
Alex and Justin are analyzing the main ingredients to their basic tomato sauce used to making different Italian
dishes in their restaurant.
The standard ingredients for one batch of tomato pasta sauce are:
$
Onions 5kg @ $2/kg 10
Tomatoes 5kg @ $4/kg 20
10 kg 30
Over the last month, 100 batches(actual output) of sauce were prepared, using the following ingredients:
Onions 600 kg
Tomatoes 900 kg
1500 kg
Required
Calculate the materials mix and yield variances and comment on their meaning
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Solution:
Mix variance
Total Actual quantity in Total Actual quantity in Difference(variance)
actual mix @ standard standard mix @ standard
price price
Onions 1500x600/1500x2=1200 1500x5/10x2=1500 300 F (as actual mix is cheaper
than standard mix)
Tomatoes 1500x900/1500x4=3600 1500x5/10x4=3000 600 A(as actual mix is
expensive than standard mix)
Total mix variance 300 Adverse
Yield variance
Total Actual quantity in Total standard quantity in Difference(variance)
standard mix @ standard standard mix @ standard
price price
(10kg x 100 batches) 500 A (as actual quantity is
Onions 1500x5/10x2=1500 x5/10x2=1000 more expensive than standard
quantity)
Tomatoes (10kg x 100 batches) x5/10x4 1000 A(as actual quantity is
1500x5/10x4=3000 =2000 more expensive than standard
quantity)
Total yield variance 1500 A
Note: An adverse mix variance may cause a company to buy a cheaper ingredient / component. Whilst improving
the mix variance this may lead to an adverse yield variance because that item is of a lower quality. This in turn
may impact sales.
It is therefore important that the price, mix and yield variances are looked at in conjunction with one another.
Understanding the bigger picture(mix and yield variance):
Now that you understand how to deal with the numerical side of materials mix and yield variances, and the fact
that these are simply a detailed breakdown of the material usage variance, it is also important to stress the fact
that quality issues cannot really be dealt with by this variance analysis. There is a direct relationship between the
mix and the yield variance and that neither of these can be considered in isolation. In addition to this, however, it
is also essential to understand the importance of producing products that are of a consistently good quality.
It can be tempting for production managers to change the product mix in order to make savings; these savings may
lead to greater bonuses for them at the end of the day.
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However, if the quality of the product is adversely affected, this is damaging to the reputation of the business and
hence its long‐term survival prospects. While substituting poor quality input materials may in some cases lead to
yield volumes that are the same as those achieved with higher quality materials, the yield may not be of the same
quality.
Unfortunately, this factor cannot be incorporated into the materials yield variance. In the long run, it may be
deduced from an adverse sales volume variance, as demand for the business’s product decreases, but it is likely to
take time for sales volumes to be affected. Any sales volume variance that does arise as a result of poor quality
products is likely to arise in a different period from the one in which the mix and yield variances arose, and the
correlation will then be more difficult to prove.
Similarly, poorer quality materials may be more difficult to work with; this may lead to an adverse labour efficiency
variance as the workforce takes longer than expected to complete the work. This, in turn, could lead to higher
overhead costs, and so on.
Fortunately, consequences such as these will occur in the same period as the mix variance and are therefore more
likely to be identified and the problem resolved. Never underestimate the extent to which a perceived
‘improvement’ in one area (e.g. a favourable materials mix variance) can lead to a real deterioration in another
area (eg decreased yield, poorer quality, higher labour costs, lower sales volumes, and ultimately lower
profitability). Always make sure you mention such interdependencies when discussing your variances in exam
questions. The number crunching is relatively simple once you understand the principles; the higher skills lie in the
discussion that surrounds the numbers.
Example Objective test Question(OT)
Product GX consists of a mix of three materials, J, K and L. The standard material cost of a unit of GX is as follows:
$
Material J 5 kg at $4 per kg 20
Material K 2 kg at $12 per kg 24
Material L 3 kg at $8 per kg 24
During March, 3,000 units of GX were produced, and actual usage was:
Material J 13,200 kg
Material K 6,500 kg
Material L 9,300 kg
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What was the materials yield variance for March?
A. $6,800 favourable
B. $6,800 adverse
C. $1,000 favourable
D. $1,000 adverse
Solution:
The correct option is A
3,000 units should use 10 kg each (3,000 x 10) = 30,000 kg
3,000 units did use = 29,000 kg
Difference = 1,000 kg favourable
Valued at $6∙80 per kg ($68/10 kg)
Variance = $6,800 favourable
Alternative methods of controlling production processes
In a modern manufacturing environment with an emphasis on quality management, using mix and yield
variances for control purposes may not be possible or may be inadequate. Other control methods could be more
useful.
Rates of wastage
Average cost of input calculations
Percentage of deliveries on time
Customer satisfaction ratings
Yield percentage calculations or output to input conversion rates
2. Sales mix and quantity variances
The sales volume variance can be analyzed further into a sales mix variance and a sales quantity variance. This
may be useful for control purposes where management is in a position to control the sales mix; for example,
through the allocation of spending on advertising and sales promotion.
Sales volume variance
It measures the difference between the budgeted and actual sales volumes for each product, and the effect
that this has had on profit. A sales volume variance in units of sale is converted into a monetary value by
applying either the standard profit per unit (standard absorption costing) or the standard contribution per unit
(standard marginal costing).
If a company sells more than one product, it is possible to analyse the overall sales volume variance into a
sales mix variance and a sales quantity variance.
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The sales mix variance occurs when the proportions of the various products sold are different from those in the
budget.
The sales quantity variance shows the difference in contribution/profit because of a change in sales volume
from the budgeted volume of sales.
When to calculate the mix and quantity variances
A sales mix variance and a sales quantity variance are only meaningful where management can control the
proportions of the products sold.
Situations where management may be able to control the sales mix are:
Where management can control the allocation of the advertising and sales promotion budget between
different products
Where the same basic product is sold in different sizes or packaging, such as large size and small size
Example: Sales mix and quantity variances (with formulas)
Mrs. Whippy Limited makes and sells two products, Chocolate ice cream cakes and blueberry pudding. The
budgeted sales and profit are as follows.
Sales Revenue Costs
Units $ $
Chocolate ice cream cakes 400 8,000 6,000
Blueberry pudding 300 12,000 11,100
Total 700
Actual sales were 280 units of Chocolate ice cream cakes and 630 units of Blueberry pudding. 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 variances:
Budgeted sales Actual sales Difference Standard variance
gross profit
per unit
Chocolate ice 400 280 120 5 600 A
cream cakes
Blueberry 300 630 330 3 990 F
pudding
Total 390 F
Sales Mix variance:
Total Actual sales in actual mix Total Actual sales in standard mix @ variance
@ standard gross profit/ unit standard gross profit/ unit
Chocolate ice 910x280/910x5=1400 910x400/700x5=2600 1200 A
cream cakes
Blueberry 910x630/910x3=1890 910x300/700x3=1170 720 F
pudding
Total 480 A
Sales quantity variance:
Total Actual sales in standard Total budgeted/standard sales in variance
mix @ standard gross profit/ standard mix @ standard gross
unit profit/ unit
Chocolate ice 910x400/700x5=2600 700x400/700x5=2000 600 F
cream cakes
Blueberry 910x300/700x3=1170 700x300/700x3=900 270 F
pudding
Total 870 F
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Example 1 objective test Question(OT)
The following budgeted data for a particular period was available for a company selling two products:
Sales price Variable cost Sales volume
per unit per unit in units
Product A $20 $8 15,840
Product B $24 $11 10,560
The actual results for the period were as follows:
Sales price Variable cost Sales volume
per unit per unit in units
Product A $22 $8 14,200
Product B $26 $11 12,500
What is the total sales quantity contribution variance for the period?
A $3,720 F
B $3,720 A
C $4,320 F
D $4,320 A
Solution:
The correct option is A
The sales quantity contribution variance is calculated as follows:
Actual sales units Standard Sales units Difference Standard Variance
In Std mix in Std mix in units Contribution
Product A 16,020 15,840 180F $12 $2,160F
Product B 10,680 10,560 120F $13 $1,560F
Total $3,720F
3. Planning and Operational variances:
Revision of budgets:
Occasionally, it may be appropriate to revise a budget or standard cost. When this happens, variances should
be reported in a way that distinguishes between variances caused by the revision to the budget and variances
that are the responsibility of operational management. A planning and operational approach to variance
analysis divides the total variance into those variances which have arisen because of inaccurate planning or
faulty standards (planning variances) and those variances which have been caused by adverse or favourable
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operational performance, compared with a standard which has been revised in hindsight (operational
variances)
When should budget revisions be allowed?
A budget revision should be allowed if something has happened which is beyond the control of the
organisation or individual manager and which makes the original budget unsuitable for use in performance
management.
Any adjustment should be approved by senior management who should look at the issues involved objectively
and independently. Operational issues are the issues that a budget is attempting to control so they should not
be subject to revision. However, it can be very difficult to establish what is due to operational problems
(controllable) and what is due to planning (uncontrollable).
Example‐Revision of budgets:
Spike Co manufactures and sells good quality leather bound diaries. Each year it budgets for its profits,
including detailed budgets for sales, materials and labour. If appropriate, the departmental managers are
allowed to revise their budgets for planning errors.
In recent months, the managing director has become concerned about the frequency of budget revisions. At a
recent board meeting he said ‘There seems little point budgeting any more. Every time we have a problem the
budgets are revised to leave me looking at a favourable operational variance report and at the same time a lot
less profit than promised.’
Two specific situations have recently arisen, for which budget revisions were sought:
Materials
A local material supplier was forced into liquidation. Spike Co’s buyer managed to find another supplier, 150
miles away at short notice. This second supplier charged more for the material and a supplementary delivery
charge on top. The buyer agreed to both the price and the delivery charge without negotiation. ‘I had no
choice’, the buyer said, ‘the production manager was pushing me very hard to find any solution possible!’ Two
months later, another, more competitive, local supplier was found. A budget revision is being sought for the
two months where higher prices had to be paid.
Labour
During the early part of the year, problems had been experienced with the quality of work being produced by
the support staff in the labour force. The departmental manager had complained in his board report that his
team were ‘unreliable, inflexible and just not up to the job’. It was therefore decided, after discussion of the
board report, that something had to be done. The company changed its policy so as to recruit only top
graduates from good quality universities. This has had the effect of pushing up the costs involved but
increasing productivity in relation to that element of the labour force.
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The support staff departmental manager has requested a budget revision to cover the extra costs involved
following the change of policy.
Required:
Discuss each request for a budget revision, putting what you see as both sides of the argument and reach a
conclusion as to whether a budget revision should be allowed. (8 marks)
solution:
Materials
Arguments in favour of allowing a revision
– The nature of the problem is outside the control of the organisation. The supplier went in to liquidation; it
is doubtful that Spike Limited could have expected this or prevented it from happening. – The buyer,
knowing that budget revisions are common, is likely to see the liquidation as outside his control and
hence expect a revision to be allowed. He may see it as unjust if this is not the case and this can be
demoralizing.
Arguments against allowing a budget revision
– There is evidence that the buyer panicked a little in response to the liquidation. He may have accepted
the first offer that became available (without negotiation) and therefore incurred more cost than was
necessary.
– A cheaper, more local supplier may well have been available, so it could be argued that the extra delivery
cost need not have been incurred. This could be said to have been an operational error.
Conclusion
The cause of this problem (liquidation) is outside the control of the organisation and this is the prime cause of
overspend.
Urgent problems need urgent solutions and a buyer should not be penalized in this case. A budget revision
should be allowed.
Labour
Arguments in favour of allowing a revision
– The board made this decision, not the departmental manager. It could be argued that the extra cost on
the department’s budget is outside their control.
Arguments against allowing a budget revision
– This decision is entirely within the control of the organisation as a whole. As such, it would fall under the
definition of an operational decision. It is not usual to allow a revision in these circumstances.
– It is stated in the question that the departmental manager complained in his board report that the staff
level needed improving. It appears that he got his wish and the board could be said to have merely
approved the change.
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– The department will have benefited from the productivity increases that may have resulted in the change
of policy. If the department takes the benefit then perhaps they should take the increased costs as well.
Conclusion
This is primarily an operational decision that the departmental manager agreed with and indeed suggested in
his board report.
No budget revision should be allowed.
An alternative view is that the board made the final decision and as such the policy change was outside the
direct control of the departmental manager. In this case a budget revision would be allowed.
Planning and operational variances‐calculations:
- Planning variances are calculated by comparing the original budget/standard cost with the revised
budget/standard cost.
- Operational variances are calculated in the same way as 'normal' basic variances, except that they are
based on a comparison between actual results and the revised budget/standard cost.
Planning and operational variances can be calculated for:
1. Labour rate and efficiency variances
2. material price and usage variances
3. sales volume and sales price variances
Labour variances
Original standard 5 hours per unit x 7 per hour = 35 per unit
Revised standard 6 hours per unit x 6 per hour = 36 per unit
Actual data
Actual production 1000 unit
Actual hours worked and paid 5500 hours
Actual labour cost $34,500
Labour total variance $
1000 units x 35/unit = 35,000
Actual labour cost = 34,500
_________
Total Variance 500 FAV
_________
Labour rate variance $
5500 hours x 7/hour = 38,500
Actual labour cost = 34,500
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_________
Rate variance 4,000 FAV
_________
Labour efficiency variance
1000 units x 5 hours = 5,000 hours
Actual hours worked = 5500 hours
___________
5oo hours
X
7
___________
Efficiency variance 3500
___________
Labour total planning variance
1000 units x 35 = 35,000
1000 units x 36 = 36,000
__________
Variance 1,000 ADV
__________
Labour Total operational variance
1000 units x 36 = 36,000
Actual labour cost = 34,500
__________
Total operational variance 1500 FAV
__________
Labour rate planning variance
5500 hours x 7/hour = 38,500
5500 hours x 6/hour = 33,000
___________
Variance 5,500 FAV
___________
Labour rate operational variance
5500 hours x 6/hour = 33,000
Actual labour cost = 34,500
__________
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Variance 1,500 ADV
__________
Labour efficiency planning variance
1000 units x 5 hours = 5,000 hours
1000 units x 6 hours = 6,000 hours
_______________
1,000 hours ADV
X
7/hour
______________
7,000 ADV
______________
Labour efficiency operational variance
1000 units x 6 hours = 6,000 hours
Actual hours worked = 5,500 hours
____________
500 hours fav
X
7/hour
____________
3,500 fav
____________
Material variances
Original standard 7kg/unit x 3/kg = 21/unit
Revised standard 6kg/unit x 4/kg = 24/unit
Actual data
Actual production 1000 units
Actual material quantity used and 5500 kg
purchased
Actual material cost 24,500
Material total variance
1000 units x 21 = 21,000
Actual material cost = 24,500
_________
3500 adv
_________
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Material usage variance
1000 units x 7 kg/unit = 7000 kg
Actual quantity used = 5500 kg
_________
Variance in kgs = 1500 kg
X
3
_________
4500 fav
_________
Material price variance
5500 kg x 3 = 16500
Actual material cost = 24500
__________
Variance 8000 adv
__________
Material total planning variance
1000 units x 21/unit = 21,000
1000 units x 24/unit = 24,000
__________
Variance 3,000 adv
__________
Material total operational
variance
1000 units x 24/unit = 24,000
Actual material cost = 24,500
___________
500 adv
___________
Material usage planning variance
1000 units x 7kg/unit = 7,000 kg
1000 units x 6kg/unit = 6,000 kg
__________
1,000 kg
X
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3
__________
3,000 fav
__________
Material usage operational
variance
1000 units x 6kg/unit = 6,000kg
Actual quantity used = 5,500 kg
__________
500 kg fav
X
3
__________
1500 fav
__________
Material price planning variance
5,500 kg x 3/kg = 16,500
5,500 kg x 4/kg = 22,000
____________
5,500 adv
____________
Material price operational
variance
5500 kg x 4/kg = 22,000
Actual material cost = 24,500
____________
2500 adv
____________
Sales variances
Original standard
Standard selling price 100 per unit
Standard contribution per unit 60 per unit
Budgeted sales 1,500 units
Revised standard selling price 105 per unit
Revised budgeted quantity 1,400 units
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Actual data
Actual unit sold 1,550 units
Actual selling price 106 per unit
Sales price variance
1,550 units x 100/unit = 155,000
1,550 units x 106/unit = 164,300
__________
Variance 9,300 fav
__________
Sales price planning variance
1,550 units x 100/unit = 155,000
1,550 units x 105/unit = 162,750
__________
Variance 7,750 fav
__________
Sales price operational variance
1,550 units x 105/unit = 162,750
1,550 units x 106/unit = 164,300
___________
Variance 1,550 fav
___________
Sales volume variance
Budgeted sales unit = 1,500 units
Actual unit sold = 1,550 units
____________
50 units
X
60
____________
Variance 3,000 fav
____________
Sales volume planning variance(also
called as market size variance)
Original Budgeted sales units = 1,500 units
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Revised budgeted sales units = 1,400 units
_____________
100 units
X
60
_____________
6,000 adv
_____________
Sales volume operational variance
(also called as market share
variance)
Revised budgeted sales units = 1,400 units
Actual unit sold = 1,550 units
__________
150 units
X
60
__________
9,000 fav
__________
Labour planning variances and the learning curve
Generally when a learning curve applies to the manufacture of a new product, it is not possible to establish a
standard labour cost. This is because the expected time to make each unit falls with each additional unit that is
produced.
A standard labour cost can only be established when a 'steady state' is reached and production of each additional
unit should take the same amount of time.
In principle, however, it would be possible to combine standard costing with the learning curve, as follows.
(a) Establish an original standard labour cost per unit, even though a learning effect will apply to production.
(b) At the end of the budget period, revise the standard time per unit. The revised standard time could be
calculated using the learning curve formula and applying this to the number of units produced in the period.
(c) With the original standard cost and the revised standard cost, planning and operational variances for labour
can be calculated. Because of the learning effect, the labour efficiency planning variance will always be
favourable.
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Example‐Objective test question(OT)
PlasBas Co uses recycled plastic to manufacture shopping baskets for local retailers. The standard price of the
recycled plastic is $0∙50 per kg and standard usage of recycled plastic is 0∙2 kg for each basket. The budgeted
production was 80,000 baskets.Due to recent government incentives to encourage recycling, the standard price of
recycled plastic was expected to reduce to $0∙40 per kg. The actual price paid by the company was $0∙42 per kg
and 100,000 baskets were manufactured using 20,000 kg of recycled plastic.
What is the materials operational price variance?
A $2,000 favourable
B $1,600 favourable
C $400 adverse
D $320 adverse
Solution:
The correct option is C
An operational variance compares revised price to actual price.
20,000 kg should cost $0∙40 per kg at the revised price (20,000 kg x $0∙40) = $8,000
20,000 kg did cost $0∙42 per kg (20,000 kg x $0∙42) = $8,400
Variance = $400 adverse
Example‐Objective test question(OT)
Caf Co budgeted to sell 10,000 units of a new product in the period at a budgeted selling price of $5 per unit.
Actual sales volumes in the period were as budgeted but the actual sales price achieved was only $4 per unit.
This was because a competitor launched a similar product at the same time. Caf Co had been unaware that
this was going to happen when it prepared its budget and, had it known this, it would have revised its
expected selling price to $3∙80 per unit, which was the price of the competitor’s product.
What is the sales price planning variance?
A $12,000 A
B $12,000 F
C $2,000 F
D $2,000 A
Solution:
The correct option is A
Planning variance = ($3∙80 – $5) x 10,000 = $12,000 A
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Investing variance:
1. Materiality
2. Controllability
3. Cost of investigation
4. Trend
5. Interdependence of variances
Reason for variances:
Variance Favourable Adverse
Material price Unforeseen discounts received Price increase
Greater care in purchasing Careless purchasing
Change in material standard Change in material standard
Material usage Material used of higher quality than Defective material
standard Excessive waste or theft
More efficient use of material Stricter quality control
Errors in allocating material to jobs Errors in allocating material to jobs
Labour rate Use of workers at a rate of pay lower Wage rate increase
than standard
Idle time The idle time variance is always adverse Machine breakdown Illness or injury to
worker
Labour efficiency Output produced more quickly than Lost time in excess of standard
expected because of worker motivation, Output lower than standard set
better quality materials etc because of lack of training,
Errors in allocating time to jobs substandard materials etc
Errors in allocating time to jobs
Fixed overhead Savings in costs incurred Increase in cost of services used
expenditure
Overhead expenditure variances ought to be traced to the individual cost centres where the variances occurred.
Fixed overhead Production or level of activity greater Production or level of activity less
volume than budgeted than budgeted
Efficiency Reasons for this tie in exactly to labour Reasons for this tie in exactly to
efficiency labour efficiency
Capacity Labour worked for more hours than Maybe a result of lower production
budgeted. Maybe due to more volumes or higher absenteeism eg
production than expected holidays / sickness
Sales price Unplanned price increase Anticipated increase in selling price
Fewer discounts given than expected did not happen
More discounts allowed than
expected
Sales volume Additional demand experienced Fall in demand Lower output
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Analyzing past performance with variance analysis
Variance analysis compares actual performance with a budget or standard cost. Differences between actual results
and the budget or standard are reported in monetary terms as variances, and variances can be used to reconcile
budgeted profit and actual profit in an operating statement. The previous chapters have focused mainly on the
techniques of calculating variances. For the exam, you also need to show an awareness of what variances tell us,
and what control measures management should take when a variance is reported.
Basic principles of variance reporting are that:
The monetary value that is given to variances should be a reasonable indication of how much profit has been
made or lost as a result of actual performance differing from the budget or standard.
The managers responsible for variances (adverse or favourable) should be identified, and they should be expected
to account for the variance and, where appropriate, indicate what corrective or control measures they are taking
(keep in mind the controllability factor).
For example operational managers cannot be held responsible for planning variances but for operational variances
.Here is a list of general responsibility of managers.
Variance Responsible manager
Sales price variance Sales or marketing management.
Sales volume variance Normally sales or marketing management However, if sales are less than
budget due to problems with production, the production manager is
responsible.
Material price variance The manager responsible for purchasing materials
Material usage variance Normally the production manager
Labour rate variance The manager responsible for pay rates. This may be senior management or
Human Resources management. However, the production manager will be
responsible for any adverse rate variances caused by working overtime and
paying employees a premium rate per hour
Labour efficiency variance Normally the production manager
Idle time variance This depends on the cause of the idle time. It may be caused by lack of sales
orders (sales management responsibility), inefficient production
management (production management responsibility) or delays in deliveries
of key raw material (buying manager responsibility)
Example‐Objective test question(OT)
A profit center manager claims that the poor performance of her division is entirely due to factors outside her
control. She has submitted the following table along with notes from a market expert, which she believes explains
the cause of the poor performance:
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Category Budget Actual Actual Market expert notes
this year this year last year
Sales volume 500 300 400 The entire market has
(units) decreased by 25%
compared to last
year. The product will
be obsolete in four years
Sales revenue $50,000 $28,500 $40,000 Rivalry in the market saw
selling prices fall by 10%
Total material cost $10,000 $6,500 $8,000 As demand for the raw
materials is decreasing,
suppliers lowered their
prices by 5%
After adjusting for the external factors outside the manager’s control, in which category/categories is
there evidence of poor performance?
A Material cost only
B Sales volume and sales price
C Sales price and material cost
D Sales price only
The correct option is A
The material price when flexed is higher than budget whilst the external environment shows that prices are
reducing. This indicates that although suppliers lowered their prices, the manager has still overspent which
indicates poor performance.
When sales volumes and prices are flexed, it can be seen that the manager has performed better
The application of standard costing (and variance analysis) in the modern environment
Modern management places great emphasis on quality ‐ Total Quality Management (TQM), and on increasing
efficiency and reducing waste ‐ Just In Time (JIT). However, traditional standard costing tends to make allowances
for waste and for idle time, which is contrary to the TQM and JIT culture.
Traditional variance analysis focuses on quantity rather than quality. This could mean, for example, using lower
quality material to save money. This would again be contrary to the TQM and JIT culture.
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Another element of the TQM culture is the idea of trying to achieve continuous improvement. Traditional variance
analysis does not really accommodate this.
Expected Values in Budgeting
Expected values may be used in budgeting to determine the best combination of expected profit and risk.
Probabilistic budgeting
Probabilistic budgeting assigns probabilities to different conditions (most likely, worst possible, best possible) to
derive an EV of budgeted profit.
END OF CHAPTER
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•Performance measurement in private sector
(financial and non‐financial KPIs
•Balanced scorecard
Chapter 13 •Building block model
•Divisional performance measurement
Performance •Transfer pricing
•Performance measurement‐Not for Profit
Measurement & organizations
Control •External consideration in performance
measurement
•Management information (sources and
systems)
Performance Measurement in private sector:
When considering measuring performance the nature of the business will determine how it is done and what
measures are appropriate. However, there are two basic measurement areas to explore:
1. Financial performance measures/indicators (FPIs)
2. Non‐financial performance measures/indicators (NFPIs)
Financial measures:
Financial performance measures are what most accounting systems focus on They have the advantages of being
quantitative, can be expressed in numbers, comparable, everything is expressed in the same monetary unit and
reconcilable and we can make sure that the numbers add up.
All traditional management accounting performance measurement systems are based on financial measures. It
also links very nicely to financial accounting to which the management accounting department is likely to be
closely linked.
Financial measures can be used to measure the following three areas of performance:
1. Profitability
2. Liquidity
3. Risk
Profitability ratios
Gross profit margin = Gross profit x100
sales
Net profit margin = Net profit(PBIT) x100
sales
(Gross profit is the ‘main‐spring’ of profit generation. If gross profit stays high, but net profit falls, this can imply
that expenses are poorly controlled.)
Return on capital employed =Profit before interest and tax × 100
capital employed
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(capital employed = long term liabilities + share capital)
Asset turnover = Revenue x 100
Capital employed
Asset turnover measures how hard the assets are worked: $ of revenue from each $ of capital.
Note :
ROCE = asset turnover × net profit margin
Liquidity ratios
Inventory days = Inventory x 100
Cost of sales
Debtors days = Trade recievable x 100
Credit sales
Payable days = Trade payables x 100
Credir purchases
Long collection periods might indicate inefficient receivable management – or agreeing longer credit to
compete or win contracts.
Current ratio = Current asset
Current lialbilities
Quick ratio = current asset – inventory
Current liabilities
If too low, the organisation will have trouble paying its suppliers and employees on time.
Risk measurement ratios/Grearing Ratios
Interest cover = profit before interest & tax
Interest charge per year
Interest cover is use to asses the compnay’s ability to pay its interest.
Gearing ratio = long term liablity
Long term liablity + capital
Gearing ratio is use to asses the risk compnay is facing because of long term debt(financial Risk)
Operation Gearing= Contribution
Profit before interest and tax PBIT)
This ratio measures the business Risk (Risk of making low profits or losses)
If operating gearing is high this indicates that a large proportion of the organisation’s operating costs are fixed.
Fixed costs make profit more volatile as PBIT becomes more vulnerable to downturns in business volume.
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Some other Ratios
P/E ratio = price per share
Earning per share
P/E ratio indicate investors expectation about companies future growth.
Earning per share = profit after tax
No of ordinary shares
Shareholders like to see this increase. It can decrease when new issues are made and the capital raised hasn’t
yet produced profits.
Paying too much for an acquisition (for example by a share exchange) can depress the EPS
Example Objective Test Question(OT)
The following ratios have been calculated for a company:
Gross profit margin 42%
Operating profit margin 28%
Gearing (debt/equity) 40%
Asset turnover 65%
What is the return on capital employed for the company?
A 27∙3%
B 18∙2%
C 11∙2%
D 16∙8%
Solution:
The correct option is B
ROCE can be calculated by multiplying the operating profit margin and the asset turnover.
28% x 65% = 18∙2%
Example Objective Test Question(OT)
A company’s sales and cost of sales figures have remained unchanged for the last two years. The following
information has been noted:
Year ended 31 May 2015 31 May 2014
Inventory turnover period 45 days 38 days
Payables payment period 40 days 35 days
Receivables payment period 60 days 68 days
Current ratio 1∙3 1∙4
Quick ratio 1∙1 1∙3
The following statements have been made about the company’s performance for the most recent year:
(i) Customers are taking longer to pay and this may have contributed to the decline in the company’s
current ratio
(ii) Inventory levels have decreased and this may have contributed to the decline in the company’s quick
ratio
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Which of the above statements is/are true?
A (i) only
B (ii) only
C Both (i) and (ii)
D Neither (i) nor (ii)
Solution:
The correct option is D
The first statement is wrong because customers are actually paying more quickly. The second statement is
wrong because inventory levels have increased.
Non‐financial performance measures:
More recently there has been an emphasis on introducing non‐financial measures to augment, and in some cases,
replace the financial measures traditionally used. The use of non‐financial measures is intended to address some of
the problems highlighted with financial measures, particularly relating to qualitative issues, wider performance
areas and internal focus.
A weakness of non‐financial measures is that they cannot be easily reconciled or linked together meaning that we
have a wide mix of unrelated measures. There is no easy way to avoid this.
Some Examples of non‐financial performance indicators are;
Service quality
Number of complaints
Number of repeat customers
On‐time deliveries
Customer waiting time
Output requiring reworking
Manufacturing lead times
Personnel
Number of complaints received
Staff turnover
Training time per employee
Short‐termism or dysfunctional Behaviour:
Where managers have a bias towards short term rather than long term to maximize their remuneration and
bonuses.
Organizations often have to make a trade‐off between short‐term and long‐term objectives. Decisions which
involve the sacrifice of longer‐term objectives include the following:
a) Postponing or abandoning capital expenditure projects, which would eventually contribute to growth and
profits, in order to protect short‐term cash flow and profits
b) Cutting R&D expenditure to save operating costs, and so reducing the prospects for future product
development
c) Reducing quality control, to save operating costs (but also adversely affecting reputation and goodwill)
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d) Reducing the level of customer service, to save operating costs (but sacrificing goodwill)
e) Cutting training costs or recruitment (so the company might be faced with skills shortages)
Methods to encourage Long Term View:
a) Making short term targets realistic (so no manipulation is required)
b) Provide sufficient management information
c) Link manager’s rewards to share price(long term incentive)
d) Set quality based and multiple targets
Balanced Scorecard (includes financial and non‐financial performance measures):
In recent years, the trend in performance measurement has been towards a broader view of performance,
covering both financial and non‐financial indicators. The most well‐known of these approaches is the balanced
scorecard proposed by Kaplan and Norton.
The balanced scorecard approach involves measuring performance under four different perspectives, as follows:
The term 'balanced' is used because managerial performance is assessed under all four headings. Each
organization has to decide which performance measures to use under each heading. Areas to measure should
relate to an organization's critical success factors.
Critical success factors (CSFs) are performance requirements which are fundamental to an organisation's success
(for example innovation in a consumer electronics company) and can usually be identified from an organisation's
mission statement, objectives and strategy.
Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key
performance indicators should be:
specific (ie measure profitability rather than 'financial performance', a term which could mean different things
to different people)
measurable (ie be capable of having a measure placed upon it, for example, number of customer complaints
rather than the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor
The following Example demonstrates a balanced scorecard approach to performance measurement in a fictitious
private sector college training ACCA students.
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Example
The balanced scorecard approach to performance measurement offers several advantages:
it Measures performance in a variety of ways, rather than relying on one figure
Managers are unlikely to be able to distort the performance measure as bad performance is difficult to hide if
multiple performance measures are used
it Takes a long‐term perspective of business performance
Success in the four key areas should lead to the long‐term success of the organization
it Is flexible as what is measured can be changed over time to reflect changing priorities
'What gets measured gets done' – if managers know they are being appraised on various aspects of
performance they will pay attention to these areas, rather than simply paying 'lip service' to them.
The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This can prove
difficult where the organization has no previous experience of performance measurement. Benchmarking with
other organisation’s is a possible solution to this problem.
Allowing for trade‐offs between KPIs can also be problematic. How should the organization judge the manager
who has improved in every area apart from, say, financial performance? One solution to this problem is to require
managers to improve in all areas, and not allow trade‐offs between the different measures.
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The Building Block Model
Fitzgerald and Moon’s Building Block Model is an evolution of the Balanced Scorecard, developed to meet the
needs of service organizations. It is a tool that helps management set a forward‐looking performance management
framework that links an organisation’s strategy and objectives to employee targets and motivation.
The Building Block model looks at three areas of performance: dimensions, standards, and rewards.
DIMENSIONS
Financial performance
competitiveness Quality
Innovation
Flexibility
Resource utlisation
STANDARD REWARDS
Ownership Clarity
Achievability Controllability
Equity Motivation
Dimensions Explained
Companies compete across a range of dimensions besides financial performance. The Building Block model
considers this and describes two categories of dimensions: ‘Results’ and ‘Determinants.’
‘Results’ are the outcome of decisions and actions taken by management in the past. These are captured under the
first two dimensions of the model, financial performance and competitiveness.
‘Determinants’ refer to the forward‐looking dimensions of the model: what areas of future performance are most
important for a company to achieve positive financial and competitive results? Quality, innovation,
flexibility and resource utilization are the determinants of future success.
Standards Explained
After an organisation’s dimensions are understood, standards can be set. These will be the benchmarks, or targets,
directly linked to performance metrics under headings for each dimension. There are three aspects to consider in
setting standards:
Who is responsible for achieving the standard (ownership)?
What level are the standards set at (achievability)?
Can we use the standards for a fair appraisal across the company (equity)?
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These three criteria are important. If it is unclear to whom targets are assigned, managers and staff will not have
accountability and performance management will fail. If personal targets are unachievable, people will not work
harder to achieve their goals and there will be little motivation. If appraisal is not fair and transparent, employee
morale will suffer.
Rewards Explained
The last part of the model looks at the overall reward structure of the organisation and is the link to HR systems.
Do compensation packages in the company lead people to achieve the standards of performance which are set out
above? This part of the model has three aspects:
Is the system understandable to all employees (clarity)?
Will the system drive employees to achieve their objectives (motivation)?
Do employees have control over their areas of responsibility (controllability)?
The reward system should be clearly understood by all employees: this means unambiguous performance
appraisal and bonus triggers. Rewards should be sufficiently desirable so that employees are motived to work hard
towards gaining them. Finally, if employees are assessed against factors out of their control, they will lose interest
in working towards their rewards.
Conclusion
Like other modern performance measurement frameworks, the Building Block model connects an organisation’s
strategic objectives to a range of forward‐looking, non‐financial performance measures. Where the Building Block
Model differs, however, is that also considers reward systems and aims to create a framework of clearly
understood and communicated individual metrics that aligns individual performance targets with organizational
objectives.
Divisional Performance Measurement:
Decentralization is essentially the delegation of decision‐making responsibility. All organizations decentralize to
some degree; some do it more than others. Decentralization is a necessary response to the increasing complexity
of the environment that organizations face and the increasing size of most organizations. Nowadays it would be
impossible for one person to make all the decisions involved in the operation of even a small company, hence
senior managers delegate decision‐making responsibility to subordinates.
One danger of Decentralization is that managers may use their decision‐making freedom to make decisions that
are not in the best interests of the overall company (so called dysfunctional decisions). To redress this problem,
senior managers generally introduce systems of performance measurement to ensure – among other things – that
decisions made by junior managers are in the best interests of the company as a whole.
Table 1 below details different degrees of Decentralization and typical financial performance measures employed.
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TABLE 1
Profit centers and investment centers are often referred to as divisions. Divisionalization refers to the delegation of
profit‐making responsibility.
What makes a good performance measure?
A good performance measure should:
provide incentive to the divisional manager to make decisions which are in the best interests of the overall
company (goal congruence)
only include factors for which the manager (division) can be held accountable
Recognises the long‐term objectives as well as short‐term objectives of the organization.
Traditional performance indicators
Cost centers
Standard costing variance analysis is commonly used in the measurement of cost center performance. It gives a
detailed explanation of why costs may have departed from the standard. Although commonly used, it is not
without its problems. It focuses almost entirely on short‐term cost minimization which may be at odds with other
objectives, for example, quality or delivery time. Also, it is important to be clear about who is responsible for which
variance – is the production manager or the purchasing manager (or both) responsible for raw material price
variances? There is also the problem with setting standards in the first place – variances can only be as good as the
standards on which they are based.
Profit centers
Controllable profit statements are commonly used in profit centers. A pro‐forma statement is given in the
following table.
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The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing
the performance of a manager we should only consider costs and revenues under the control of that manager, and
hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on
costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example,
depreciation on divisional machinery would not be included as a controllable cost in a profit center. This is because
the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed
cost in assessing the performance of the division.
Investment centers
In an investment center, managers have the responsibilities of a profit center plus responsibility for capital
investment. Two measures of divisional performance are commonly used:
1. Return on investment (ROI) % = controllable (traceable) profit/controllable (traceable) investment.
2. Residual income = controllable (traceable) profit – an imputed interest charge on controllable (traceable)
investment.
Note: Imputed interest is calculated by multiplying the controllable (traceable) investment by the cost of capital.
Example 1:
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of $2.2m per annum.
Division X's cost of capital is 10% per annum. The division is considering two proposals.
Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m.
Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a reduction in
profits of $0.3m.
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Proceeds from the disposal of assets would be credited to head office not to Division X.
Required:
Calculate the current ROI and residual income for Division X and show how they would change under each of the
two proposals.
Commentary:
Under the current situation ROI exceeds the cost of capital and residual income is positive. The division is
performing well.
In simple terms Proposal 1 is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m) which is
greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting
Proposal 1. This would be a dysfunctional decision. Residual income increases if Proposal 1 is adopted and this
performance measure should lead to goal congruent decisions.
In simple terms Proposal 2 is not acceptable to the company. The existing assets have a rate of return on 13%
($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional
ROI rises and this could lead to the divisional manager accepting Proposal 2. This would be a dysfunctional
decision. Residual income decreases if Proposal 2 is adopted and once again this performance measure should lead
to goal congruent decisions.
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Relative merits of ROI and residual income
Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow
unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow £100 and invest
it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%?
Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net
return (residual income) of $15 per annum after borrowing costs. The bigger investment would give a net return of
$50,000. Residual income, being an absolute measure, would lead you to select the project that maximizes your
wealth.
Residual income also ties in with net present value, theoretically the best way to make investment decisions. The
present value of a project's residual income equals the project's net present value. In the long run, companies that
maximize residual income will also maximize net present value and in turn shareholder wealth. Residual income
does, however, experience problems in comparing managerial performance in divisions of different sizes. The
manager of the larger division will generally show a higher residual income because of the size of the division
rather than superior managerial performance.
In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be adjusted
to recognises the risk in different projects.
Problems common to both ROI and residual income
The following problems are common to both measures:
Identifying controllable (traceable) profits and investment can be difficult.
If used in a short‐term way they can both overemphasize short‐term performance at the expense of long‐term
performance. Investment projects with positive net present value can show poor ROI and residual income
figures in early years leading to rejection of projects by managers (see Example 2).
If assets are valued at net book value, ROI and residual income figures generally improve as assets get older.
This can encourage managers to retain outdated plant and machinery (see Example 2).
Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of
modern businesses, multi‐faceted measures of performance are necessary.
Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.
Example 2:
PQR plc is considering opening a new division to manage a new investment project. Forecast cash flows of the new
project are as follows:
PQR's cost of capital is 10% per annum. Straight line depreciation is used.
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Required:
Calculate the project's net present value and its projected ROI and residual income(RI) over its five‐year life.
NPV
ROI
Residual income(RI)
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Commentary:
This example demonstrates two points. Firstly, it illustrates the potential conflict between NPV and the two
divisional performance measures. This project has a positive NPV and should increase shareholder wealth.
However, the poor ROI and residual income figures in the first year could lead managers to reject the project.
Secondly, it shows the tendency for both ROI and residual income to improve over time. Despite constant annual
cash flows, both measures improve over time as the net book value of assets falls. This could encourage managers
to retain outdated assets.
Example Objective test question(OT):
At the end of 20X1, an investment centre has net assets of $1m and annual operating profits of $190,000.
However,the bookkeeper forgot to account for the following:
A machine with a net book value of $40,000 was sold at the start of the year for $50,000 and replaced with a
machine costing $250,000. Both the purchase and sale are cash transactions. No depreciation is charged in the
year of purchase or disposal. The investment centre calculates return on investment (ROI) based on closing net
assets.
Assuming no other changes to profit or net assets, what is the return on investment (ROI) for the year?
A 18∙8%
B 19∙8%
C 15∙1%
D 15∙9%
Solution:
The correct option is B
Revised annual profit = $190,000 + $10,000 profit on the sale of the asset = $200,000
Revised net assets = $1,000,000 – $40,000 NBV + $50,000 cash – $250,000 cash + $250,000 asset = $1,010,000
ROI = ($200,000/$1,010,000) x 100 = 19∙8%
Example Objective test question(OT):
A division is considering investing in capital equipment costing $2∙7m. The useful economic life of the
equipment is expected to be 50 years, with no resale value at the end of the period. The forecast return on
the initial investment is 15% per annum before depreciation. The division’s cost of capital is 7%.
What is the expected annual residual income of the initial investment?
A $0
B ($270,000)
C $162,000
D $216,000
Solution:
The correct option is C
Divisional profit before depreciation = $2∙7m x 15% = $405,000 per annum.
Less depreciation = $2∙7m x 1/50 = $54,000 per annum. Divisional profit after depreciation = $351,000
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Imputed interest = $2∙7m x 7% = $189,000
Residual income = $162,000.
Transfer Pricing:
When one division transfers goods to another division, the price they charged is called as transfer price.
Why Transfer Pricing Is Important
It is essential to understand that transfer prices are only important in so far as they encourage divisions to trade in
a way that maximizes profits for the company as a whole. The fact is that the effects of inter‐divisional trading are
wiped out on consolidation anyway. Hence, all that really matters is the total value of external sales compared to
the total costs of the company. So, while getting transfer prices right is important, the actual transfer price itself
doesn’t matter since the selling division’s sales (a credit in the company accounts) will be cancelled out by the
buying division’s purchases (a debit in the company accounts) and both figures will disappear altogether. All that
will be left will be the profit, which is merely the external selling price less any cost incurred by both divisions in
producing the goods, irrespective of which division they were incurred in.
As well as transfer prices needing to be set at a level that maximises company profits, they also need to be set in a
way that is compliant with tax laws, allows for performance evaluation of both divisions and staff/managers, and is
fair and therefore motivational. A little more detail is given on each of these points below:
If your company is based in more than one country and it has divisions in different countries that are trading
with each other, the price that one division charges the other will affect the profit that each of those divisions
makes. In turn, given that tax is based on profits, a division will pay more or less tax depending on the transfer
prices that have been set. While you don’t need to worry about the detail of this for the Performance
Management exam, it’s such an important point that it’s simply impossible not to mention it when discussing
why transfer pricing is important.
From bullet point 1, you can see that the transfer price set affects the profit that a division makes. In turn, the
profit that a division makes is often a key figure used when assessing the performance of a division. This will
certainly be the case if return on investment (ROI) or residual income (RI) is used to measure performance.
Consequently, a division may, for example, be told by head office that it has to buy components from another
division, even though that division charges a higher price than an external company. This will lead to lower
profits and make the buying division’s performance look poorer than it would otherwise be. The selling
division, on the other hand, will appear to be performing better. This may lead to poor decisions being made
by the company.
If this is the case, the manager and staff of that division are going to become unhappy. Often, their pay will be
linked to the performance of the division. If divisional performance is poor because of something that the
manager and staff cannot control, and they are consequently paid a smaller bonus for example, they are going
to become frustrated and lack the motivation required to do the job well. This will then have a knock‐on effect
to the real performance of the division. As well as being seen not to do well because of the impact of high
transfer prices on ROI and RI, the division really will perform less well.
The impact of transfer prices could be considered further but these points are sufficient for the level of
understanding needed for the Performance Management exam. Let us now go on to consider the general
principles that you should understand about transfer pricing. Again, more detail could be given here and these are,
to some extent, oversimplified. However, this level of detail is sufficient for the Performance Management exam.
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General Principles about Transfer Pricing
1. Where there is an external market for the product being transferred
Minimum transfer price
When we consider the minimum transfer price, we look at transfer pricing from the point of view of the selling
division. The question we ask is: what is the minimum selling price that the selling division would be prepared
to sell for? This will not necessarily be the same as the price that the selling division would be happy to sell for,
although, as you will see, if it does not have spare capacity, it is the same.
The minimum transfer price that should ever be set if the selling division is to be happy is: marginal cost +
opportunity cost.
Opportunity cost is defined as the 'value of the best alternative that is foregone when a particular course of
action is undertaken'. Given that there will only be an opportunity cost if the seller does not have any spare
capacity, the first question to ask is therefore: does the seller have spare capacity?
Spare capacity
If there is spare capacity, then, for any sales that are made by using that spare capacity, the opportunity cost is
zero. This is because workers and machines are not fully utilized. So, where a selling division has spare
capacity the minimum transfer price is effectively just marginal cost. However, this minimum transfer price is
probably not going to be one that will make the managers happy as they will want to earn additional profits.
So, you would expect them to try and negotiate a higher price that incorporates an element of profit.
No spare capacity
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all external
demand and internal demand, then the next question to consider is: how can the opportunity cost be
calculated? Given that opportunity cost represents contribution foregone, it will be the amount required in
order to put the selling division in the same position as they would have been in had they sold outside of the
group. Rather than specifically working an 'opportunity cost' figure out, it’s easier just to stand back and take a
logical approach rather than a rule‐based one.
Logically, the buying division must be charged the same price as the external buyer would pay, less any
reduction for cost savings that result from supplying internally. These reductions might reflect, for example,
packaging and delivery costs that are not incurred if the product is supplied internally to another division. It is
not really necessary to start breaking the transfer price down into marginal cost and opportunity cost in this
situation.
It’s sufficient merely to establish:
(i) what price the product could have been sold for outside the group
(ii) establish any cost savings, and
(iii) deduct (ii) from (i) to arrive at the minimum transfer price.
At this point, we could start distinguishing between perfect and imperfect markets, but this is not necessary in
Performance Management. There will be enough information given in a question for you to work out what the
external price is without focusing on the market structure.
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We have assumed here that production constraints will result in fewer sales of the same product to external
customers. This may not be the case; perhaps, instead, production would have to be moved away from
producing a different product. If this is the case the opportunity cost, being the contribution foregone, is
simply the shadow price of the scarce resource.
In situations where there is no spare capacity, the minimum transfer price is such that the selling division
would make just as much profit from selling internally as selling externally. Therefore, it reflects the price that
they would actually be happy to sell at. They shouldn’t expect to make higher profits on internal sales than on
external sales.
Maximum transfer price
When we consider the maximum transfer price, we are looking at transfer pricing from the point of view of
the buying division. The question we are asking is: what is the maximum price that the buying division would
be prepared to pay for the product? The answer to this question is very simple and the maximum price will be
one that the buying division is also happy to pay.
The maximum price that the buying division will want to pay is the market price for the product – i.e.
whatever they would have to pay an external supplier for it. If this is the same as the selling division sells the
product externally for, the buyer might reasonably expect a reduction to reflect costs saved by trading
internally. This would be negotiated by the divisions and is called an adjusted market price.
2. Where there is no external market for the product being transferred
Sometimes, there will be no external market at all for the product being supplied by the selling division;
perhaps it is a particular type of component being made for a specific company product. In this situation, it is
not really appropriate to adopt the approach above. In reality, in such a situation, the selling division may well
just be a cost center, with its performance being judged on the basis of cost variances. This is because the
division cannot really be judged on its commercial performance, so it doesn’t make much sense to make it a
profit center. Options here are to use a cost based approach to transfer pricing but these also have their
advantages and disadvantages.
Cost based approaches
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Variable cost
A transfer price set equal to the variable cost of the transferring division produces very good economic
decisions. If the transfer price is $18, Division B’s marginal costs would be $28 (each unit costs $18 to buy in
then incurs another $10 of variable cost). The group’s marginal costs are also $28, so there will be goal
congruence between Division B’s wish to maximise its profits and the group maximising its profits. If marginal
revenue exceeds marginal costs for Division B, it will also do so for the group.
Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain
drawbacks:
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
Performance measurement is also distorted. Division A is condemned to making losses while Division B gets
an easy ride as it is not charged enough to cover all costs of manufacture. This effect can also distort
investment decisions made in each division. For example, Division B will enjoy inflated cash inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price.
Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used as a
transfer price, it at least should be standard marginal cost, so that efficiencies and inefficiencies stay within
the divisions responsible for them.
Full cost/Full cost plus/Variable cost plus
A transfer price set at full cost or better, full standard cost is slightly more satisfactory for Division A as it
means that it can aim to break even. Its big drawback, however, is that it can lead to dysfunctional decisions
because Division B can make decisions that maximise its profits but which will not maximise group
profits. For example, if the final market price fell to $35, Division B would not trade because its marginal cost
would be $40 (transfer‐in price of $30 plus own marginal costs of $10). However, from a group perspective,
the marginal cost is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of
only $35. Head office could, of course, instruct Division B to trade but then divisional autonomy is
compromised and Division B managers will resent being instructed to make negative contributions which will
impact on their reported performance. Imagine you are Division B’s manager, trying your best to hit profit
targets, make wise decisions, and move your division forward by carefully evaluated capital investment.
The full cost plus approach would increase the transfer price by adding a mark‐up. This would now motivate
Division A, as profits can be made there and may also allow profits to be made by Division B. However, again
this can lead to dysfunctional decisions as the final selling price falls.
The difficulty with full cost, full cost plus and variable cost plus is that they all result in fixed costs and profits
being perceived as marginal costs as goods are transferred to Division B. Division B therefore has the wrong
data to enable it to make good economic decisions for the group – even if it wanted to. In fact, once you get
away from a transfer price equal to the variable cost in the transferring division, there is always the risk of
dysfunctional decisions being made unless an upper limit – equal to the net marginal revenue in the receiving
division – is also imposed.
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Tackling a Transfer Pricing Question in Exams:
Thus far, we have only talked in terms of principles and, while it is important to understand these, it is equally
as important to be able to apply them. The following question came up in June 2014’s exam. It was actually a
20‐mark question with the first 10 marks in part (a) examining divisional performance measurement and the
second 10 marks in part (b) examining transfer pricing. Parts of the question that were only relevant to part
(a) have been omitted here however the full question can be found on ACCA’s website. The question read as
follows:
Reproduction of exam question
Relevant extracts from part (a)
The Rotech group comprises two companies, W Co and C Co.
W Co is a trading company with two divisions: the design division, which designs wind turbines and supplies
the designs to customers under licences and the Gearbox division, which manufactures gearboxes for the car
industry.
C Co manufactures components for gearboxes. It sells the components globally and also supplies W Co with
components for its Gearbox manufacturing division.
The financial results for the two companies for the year ended 31 May 2014 are as follows:
(b) C Co is currently working to full capacity. The Rotech group’s policy is that group companies and divisions
must always make internal sales first before selling outside of the group. Similarly, purchases must be made
from within the group wherever possible. However, the group divisions and companies are allowed to
negotiate their own transfer prices without interference from head office.
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C Co has always charged the same price to the Gearbox division as it does to its external customers. However,
after being offered a 5% lower price for the similar components from an external supplier, the manager of
the Gearbox division feels strongly that the transfer price is too high and should be reduced. C Co currently
satisfies 60% of the external demand for its components. Its variable costs represent 40% of the total revenue
for the internal sales of the components.
Required:
Advise, using suitable calculations, the total transfer price or prices at which the components should be
supplied to the Gearbox division from C Co.
(10 marks)
Approach
1. As always, you should begin by reading the requirement. In this case, it is very specific as it asks you to ‘advise,
using suitable calculations…’ In a question like this, it would actually be impossible to ‘advise’ without using
calculations anyway and your answer would score very few marks. However, this wording has been added in
to provide assistance. In transfer pricing questions, you will sometimes be asked to calculate a transfer
price/range of transfer prices for one unit of a product. However, in this case, you are being asked to calculate
the total transfer price for the internal sales. You don’t have enough information to work out a price per unit.
2. Allocate your time. Given that this is a 10‐mark question then, since it is a three‐hour exam, the total time that
should be spent on this question is 18 minutes.
3. Work through the scenario, highlighting or underlining key points as you go through. When tackling part (a)
you would already have noted that C Co makes $7.55m of sales to the Gearbox Division (and you should have
noted who the buying division was and who the selling division was). Then, in part (b), the first sentence tells
you that C Co is currently working to full capacity. Highlight this; it’s a key point, as you should be able to tell
now. Next, you are told that the two divisions must trade with each other before trading outside the group.
Again, this is a key point as it tells you that, unless the company is considering changing this policy, C Co is
going to meet all of the Gearbox division’s needs.
Next, you are told that the divisions can negotiate their own transfer prices, so you know that the price(s) you
should suggest will be based purely on negotiation.
Finally, you are given information to help you to work out maximum and minimum transfer prices. You are
told that the Gearbox division can buy the components from an external supplier for 5% cheaper than C Co
sells them for. Therefore, you can work out the maximum price that the division will want to pay for the
components. Then, you are given information about the marginal cost of making gearboxes, the level of
external demand for them and the price they can be sold for to external customers. You have to work all of
these figures out but the calculations are quite basic. These figures will enable you to calculate the minimum
prices that C Co will want to sell its gearboxes for; there are two separate prices as, when you work the figures
through, it becomes clear that, if C Co sold purely to the external market, it would still have some spare
capacity to sell to the Gearbox division. So, the opportunity cost for some of the sales is zero, but not for the
other portion of them.
4. Having actively read through the scenario, you are now ready to begin writing your answer. You should work
through in a logical order. Consider the transfer from both C Co’s perspective (the minimum transfer price),
then Gearbox division’s perspective (the maximum transfer price), although it doesn’t matter which one you
deal with first. Head up your paragraphs so that your answer does not simply become a sea of words. Also, by
heading up each one separately, it helps you to remain focused on fully discussing that perspective first.
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Study Notes Performance Management ‐ PM
Finally, consider the overall position, which in this case is to suggest a sensible range of transfer prices for the
sale. There is no single definitive answer but, as is often the case, a range of prices that would be acceptable.
The suggested solution is shown below.
Always remember that you should only show calculations that actually have some relevance to the answer. In this
exam, many candidates actually worked out figures that were of no relevance to anything. Such calculations did
not score marks.
Reproduction Of Answer
From C Co’s perspective:
C Co transfers components to the Gearbox division at the same price as it sells components to the external market.
However, if C Co were not making internal sales then, given that it already satisfies 60% of external demand, it
would not be able to sell all of its current production to the external market. External sales are $8,010,000,
therefore unsatisfied external demand is ([$8,010,000/0.6] – $8,010,000) = $5,340,000.
From C Co’s perspective, of the current internal sales of $7,550,000, $5,340,000 could be sold externally if they
were not sold to the Gearbox division. Therefore, in order for C Co not to be any worse off from selling internally,
these sales should be made at the current price of $5,340,000, less any reduction in costs that C Co saves from not
having to sell outside the group (perhaps lower administrative and distribution costs).
As regards the remaining internal sales of $2,210,000 ($7,550,000 – $5,340,000), C Co effectively has spare
capacity to meet these sales. Therefore, the minimum transfer price should be the marginal cost of producing
these goods. Given that variable costs represent 40% of revenue, this means that the marginal cost for these sales
is $884,000. This is, therefore, the minimum price which C Co should charge for these sales.
In total, therefore, C Co will want to charge at least $6,224,000 for its sales to the Gearbox division.
From the Gearbox division’s perspective:
The Gearbox division will not want to pay more for the components than it could purchase them for externally.
Given that it can purchase them all for 95% of the current price, this means a maximum purchase price of
$7,172,500.
Overall:
Taking into account all of the above, the transfer price for the sales should be somewhere between $6,224,000 and
$7,172,500.
SUMMARY
The level of detail given in this article reflects the level of knowledge required for Performance Management as
regards transfer pricing questions of this nature. It’s important to understand why transfer pricing both does and
doesn’t matter and it is important to be able to work out a reasonable transfer price/range of transfer prices.
The thing to remember is that transfer pricing is actually mostly about common sense. You don’t really need to
learn any of the specific principles if you understand what it is trying to achieve: the trading of divisions with each
other for the benefit of the company as a whole. If the scenario in a question was different, you may have to
consider how transfer prices should be set to optimize the profits of the group overall. Here, it was not an issue as
group policy was that the two divisions had to trade with each other, so whether this was actually the best thing
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for the company was not called into question. In some questions, however it could be, so bear in mind that this
would be a slightly different requirement. Always read the requirement carefully to see exactly what you are being
asked to do.
Performance measurement in not‐for‐profit organizations:
Not‐for‐profit organizations have a range of multiple objectives which are difficult to define and hence make the
performance measurement process difficult.
Objectives for NFPOs:
The objectives for such an organization will differ widely from one organization 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)
Maximization 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)
Problem with performance measurement Solutions
Multiple objectives Judge performance in terms of inputs
Measuring outputs Use experts’ subjective judgment
Lack of profit measure Use benchmarking
Nature of service provided Use unit cost quantitative measures
Financial constraints
Political, legal and social considerations
Value for Money
‐ Efficiency: Relationship between inputs and outputs(measures of productivity)
‐ Effectiveness: Relationship between outputs and objectives(whether objectives are achieved or not)
‐ Economy: Obtaining the right quality and quantity of inputs at lowest cost(related to costs)
Example Objective test question(OT):
A government is trying to assess schools by using a range of financial and non‐financial factors. One of the chosen
methods is the percentage of students passing five exams or more.
Which of the three Es in the value for money framework is being measured here?
A Economy
B Efficiency
C Effectiveness
D Expertise
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Study Notes Performance Management ‐ PM
Solution:
The correct option is C
Exam success will be a given objective of a school, so it is a measure of effectiveness
External Considerations‐Performance Measurement :
Stakeholders Market Conditions Competitors
• Internal – Employees • Economic growth and • Pricing strategies
inflation
• Connected – • React quickly to
Shareholders & • Government fiscal and changing market
customers spending policies conditions
• External ‐ Government
Behavioural Aspects: principle of controllability is important.
Performance Management Information Systems:
The purpose of the information system in a business is to provide management with the information that they
need in order to make good decisions and in order to monitor the progress of the company. In this chapter we will
look at the different information needs of management for different levels of decision making.
Levels of management and information requirements
Strategic planning Management control Operational control
Strategic planning is deciding on the Management (or tactical) Operational control is
long‐term (usually at least five control is managing the concerned with monitoring
years) direction of the business implementation of the and controlling the day‐by‐
Making decisions on how to follow strategic plan in the short‐ day performance of the
this strategy. The sorts of decisions term ‐ generally around business
that may be considered are, for twelve months. The information required will
example, what new products to Short‐term budgets will be be primarily be internal to
launch, or which new markets to prepared and operations the business and will include
enter. measured against the such things as hours worked
Information is required mainly from budgets. by employees, raw material
external sources (for example, Information will be usage and wastage reports,
information about competitors, and required from both and quality control reports.
information about government external and internal
policies insofar as they may affect sources, and will include
the business), and also from such things as variance
internal sources (for example, analysis reports and
overall profitability forecasts, and productivity
capital spending requirements). measurements.
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Information Systems used by Management
In order to make decisions at the various levels outlined in the previous heading, management need information
systems to supply the information they require and to present it in a way that is useful for them.
You should be aware of the following types of information processing system, and the level of management that
benefits from them.
1) Transaction processing systems(TPS)
Transaction processing is the recording of the daily routine transactions of the business. This includes
recording all the financial transactions, keeping records of inventory, the processing of orders etc. The
information provided is used mainly for operational control.
TPS can be:
‐ Batch transaction processing (BTP) collects transaction data as a group and processes it later, after a time
delay, as batches of identical data
‐ Real time transaction processing (RTTP) is the immediate processing of data.
2) Management information systems(MIS)
The purpose of the management information system is to convert data into information that is useful for
managers at all levels, but is particularly useful at the level of management control.
For example, the transaction processing system will provide a list of all receivables on a given day, but the
management information system can process the transactions and provide information as to sales per
customer and as to the trends in sales.
Similarly, it is the management information system that can process the transaction information and produce
reports of variances.
3) Executive information systems(EIS)
Whereas the traditional management information system can produce reports as outlined above, these
reports tend to be standard reports and need planning for in advance (for example, it may be programmed to
produce a standard variance report each month).
An executive information system enables the user to access the data and produce flexible ‘non‐standard’
reports. They are designed to be easy to use ‐ the user can request a report without any programming
knowledge, there is an emphasis on presenting the information graphically, and there is the ability to ‘drill‐
down’ (the information is initially presented very much in summary, but by clicking on the graphs it is possible
to get more and more detail as required).
These systems are mainly for the use of top management and are more for the strategic level of decision
making.
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4) Enterprise resource planning systems(ERP)
The word ‘planning’ here gives the wrong impression in that these systems are not really anything directly to
do with planning.
These systems integrate all departments and functions into a single computer system. Instead of the
accounting department having their own system, separate from (for example) the system used by the
warehouse, there is a single system serving all the departments.
The system runs off a single database so that the various departments can more easily share information.
As an example of its usefulness, an order received from a customer will be entered into the system and its
status will be updated by the relevant department as it progresses (the warehouse will update when it is
dispatched, the accounts department will update when it is invoiced for, and so on.)
If implemented well, it means greater efficiency, less duplication, greater accuracy, and the ability of any
department to access information related to other departments.
Example Objective test question(OT):
A manufacturer and retailer of kitchens introduce an enterprise resource planning system.
Which of the following is NOT likely to be a potential benefit of introducing this system?
A Schedules of labour are prepared for manufacturing
B Inventory records are updated automatically
C Sales are recorded into the financial ledgers
D Critical strategic information can be summarized
Solution:
The correct option is D
The tracking and summarizing of critical strategic information is done by an Executive Information System (EIS).
The other three options are all likely to be potential benefits which would result from the introduction of an ERPS.
Example Objective test question(OT):
The following statements have been made about transaction processing systems and executive information
systems:
(i) A transaction processing system collects and records the transactions of an organization
(ii) An executive information system is a way of integrating the data from all operations within the
organisation into a single system
Which of the above statements is/are true?
A (i) only
B (ii) only
C Both (i) and (ii)
D Neither (i) nor (ii)
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Solution:
The correct option is A
Statement (ii) describes an enterprise resource planning system, not an executive information system.
Open and closed systems
Open systems are systems that can respond to changes external to the company, whereas closed systems do not
interact with environment and follow a fixed set of ‘rules’ and do not change.
For example, basic accounting system is a closed system in that it follows fixed rules.
However, businesses do need to change in response to changes in external factors such as the actions of
competitors and changes in the economic environment. As a result, although there may be sub‐systems that are
closed, the overall information system needs to be an open system in that information requirements will change as
the business itself changes.
Closed systems are easier to control and maintain because they do not change. Open systems provide flexibility
and can provide better information, but are harder to control and maintain because of the changes made.
Sources of information
Possible external sources(primary and Possible internal sources of information
secondary data) of information include: include:
‐ government statistics ‐ receivables ledger
‐ industry publications ‐ payables ledger
‐ competitors financial statements ‐ payroll system
‐ the internet(cheaper)
Example Objective test question(OT):
Which of the following is an external source of information?
A Value of sales, analysed for each customer
B Value of purchases, analysed for each supplier
C Prices of similar products, analysed for each competitor company
D Hours worked, analysed for each employee
Solution:
The correct option is C
All of the others are internal sources of information.
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Controls over highly Confidential Information:
a procedure manual sets out the controls over distributing internal information
some control procedure may include:
‐ Passwords to get access to information
‐ Logical access systems to prevent those who already have access to computer system to gaining access to data
‐ Database controls
‐ Firewalls
‐ Encryption
‐ Anti‐virus
‐ Supervision and observation by a supervisor etc.
Example Objective test question(OT):
A government department generates information which should not be disclosed to anyone who works outside of
the department. There are many other government departments working within the same building.
Which of the following would NOT be an effective control procedure for the generation and distribution of the
information within the government department?
A. If working from home, departmental employees must use a memory stick to transfer data, as laptop
computers are not allowed to leave the department
B. All departmental employees must enter non‐disclosed and regularly updated passwords to access their
computers
C. All authorized employees must swipe an officially issued, personal identity card at the entrance to the
department before they can gain access
D. All hard copies of confidential information must be shredded at the end of each day or locked overnight in a
safe if needed again
Solution:
The correct option is A
A memory stick is much more likely to get mislaid and compromise security than a password protected laptop. It is
likely that memory sticks could get lost or that information is left on home computers. In the context of the
scenario all the other options are good practice.
Cost of information:
Companies need to be aware of the cost of inefficient use of information
There are three types of cost incurred in capturing, collecting, processing and production of internal information:
1. Direct data capture: for example use of bar coding and scanner, employee time spent on filling in time sheets
2. Processing: for example analyzing personnel costs
3. Inefficient use of information: for example information was collected but not needed
END OF CHAPTER
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