How is direct labor rate variance calculated and what does it reveal about labor cost management?

Direct labor rate variance is calculated by comparing the actual labor cost of hours paid with the standard labor cost for those hours. It reveals differences between the actual wage rate paid and the standard rate that should have been paid, indicating management's efficiency in controlling labor costs .

How can variance analysis be used to assess the efficiency of production processes?

Variance analysis allows assessment of production efficiency by comparing standard cost and time against actual cost and time. An efficiency variance, for instance, shows whether production took longer or was more costly than expected, helping management identify areas for improvement .

In what scenarios is a negotiated 'cost plus' transfer price appropriate, and why?

A negotiated 'cost plus' transfer price is appropriate when the selling division operates as a profit center without an external intermediate market. It ensures that the division can cover its costs and earn a profit, aligning its objectives with the company's overall profitability goals .

What considerations determine the ideal transfer price when there is no external intermediate market?

When there's no external intermediate market, the ideal transfer price is either cost or cost plus a contribution margin, depending on whether the selling division is a profit center. Transfers at cost are suitable for cost centers, whereas cost plus is more appropriate for profit centers to ensure profitability .

How does budgeting facilitate communication of corporate goals in the context of performance management?

Budgeting facilitates communication of corporate goals by setting clear objectives and encouraging alignment of departmental and individual performance with these goals. It serves as a framework to assess performance toward strategic objectives, thus integrating financial planning with corporate strategy .

What are the key components of calculating a break-even point using CVP analysis, and how does it inform business decisions?

The break-even point in CVP analysis is calculated by dividing fixed costs by the contribution per unit. It informs business decisions by identifying the sales volume required to cover all costs, aiding in setting sales targets and pricing strategies to ensure profitability .

What are the criticisms of traditional budgeting systems in terms of flexibility and strategic alignment?

Traditional budgeting systems are criticized for their rigidity, focus on internal rather than external factors, and failure to consider shareholder value. They prevent fast responses to changes due to their focus on fixed targets. These systems also discourage continuous improvement and innovation, focusing more on financial control rather than strategic implementation .

How do strategic, tactical, and operational management levels differ in decision-making processes to achieve a strategic target?

At the strategic level, management makes broad decisions such as increasing sales by assessing business development options. Tactical management involves preparing detailed budgets and plans to achieve these strategic decisions, such as advertising or recruiting plans. Operational management handles the execution of these strategies by administering day-to-day activities, like running courses or collecting fees .

What role does performance measurement systems play in clarifying organizational objectives and improving understanding of internal processes?

Performance measurement systems clarify the objectives of the organization by providing a structured approach that outlines how departments, work groups, and individuals contribute to achieving these objectives. They establish agreed measures of activity based on key success factors, enhancing the understanding of processes within the organization and what each should aim to achieve .

Why might an entity use multiple information systems rather than relying solely on a management accounting system?

An entity might use multiple information systems because a management accounting system might not provide comprehensive information, especially non-financial data. Relying solely on it could lead to inefficiencies and less effective management if it doesn't integrate with other information sources .

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Performance Management

The document is a study text on performance management published by the Institute of Chartered Accountants of Nigeria. It provides an introduction to strategic management in the first chapter. The study text was published to assist candidates preparing for the Institute's professional examinations and contains 15 subjects at the foundation, skills and professional levels. It was developed with input from local writers and reviewers with subject matter expertise and was reviewed by a committee at the Institute.

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0% found this document useful (0 votes)

2K views992 pages

Performance Management

Uploaded by

blessedumoh311

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

Performance

Management

Study Text

The Institute of Chartered

Accountants of Nigeria

ICAN
Performance management

i
Published by
The Institute of Chartered Accountants of Nigeria
PC 16, Idowu Taylor Street
Victoria Island, Lagos, Nigeria
Email: [email protected]
www.ican-ngr.org

ISBN 978-978-57010-0-5

© The Institute of Chartered Accountants of Nigeria

August 2021

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, scanning or otherwise, without the prior permission in writing of
The Institute of Chartered Accountants of Nigeria, or as expressly permitted by law, or
under the terms agreed with the appropriate reprographics rights organisation.

You may not circulate this Study Text in any other binding or cover, and you must impose
the same condition on any acquirer.

Notice

The Institute of Chartered Accountants of Nigeria has made every effort to ensure that at
the time of writing the contents of this Study Text are accurate, but neither the Council of
the Institute of Chartered Accountants of Nigeria, nor its management or employees shall
be under any liability whatsoever for any inaccurate or misleading information this work
could contain.

www.icanig.org

ii
F
Foreword
The business environment has been undergoing rapid changes caused, by globalisation and
advancement in Information Technology. The impact of these changes on the finance function
and the skills set needed by professional accountants to perform their various tasks have
been profound. These developments have made it inevitable for the Institute’s syllabus and
training curriculum to be reviewed to align its contents with current trends and future needs of
users of accounting services.

The Institute of Chartered Accountants of Nigeria (ICAN) reviews its syllabus and training
curriculum every three years, however, the syllabus is updated annually to take cognisance of
new developments in the national environment and the global accountancy profession. The
Syllabus Review, Professional Examination and Students’ Affairs Committees worked
assiduously to produce a 3-level, 15-subject ICAN syllabus. As approved by the Council,
examinations under the new syllabus will commence with the November 2021 diet.

It is instructive to note that the last four syllabus review exercises were accompanied with the
publication of Study Texts. Indeed, when the first four editions of Study Texts were produced,
the performances of professional examination candidates significantly improved. In an effort
to consolidate on these gains and to further enhance the success rates of students in its
qualifying examinations, the Council approved that a new set of learning materials (Study
Texts) be developed for each of the subjects. Although, these learning materials may be
regarded as the fifth edition, they have been updated to include IT and soft skills in relevant
subjects, thereby improving the contents, innovation, and quality.

Ten of the new learning materials were originally contracted to Emile Woolf International
(EWI), UK. However, these materials were reviewed and updated to take care of new
developments and introduced IT and soft skills in relevant subjects. Also, renowned writers
and reviewers which comprised eminent scholars and practitioners with tremendous
experiences in their areas of specialisation, were sourced locally to develop learning materials
for five of the subjects because of their local contents. The 15 subjects are as follows:

iii
Foundation Level
1. Business, Management and Finance EWI/ICAN
2. Financial Accounting EWI/ICAN
3. Management Information EWI/ICAN
4. Business Law ICAN

Skills Level
5 Financial Reporting EWI/ICAN
6 Audit and Assurance EWI/ICAN
7. Taxation ICAN
8. Corporate Strategic Management and Ethics EWI/ICAN
9. Performance Management EWI/ICAN
10. Public Sector Accounting and Finance ICAN

Professional Level
11. Corporate Reporting EWI/ICAN
12. Advanced Audit and Assurance EWI/ICAN
13. Strategic Financial Management EWI/ICAN
14. Advanced Taxation ICAN
15. Case Study ICAN

As part of the quality control measures, the output of the writers and reviewers were
subjected to further comprehensive review by the Study Texts Review Committee.

Although the Study Texts were specially produced to assist candidates preparing for the
Institute’s Professional Examination, we are persuaded that students of other
professional bodies and tertiary institutions will find them very useful in the course of
their studies.

Haruna Nma Yahaya (Mallam), mni, BSc, MBA, MNIM, FCA

Chairman, Study Texts Review Committee

iv
A
Acknowledgement
The Institute is deeply indebted to the underlisted locally-sourced rewriters, reviewers and
members of the editorial board for their scholarship and erudition which led to the
successful production of these new study texts. They are:

Taxation
1. Enigbokan, Richard Olufemi Reviewer
2. Clever, Anthony Obinna Writer
3. Kajola, Sunday Olugboyega Writer

Business Law
1. Oladele, Olayiwola.O Writer/Reviewer
2. Adekanola, Joel .O Writer

Public Sector Accounting and Finance

1. Osho, Bolaji Writer/Reviewer
1. Biodun, Jimoh Reviewer
2. Osonuga, Timothy Writer
3. Ashogbon, Bode Writer

Advanced Taxation
1. Adejuwon, Jonathan Adegboyega Reviewer
2. Kareem, Kamilu Writer

Information Technology Skills

1. Ezeilo, Greg Reviewer
2. Ezeribe, Chimenka Writer
3. Ikpehai, Martins Writer
v
Case Study

1. Adesina, Julius Babatunde Writer/Reviewer

Soft Skills
1. Adesina, Julius Babatunde Reviewer
2. Adepate, Olutoyin Adeagbo Writer

The Institute also appreciates the services of the experts who carried out an update and
review of the following Study Texts:

Business Management and Finance

1. Ogunniyi, Olajumoke

Management Information
1. Adesina, Julius Babatunde
2. Ezeribe, Chimenka

Financial Accounting
1. Adeyemi, Semiu Babatunde

Financial Reporting

1. Okwuosa, Innocent

Performance Management

1. Durukwaku, Sylvester

Corporate Strategic Management and Ethics

1. Adepate, Olutoyin Adeagbo

Audit & Assurance

1. Amadi, Nathaniel

Corporate Reporting

1. Adeadebayo, Shuaib

Advanced Audit and Assurance

1. Okere, Onyinye

Strategic Financial Management

1. Omolehinwa, Ademola

vi
The Institute also appreciates the services of the following:

STUDY TEXTS REVIEW COMMITTEE

Members

Haruna Nma Yahaya (Mallam), mni, BSc, MBA, ANIM, FCA Chairman
Okwuosa, Innocent, PhD, FCA Adviser
Akinsulire, O. O. (Chief), B.Sc, M.Sc., MBA, FCA Deputy Chairman
Adesina, Julius, B. B.Sc, M.Sc, MBA,FCA Member
Adepate, Olutoyin, B.Sc, MBA, FCA Member
Enigbokan, Richard Olufemi, PhD, FCA Member
Anyalenkeya, Benedict, B.Sc, MBA, FCA Member (Deceased)

Secretariat Support

Kumshe, Ahmed Modu, (Prof.), FCA Registrar/Chief Executive

Momoh, Ikhiegbia B., MBA, FCA Director, Examinations

Otitoju, Olufunmilayo, B.Sc, arpa, ANIPR HOD, Students’ Affairs

Anifowose, Isaac, B.Sc., MMP Manager, Students’ Affairs

Evbuomwan, Yewande, B.Sc. (Ed.), M.Ed., ACIS Asst. Manager, Students’ Affairs

Ahmed M. Kumshe, (Prof.), FCA

Registrar/Chief Executive

vii
C
Skills level
Performance management

Contents

Page
Syllabus v
Chapter
1 Introduction to strategic management 1
2 Overview of cost planning and control 27
3 Modern management accounting techniques 71
4 Learning and experience curve theory 123
5 Quality and quality costs 138
6 Budgetary control systems 154
7 Variance analysis 209
8 Advanced variance analysis 287
9 Performance analysis 322
10 Other aspects of performance measurement 371
11 Transfer pricing 384
12 Divisional performance 419
13 Relevant costs 454
14 Cost-volume-profit (CVP) analysis 473
15 Limiting factors 507
16 Linear programming 521
17 Further aspects of linear programming 545
18 Other decisions 573
19 Pricing 591
20 Risk and decision making 627

viii
Performance management

Page

21 Working capital management 661

22 Inventory management 685
23 Management of receivables and payables 711
24 Cash management 733
25 Introduction to capital budgeting 759
26 Discounted cash flow 775
27 Replacement theory 824
28 Strategic models and performance management 851
29 Information systems and performance management 901
30 Implementing performance management systems 945
31 Application of Information technology in performance 970
Index 975
0

ix
S
Skills level
Performance management

Syllabus

SKILLS LEVEL

PERFORMANCE MANAGEMENT

Aim

Performance management develops and deepens candidates’ capability to provide

information and decision support to management in operational and strategic contexts
with a focus on linking costing, management accounting and quantitative methods to
critical success factors and operational strategic objectives whether financial, operational
or with a social purpose. Candidates are expected to be capable of analysing financial
and non-financial data and information to support management decisions.

Linkage with other subjects

The diagram below depicts the relationship between this subject and other subjects.

Strategic Financial Management

Performance Management Corporate Strategic

Management & Ethics

Business, Management and

Management Information Finance

x
Performance management

Main competencies
On successful completion of this paper, candidates should be able to:
Identify and apply appropriate budgeting techniques and standard costing to planning and control in
business;
Select and apply performance measurement techniques;

Apply strategic performance measurement techniques in evaluating and improving organizational

performance;
Discuss the accounting information requirements and the role of accountants in project management; and

Select and apply decision-making techniques to facilitate efficient and effective business
decisions in the use of scarce resources.

xi
Syllabus

Linkage of the main competencies

This diagram illustrates the linkage between the main competencies of this subject and is to
assist candidates in studying for the examination.

Performance measurement and control

Performance and management systems

Planning and
control Strategic performance measurement and
management systems

Decision making

xii
Performance management

Syllabus overview

Grid Weighting
A Cost planning and control 20
B Planning and control 20
C Performance measurement and control 20
D Decision making 30
E Strategic performance measurement 5
F Performance and management system 5
Total 100

xiii
Syllabus

Detailed syllabus Chapter

A Cost planning and control
1 Overview of costs for planning and control
a Discuss and evaluate the sources of performance management 2
information.
b Analyse fixed and variable cost elements from total cost data 2
using high/low method and regression analysis.
c Differentiate between marginal costing and absorption costing. 2
d Analyse overhead costs using activity based costing. 2
2 Cost planning and control for competitive advantage
a Discuss and apply the principles of: 3
i Target costing; 3
ii Life cycle costing; 3
iii Theory of constraints (TOC); 3
iv Throughput accounting; 3
v Back flush accounting; 3
vi Environmental accounting; and 3
vii Kaizen costing. 3
b Learning and experience curve theory 4
i Discuss and apply the learning and experience curve theory 4
to pricing, budgeting and other relevant problems.
ii Calculate and apply learning rate to cost estimation. 4
c Cost of quality 5
i Explain quality costs. 5
ii Analyse quality costs into costs of conformance and costs of 5
non-conformance.
iii Discuss the significance of quality costs for organisations. 5
3 Ethical issues in performance management
a Discuss ethical issues in performance management. 2
b Discuss the professional accountants’ code of ethics as it relates 2
to performance management.

xiv
Performance management

Detailed syllabus Chapter

B Planning and control
1 Budgetary system, planning and control
a Discuss and apply forecasting techniques to planning and control. 6
b Discuss budgetary system in an organization as an aid to 6
performance management.
c Evaluate the information used in budgetary system. 6
d Discuss the behavioural aspects of budgeting. 6
e Discuss the usefulness and problems associated with different 6
types of budget.
f Explain beyond budgeting models. 6
2 Variance analysis
a Explain the uses of standard cost and types of standard. 7
b Discuss the methods used to derive standard cost. 7
c Explain and analyse the principle of controllability in the
performance management system.
d Calculate and apply the following variances: 7, 8
i Material usage and price variances; 7
ii Material mix and yield variances; 8
iii Labour rate, efficiency and idle time variances; 7
iv Variable overhead expenditure and efficiency variances; 7
v Fixed overhead budget, volume, capacity and productivity 7
variances;
vi Sales volume variance; 7
vii Sales mix and quantity variances; 8
viii Sales market size and market share variances; and 8
ix Planning and operational variances. 8
e Identify and explain causes of various variances and their inter- 7, 8
relationship.
f Analyse and reconcile variances using absorption and marginal 7, 8
costing techniques

xvi
Syllabus

Detailed syllabus Chapter

C Performance measurement and control
1 Performance analysis
a Select and calculate suitable financial performance measures for 9
a business from a given data and information.
b Evaluate the results of calculated financial performance measures 9
based on business objectives and advise management on
appropriate actions.
c Select and calculate suitable non-financial performance measures 9
for a business from a given data and information.
d Evaluate the results of calculated non-financial performance 9
measures based on business objectives and advise management
on appropriate actions.
e Explain the causes and problems created by short-termism and 9
financial manipulation of results and suggest methods to
encourage a long term view.
f Discuss sustainability consideration in performance measurement 9
of a business.
g Select and explain stakeholders based measures of performance 9
that may be used to evaluate social and environmental
performance of a business.
h Explain and interpret the Balanced Scorecard and Fitzgerald and 9
Moon Building Block model.
2 Performance analysis in not-for-profit organisations
a Discuss the problems of having non-quantifiable objectives in 10
performance management.
b Explain how performance may be measured in the not-for-profit 10
organisations.
c Discuss the problems of having multiple objectives. 10
d Demonstrate value for money (VFM) as a public sector objective. 10
3 Divisional performance and transfer pricing 10, 11
a Discuss the various methods of setting transfer prices and 10
evaluate the suitability of each method.
b Determine the optimal transfer price using appropriate models. 10
c Explain the benefits and limitations of transfer pricing methods. 10
d Demonstrate and explain the impact of taxation and repatriation of 10
funds on international transfer pricing.
e Select and explain suitable divisional performance measures for a 12
given business using return on investment, residual income and
economic value added approaches. Evaluate the results and
advise management.

xvii
Performance management

Detailed syllabus Chapter

D Decision making
1 Advanced decision-making and decision-support
a Select and calculate suitable relevant cost based on given data 13
and information. Evaluate the results and advise management.
b Select, calculate and present cost-volume-profit analyses based 14
on a given data and information (including single and multiple
products) using both numerical and graphical techniques. Advise
management based on the results.
c Apply relevant cost concept to short term management decisions 18
including make or buy, outsourcing, shut down, one-off contracts,
adding a new product line, sell or process further, product and
segment profitability analysis, etc.
d Apply key limiting factors in a given business scenario to:
i Single constraint situation including make or buy; and 15
ii Multiple constraint situations involving linear programming 16, 17
using simultaneous equations, graphical techniques and
simplex method. (The simplex method is limited to
formulation of initial tableau and interpretation of final
tableau).
NB. Computation and interpretation of shadow prices are also 17
required.
e Explain different pricing strategies, including: 19
i Cost-plus; 19
ii Skimming; 19
iii Market penetration; 19
iv Complementary product; 19
v Product-line; 19
vi Volume discounting; and 19
vii Market discrimination. 19
f Calculate and present numerically and graphically the optimum 19
selling price for a product or service using given data and
information by applying relevant cost and economic models and
advise management.
g Evaluate how management can deal with uncertainty in decision- 20, 27
making including the use of simulation, decision-trees,
replacement theory, expected values, sensitivity analysis and
value of perfect and imperfect information.

xviii
Syllabus

Detailed syllabus Chapter

D Decision making (continued)
2 Working capital management
a Discuss the nature, elements and importance of working capital. 21 to 24
b Calculate and explain the cash operating cycle. 21
c Evaluate and discuss the use of relevant techniques in managing
working capital in relation to:
i Inventory (including economic order quantity model and Just- 22
in-Time techniques);
ii Account receivables (including cash discounts, factoring and 23
invoice discounting);
iii Account payables; and 23
iv Cash (including Baumol and Miller-Orr Models). 24
3 Capital budgeting decisions
a Discuss the characteristics of capital budgeting decisions. 25
b Calculate and discuss various investment appraisal techniques
such as:
i Traditional techniques 25
 Accounting rate of return 25
 Pay-back period 25
ii Discounted cash flow technique 26
 Net Present Value 26
 Internal Rate of Return 26
NB: These may Include basic profitability index and 26
inflation but excluding tax consideration and capital
rationing.
c Evaluate asset replacement decision for mutually exclusive 27
projects with unequal lives.

xiv
Performance management

Detailed syllabus Chapter

E Strategic performance measurement
1 Analyse and evaluate business objectives and strategies using 28
techniques such as:
a C-analysis; 28
b Five forces analysis; 28
c The Boston Consulting Group Model; 28
d Value chain analysis; 28
e Ansoff’s matrix; 28
f Benchmarking; and 28
g SWOT analysis. 28
2 Analyse and evaluate suitable performance measures for:
a Profitability (GP, ROCE, ROI, EPS, EBITDA, etc.); 9
b Liquidity; and 9
c Solvency. 9
F Performance and management systems
1 Evaluate and advise management on suitable information technology 29
and strategic performance management system covering:
a Sources of information; 29
b Information technology tools for performance management at 29
various levels (strategic, tactical and operational); and
c Use of internet technologies for performance management and 29
key performance indicators.
2 Evaluate and advise management on suitable approaches that may 30
be used to manage people, issues and change when implementing
performance management systems.
3 Discuss the accounting information requirements and analyse the 30
different types of information systems used for strategic planning,
management control and operational control and decision-making.
4 Discuss roles of accountants in:
a Project management; 30
b Project planning; and 30
c Project control methods and standards. 30

xx
1
Skills level
Performance management

CHAPTER
Introduction to strategic management

Contents

1 Introduction to strategic planning and control

2 Strategic objectives
3 Levels of management
4 Chapter review

1
Performance management

INTRODUCTION

Purpose
Performance management develops and deepens candidates’ capability to provide
information and decision support to management in operational and strategic contexts with a
focus on linking costing, management accounting and quantitative methods to critical
success factors and operational strategic objectives whether financial, operational or with a
social purpose. Candidates are expected to be capable of analysing financial and non-
financial data and information to support management decisions.

Exam context
This chapter does not address a specific syllabus competency. It has been written to explain
the meaning of strategic planning to provide a foundation for understanding the above and
other areas in the syllabus. In particular, it explains strategic objectives and the differing
informational needs of management at different levels in an organisation.

By the end of this chapter, you should be able to:

 Explain the difference between strategic, tactical and operational planning and control
 Understand the strategic planning process in overview
 Explain the importance of corporate objectives and the link to performance
management
 Explain the different informational needs for strategic, tactical and operational
management
 Understand the potential conflict that may arise between strategic objectives and short-
term decisions.

1 INTRODUCTION TO STRATEGIC PLANNING AND CONTROL

Section overview

 Management accounting
 Levels of strategic planning
 Definition of strategic planning and control
 Strategic planning process

1.1 Management accounting

The purpose of management accounting is to provide relevant and reliable
information so that managers can make well-informed decisions. The value of
management accounting depends on the quality of the information provided, and
whether it helps managers to make better decisions.
In other words, the purpose of management accounting is to provide information
for:
 planning;
 control; and
 decision making.
Performance management includes these three concepts:

16
Planning
Planning involves the following:
 setting the objectives for the organisation;
 making plans for achieving those objectives.
The planning process is a formal process and the end-result is a formal plan,
authorised at an appropriate level in the management hierarchy. Formal plans
include long-term business plans, budgets, sales plans, weekly production
schedules, capital expenditure plans and so on.
Information is needed in order to make sensible plans – for example in order to
prepare an annual budget, it is necessary to provide information about expected
sales prices, sales quantities and costs, in the form of forecasts or estimates.

Control
Control of the performance of an organisation is an important management task.
Control involves the following:
 monitoring actual performance, and comparing same with the objective or
plan;
 taking control action where appropriate;
 evaluating actual performance.
When operations appear to be getting out of control, management should be
alerted so that suitable measures can be taken to deal with the problem. Control
information might be provided in the form of routine performance reports or as
special warnings or alerts when something unusual has occurred.

Decision making
Managers might need to make ‘one-off’ decisions, outside the formal planning
and control systems. Management accounting information can be provided to
help a manager decide what to do in any situation where a decision is needed.

1.2 Levels of strategic planning

Planning is a hierarchical activity, linking strategic planning at the top with
detailed operational planning at the bottom. Strategic plans set a framework and
guidelines within which more detailed plans, and shorter-term planning decisions,
can be made.
R. N. Anthony (1965) identified three levels of planning within an organisation:
 Strategic planning. This involves identifying the objectives of the entity,
and plans for achieving those objectives, mostly over the longer term.
Strategic plans include corporate strategic plans, business strategic plans
and functional strategic plans.
 Tactical planning. These are shorter-term plans for achieving medium-
term objectives. An example of tactical planning is the annual budget.
Budgets and other tactical plans can be seen as steps towards the
achievement of longer-term strategic objectives.
 Operational planning. This is a detailed planning of activities, often at a
supervisory level or junior management level, for the achievement of short-
term goals and targets. For example, a supervisor might divide the
workload between several employees in order to complete all the work
before the end of the day.

17
Chapter 1: Introduction to strategic management

1.3 Definition of strategic planning and control

‘Strategic planning and control’ within an entity is the continuous process of:
 identifying the goals and objectives of the entity;
 planning strategies that will enable these goals and objectives to be
achieved;
 setting targets for each strategic objective (performance targets);
 converting strategies into shorter-term operational plans;
 implementing the strategy;
 monitoring actual performance (performance measurement and review);
and
 taking control measures where appropriate when actual performance is
below the target.
Other aspects of strategic planning and control are:
 re-assessing plans and strategies when circumstances in the business
environment change; and
 where necessary, changing strategies and plans.

Formal planning process

Companies might have a formal strategic planning process. Such a process:
 clarifies objectives;

 helps management to make strategic decisions. Strategic planning forces

managers to think about the future: companies are unlikely to survive
unless they plan ahead;
 establishes targets for achievement;
 co-ordinates objectives and targets throughout the organisation, from the
mission statement and strategic objectives at the top of a hierarchy of
objectives, down to operational targets;
 provides a system for checking progress towards the objectives.
However, planning must also be flexible. Plans and targets might need to change
in response to changes in the business environment, for example, a new initiative
by a rival company.

Changes in strategic plans

Strategic plans often cover a period of several years, typically five years or
longer. They are prepared on the basis of the best information available at the
time, using assumptions about the nature of the business environment –
competitive conditions, market conditions, available technology, the economic,
social and political climate, and so on.
However, the business environment can change very quickly, in unexpected
ways. Changes can create new threats to a company, or they can create new
business opportunities. Whenever changes occur, a company should be able to
respond – by taking measures to deal with new threats, or to exploit new
opportunities.
The response of a company to changes in its environment could mean having to
develop new strategies and abandon old ones. When changes are made, the
original strategic plan will no longer be entirely valid, although large parts of it
might be unaffected.
18
Chapter 1: Introduction to strategic management

Strategic planning in practice is therefore often a mixture of:

 formal planning, and
 developing new strategies and making new plans whenever significant
changes occur in its business environment.
Responding to unexpected changes by doing something that is not in the formal
plan is sometimes called ‘freewheeling opportunism’. It means making unplanned
decisions, to take advantages of opportunities as they arise, or to deal with
unexpected threats.

1.4 Strategic planning process

Different methods and approaches may be used to develop strategic plans but
they share common features.
A basic approach to strategic planning is shown in the following diagram.

Illustration: Strategic planning process

Set objectives

Strategic analysis
(Corporate appraisal)

Strategic choice

Evaluation of
strategies

Implementation of Review and

strategies control

Each stage will be explained in further detail later. For the moment, the text only
provides an overview in order to provide a foundation for understanding key
elements of performance management.

Objectives
The entity must develop clear objectives, such as, the maximisation of
shareholders’ wealth. These objectives should be consistent with the mission
statement. Targets can be established for the achievement of objectives within
the planning period.
Objectives should take into account the interest and power of stakeholders.
Stakeholder mapping is a useful tool in this regard.

19
Chapter 1: Introduction to strategic management

Strategic analysis
A strategic analysis comprises:
 an environmental analysis; and
 a position audit.
Environmental analysis involves an analysis of developments outside the
organisation that are already affecting the organisation or could affect the
organisation in the future. These are external factors that might affect the
achievement of objectives and strategy selection.
A position audit is an internal analysis which identifies the strengths and
weaknesses within the organisation – its products, existing customers,
management, employees, technical skills and ‘know-how’, its operational systems
and procedures, its reputation for quality, the quality of its suppliers, its liquidity
and cash flows, and so on.
The results of the environmental analysis and the position audit can be combined
in a SWOT analysis. The SWOT analysis depicts the strengths and weaknesses
of an organisation, and the opportunities and threats in its environment. This
method of strategic analysis is often used by organisations as a starting point for
strategic planning.

Strategic choice
Strategies should be developed to make full use of strengths within the entity and
to reduce or remove significant weaknesses.
Strategies should be developed to:
 take advantage of opportunities;
 make full use of strengths;
 remove weaknesses; and
 take action to protect against threats.
These components of the strategic choice decisions will be covered later.

Evaluation of strategic options

Strategies should be evaluated to decide whether they might be appropriate.
Johnson and Scholes have suggested that strategies should be assessed for:
 suitability;
 feasibility; and
 acceptability.

Strategic implementation
The selected strategies should then be implemented.
The implementation of strategies should be monitored. Changes and adjustments
should be made where these become necessary.
Areas of importance here are change management and project management.
These are covered in more detail later.

Review and control

This is a key area. An entity will have management information systems in place
to monitor the progress of the business. These are particularly important to the
introduction of a new strategy where timing and achievement of progress points
might be vital to its success. This is covered in more detail later.
20
2 STRATEGIC OBJECTIVES

Section overview

 Planning and corporate objectives

 The need for performance measurement

 Management accounting and performance measurement

2.1 Planning and corporate objectives

The purpose of strategic planning and control is to help an entity to achieve its
strategic objectives. It is normally assumed that the objective of a company is to
provide a high return to its owners, the shareholders, consistent with the level of
risk in the business.
Not-for-profit entities also have strategic objectives, which relate to the purpose
for which they exist. These objectives are non-financial in nature.
Performance measurement is an integral part of a system of planning and
control.
 Planning targets clarify the objectives of the organisation. Corporate
objectives are converted into planning targets. Similarly, the objectives of
strategic plans are converted into planning targets. A target should be a
clear statement of what an entity wants to achieve within a specified period
of time. Planning targets are usually quantified, but may be expressed in
qualitative terms.
 Measurements of performance (target and actual) help to
improve management’s understanding of processes and systems.
 Planning targets are set at strategic, tactical and operational management
levels. Using quantitative measures of performance makes it easier to set
targets for managers and the organisation as a whole.
 In a well-designed performance management system, all planning targets
are consistent with each other, at the strategic, tactical and operational
levels.
 When the business environment is changing, a performance measurement
system should provide for the continual re-assessment of planning targets,
so that targets can be altered as necessary to meet the changing
circumstances.
 Actual performance, at the strategic, tactical and operational levels should
be measured and monitored. Comparing actual performance with targets
provides useful control information. Differences between actual
performance and targets can be analysed, to establish the causes. Where
appropriate, action can be taken to improve performance by dealing with
the causes of the poor performance.
 Performance measures also make it possible to compare the performance
of different organisations or different divisions within the same organisation.
 Performance measurement systems promote accountability of the
organisation to its stakeholders.
 A performance management system may be linked to a system of
rewarding individuals for the successful achievement of planning targets.

21
2.2 The need for performance measurement
Every managed organisation needs a system of performance measurement.
 Managers need to understand what they should be trying to achieve. A
sense of purpose and direction is provided by plans (strategies, budgets,
operational plans and so on), and for each plan there should be objectives
and targets. Setting targets for achievement (performance targets) is an
essential part of planning.
 Managers also need to know whether they are successful. The information
they need is provided by comparing:
 their actual results or performance with the performance target, and
 the performance target with the current forecast of what performance
will be.
Targets, forecasts and actual performance should be measured, in order to
compare them. Ideally measures of performance should be quantified values
(financial or non-financial measures), because numerical measures of
performance are easier to compare than non-quantified (‘qualitative’) measures.

The benefits of performance measurement systems

The advantages of having a formal system of performance measurement can be
summarised as follows:
 A well-structured system of performance measurement clarifies the
objectives of the organisation, and shows how departments, work groups
and individuals within the organisation contribute to the achievement of
those objectives.
 It establishes agreed measures of activity, based on key success factors.
 It helps to provide a better understanding of the processes within the
organisation, and what each should be trying to achieve.
 It provides a system for comparing the performance of different
organisations or departments.
 The system establishes performance targets for the organisation’s
managers, over a suitable time period for achievement.

2.3 Management accounting and performance measurement

Management accounting is an important element in performance measurement
systems. Many performance targets are financial in nature, such as achieving
targets for return on capital, profits and sales revenue and targets for keeping
expenditure under control.
However, a performance measurement system uses a wide range of targets at
the strategic, tactical and operational level. Many of these are non-financial
targets, and not all targets are quantifiable.
Clearly, a comprehensive management accounting system should therefore
provide information for setting targets and measuring actual performance at all
levels. It should also provide non-financial information as well as financial
information.
If a management accounting system cannot provide all this information to
management, managers will have to rely on other information systems in addition
to the management accounting system. An entity might then have several
different information systems, which is probably inefficient and less effective than
a fully co-ordinated management information system.

22
Chapter 1: Introduction to strategic management

3 LEVELS OF MANAGEMENT

Section overview

 Levels of management
 Potential conflict between strategic plans and short-term decisions

3.1 Levels of management

In ‘traditionally-structured’ large organisations, there is a hierarchy of managers,
from senior management down to junior managers and supervisors. The
responsibilities of managers vary according to their position in the management
hierarchy.
Even in small organisations, the nature of management activities can be
analysed into different levels.
A common approach to analysing levels of management and management
decision-making process is to identify three levels:
 strategic management;
 tactical management; and
 operational management.

Strategic management
Strategic management is concerned with:
 deciding on the objectives and strategies for the organisation;
 making or approving long-term plans for the achievement of strategic
targets;
 monitoring actual results, to check whether these are in line with strategic
targets;
 where appropriate, taking control action to bring actual performance back
into line with strategic targets; and
 reviewing and amending strategies.
A strategy is a plan for the achievement of a long-term objective. The main
objective of a profit-making entity may be to maximise the wealth of its owners.
Several strategies are selected for the achievement of this main objective, and
each individual strategy might have its own specific objective.
Strategic planning is often concerned with developing products and markets and
for long-term investment. For example, a company seeking to increase its profits
by 10% a year for the next five years might select the following strategies:
 Marketing strategy: to expand into markets in other countries (with specific
countries selected as planning targets for each year of the plan)
 Innovation strategy: to invest in research and development (with a target to
launch, say, two new products on the market each year for the next five
years)
 Investment strategy: to invest in new technology (with a target, say, of
replacing all existing equipment with new technology within the next five
years).

23
Performance management

Tactical management
Tactical management is associated with the efficient and effective use of an
organisation’s resources, and the control over expenditure. In a large
organisation, tactical managers are the ‘middle managers’.
Tactical management is concerned with implementation and control of medium-
term plans, within the guidelines of the organisation’s strategic plans. For
example, budgeting and budgetary control are largely tactical management
responsibilities.

Operational management
Operational management is the management of day-to-day operating activities. It
is usually associated with operational managers and supervisors.
At an operational level, managers need to make sure on a day-to-day basis that
they have the resources they need and that those resources are being used
efficiently. It includes scheduling of operations and monitoring output, such as
daily efficiency levels.
There is no clear dividing line between tactical management and operational
management, but essentially the differences are a matter of detail. Tactical
management may be concerned with the performance of an entire department
during a one-week period, whereas operational management may be concerned
with the activities of individuals or small work groups on a daily basis.

3.2 Potential conflict between strategic plans and short-term decisions

Problems may occur in any organisation,especially large organisations with a
large number of managers, when ‘local’ operational managers take decisions that
are inconsistent with long-term strategic objectives.
There are several reasons why this might happen.
 ‘Local’ managers might be rewarded for achieving short-term planning
targets, such as keeping actual expenditure within the budget limit.
However, although there is a short-term benefit, there might be longer-term
damage. For example, a local manager might decide to cut the training
budget for his staff in order to reduce costs, but in the long-term the future
success of the company might depend on having well-trained and skilled
employees.
 ‘Local’ managers might fail to buy into the plan because they believe it to
be unfair.
 ‘Local’ managers might be unaware of the strategic plans and objectives,
due to poor communication within the entity.
In any system of performance management, especially in systems where
managers are rewarded for achieving planning targets, it is important to make
sure that the short-term planning targets are consistent with longer-term strategic
objectives.

24
Chapter 1: Introduction to strategic management

4 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Explain the difference between strategic, tactical and operational planning and
control
 Understand the strategic planning process in overview
 Explain the importance of corporate objectives and the link to performance
management
 Explain the different informational needs for strategic, tactical and operational
management
 Understand the potential conflict that may arise between strategic objectives and
short-term decisions.

25
Performance management

2
Skills level

CHAPTER
Performance management

Overview of cost planning and control

Contents
1 Performance management information
2 Sources of information
3 High/low method
4 Linear regression analysis
5 Marginal costing and absorption costing
6 Activity based costing
7 Ethics in performance management
8 Chapter review

27
Performance management

Aim
Performance management develops and deepens candidates’ capability to provide
information and decision support to management in operational and strategic contexts with a
focus on linking costing, management accounting and quantitative methods to critical
success factors and operational strategic objectives whether financial, operational or with a
social purpose. Candidates are expected to be capable of analysing financial and non-
financial data and information to support management decisions.

Detailed syllabus
The detailed syllabus includes the following:
A Cost planning and control
1 Overview of costs for planning and control
a Discuss and evaluate the sources of performance management information.
b Analyse fixed and variable cost elements from total cost data using high/low
method and regression analysis.
c Differentiate between marginal costing and absorption costing.
d Analyse overhead costs using activity based costing.

3 Ethical issues in performance management

a Discuss ethical issues in performance management.
b Discuss the professional accountants’ code of ethics as it relates to
performance management.

Exam context
You will have covered much of the content of this chapter in your earlier studies. A full
explanation has been included here for your convenience.

By the end of this chapter, you should be able to:

 Calculate fixed and variable costs by using high-low points method
 Calculate fixed and variable costs by using regression analysis
 Calculate profit using total absorption costing and marginal costing and explain the
difference
 Explain the difference between traditional volume based absorption methods and
activity based costing
 Apportion overheads using activity based costing
 Estimate unit cost using activity based costing
 Discuss ethical issues in performance management and compliance with ICAN’s code
of ethics

16
Chapter 2: Overview of cost planning and control

1 PERFORMANCE MANAGEMENT INFORMATION

Section overview

 Business information
 Information for different management levels

1.1 Business information

Information is processed data. Data can be defined as facts that have not been
assembled into a meaningful structure. Data is processed into a structured form
that has some meaning: this is called ‘information’.
Businesses use information in several ways.
 Information is used to perform routine transactions, such as order
processing and invoicing.
 Information is used to make decisions.
 Information is also developed into knowledge that can be used to improve
the business.
Managers could not make decisions without information. However, information
can vary in quality, and as a general rule managers will make better decisions
when they have better-quality information.

Information and management decisions

Decisions are taken continually in business. Routine decisions may be taken by
any employee as a part of normal procedures. However, a specific role of
management is to make decisions. For this, managers need information.
Managers use information:
 to make plans and reach planning decisions;
 to measure performance, and take control action on the basis of comparing
actual or expected performance with a target;
 to make ‘one-off’ or non-routine decisions;
 to communicate decisions to other people; and
 to co-ordinate activities with other people.

1.2 Information for different management levels

Information should be provided to managers to help them to make decisions. The
nature of the information required varies according to the level of management
and the type of decision. Within organisations, there are management information
systems that provide this information. A major element of the overall
management information system should be the management accounting system.
A management accounting system should provide information for strategic
management, tactical management and operational management.

© Emile Woolf International 17 The Institute of Chartered Accountants of Nigeria

Performance management

The requirements of management for information vary with the level of

management. This concept is set out simply in the diagram below.

Levels of management and information requirements

Strategic management information

Strategic management information is information that helps strategic managers
to:
 make long-term plans;
 assess whether long-term planning targets will be met; and
 review existing strategies and make changes or improvements.
Strategic management needs strategic information. The characteristics of
strategic information may be summarised as follows:
 It is often information about the organisation as a whole, or a large part of it.
 It is often in summary form, without too much detail.
 It is generally relevant to the longer-term.
 It is often forward-looking.
 The data that is analysed to provide the information comes from both
internal and external sources (from sources inside and outside the
organisation).
 It is often prepared on an ‘ad hoc’ basis, rather than in the form of regular
and routine reports.
 It may contain information of a qualitative nature as well as quantified
information.
 There is often a high degree of uncertainty in the information. This is
particularly true when the information is forward-looking (for example, a
forecast) over a number of years in the future.

© Emile Woolf International 18 The Institute of Chartered Accountants of Nigeria

Chapter 2: Overview of cost planning and control

Tactical information
Tactical information is information reported to middle managers in a large
organisation, or for the purpose of annual planning and budgetary control.
Tactical information is used to decide how the resources of the organisation
should be used, and to monitor how well they are being used. It is useful to relate
tactical information to the sort of information that is contained in an annual
budget. A budget is planning at a tactical management level, where the plan is
expressed in financial terms.
The general features of tactical information are as follows:
 It is often information about individual departments and operations.
 It is often in summary form, but at a greater level of detail than strategic
information.
 It is generally relevant to the short-term and medium-term.
 It may be forward-looking (for example, medium-term plans) but it is often
concerned with performance measurement. Control information at a tactical
level is often based on historical performance.
 The data that is analysed to provide the information comes from both
internal and external sources (from sources inside and outside the
organisation), but most of the information comes from internal sources.
 It is often prepared on a routine and regular basis (for example, monthly or
weekly performance reports).
 It consists mainly of quantified information.
 There may be some degree of uncertainty in the information. However, as
tactical plans are short-term or medium-term, the level of uncertainty is
much less than for strategic information.
Control reports might typically be prepared every month, comparing actual results
with the budget or target, and much of the information comes from internal
sources. Examples of tactical information might be:
 variance reports in a budgetary control system;
 reports on resource efficiency, such as the productivity of employees;
 sales reports: reports on sales by product or by customer; and
 reports on capacity usage.

Operational information
Operational information is needed to enable supervisors and front line
(operational) managers to organise and monitor operations, and to make on-the-
spot decisions whenever operational problems arise. Operational information
may also be needed by employees, to process transactions in the course of their
regular work.
The general features of operational information are as follows:
 It is normally information about specific transactions, or specific jobs, tasks,
daily work loads, individuals or work groups. (It is ‘task-specific’.)

© Emile Woolf International 19 The Institute of Chartered Accountants of Nigeria

Performance management

 It may be summarised at a work group or section level, but is in a more

detailed form than tactical information.
 It is generally relevant to the very short-term.
 It may be forward-looking (for example, daily plans) but it is often
concerned with transactions, procedures and performance measurement at
a daily level.
 The data that is analysed to provide the information comes almost
exclusively from both internal sources (from sources inside the
organisation).
 It consists mainly of quantified information. Most of this information is
‘factual’ and is not concerned with uncertainty.
Operational information is provided regularly, or is available online when
required. It is concerned with operational details, such as:
 the number of employees in the department absent from work
 wastage rates in production
 whether the scheduled work load for the day has been completed
 delays and hold-ups in work flow, and the reasons for the delay
 whether a customer’s order will be completed on time.
In many respects, strategic information, tactical information and operational
information are all concerned with the same things – business plans and actual
performance. They are provided in different amounts of detail and with differing
frequency. However, with the development of IT systems and internal and
external databases, it is possible for all levels of information to be available to
managers online and on demand.

© Emile Woolf International 20 The Institute of Chartered Accountants of Nigeria

Chapter 2: Overview of cost planning and control

Example: Levels of information

An accountancy tuition company has a strategic target of increasing its annual
sales.
What strategic, tactical and operational decisions might be taken towards
achieving this target?
Here is a suggested answer.
(a) At a strategic level management may decide it is necessary to increase
sales by 20%. It will then need to study the company and its business
environment and decide how this might be done – for example by
developing the existing business, buying a competitor company, or
diversifying into other forms of training, such as training lawyers or
bankers.
(b) At a tactical level, a budget should be prepared for the next year, based on
strategic decisions already taken. Middle management should consider a
variety of plans for achieving targets, such as spending more money on
advertising, recruiting more trainers and running more training
programmes. Targets might be set for each type of course or each
geographical training centre location.
(c) Operational management will make decisions about the courses and their
administration, such as making special offers (free study materials) to
attract more students, running additional courses when demand is strong,
and making sure that all student fees are collected.

© Emile Woolf International 21 The Institute of Chartered Accountants of Nigeria

Performance management

2 SOURCES OF INFORMATION

Section overview

 Introduction
 Information from internal sources
 Information from external sources
 Costs of information
 Methods of gathering information

2.1 Introduction
Performance measurement systems, both for planning and for monitoring actual
performance, rely on the provision of relevant, reliable and timely information.
Information comes from both inside and outside the organisation.
Traditionally, management accounting systems have been an information system
providing financial information to managers from sources within the organisation.
In large organisations, management accounting information might be extracted
from a cost accounting system, which records and analyses cost.
With the development of IT systems, management information systems have
become more sophisticated, using large databases to hold data, from external
sources as well as internal sources. Both financial and non-financial data are held
and analysed. The analysis of data has also become more sophisticated,
particularly through the use of spreadsheets and other models for planning and
cost analysis (for example, activity based costing).

2.2 Information from internal sources

A control system such as a management accounting system must obtain data
from within the organisation (from internal sources) for the purposes of planning
and control. The system should be designed so that it captures and measures all
the data required for providing management with the information they need.
Potential internal sources include:
 the financial accounting records;
 human resource records maintained in support of the payroll system;
 production information;
 sales information; and
 staff (through minutes of meetings etc.)
The essential qualities of good information are as follows:
 Relevance: Information should be relevant to the needs of management.
Information must help management to make decisions. Information that is
not relevant to a decision is of no value. An important factor in the design
of information systems should be the purpose of the information – in what
decisions should be made, and what information will be needed to make
those decisions?

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Chapter 2: Overview of cost planning and control

 Reliability: Information should be reliable. This means that the

data should be sufficiently accurate for its purpose. It should also
be complete.
 Timeliness: Information should be available in a timely manner. In other
words, it should be available for when it is needed by management.
 Economy: The cost of providing the information should not exceed the
benefits that it provides. The key factor that limits the potential size of many
information systems is that the cost of obtaining additional information is
not justified by the additional benefits that the information will provide.
Other qualities of good information include:
 Completeness: Information should have all the variables that will be needed
for the intended decision.
 Accuracy: Information should be correct and precise for the intended
purpose.
 Clarity: Information must be clear to the user (s).
 Consistency: Information must agree at all times with established norms and
frameworks.
 Comprehension: Information should be presented in a way that the user/
reader can easily comprehend it.
 Comparability: This is the degree to which accounting information and
policies are consistently applied from one period to another in line with
standards.
 Verifiability: Verifiability is the extent to which information is reproducible
given the same data and assumptions.
In designing a performance measurement system, and deciding what information
is required from internal sources, these desirable qualities of good information
should influence the design of the system.
Traditionally, management accounting systems obtain internal data from the
cost accounting system and costing records. In many organisations, IT systems
now integrate costing data with other operational data. This means that data is
available to the management accounting system from non-accounting sources.

Example: Information
An information system might be required to provide information about the
profitability of different types of customer.
The starting point for the design of this information system is the purpose of the
information. Why is information about customer profitability needed? The answer
might be that the company wants to know which of its customers contribute the
most profits, and whether some customers are unprofitable. If some customers
are unprofitable, the company will presumably consider ways of improving
profitability (for example, by increasing prices charged to those customers) or will
decide to stop selling to those customers.
The next consideration is: What data is needed to measure customer
profitability? The answer might be that customers should first be divided into
different categories, and each category of customer should have certain unique
characteristics. Having established categories of customer, information is needed
about costs that are directly attributable to each category of customers.

© Emile Woolf International 24 The Institute of Chartered Accountants of Nigeria

This might be information relating to gross profits from sales, minus the directly
attributable selling and distribution costs (and any directly attributable
administration costs and financing costs).
Having established what information is required, the next step is to decide how
the information should be ‘captured’ and measured. In this example, a system is
needed for measuring each category of customer, sales revenues, costs of sales
and other directly attributable costs.
The information should be available for when management intend to review
customer profitability. This might be every three months, six months or even
annually.
Information from external sources
Managers need information about customers, competitors and other elements
in their business environment. The management information system must be
able to provide this in the form that managers need, and at the time that they
need it.
External information is needed for strategic planning and control. However, it
is also often needed for tactical and operational management decisions.
Examples of the external information needed by companies are set out in
the table below.

Information area Examples of information needed

Customers What are the needs and expectations of customers in the
market?
Are these needs and expectations changing?
What is the potential for our products or services to meet
these needs, or to meet them better?
Competitors Who are they?
What are they doing?
Can we copy some of their ideas?
How large are they, and what is their market share?
How profitable are they?
What is their pricing policy?
Legal What are the regulations and laws that must be complied
environment with?
Suppliers What suppliers are there for key products or services?
What is the quality of their products or services?
What is the potential of new suppliers?
What is the financial viability of each supplier?
Political/ Are there any relevant political developments or
environmental developments relating to environmental regulation or
issues environmental conditions?
Economic/ What is happening to interest rates?
financial What is happening to exchange rates?
environment What is happening in other financial markets?
What is the predicted state of the economy?

© Emile Woolf International 25 The Institute of Chartered Accountants of Nigeria

Possible sources of external information
Sources of external information, some accessible through the Internet, include:
 market research
 supplier price lists and brochures
 trade journals
 newspapers and other media
 government reports and statistics
 reports published by other organisations, such as trade bodies.

Limitations of external information

It is important to recognise the limitations of external information.
 It might not be accurate, and it might be difficult to assess how accurate it
is.
 It might be incomplete.
 It might provide either too much or not enough detail.
 It might be difficult to obtain information in the form that is ideally required.
 It might not always be available when required.
 It might be difficult to find.
 It might be out of date.
 It might be misinterpreted.

2.3 Costs of information

Information must be captured and processed, if it is to be useful, and used
effectively.
The costs of capturing and processing data should include the cost of the
hardware and software used, time spent inputting, analysing and interpreting
data (though this might be automated in some instances, for example data input
using EPOS systems).
Modern computing equipment makes it very easy to amass huge amounts of data
which can be processed into information, but this can bring its own problems:
 The information might not be useful, in which case, the cost of producing it
is a waste.
 Important details might be omitted in large volumes of information.
Another important cost is the associated cost of poor decisions based on
incomplete information or on a misinterpretation of that information. That could
prove very costly indeed.

2.4 Methods of gathering information

Observation
This method involves looking at a process of procedure being executed by
others. It is useful in understanding how a programme, system or process
actually operates.

© Emile Woolf International 25 The Institute of Chartered Accountants of Nigeria

Advantages Disadvantages
Can view operations of a program as they are actually occurring and focus on the
information required.
The observer can adapt to events as they occur. The fact of being
observed might affect the behaviour of those being observed.
It can be difficult to summarise or categorise observations.
It is time consuming and can be expensive.

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Performance management

Interviews
Interviews are useful when there is a need to understand the interviewee’s
responses in more depth.

Advantages Disadvantages
The interview can deliver a full range Can be time consuming and costly.
at the depth required. It can be hard to analyse and
The approach is flexible as it allows compare the information obtained.
the interviewer to drill down into the An interviewer might bias the
interviewee’s responses. interviewee’s responses.
An interviewee might not answer the
questions objectively.

Documentation review
Useful to help understand how a system program operates without interrupting

Advantages Disadvantages
The researcher can use gain a Can be time consuming and costly.
complete understanding of how a The available information might be
system is meant to operate. incomplete.
Does not disturb the operation of the The interested party must have a
system. clear objective.
The information already exists and is
free from bias.

Questionnaires
This method can be used gather information in a structured way from a large
number of people

Advantages Disadvantages
It can be completed anonymously Addressees may fail to respond.
Inexpensive to administer Feedback may not be a true reflection
Easy to compare and analyse (but of the respondent’s view
analysis may require significant The wording of questions can bias
expertise) responses so they must be designed
Can be used to reach a large number with care
of respondents (particularly for online Information must be analysed
research). carefully as the respondees are a
Can gather a lot of data. biased group (i.e. information is
gathered only from those who
respond and they may have a
personal motive for doing so).

© Emile Woolf International 26 The Institute of Chartered Accountants of Nigeria

Chapter 2: Overview of cost planning and control

3 HIGH/LOW METHOD

Section overview

 The need to estimate fixed and variable costs

 High/low analysis
 High/low analysis and forecasting
 High/low analysis with a step change in fixed costs
 High/low analysis with a change in the variable cost per unit

3.1 The need to estimate fixed and variable costs

To prepare accurate cost budgets, it is important to understand how costs
‘behave’. Cost behaviour refers to the way in which total costs increase as the
volume of an activity increases.
It is normally assumed that total costs can be analysed into fixed costs and a
variable cost per unit of activity, such as a variable cost per unit of product or per
hour of service. Some overhead costs are a mixture of fixed costs and variable
costs, but these can be separated into a fixed cost portion and a variable cost
portion.
To prepare reliable cost budgets or cost estimates, it may be necessary to
estimate fixed costs and variable costs.
 Direct material costs are normally 100% variable costs.
 Direct labour costs may be treated as variable costs. However, when there
is a fixed labour force, direct labour costs may be budgeted as fixed costs.
 Overhead costs may be treated as fixed costs. However, for an accurate
analysis of overhead costs, it may be necessary to make an estimate of
fixed costs and variable costs. These estimates are often based on an
analysis of historical costs.
You will be familiar with the following two techniques for estimating fixed and
variable costs from your previous studies:
 the high low method; and
 linear regression analysis.
A full explanation of each of these techniques is repeated here for your
convenience.

3.2 High/low analysis

High/low analysis can be used to estimate fixed costs and variable costs per unit
whenever:
 there are figures available for total costs at two different levels of output or
activity;
 it can be assumed that fixed costs are the same in total at each level of
activity; and
 the variable cost per unit is constant at both levels of activity.

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Performance management

High/low analysis uses two historical figures for cost:

 the highest recorded output level, and its associated total cost
 the lowest recorded output level, and its associated total cost.
It is assumed that these ‘high’ and ‘low’ records of output and historical cost are
representative of costs at all levels of output or activity.
The difference between the total cost at the high level of output and the total cost
at the low level of output is entirely variable cost. This is because fixed costs are
the same in total at both levels of output.

The method
Step 1: Take the activity level and cost for:
 the highest activity level
 the lowest activity level.
Step 2: The variable cost per unit of activity can be calculated as:
difference in total costs
/difference in the number of units of activity.
Step 3: Having calculated a variable cost per unit of activity, fixed cost can be
calculated by substitution into one of the cost expressions. The difference
between the total cost at this activity level and the total variable cost at this
activity level is the fixed cost.
Step 4: Construct the total cost function.
This is best seen with an example.

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Chapter 2: Overview of cost planning and control

Example: High/low method

A company has recorded the following costs in the past six months:
Month Production (units) Total cost (₦)
January 5,800 40,300
February 7,700 47,100
March 8,200 48,700
April 6,100 40,600
May 6,500 44,500
June 7,500 47,100

Step 1: Identify the highest and lowest activity levels and note the costs
associated with each level.
Production (units) Total cost (₦)
March 8,200 48,700
January 5,800 40,300

Step 2: Compare the different activity levels and associated costs and
calculate the variable cost:
Production (units) Total cost (₦)
March 8,200 48,700
January 5,800 40,300
2,400 8,400

Therefore: 2,400 units cost an extra ₦8,400.

Therefore: The variable cost per unit = ₦8,400/2,400 units = ₦3.5 per unit

Step 3: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 8,200 units:
Fixed cost + Variable cost = ₦48,700
Fixed cost + (8,200  ₦3.5) = ₦48,700
Fixed cost + ₦28,700 = ₦48,700
Fixed cost = ₦48,700  ₦28,700 = ₦20,000

Step 4: Construct total cost function

Total cost = a +bx = 20,000 + 3.5x

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Performance management

Note that at step 3 it does not matter whether the substitution of variable cost is
into the high figures or the low figures.

Example: Cost of other levels of activity

Return to step 3 above. Then, substitute the low figures for high figures.

Step 3: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 5,800 units:
Fixed cost + Variable cost = ₦40,300
Fixed cost + (5,800  ₦3.5) = ₦40,300
Fixed cost + ₦20,300 = ₦40,300
Fixed cost = ₦40,300  ₦20,300 = ₦20,000

3.3 High/low analysis and forecasting

Once derived, the cost function can be used to estimate the cost associated with
levels of activity outside the range of observed data. Thus it can be used to
forecast costs associated with future planned activity levels.

Example: High/low method

The company is planning to make 7,000 units and wishes to estimate the total
costs associated with that level of production.

Total cost = ₦20,000 + ₦3.5x

Total cost of 7,000 units = ₦20,000 + (₦3.5  7,000) = ₦44,500

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Chapter 2: Overview of cost planning and control

3.4 High/low analysis with a step change in fixed costs

High/low analysis can also be used when there is a step increase in fixed costs
between the ‘low’ and the ‘high’ activity levels, provided that the amount of the
step increase in fixed costs is known.
If the step increase in fixed costs is given in naira value, the total cost of the ‘high’
or the ‘low’ activity level should be adjusted by the amount of the increase, so
that total costs for the ‘high’ and ‘low’ amounts use the same fixed cost figure.
After this adjustment the difference between the high and low costs is solely due
to variable cost. The variable cost can be identified and cost functions
constructed for each side of the step.

The method
Step 1: Take the activity level and cost for:
 the highest activity level
 the lowest activity level.
Step 2: Make an adjustment for the step in fixed costs;
 add the step in fixed costs to the total costs of the lower level of activity; or
 deduct the step in fixed costs from the total costs of the higher level of
activity.
Step 3: The variable cost per unit of activity can be calculated as:
difference in total costs
/difference in the number of units of activity.
Step 4: Having calculated a variable cost per unit of activity, fixed cost can be
calculated by substitution into one of the cost expressions. (use the unadjusted
pair).
Step 5: Construct the total cost function of the unadjusted level.
Step 6: Construct the total cost function for the adjusted level by reversing the
adjustment to its fixed cost.

This is best seen with an example.

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Performance management

Example: High/low method with step in fixed costs

A company has identified that total fixed costs increase by ₦15,000 when activity
level equals or exceeds 19,000 units. The variable cost per unit is constant over
this range of activity.
The company has identified the following costs at two activity levels. (Step 1)

Production (units) Total cost (₦)

High 22,000 195,000
Low 17,000 165,000

Step 2: Make an adjustment for the step in fixed costs.

Production (units) Total cost (₦)
High 22,000 195,000
Low (165,000 + 15,000) 17,000 180,000

Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
Production (units) Total cost (₦)
High 22,000 195,000
Low 17,000 180,000
5,000 15,000

Therefore: 5,000 units cost an extra ₦15,000.

Therefore: The variable cost per unit = ₦15,000/5,000 units = ₦3 per unit

Step 4: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 22,000 units:
Fixed cost + Variable cost = ₦195,000
Fixed cost + (22,000  ₦3) = ₦195,000
Fixed cost + ₦66,000 = ₦195,000
Fixed cost = ₦195,000  ₦66,000 = ₦129,000

Step 5: Construct total cost function (unadjusted level) above 19,000 units
Total cost = a +bx = 129,000 + 3x

Step 6: Construct total cost function below 19,000 units

Total cost = a +bx = (129,000  15,000) + 3x
Total cost = a +bx = 114,000 + 3x

The cost functions can be used to estimate total costs associated with a level as
appropriate.

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Chapter 2: Overview of cost planning and control

Example: High/low method

The company is planning to make 20,000 units and wishes to estimate the total
costs associated with that level of production.

Total cost = ₦129,000 + ₦3x

Total cost of 20,000 units = 129,000 + (₦3  20,000) = ₦189,000

The step increase in fixed costs is given as a percentage amount

When the step change in fixed costs between two activity levels is given as a
percentage amount, the problem is a bit more complex.
The costs associated with a third activity level must be found. This activity level
could be either side of the activity level that triggers the step increase in fixed
costs. This means that there are two activity levels which share the same fixed
cost (though it is unknown).These can be compared to identify the variable cost.
The fixed cost at any level can then be calculated by substitution and the fixed
cost the other side of the step can be calculated from the first fixed cost.

Example: High/low method with step in fixed costs

A company has identified that total fixed costs increase by 20% when activity level
equals or exceeds 7,500 units. The variable cost per unit is constant over this
range of activity.
The company has identified the following costs at three activity levels. (Step 1)

Production (units) Total cost (₦)

High 11,000 276,000
Middle 8,000 240,000
Low 5,000 180,000

Step 2: Choose the pair which is on the same side as the step.
Production (units) Total cost (₦)
High 11,000 276,000
Middle 8,000 240,000

Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
Production (units) Total cost (₦)
High 11,000 276,000
Middle 8,000 240,000
3,000 36,000

Therefore: 3,000 units cost an extra ₦36,000.

Therefore: The variable cost per unit = ₦36,000/3,000 units = ₦12 per unit

Step 4: Substitute the variable cost into one of the cost functions
© Emile Woolf International 35 The Institute of Chartered Accountants of Nigeria
Total cost of 11,000 units:
Fixed cost + Variable cost = ₦276,000
Fixed cost + (11,000  ₦12) = ₦276,000
Fixed cost + ₦132,000 = ₦276,000
Fixed cost = ₦276,000  ₦132,000 = ₦144,000

Step 5: Construct total cost function above 7,500 units

Total cost = a +bx = 144,000 + 12x

Step 6: Construct total cost function below 7,500 units

Total cost = a +bx = (144,000  100/120) + 12x
Total cost = a +bx = 120,000 + 12x

The cost functions can be used to estimate total costs associated with a level as
appropriate.

3.5 High/low analysis with a change in the variable cost per unit
High/low analysis can also be used when there is a change in the variable cost
per unit between the ‘high’ and the ‘low’ levels of activity. The same approach is
needed as for a step change in fixed costs, as described above.
When the change in the variable cost per unit is given as a percentage amount, a
third ‘in between’ estimate of costs should be used, and the variable cost per unit
will be the same for:
 the ‘in between’ activity level and
 either the ‘high’ or the ‘low’ activity level.
High/low analysis may be applied to the two costs and activity levels for which
unit variable costs are the same, to obtain an estimate for the variable cost per
unit and the total fixed costs at these activity levels. The variable cost per unit at
the third activity level can then be calculated making a suitable adjustment for the
percentage change.

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Performance management

Example: High/low method with step in fixed costs

A company has identified that total fixed costs are constant over all levels of
activity but there is a 10% reduction in the variable cost per unit above 24,000
units of activity. This reduction applies to all units of activity, not just the additional
units above 24,000.
The company has identified the following costs at three activity levels. (Step 1)

Production (units) Total cost (₦)

High 30,000 356,000
Middle 25,000 320,000
Low 20,000 300,000
Step 2: Choose the pair which is on the same side as the change.
Production (units) Total cost (₦)
High 30,000 356,000
Middle 25,000 320,000
Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
Production (units) Total cost (₦)
High 30,000 356,000
Middle 25,000 320,000
5,000 36,000

Therefore: 5,000 units cost an extra ₦36,000.

Therefore: The variable cost per unit above 24,000 units
= ₦36,000/5,000 units = ₦7.2 per unit
Therefore: The variable cost per unit below 24,000 units
= ₦7.2 per unit  100/90 = ₦8 per unit
Step 4: Substitute the variable cost into one of the cost functions
Total cost of 30,000 units:
Fixed cost + Variable cost = ₦356,000
Fixed cost + (30,000  ₦7.2) = ₦356,000
Fixed cost + ₦216,000 = ₦356,000
Fixed cost = ₦356,000  ₦216,000 = ₦140,000
Step 5: Construct total cost function above 24,000 units
Total cost = a +bx = 140,000 + 7.2x
Step 6: Construct total cost function below 24,000 units
Total cost = a +bx = 140,000 + 8x

The cost functions can be used to estimate total costs associated with a level as
appropriate.

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Chapter 2: Overview of cost planning and control

4 LINEAR REGRESSION ANALYSIS

Section overview

 The purpose of linear regression analysis

 The linear regression formulae
 Linear regression analysis and forecasting

4.1 The purpose of linear regression analysis

Linear regression analysis is a statistical technique for calculating a line of best fit
from a set of data:
y = a + bx
The data is in ‘pairs’, which means that there are different values for x, and for
each value of x there is an associated value of y in the data.
Linear regression analysis can be used to estimate fixed costs and the variable
cost per unit from historical data for total costs. It is an alternative to the high-low
method.
Linear regression analysis can also be used to predict future sales by projecting
the historical sales trend into the future (on the assumption that sales growth is
rising at a constant rate, in a ‘straight line’).

Regression analysis and high-low analysis compared

There are important differences between linear regression analysis and the high-
low method.
 High-low analysis uses just two sets of data for x and y, the highest value
for x and the lowest value for x. Regression analysis uses as many sets of
data for x and y as are available.
 Because regression analysis calculates a line of best fit for all the available
data, it is likely to provide a more reliable estimate than high-low analysis
for the values of a and b.
 In addition, regression analysis can be used to assess the extent to which
values of y depend on values of x. For example, if a line of best fit is
calculated that estimates total costs for any volume of production, we can
also calculate the extent to which total costs do seem to be linked (or
‘correlated’) to the volume of production. This is done by calculating a
correlation co-efficient, which is explained later.
 Regression analysis uses more complex arithmetic than high-low analysis,
and a calculator or small spreadsheet model is normally needed
In summary, linear regression analysis is a better technique than high-low
analysis because:
 it is more reliable and
 its reliability can be measured.

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Performance management

4.2 The linear regression formulae

Linear regression analysis is a statistical technique for calculating a line of best fit
where there are different values for x, and for each value of x there is an
associated value of y in the data.
The linear regression formulae for calculating a and b are shown below.

Formula: Regression analysis formula

Given a number of pairs of data a line of best fit (y = a + bx) can be constructed by
calculating values for a and b using the following formulae.

Where:
x, y = values of pairs of data.
n= the number of pairs of values for x and y.
= A sign meaning the sum of. (The capital of the Greek letter
sigma).
x= Independent variable (units of activity)
y = Dependent variable (Amounts / Costs)
a = Fixed costs / y intercept
b = Variable costs per unit of activity /Slope/Gradient/Regression
coefficient.
Note: the term b must be calculated first as it is used in calculating a.

Approach
 Set out the pairs of data in two columns, with one column for the values of
x and the second column for the associated values of y. (For example, x for
output and y for total cost.
 Set up a column for x², calculate the square of each value of x and enter
the value in the x² column.
 Set up a column for xy and for each pair of data multiply x by y and enter
the value in the xy column.
 Sum each column.
 Enter the values into the formulae and solve for b and then a. (It must be in
this order as you need b to find a).
Linear regression analysis is widely used in economics and business. One
application is that it can be used to estimate fixed costs and variable cost per unit
(or number of units) from historical total cost data.

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Chapter 2: Overview of cost planning and control

The following example illustrates this use

Example: Linear regression analysis

A company has recorded the following output levels and associated costs in the
past six months:
Month Output (000 Total cost
of units) (₦m)
January 5.8 40.3
February 7.7 47.1
March 8.2 48.7
April 6.1 40.6
May 6.5 44.5
June 7.5 47.1

Required: Construct the equation of a line of best fit for this data.
Working:
x y x2 xy
January 5.8 40.3 33.64 233.74
February 7.7 47.1 59.29 362.67
March 8.2 48.7 67.24 399.34
April 6.1 40.6 37.21 247.66
May 6.5 44.5 42.25 289.25
June 7.5 47.1 56.25 353.25
41.8 268.3 295.88 1,885.91
= x = y = x 2
= xy

This is the cost in millions of naira of making

1,000 units

Line of best fit:

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Performance management

4.3 Linear regression analysis and forecasting

Example: Linear regression analysis

The company is planning to make 9,000 units and wishes to estimate the total
costs associated with that level of production.

Linear regression analysis can also be used to forecast other variables (e.g.
demand, sales volumes etc.).
This is done by constructing an equation to describe a change in value over time.
Regression analysis is carried out in the usual way with time periods identified as
the independent variable. The dependent variable under scrutiny can then be
estimated for various periods into the future.
This rests on the assumption that a linear trend in the past will continue into the
future.

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Chapter 2: Overview of cost planning and control

5 MARGINAL COSTING AND ABSORPTION COSTING

Section overview

 Absorption costing
 Marginal costing
 The difference in profit between marginal costing and absorption costing
 Advantages and disadvantages of absorption costing
 Advantages and disadvantages of marginal costing

5.1 Absorption costing

Absorption costing measures cost of a product or a service as:
 its direct costs (direct materials, direct labour and sometimes direct
expenses and variable production overheads); plus
 a share of fixed production overhead costs.
It is a system of costing in which a share of fixed overhead costs is added to
direct costs and variable production overheads, to obtain a full cost.
This might be:
 a full production cost, or
 a full cost of sale
This was covered in an earlier chapter but a brief revision is provided here for
your convenience.
 Production overheads are indirect costs. This means that the costs (unlike
direct costs) cannot be attributed directly to specific items (products) for
which a cost is calculated.
 A ‘fair’ share of overhead costs is added to the direct costs of the product,
using an absorption rate.
 A suitable absorption rate is selected. This is usually a rate per direct
labour hour, a rate per machine hour, a rate per amount of material or
possibly a rate per unit of product.
 Production overheads may be calculated for the factory as a whole;
alternatively, separate absorption rates may be calculated for each different
production department. (However, it is much more likely that a question
involving absorption costing will give a factory-wide absorption rate rather
than separate departmental absorption rates.)
 The overhead absorption rate (or rates) is determined in advance for the
financial year. It is calculated as follows:

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Performance management

Formula: Overhead absorption rate

Total allocated and apportioned overheads
Volume of activity in the period

Which is:
Budgeted production overhead expenditure for the period
Budgeted activity in the period

The ‘activity’ is the number of labour hours in the year, the number of machine
hours or the number of units produced, depending on the basis of absorption
(labour hour rate, machine hour rate or rate per unit) that is selected.

Under- and over-absorption

Overhead absorption rates are decided in advance (before the period under
review).
Actual overhead expenditure and actual production volume might differ from the
estimates used in the budget to work out the absorption rate.
As a consequence, the amount of overheads added to the cost of products
manufactured is likely to be different from actual overhead expenditure in the
period. The difference is under- or over-absorbed overheads.

Illustration: Under of over-absorbed fixed overhead

₦
Amount absorbed:
Actual number of units Predetermined
made (or hours used)  absorption rate
X

Actual expenditure in the period (X)

Over/(under) absorbed X

Overheads are under-absorbed when the amount of overheads absorbed into

production costs is less than the actual amount of overhead expenditure.
Overheads are over-absorbed when the amount of overheads absorbed into
production costs is more than the actual amount of overhead expenditure.

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Chapter 2: Overview of cost planning and control

Example: Absorption costing

A company manufactures and sells a range of products in a single factory. Its
budgeted production overheads for Year 6 were ₦150,000, and budgeted direct
labour hours were 50,000 hours.
Actual results in Year 6 were as follows:
₦
Sales 630,000
Direct materials costs 130,000
Direct labour costs 160,000
Production overhead 140,000 (40,000 hours)
Administration overhead 70,000
Selling and distribution overhead 90,000
There was no opening or closing inventory at the beginning or end of Year 6.
The company uses an absorption costing system, and production overhead is
absorbed using a direct labour hour rate.
The above information would be used as follows:
a. The predetermined absorption rate is ₦150,000/50,000 hours = ₦3 per direct labour
hour.
b Under absorption ₦
Overhead absorbed (40,000 hours @ ₦3 per hour) 120,000
Overhead incurred (actual cost) (140,000)
Under absorption (20,000)

c The full production cost: ₦

Direct materials costs 130,000
Direct labour costs 160,000
Production overhead absorbed (40,000 hours  ₦3) 120,000
Full production cost (= cost of sales in this example) 410,000
The profit for the year is reported as follows. Notice that under-absorbed overhead
is an adjustment that reduces the reported profit. Over-absorbed overhead would
be an adjustment that increases profit.
₦ ₦
d Sales 630,000
Full production cost of sales 410,000
Under-absorbed overhead 20,000
(430,000)
200,000
Administration overhead 70,000
Selling and distribution overhead 90,000
(160,000)
Profit for Year 6 40,000

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Performance management

The amount of under- or over-absorbed overheads is written to profit or loss for

the year as an adjusting figure.
 If overhead is under-absorbed overhead the profit is adjusted down
(because production costs have been understated)
 If overhead is over-absorbed the profit is adjusted upwards.
Note that the recognition of the under or over absorbed overhead in the
statement of profit or loss results in the fixed production overhead figure (which
was originally based on an absorption rate) being restated to the actual fixed
overhead incurred.

Example: Absorption costing

Returning to the facts of the previous example.
₦
Overhead absorbed (40,000 hours @ ₦3 per hour) 120,000
Under absorption 20,000
Overhead incurred (actual cost) 140,000

5.2 Marginal costing

Marginal costing is an alternative to absorption costing. In marginal costing, fixed
production overheads are not absorbed into product costs but expensed in the
period.
Marginal costing is useful in decision making as it focuses on the change in total
costs brought about by an increase or decrease in a level of activity. This is
covered in more detail in later chapters of this text.

5.3 The difference in profit between marginal costing and absorption costing
The profit for an accounting period calculated with marginal costing is different
from the profit calculated with absorption costing.
The difference in profit is due entirely to the differences in inventory valuation.
The main difference between absorption costing and marginal costing is that in
absorption costing, inventory cost includes a share of fixed production overhead
costs.
 The opening inventory contains fixed production overhead that was
incurred last period. Opening inventory is written off against profit in the
current period. Therefore, part of the previous period’s costs are written off
in the current period income statement.
 The closing inventory contains fixed production overhead that was incurred
in this period. Therefore, this amount is not written off in the current period
income statement but carried forward to be written off in the next period
income statement.

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Chapter 2: Overview of cost planning and control

The implication of this is as follows (assume costs per unit remain constant):
 When there is no change in the opening or closing inventory, exactly the
same profit will be reported using marginal costing and absorption costing.
 If inventory increases in the period (closing inventory is greater than
opening inventory),
 the increase is a credit to the income statement reducing the cost of
sales and increasing profit;
 the increase will be bigger under total absorption valuation than under
marginal costing valuation (because the absorption costing inventory
includes fixed production overhead); therefore
 the total absorption profit will be higher.
 If inventory decreases in the period (closing inventory is less than opening
inventory),
 the decrease is a debit to the income statement;
 the decrease will be bigger under total absorption valuation than
under marginal costing valuation (because the absorption costing
inventory includes fixed production overhead); therefore
 the total absorption profit will be lower.

Example: Absorption costing

Makurdi Manufacturing makes and sells a single product:
₦
Selling price per unit 150
Variable production costs per unit 70
Fixed overhead per unit (see below) 50
Total absorption cost per unit (used in inventory valuation) 120

Normal production 2,200 units per month

Budgeted fixed production overhead ₦110,000 per month
Fixed overhead absorption rate ₦110,000/2,200 units=
₦50 per unit

The following data relates to July and August:

July August
Fixed production costs ₦110,000 ₦110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000units

There was no opening inventory in July.

This means that there is no closing inventory at the end of August as
production in the two months (2,000 + 2,500 units = 4,500 units) is the
same as the sales (1,500 + 3,000 units = 4,500 units)

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Performance management

Example (continued): Total absorption cost profit statement

July August
Sales:
1,500 units  ₦150 225,000
3,000 units  ₦150 450,000

Opening inventory nil 60,000

Variable production costs
2,000 units  ₦70 140,000
2,500 units  ₦70 175,000

Fixed production costs (absorbed)

2,000 units  ₦50 100,000
2,500 units  ₦50 125,000

Under (over) absorption

200 units @ ₦50 10,000
300 units @ ₦50 (15,000)
250,000 345,000

Closing inventory
500 units @ (70 + 50) (60,000)
Zero closing inventory nil
Cost of sale (190,000) (345,000)
Profit for the period 35,000 105,000

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Chapter 2: Overview of cost planning and control

Example (continued): Marginal costing

Makurdi Manufacturing makes and sells a single product:

₦
Selling price per unit 150
Variable production costs per unit 70

Budgeted fixed production overhead ₦110,000 per month

The following actual data relates to July and August:

July August
Fixed production costs ₦110,000 ₦110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000units
There was no opening inventory in July.

Marginal costing profit statements are as follows:

July August
Sales:
1,500 units  ₦150 225,000
3,000 units  ₦150 450,000

Opening inventory nil 35,000

Variable production costs
Direct material: 2,000 units  ₦35 70,000
Direct labour: 2,000 units  ₦25 50,000
Variable overhead 2,000 units  ₦10 20,000

Direct material: 2,500 units  ₦35 87,500

Direct labour: 2,500 units  ₦25 62,500
Variable overhead 2,500 units  ₦10 25,000
Closing inventory
500 units @ (70) (35,000)
Zero closing inventory nil
Cost of sale (105,000) (210,000)
Contribution 120,000 240,000
Fixed production costs (expensed) (110,000) (110,000)
Profit for the period 10,000 130,000

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Performance management

The difference between the two profit figures is calculated as follows:

Formula: Profit difference under absorption costing (TAC = total absorption costing)
and marginal costing (MC)
Assuming cost per unit is constant across all periods under consideration.

Number of units increase or decrease  fixed production overhead per unit

Returning to the previous example:

Example(continued): Profit difference

Over the two
July August months
₦ ₦ ₦
Absorption costing profit 35,000 105,000 140,000
Marginal costing profit 10,000 130,000 140,000
Profit difference 25,000 (25,000) nil

This profit can be explained the different way the inventory movement is
costed under each system:
Units Units Units
Closing inventory nil nil
2,000 units made less 1,500
sold 500

Opening inventory nil 500 nil

500 (500) nil
Absorbed fixed production
overhead per unit (₦) 50 50 50
Profit difference (₦) 25,000 (25,000) nil

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Chapter 2: Overview of cost planning and control

Note that the difference is entirely due to the movement in inventory value:

Example: Profit difference – due to inventory movement

Over the two

TAC inventory movement: July August months
₦ ₦ ₦
Closing inventory 60,000 nil nil
Opening inventory nil (60,000) nil
60,000 (60,000) nil
MC inventory movement:
Closing inventory 35,000 nil nil
Opening inventory nil (35,000) nil
35,000 (35,000) nil
Profit difference 25,000 (25,000) nil

Example: MC vs TAC
A company manufactures and sells a product.
The following information is relevant about the product

₦
Selling price per unit 35
Variable cost per unit 8
Fixed cost per unit (based on budgeted overhead of ₦120,000
and normal level of activity of 20,000 units). 6

Units
Opening inventory 4,000
Actual production 20,000
Closing inventory 3,000
Therefore, sales are (4,000 + 20,000 – 3,000) 21,000

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Performance management

Example (continued): MC vs TAC

Operating statements can be prepared as follows:
MC TAC
Sales (21,000  ₦35) 735,000 735,000
Cost of sales
MC = (21,000  ₦8) (168,000)
TAC = (21,000  ₦14) (294,000)
Fixed production cost (120,000)
447,000 441,000

The profit figures are reconciled as follows:

Units
Opening inventory 4,000
Closing inventory 3,000
Decrease 1,000
Difference in cost per unit ₦6
₦6,000
₦
MC profit 447,000
Inventory valuation difference (6,000)
TAC profit 441,000

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Chapter 2: Overview of cost planning and control

Practice question 1
The following information is relevant about a product

₦
Selling price per unit 35
Variable cost per unit 8
Fixed cost per unit (based on budgeted overhead of ₦120,000
and normal level of activity of 20,000 units). 6

Units
Opening inventory 2,000
Actual production 20,000
Closing inventory 4,000
Therefore, sales are (2,000 + 20,000 – 4,000) 18,000

Required:
Prepare MC and TAC operating statements and reconcile the profit
difference.

Practice question 2
A company manufactures and sells product X.
The following information is relevant about the product:

₦
Selling price per unit 50
Variable cost per unit 30
Fixed cost per unit (based on budgeted overhead of ₦100,000 4
and normal level of activity of 25,000 units).
Units
Opening inventory 2,000
Closing inventory 1,500
Actual production 25,500

Required
a) Prepare a marginal cost profit statement.
b) Prepare an absorption cost profit statement. (Remember to adjust for
the over absorption of overhead).
c) Reconcile the two profit figures by comparing the impact of the
inventory movement under each approach.

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5.4 Advantages and disadvantages of absorption costing

Advantages of absorption costing

 Inventory values include an element of fixed production overheads. This is
consistent with the requirement in financial accounting that (for the purpose
of financial reporting) inventory should include production overhead costs.
 Calculating under/over absorption of overheads may be useful in controlling
fixed overhead expenditure.
 By calculating the full cost of sale for a product and comparing it will the
selling price, it should be possible to identify which products are profitable
and which are being sold at a loss.

Disadvantages of absorption costing

 Absorption costing is a more complex costing system than marginal
costing.
 Absorption costing does not provide information that is useful for decision
making (like marginal costing does).

5.5 Advantages and disadvantages of marginal costing

Advantages of marginal costing

 It is easy to account for fixed overheads using marginal costing. Instead of
being apportioned they are treated as period costs and written off in full as
an expense the income statement for the period when they occur.
 There is no under/over-absorption of overheads with marginal costing, and
therefore no adjustment necessary in the income statement at the end of
an accounting period.
 Marginal costing provides useful information for decision making.
 Contribution per unit is constant, unlike profit per unit which varies as the
volume of activity varies.

Disadvantages of marginal costing

 Marginal costing does not value inventory in accordance with the
requirements of financial reporting. (However, for the purpose of cost
accounting and providing management information, there is no reason why
inventory values should include fixed production overhead, other than
consistency with the financial accounts.)
 Marginal costing can be used to measure the contribution per unit of
product, or the total contribution earned by a product, but this is not
sufficient to decide whether the product is profitable enough. Total
contribution has to be big enough to cover fixed costs and make a profit.

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6 ACTIVITY BASED COSTING

Section overview

 Criticisms of absorption costing

 Introduction to activity based costing
 Activities
 Cost drivers and cost pools
 When using ABC might be appropriate
 Advantages and disadvantages of ABC

6.1 Criticisms of absorption costing

Traditional absorption costing has many weaknesses, especially in a ‘modern’
manufacturing environment.
 Production overhead costs are often high relative to direct production costs.
Therefore, a system of adding overhead costs to product costs by using
time spent in production (direct labour hours or machine hours) is difficult to
justify.
 A full cost of production has only restricted value for many types of
management decision.
However, traditional absorption costing is still in use with some companies.
 It provides a rational method of charging overhead costs to production
costs, so that a full cost of production can be calculated for closing
inventories.
 It is also argued that absorption costing is useful for some pricing decisions.
(Pricing is covered in a later paper).
A number of alternative costing methods have been developed with a view to
replacing the traditional methods. One such method is activity-based costing.

6.2 Introduction to activity-based costing

Activity-based costing (ABC) is a form of absorption costing that takes a different
approach to the apportionment and absorption of production overhead costs.
Activity-based costing is based on the following ideas:
 In a modern manufacturing environment, a large proportion of total costs
are overhead costs, and direct labour costs are relatively small.
 It is appropriate to trace these costs as accurately as possible to the
products that create the cost because overhead costs are large.

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Performance management

 The traditional methods of absorbing production overhead costs on the

basis of direct labour hours or machine hours have no rational justification
as many production overhead costs are not directly related to the
production work that is carried out. For example:
 The costs of quality control and inspection depend on the quality
standards and inspection methods that are used: these do not
necessarily relate to the number of hours worked in production.
 The costs of processing and chasing customer orders through the
factory relate more to the volume of customer orders rather than the
hours worked on each job in production.
 Costs of managing the raw materials inventories (storage costs)
relate more to the volume of materials handled rather than hours
worked on the material in production.
 The costs of production relate more to the volume and complexity of
customer orders or the number of batch production runs, rather than
hours worked in production.

6.3 Activities
Activity-based costing (ABC) takes the view that many production overhead costs
can be associated with particular activities other than direct production work.
If such activities can be identified and costs linked to them overhead costs can
then be added to product costs by using a separate absorption rate for each
activity.
ABC costing of overheads and estimate of full production costs is therefore based
on activities, rather than hours worked in production.

Identifying activities
A problem with introducing activity-based costing is deciding which activities
create or ‘drive’ overhead costs.
There are many different activities within a manufacturing company, and it is not
always clear which activities should be used for costing.
Activities might include, for example:
 materials handling and storage;
 customer order processing and chasing;
 purchasing;
 quality control and inspection;
 production planning; and
 repairs and maintenance.
These activities are not necessarily confined to single functional departments
within production departments.

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Chapter 2: Overview of cost planning and control

Although ABC is often concerned with production costs, it can also be applied to
activities outside production, such as sales and distribution. Sales and distribution
activities might include:
 selling activities;
 warehousing and despatch; and
 after-sales service.
In a system of activity-based costing, it is preferable to select a fairly small
number of activities. If a large number of activities are selected, the costing
system could become too complex and time-consuming to operate.
The activities are selected on the basis of management judgement and
experience, and their knowledge of the activities within manufacturing.

6.4 Cost drivers and cost pools

Cost drivers
For each activity, there should be a cost driver. A cost driver is the factor that
determines the cost of the activity. It is something that will cause the costs for an
activity to increase as more of the activity is performed.
Overhead costs are therefore caused by activities, and the costs of activities are
driven by factors other than production volume.
Each cost driver must be a factor that can be measured so that the number of
units of the cost driver that have occurred during each period can be established.
Possible examples include:

Activity Possible cost driver Information needed for

ABC
Customer order Number of customer Number of orders for
Processing orders each product
Materials purchasing Number of purchase Number of orders for
orders materials for each
finished product
Quality control and Number of inspections Number of inspections
inspection of output of each
product
Production planning Number of production Number of runs or
runs or batches batches of each product
Repairs and Number of machines, or Number of machines or
Maintenance machine hours operated machine hours worked
for each product
Selling Number of sales orders Number of orders for
each product
Warehousing and Number of deliveries Number of deliveries for
dispatch Made each product

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Performance management

Cost pools
A cost pool is simply the overhead expenditure allocated and apportioned to an
activity. Overhead costs are allocated (or allocated and apportioned) to each
activity, and for each activity there is a ‘cost pool’.
ABC absorbs overheads into the cost of products (or services) at a separate rate
for each cost pool (each activity).
The total production cost for each product or service is therefore direct production
costs plus absorbed overheads for each activity.
The cost absorbed under ABC might be very different to that absorbed using a
traditional, volume-based approach.

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Chapter 2: Overview of cost planning and control

Example: ABC vs traditional, volume based absorption

A manufacturing company makes four products and incurs estimated material
handling costs of ₦250,000 per month. (This is the cost pool for material
handling cost).
The company produces 160,000 units per month and absorbs material handling
cost on the number of units. This gives a material handling cost of ₦1.5625
(₦250,000 ÷ 160,000 units)
The material handling cost is absorbed as follows:
Units Unit cost Cost absorbed
Product produced (₦) (₦)
W 60,000 ₦1.5625 93,750
X 33,000 ₦1.5625 51,563
Y 40,000 ₦1.5625 62,500
Z 27,000 ₦1.5625 42,187
160,000 ₦1.5625 250,000

The company has instigated a project to see if ABC costing would be

appropriate.
The project has identified that a large part of the material handling costs are
incurred in receiving material orders and that the same effort goes into receiving
orders regardless of the size of the order. Order sizes differ substantially.
The company has identified the following number of orders in respect of material
for each type of product.
Number of
Product orders
W 15
X 22
Y 4
Z 9
50

An ABC cost per order (hence cost per unit) can be estimated as follows:
If the cost driver for order handling is the number of orders handled, the budgeted
order handling cost will be ₦5,000 per order (₦250,000/50).
Overhead costs will be charged to products as follows:
Number Cost per Apportioned Units
Product of orders order cost produced Unit cost
W 15 ₦5,000 75,000 60,000 1.25
X 22 ₦5,000 110,000 33,000 3.33
Y 4 ₦5,000 20,000 40,000 0.50
Z 9 ₦5,000 45,000 27,000 1.67
50 ₦5,000 250,000 160,000

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Performance management

The above example shows that the material handling overhead absorbed to each
type of product is very different under the two approaches.
For example, only 33,000 units of product X are made (out of a total of 160,000
units). However, product X requires 22 orders out of a total of 60 and it is the
number of orders that drive this cost.
The traditional approach recognised ₦51,563 as relating to product but ABC,
using the number of orders as the driver results in ₦110,000 being absorbed by
product X.
The above example shows the difference between traditional absorption and
ABC using a single cost. In reality there would be more than one activity used as
a basis for absorption leading to a series of absorption rates (per activity).
Also note that one of the absorption methods might be a volume-based method.
The point is that traditional absorption methods treat all costs as varying
according to a volume measure whereas ABC splits the total and treats each part
of the total cost according to what drives it.

Example: ABC
A company makes three products, X, Y and Z using the same direct labour
employees and the same machine for production.
Production details for the three products for a typical period are as follows:
Labour Machine Material Number of
hours per hours per cost per units
unit unit unit (₦) produced
Product X 0.25 0.75 100 1,500
Product Y 0.75 0.50 60 2,500
Product Z 0.50 1.50 120 14,000

Direct labour costs ₦160 per hour.

Total production overheads are ₦1,309,000 and further analysis shows that the
total production overheads can be divided as follows:

₦
Costs relating to machinery 196,350
Costs relating to inspection 458,150
Costs relating to set-ups 392,700
Costs relating to materials handling 261,800
Total production overhead 1,309,000

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Example (continued): ABC

The following total activity volumes are associated with each product for the
period:
Number of
Number of Number movements Machine
inspections of set-ups of materials hours
Product X 360 80 40 1,125
Product Y 80 120 80 1,250
Product Z 960 500 280 21,000
1,400 700 400 23,375

Machine costs are absorbed on a machine hour basis.

The costs per unit for each product may be estimated as follows using ABC
principles.
Step 1: Cost per activity
Cost Overhead
allocated Activity per absorption
Activity (₦) Cost driver period rate
₦327.25 per
Inspection 458,150 Inspections 1,400 inspection
₦561 per set-
Set-ups 392,700 Set-ups 700 up
Materials ₦654.50 per
handling 261,800 Movements 400 movement
Machinery ₦8.40 per
operations 196,350 Machine hrs 23,375 machine hour
Total 1,309,000

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Performance management

Example (continued): ABC

Step 2: Allocate overheads to product types based on cost per activity and
cost drivers
X Y Z
₦ ₦ ₦
Set-ups
80 set ups  ₦561 44,880
120 set ups  ₦561 67,320
500 set ups  ₦561 280,500
Inspection
360 set ups  ₦327.25 117,810
80 set ups  ₦327.25 26,180
960 set ups  ₦327.25 314,160
Materials handling
40 movements  ₦654.50 26,180
80 movements  ₦654.50 52,360
280 movements  ₦654.50 183,260
Machinery operations
1,125 hours  ₦8.40 9,450
1,250 hours  ₦8.40 10,500
21,000 hours  ₦8.40 176,400
Overhead costs per product 198,320 156,360 954,320

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Chapter 2: Overview of cost planning and control

Example (continued): ABC

Step 3: Calculate overhead per unit (if required)
X Y Z
Overhead costs per product
(from step 2) ₦198,320 ₦156,360 ₦954,320
Number of units 1,500 2,500 14,000
Overhead cost per unit ₦132.21 ₦62.54 ₦68.17

Step 4: Calculate total production cost per unit (if required)

Production cost per unit: ABC X Y Z
₦ ₦ ₦
Direct materials 100.00 60.00 120.00
Direct labour 40.00 120.00 80.00
Production overhead (from step3) 132.21 62.54 68.17
Full production cost per unit 272.21 242.50 268.17

Although ABC is a form of absorption costing, the effect of ABC could be to

allocate overheads in a completely different way between products. Product costs
and product profitability will therefore be very different with ABC compared with
traditional absorption costing.

6.5 When using ABC might be appropriate

Activity-based costing could be suitable as a method of costing in the following
circumstances:
 In a manufacturing environment, where absorption costing is required for
inventory valuations.
 Where a large proportion of production costs are overhead costs, and direct
labour costs are relatively small.
 Where products are complex.
 Where products are provided to customer specifications.
 Where order sizes differ substantially, and order handling and despatch
activity costs are significant.

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6.6 Advantages and disadvantages of ABC

Advantages
 ABC provides useful information about the activities that drive overhead
costs. Traditional absorption costing and marginal costing do not do this.
 ABC also provides information that could be relevant to long-term cost
control and long-term product selection or product pricing.
 With ABC, overheads are charged to products on the basis of the activities
that are required to provide the product: Each product should therefore be
charged with a ‘fair share’ of overhead cost that represents the activities
that go into making and selling it.
 It might be argued that full product costs obtained with ABC are more
‘realistic’, although it can also be argued that full product cost information is
actually of little practical use or meaning for management.
 There is also an argument that in the long-run, all overhead costs are
variable (even though they are fixed in the short-term). Measuring costs
with ABC might therefore provide management with useful information for
controlling activities and long-term costs.

Disadvantages
 ABC systems are costly to design and use. The costs might not justify the
benefits.
 The analysis of costs in an ABC system may be based on unreliable data
and weak assumptions. In particular, ABC systems may be based on
inappropriate activities and cost pools, and incorrect assumptions about
cost drivers.
 ABC provides an analysis of historical costs. Decision-making by
management should be based on expectations of future cash flows.
 Within ABC systems, there is still a large amount of overhead cost
apportionment. General overhead costs such as rental costs, insurance
costs and heating and lighting costs may be apportioned between cost
pools. This reduces the causal link between the cost driver and the activity
cost.
 Many ABC systems are based on just a small number of cost pools and
cost drivers. More complex systems are difficult to justify, on grounds of
cost.
 Identifying the most suitable cost driver for a cost pool/activity is often
difficult. Many activities and cost pools have more than one cost driver.
 Traditional cost accounting systems may be more appropriate for the
purpose of inventory valuation and financial reporting.

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Chapter 2: Overview of cost planning and control

7 ETHICS IN PERFORMANCE MANAGEMENT

Section overview

 ICAN’s Code of Ethics

 Threats for accountants in business
 Preparation and reporting of accounting information

7.1 ICAN’s Code of Ethics

Accountants in business may sometimes find themselves in a situation where
their professional values are in conflict with their responsibilities in their job.
ICAN’s Professional Code of Conduct provides rules and guidance that members
and student members must follow when ethical issues arise.
ICAN’s Code of Ethics sets out five fundamental principles of ethical behaviour
for accountants. These are:
 integrity;
 objectivity: accountants should not allow bias, conflicts of interest or undue
influence of others to override their objectivity and judgement;
 professional competence and due care: accountants have a duty to
maintain their professional knowledge and skill and they should not
undertake work where they do not have sufficient knowledge to do the work
well;
 confidentiality: accountants must respect the confidentiality of information
acquired in their work and should not disclose such information to third
parties without authority; and
 professional behaviour.
Integrity
Members should be straightforward and honest in all professional and business
relationships. Integrity implies not just honesty but also fair dealing and
truthfulness.
For example, an accountant preparing performance information must not be
associated with reports, returns, or any other communications where they believe
that the information:
 Contains a materially false or misleading statement;
 Contains statements or information furnished recklessly; or
 Omits or obscures information where the omission or obscurity would be
misleading.

7.2 Threats for accountants in business

Working for an employer should have no bearing on the requirement for
accountants to respect the five fundamental principles. The work of accountants
will often further the aims of their employer, and this is not a problem except
when circumstances arise that create a conflict with their duty to comply with the

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Performance management

fundamental principles. Threats to compliance with the fundamental principles

may arise due to:
 self-interest;
 self-review;
 advocacy;
 familiarity; and
 intimidation.
Accountants in business are often responsible for the preparation of accounting
information.
They must not prepare financial information in a way that is misleading. However
threats to compliance with the fundamental principles may arise in the area of
performance management, for example where accountants may be tempted or
may come under pressure to produce misleading performance reports or
forecasts.
Accountants responsible for the preparation of financial information must ensure
that the information is technically correct and is adequately disclosed.
There is danger of influence from senior managers to present figures that inflate
profits or assets. This puts the accountant in a difficult position. On one hand,
they wish to prepare proper information and on the other hand, there is a
possibility they might lose their job if they do not comply with their manager’s
wishes.

Self- interest threats

Self-interest threats may occur as a result of the financial or other personal
interests of an accountant or their immediate or close family members. Self-
interest may tempt an accountant to withhold information that might damage
them financially or get them into trouble with their bosses.
Examples of circumstances that may create self-interest threats in performance
management include:
 Incentive compensation arrangements: an accountant’s bonus may depend
on improvements in reported efficiencies or profitability
 Inappropriate personal use of company assets
 Concern about job security
 Commercial pressures from outside the employing organisation.

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Chapter 2: Overview of cost planning and control

Example: Self- interest threats

Adeola is member of ICAN working as a unit accountant.
He is a member of a bonus scheme under which staff receive a bonus of 10% of
their annual salary if costs for the year are less than budget.
Adeola has been preparing a report on costs, and he has found that by omitting
some items of cost, the reported costs will just come in under budget, making him
(and his colleagues) eligible for their bonus.
Analysis:
Adeola faces a self-interest threat. He must ignore the temptation to falsify the
cost figures.

Self-review threats
Self-review threats occur when a previous judgement or decision is reviewed by
the person who made the original judgement or decision. The temptation may be
for the individual concerned to confirm on review that the original judgement or
decision was correct - when it was not - instead of admitting a mistake.

Example: Self-interest threat

Kunle, an accountant with a manufacturing company, worked on a costing exercise
for a new product. He estimated that the unit cost for the new product would be
₦100. However, he made several mistakes in his cost estimate and the actual unit
cost was 40% higher than he had stated.
After the product went into production, Kunle was asked to review his original cost
estimate and report on its accuracy. On carrying out the review, Kunle was alarmed
to find the errors he had made and was concerned that admitting his mistake
would damage his career prospects with his employer. He was therefore tempted
to report that actual unit costs for the product were very close to his original
estimate.
Analysis:
Kunle faces a threat to his integrity and objectivity from this self-review.
Kunle must admit his mistake and report the ‘correct’ actual cost of the new
product.

Advocacy threats
An accountant in business may often need to promote the organisation’s position
by providing financial information. As long as information provided is neither false
nor misleading such actions would not create an advocacy threat.

Familiarity threats
Familiarity threats occur when, because of a close relationship, members
become too sympathetic to the interests of others. Examples of circumstances
that may create familiarity threats include:

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Performance management

 An accountant being in a position to influence financial or non-financial

reporting or business decisions where an immediate or close family
member is in a position to benefit from that influence.
 Long association with business contacts can influence the contents of a
performance report.

Intimidation threats
Intimidation threats occur when an individual’s conduct is influenced by fear or
threats (for example, from an aggressive and dominating boss).
Examples of circumstances that may create intimidation threats include:
 Threat of dismissal or replacement over a disagreement about the way in
which performance information is to be reported.
 A dominant personality attempting inappropriately to influence the content
of a report.

7.3 Preparation and reporting of accounting information

Performance reporting involves the preparation and reporting of information that
is used mostly by managers inside the employing organisation. Such information
may include financial or management information, for example:
 forecasts and budgets;
 performance statements; and
 performance analysis.
Information must be prepared and presented honestly.
Threats to compliance with the fundamental principles, for example self-interest
threats or intimidation threats to objectivity or professional competence and due
care, may be created where an accountant in business is pressured (either by a
boss or by the possibility of personal gain) to become associated with misleading
information.
The significance of such threats will depend on factors such as the source of the
pressure and the degree to which the information is, or may be, misleading.
The significance of the threats should be evaluated and unless they are clearly
insignificant, safeguards should be considered and applied as necessary to
eliminate them or reduce them to an acceptable level. Such safeguards may
include consultation with a senior manager within the employing organisation.
Where it is not possible to reduce the threat to an acceptable level, an
accountant should refuse to remain associated with information they consider is
or may be misleading.

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Chapter 2: Overview of cost planning and control

8 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Calculate fixed and variable costs by using high-low points method
 Calculate fixed and variable costs by using regression analysis
 Calculate profit using total absorption costing and marginal costing and explain
the difference
 Explain the difference between traditional volume based absorption methods and
activity-based costing
 Apportion overheads using activity-based costing
 Estimate unit cost using activity-based costing
 Discuss ethical issues in performance management and compliance with ICAN’s
Code of Ethics

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Performance management

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
Operating statements can be prepared as follows:
MC TAC
Sales (18,000  ₦35) 630,000 630,000
Cost of sales
MC = (18,000  ₦8) (144,000)
TAC = (18,000  ₦14) (252,000)
Fixed production cost (120,000)
366,000 378,000

The profit figures are reconciled as follows:

Units
Opening inventory 2,000
Closing inventory (4,000)
Increase 2,000
Difference in cost per unit ₦6
₦12,000
₦
MC profit 366,000
Inventory valuation difference 12,000
TAC profit 378,000

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Chapter 2: Overview of cost planning and control

Solutions 2

a) Marginal cost profit statement.

Per unit
Units (₦) ₦000
Sales (balancing figure) 26,000 50 1,300
Cost of sales
Opening inventory 2,000 30 60
Actual production 25,500 30 765
Closing inventory (1,500) 30 (45)
26,000 30 (780)
Fixed costs (25,000  ₦4) (100)
420
Alternatively:
Marginal cost profit statement. ₦000
Sales (26,000 units  ₦50) 1,300
Variable production costs (26,000  ₦30) (780)
Fixed costs (25,000  ₦4) (100)
Marginal cost profit 420

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Performance management

Solutions (continued) 2
b) Absorption cost profit statement
Per unit
Units (₦) ₦000
Sales 26,000 50 1,300
Cost of sales
Opening inventory 2,000 34 68
Actual production
Variable production costs 25,500 30 765
Fixed production costs Over 25,500 4 102
absorption (500) 4 (2)
865
Closing inventory (1,500) 34 (51)
26,000 34 (882)
418
Alternatively:
b) Absorption cost profit statement ₦000
Sales (26,000 units  ₦50) 1,300
Variable costs (26,000  ₦30) (780)
Fixed costs (26,000  ₦4) (104)
Over absorption of fixed overhead (500 units  ₦4) 2
418

The profit figures are reconciled as follows:

Units
Opening inventory 2,000
Closing inventory 1,500
Decrease 500
Difference in cost per unit ₦4
₦2,000
₦
MC profit 420,000
Inventory valuation difference (2,000)
TAC profit 418,000

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3
Skills level
Performance management

CHAPTER
Modern management
accounting techniques

Contents
1 The relevance of traditional management accounting
systems
2 Target costing
3 Life cycle costing
4 Throughput accounting
5 Backflush accounting
6 Environmental accounting
7 Kaizen costing
8 Product profitability analysis
9 Segment profitability analysis
10 Chapter review

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INTRODUCTION
Aim
Performance management develops and deepens candidates’ capability to provide
information and decision support to management in operational and strategic contexts with a
focus on linking costing, management accounting and quantitative methods to critical
success factors and operational strategic objectives whether financial, operational or with a
social purpose. Candidates are expected to be capable of analysing financial and non-
financial data and information to support management decisions.

Detailed syllabus
The detailed syllabus includes the following:
A Cost planning and control
2 Cost planning and control for competitive advantage
a Discuss and apply the principles of:
i Target costing;
ii Life cycle costing;
iii Theory of constraints (TOC);
iv Throughput accounting;
v Back flush accounting;
vi Environmental accounting; and
vii Kaizen costing.

D Decision making
1 Advanced decision-making and decision-support
c Apply relevant cost concept to short term management decisions
including …… product and segment profitability analysis, etc.

Exam context
This chapter explains each of the above topics in turn.

By the end of this chapter, you should be able to:

 Describe target costing and how target cost is determined
 Apply the target costing tools to given scenarios
 Explain lifecycle costing
 Explain throughput accounting and solve throughput accounting problems
 Explain and apply backflush accounting
 Explain and apply environmental accounting
 Explain Kaizen costing
 Explain and calculate product profitability
 Explain and calculate segment profitability using full cost and contribution approaches

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Chapter 3: Modern management accounting techniques

1 THE RELEVANCE OF TRADITIONAL MANAGEMENT ACCOUNTING

SYSTEMS

Section overview

 The purpose of management accounting systems

 Are traditional management accounting methods still relevant?
 Kaplan: ‘relevance lost’
 Problems with standard costing and variances
 The continuing relevance of standard costing systems
 Making management accounting relevant
 Trends in management accounting

1.1 The purpose of management accounting systems

A management accounting system is a part of the management information
system within an organisation. The purpose of management accounting is to
provide information to managers that can be used to help them with making
decisions. Traditionally, management accounting systems have provided financial
or accounting information, obtained from accounting records and other data
within the organisation. Commonly-used management accounting techniques
have included absorption costing, marginal costing and cost-volume-profit
analysis, budgeting, standard costing and budgetary control and variance
analysis.
For various reasons, questions have been raised about the relevance of
traditional management accounting to the needs of management in the modern
business environment.
 Traditional management accounting techniques such as standard costing
and variance analysis do not provide all the information that managers
need in manufacturing companies where Total Quality Management or Just
in Time management approaches are used.
 Traditional absorption costing is probably of limited value in a
manufacturing environment where production processes are highly
automated, and production overhead costs is a much more significant
element of cost than direct labour.
 Traditional management accounting focuses on manufacturing costs,
whereas many companies (and other organisations) operate in service
industries and provide services rather than manufactured products.
 The traditional focus of management accounting has been on cost control
or cost reduction. Lower costs mean that lower prices can be charged to
customers, or higher profits can be made. However, many companies now
seek to increase customer satisfaction and meet customer needs. To meet
customer needs, other factors in addition to cost can be important –
particularly product (or service) quality. Traditional management accounting
ignores factors such as quality, reliability or speed of service.

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 Many traditional management accounting techniques have a short-term

focus. There are exceptions. Discounted cash flow, for example, is used to
evaluate long-term capital projects. However, traditional management
accounting systems do not provide senior managers with the information
they need for making strategic decisions. Strategic decision-making needs
information about competitors, customers, developments in technology and
other environmental (external) factors.
Management information systems should be capable of providing the information
that managers need. For the management accounting system to be the main
management information system within an organisation, it must be able to
provide the necessary variety of information – financial and non-financial, long-
term as well as short-term – using suitable techniques of analysis.

1.2 Are traditional management accounting methods still relevant?

Many businesses compete with each other on the basis of:
 product or service quality and price
 delivery
 reliability
 after-sales service
 customer satisfaction – meeting customer needs.
These are critical variables in competitive markets and industries. Business
organisations, faced with an increasingly competitive global market environment,
must be able to deliver what the customer wants more successfully than their
rivals. This means making sure that they provide quality for the price, and
customer satisfaction, including the delivery, reliability and after-sales service that
customers want or expect.

1.3 Kaplan: ‘relevance lost’

Some years ago, Robert Kaplan put forward an argument that management
accounting systems had lost their relevance and did not provide the information
that managers need to make their decisions.
He suggested that the information needs of management had changed, but the
information provided by management accountants had not. There was a danger
that management accounting would lose its relevance – and value – entirely.
Kaplan made the following criticisms of traditional management accounting
systems:
 Traditional overhead costing systems, where overheads were absorbed
into costs at a rate per direct labour hour, were irrelevant. (Activity based
costing has been developed as just one alternative for overhead cost
analysis.)
 Standard costing systems are largely irrelevant, because in many markets
customers do not want to buy standard products. They want product
differentiation.

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 Traditional management accounting systems fail to provide information

about aspects of performance that matter – product and service quality
(and price), delivery, reliability, after-sales service and customer
satisfaction.
He argued that in today’s competitive market environment ‘traditional cost
accounting systems based on an assumption of long production runs of a
standard product, with unchanging characteristics and specifications, [are not]
relevant in this new environment.’

The need for a change of focus in providing information to management

Traditional management accounting systems focus on reducing costs and
budgetary control of costs. Kaplan argued that the focus was wrong:
 In modern production systems, products are often designed and
manufactured to specific customer demands and often have a short life
cycle. Their design is often sophisticated, and they are overhead-intensive.
Traditional management accounting systems, in contrast, assume standard
products whose manufacture is directly labour-intensive.
 Machinery used in production is often flexible, and can be switched
between different uses and purposes. Traditional manufacturing systems
assume that standard tasks require particular types of machine. Although
they may focus on minimising the machine time per product manufactured,
these systems do not provide information to help with optimising the use of
available multi-purpose machinery.

1.4 Problems with standard costing and variances

Kaplan and Johnson have argued that standard costing and standard cost
variances should not be used in a modern manufacturing environment for either:
 cost control, or
 performance measurement.
They argued that standard costs are no longer relevant in a modern
manufacturing environment. Standard costing is used for standard products and
the focus is on keeping production costs under control.
Kaplan and Johnson argued that using variance analysis to control costs and
measure performance is inconsistent with a focus on the objectives of
quality, time and innovation, which are now key factors in successful
manufacturing operations.
 Standard cost variances ignore quality issues and ignore quality costs.
However, in a competitive market quality is a key success factor.
 When a company relies for success on innovation and new product design,
many of its resources are committed to product design and development,
and so many of its costs are incurred at this early stage of the product’s life.
Cost control should therefore focus on design and development costs,
whereas standard costing provides information about production costs for
products that have already been developed and are now in production.

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 When product design and innovation are important, product life cycles will
be short. It may therefore be appropriate to look at all the costs of a product
over its full life cycle (including its design and development stages, and
including marketing costs as well as production costs).
 Standard costing variance analysis is restricted to monitoring the
manufacturing costs of products during just a part of their life cycle.
 Standard costs are only likely to apply in a stable and non-changing
business environment. In many industries, the environment is continually
changing, and products are adapted to meet the changing circumstances
and conditions.

1.5 The continuing relevance of standard costing systems

However, there are still some advantages to be obtained from using a standard
costing system.
 Standard costs can be a useful aid for budgeting even in a Total Quality
Management environment. Standard costs can be established for making
products within the budget period to a target level of quality. If the TQM
goals of continuous improvement and elimination of waste are achieved,
the standard costs can be adjusted down for the next budget period.
 Managers need short-term (‘real time’) feedback on costs. They need to
know whether costs are under control, and they also need to understand
the financial consequences of their decisions and actions. Variance
analysis is a useful method of providing ‘real time’ feedback on costs.
 Cost control is still an important aspect of management control. Quality,
time and innovation may be critical factors, but so too is cost control.
Standard costing and variance analysis provides a system for controlling
costs in the short term.
 Standard costs for existing products can provide a useful starting point for
planning the cost for new products.
 Standard costs can also be useful for target costing. The difference
between the target cost for a product and its current standard cost is a ‘cost
gap’. Standard costs can be used to measure the size of the cost gap. In
order to achieve the target cost, managers can focus on this cost gap and
consider ways in which it can be closed.
 Overhead variances can provide useful information for cost control when
many overhead costs are volume-driven.

1.6 Making management accounting relevant

If it is accepted that traditional management accounting systems are no longer
relevant to the information needs of managers in a competitive business world,
the obvious next question is what has to be done to make them relevant?
The suggested answer is that management accounting systems need to
recognise the factors that are critical for business success that management
need to know about. These factors may be:
 non-financial, as well as financial;

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Chapter 3: Modern management accounting techniques

 longer-term (strategic) in nature, as well as short-term;

 strategic (concerned with objectives and strategies), as well as tactical
(concerned with day-to-day management control); and
 related to factors in the business environment as well as to factors within
the business entity itself (in other words, making use of external as well as
internal information).

1.7 Trends in management accounting

New techniques have been developed in management accounting, in response
to changes in the business environment.
Examples of techniques that have been developed include:
 target costing;
 life cycle costing;
 product profitability analysis;
 segment profitability analysis;
 throughput accounting;
 backflush accounting;
 activity based management; and
 balanced scorecard (covered in an earlier chapter)
Some of these techniques have been developed in response to changes in
manufacturing methods and systems.

Evaluating a management accounting technique

Management accounting techniques used in practice will vary with the particular
information needs of the organisation.
The management accounting techniques used within an organisation must
provide information that management need and will use. The key questions to
ask, when assessing the usefulness of a management accounting system, are as
follows:
The information needs of management
What decisions do managers need to make?
What are the key factors that will affect their decisions?
What are the critical items of information they need for their decisions?
The information provided by the management accounting system
 Is the information provided:
 relevant to the decision-making needs of the managers?
 sufficiently comprehensive for these needs?
 reliable?
 available when needed?

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Performance management

 Is the information provided in a clear and understandable form?

 Are key items of information drawn to the attention of the manager, such as
issues relating to controllability, trend or materiality?
 Does the benefit of having the information justify the cost of providing it?

Chapter 3: Modern management accounting techniques

2 TARGET COSTING

Section overview

 Origins of target costing

 The purpose of target costing
 The target costing method
 Elements in the estimated cost and target cost
 Closing the target cost gap
 Advantages of target costing
 The implications of using target costing
 Target costing and services
 Comprehensive example

2.1 Origins of target costing

Target costing originated in Japan in the 1970s. It began with recognition that
customers were demanding more diversity in products that they bought, and the
life cycles of products were getting shorter. This meant that new products had to
be designed more frequently to meet customer demands.
Companies then became aware that a large proportion of the costs of making a
product are committed at the design stage, before the product goes into
manufacture. The design stage was therefore critical for ensuring that new
products could be manufactured at a cost that would enable the product to make
a profit for the company.

2.2 The purpose of target costing

Target costing is a method of strategic management of costs and profits. As its
name suggests, target costing involves setting a target or objective for the
maximum cost of a product or service, and then working out how to achieve this
target.
It is used for business strategy in general and marketing strategy in particular, by
companies that operate in a competitive market where new products are
continually being introduced to the market. In order to compete successfully,
companies need to be able to:
 continually improve their existing products or design new ones
 sell their products at a competitive price; this might be the same price that
competitors are charging or a lower price than competitors, and
 make a profit.
© Emile Woolf International 80 The Institute of Chartered Accountants of Nigeria
In order to make a profit, companies need to make the product at a cost below
the expected sales price.

Target costing and new product development

Target costing is used mainly for new product development. This is because
whenever a new product is designed and developed for a competitive market, a
company needs to know what the maximum cost of the new product must be so
that it will sell at a profit.
A company might decide the price that it would like to charge for a new product
under development, in order to win a target share of the market. The company
then decides on the level of profitability that it wants to achieve for the product, in
order to make the required return on investment. Having identified a target price
and a target profit, the company then establishes a target cost for the product.
This is the cost at which the product must be manufactured and sold in order to
achieve the target profits and return at the strategic market price.
Keeping the costs of the product within the target level is then a major factor in
controlling its design and development.

Illustration: Target cost

New product design and development ₦

Decide: The target sales price X
Deduct: The target profit margin (X)
Equals: The target cost (maximum cost in order to meet or
exceed the target profit) X

The reason that target costing is used for new products, as suggested earlier, is
that the opportunities for cutting costs to meet a target cost are much greater
during the product design stage than after the product development has been
completed and the production process has been set up.
 Typically, when a new product is designed, the first consideration is to
design a product that will meet the needs of customers better than rival
products. However, this initial product design might result in a product with
a cost that is too high, and which will therefore not be profitable.
 The estimated cost of a product design can be compared with the target
cost. If the expected cost is higher than the target cost, there is a cost ‘gap’.
 A cost gap must be closed by finding ways of making the product more
cheaply without losing any of the features that should make it attractive to
customers and give it ‘value’. For example, it might be possible to simplify
that product design or the production process without losing any important
feature of the product. It might also be possible to re-design the product
using a different and cheaper material, without loss of ‘value’.
 Having worked out how to reduce costs at the product design stage,
management should try to ensure that the product is developed and the
method of producing it is introduced according to plan, so that the target
cost is achieved.

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2.3 The target costing method

The principles of target costing may therefore be summarised as follows.
Target costing is based on the idea that when a new product is developed, a
company will have a reasonable idea about:
 the price at which it will be able to sell the product, and
 the sales volumes that it will be able to achieve for the product over its
expected life.
There may also be estimates of the capital investment required, and any
incremental fixed costs (such as marketing costs or costs of additional salaried
staff).

Taking estimates of sales volumes, capital investment requirements and

incremental fixed costs over the life cycle of the product, it should be possible to
calculate a target cost.
 The target cost for the product might be the maximum cost for the product
that will provide at least the minimum required return on investment.
 However, an examination question might expect you to calculate the target
cost from a target selling price and a target profit margin.
The elements in the target costing process are shown in the diagram below.

Illustration: Target costing

2.4 Elements in the estimated cost and target cost

A problem with target costing is to make sure that the estimates of cost are
realistic. It is difficult to measure the cost of a product that has not yet been
created, and the cost must include items such as raw material wastage rates and
direct labour idle time, if these might be expected to occur in practice.

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Raw materials costs

The target cost should allow for expected wastage rates or loss in processing.
The price of materials should also allow for any possible increases up to the time
when the new product development has been completed. Estimating prices of
materials can be difficult when prices are volatile – such as commodity prices,
which can be subject to large increases and falls within relatively short periods of
time.

Direct labour
The target cost should allow for any expected idle time that will occur during the
manufacture of the product. This might be the normal level of idle time in the
company’s manufacturing operations.

Production overheads
A target cost could be a target marginal cost. However production overhead costs
are often a large proportion of total manufacturing costs, and it is therefore more
likely that the target cost will be a full cost, including production overheads. If
activity-based costing is used, it might be possible to identify opportunities for
limiting the amount of production overheads absorbed into the product cost by
designing the product in a way that limits the use of activities that drive costs, for
example by reducing the need for materials movements or quality inspections.

Example: Target costing

A company has designed a new product. NP8. It currently estimates that in the
current market, the product could be sold for ₦70 per unit. A gross profit margin
of at least 30% on the selling price would be required, to cover administration
and marketing overheads and to make an acceptable level of profit.
A cost estimation study has produced the following estimate of production cost
for NP8.
Cost item
Direct material M1 ₦9 per unit
Direct material M2 Each unit of product NP8 will require three metres of
material M2, but there will be loss in production of
10% of the material used. Material M2 costs ₦1.80
per metre.
Direct labour Each unit of product NP8 will require 0.50 hours of
direct labour time. However it is expected that there
will be unavoidable idle time equal to 5% of the total
labour time paid for. Labour is paid ₦19 per hour.
Production It is expected that production overheads wil lbe
overheads absorbed into product costs at the rate of ₦60 per
direct labour hour, for each active hour worked.
(Overheads are not absorbed into the cost of idle time.)
Required
Calculate:
(a) the expected cost of Product NP8
(b) the target cost for NP8
(c) the size of the cost gap.

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Answer
a) Expected cost per unit ₦ ₦
Direct material M1 9.0
Direct material M2: 3 metres  100/90  6.0
₦1.80
Direct labour: 0.5 hours  100/95  ₦19 10.0
Production overheads: 0.5 hours  ₦60 30.0
Expected full cost per unit 55.0
b) Target cost
Sales price 70.0
Minimum gross profit margin (30%) 21.0
Target cost 49.0
c) Cost gap 6.0
The company needs to identify ways of closing this cost gap.

2.5 Closing the target cost gap

Target costs are rarely achievable immediately and ways must be found to
reduce costs and close the cost gap.
Target costing should involve a multi-disciplinary approach to resolving the
problem of how to close the cost gap. The management accountant should be
involved in measuring estimated costs. Ways of reducing costs might be in
product design and engineering, manufacturing processes used, selling methods
and raw materials purchasing. Ideas for reducing costs can therefore come from
the sales, manufacturing, engineering or purchasing departments.
Common methods of closing the target cost gap are:
 To re-design products to make use of common processes and components
that are already used in the manufacture of other products by the company.
 To discuss with key suppliers methods of reducing materials costs. Target
costing involves the entire ‘value chain’ from original suppliers of raw
materials to the customer for the end-product, and negotiations and
collaborations with suppliers might be an appropriate method of finding
important reductions in cost.
 To eliminate non value-added activities or non-value added features of the
product design. Something is ‘non-value added’ if it fails to add anything of
value for the customer. The cost of non-value added product features or
activities can therefore be saved without any loss of value for the customer.
Value analysis may be used to systematically examine all aspects of a
product cost to provide the product at the required quality at the lowest
possible cost.
 To train staff in more efficient techniques and working methods.
Improvements in efficiency will reduce costs.

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 To achieve economies of scale. Producing in larger quantities will reduce

unit costs because fixed overhead costs will be spread over a larger
quantity of products. However, production in larger quantities is of no
benefit unless sales demand can be increased by the same amount.

2.6 Advantages of target costing

There are several possible advantages from the use of target costing.
 It helps to improve the understanding within a company of product costs.
 It recognises that the most effective way of reducing costs is to plan and
control costs from the product design stage onwards.
 It helps to create a focus on the final customer for the product or service,
because the concept of ‘value’ is important: target costs should be
achieved without loss of value for the customer.
 It is a multi-disciplinary approach, and considers the entire supply chain. It
could therefore help to promote co-operation, both between departments
within a company and also between a company and its suppliers and
customers.
 Target costing can be used together with recognised methods for reducing
costs, such as value analysis, value engineering, just in time purchasing
and production, Total Quality Management and continuous improvement.

2.7 The implications of using target costing

The use of a target costing system has implications for pricing, cost control and
performance measurement.
Target costing can be used with pricing policy for a company’s products or
services. A company might decide on a target selling price for either a new or an
existing product, which it considers necessary in order to win market share or
achieve a target volume of sales. Having identified the selling price that it wants
for the product, the company can then work out a target cost.
Cost control and performance measurement has a different emphasis when
target costing is used.
 Cost savings are actively sought and made continuously over the life of the
product
 There is joint responsibility for achieving benchmark savings. If one
department fails to deliver the cost savings expected, other departments
may find ways to achieve the savings
 Staff are trained and empowered to find new ways to reduce costs while
maintaining the required quality.
Target costing is more likely to succeed in a company where a culture of
‘continuous improvement’ exists.

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2.8 Target costing and services

Target costing can be used for services as well as products. Services vary widely
in nature, and it is impossible to make general statements that apply to all types
of services. However, features of some service industries that make them
different from manufacturing are as follows.
 Some service industries are labour-intensive, and direct materials costs are
only a small part of total cost. Opportunities for achieving reductions in
materials costs may therefore be small.
 Overhead costs in many services are very high. Effective target costing will
therefore require a focus on how to reduce overhead costs.
A service company might deliver a number of different services through the same
delivery system, using the same employees and the same assets. Introducing
new services or amendments to existing services therefore means adding to the
work burden of employees and the diversity or complexity of the work they do.
 A system of target costing therefore needs to focus on quality of service
and value for the customer. Introducing a new service might involve a loss
of value in the delivery of existing services to customers. For example,
adding a new service to a telephone call centre could result in longer
waiting times for callers.
 New services might be introduced without proper consideration being given
to whether the service is actually profitable. For example, a restaurant
might add additional items to its menu, in the belief that the only additional
cost is the cost of the food. In practice there would be implications for the
purchasing and preparation of the food and possibly also for the delivery of
food from the kitchen to the restaurant dining area. New items added to the
menu might therefore make losses unless all aspects of cost are properly
considered.
 When a single delivery system is used for services, the cost of services will
consist largely of allocated and apportioned overheads. For target costing
to be successful, there must be a consistent and ‘fair’ method of attributing
overhead costs to services (both existing services and new services).
 Services might be provided by not-for-profit entities. For example, health
services might be provided free of charge by the government. When
services are provided free of charge, target costing can be used for new
services. However, it is doubtful whether concepts of ‘target price’ and
‘target profit’ can be used by a not-for-profit entity. This raises questions
about how to decide what the target cost should be.

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2.9 Comprehensive example

Example: Target costing

A company wishes to introduce a new product to the market.
The company estimates the market for the product to be 50,000 units.
The company uses target costing.
Current projected costs are as follows:
₦‘000
Manufacturing cost
Bought in parts (100 components) 50,000
Direct labour (assembly of components)
10 hours  ₦500 per hour 5,000
Machine costs (750,000,000 ÷ 50,000) 15,000
Ordering and receiving
(500 orders  100 components ₦500 per order) ÷ 50,000
units 500
Quality assurance (10 hours  ₦800 per hour) 8,000
Rework costs
10% (probability of failure)  ₦10,000 (cost of rework) 1,000

Nonmanufacturing costs
Distribution 10,000
Warranty costs
10% (probability of recall)  ₦15,000 (cost to correct) 1,500
91,000

Target selling price (₦) 100,000

Target margin 20%
Target profit (₦) 20,000
Target cost (₦) 80,000

The company has undertaken market research which found that several
proposed features of the new product were not valued by customers.
Redesign to remove the features leads to a reduction in the number of
components down to 80 components and a direct material cost reduction of
12%.
The reduction in complexity has other impacts:
1. Assembly time will be reduced by 20%.
2. Quality assurance will only require 6 hours.
3. The probability of a failure at the inspection stage will fall to 5%.
4. The probability of an after-sales failure will also fall to 5%.
5. Cost of warranty corrections will fall by ₦2,000.
6. Reduced weight of the product will reduce shipping costs by ₦1,000 per
unit.

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Example (continued): Target costing

The revised projected costs are as follows:
Before After
₦‘000 ₦‘000
Manufacturing cost
Bought in parts (100 components) 50,000
Bought in parts (80 components with 12% reduction) 44,000
Direct labour (assembly of components)
10 hours  ₦500 per hour 5,000
8 hours  ₦500 per hour (10% reduction) 4,000
Machine costs (750,000,000 ÷ 50,000) 15,000 15,000
Ordering and receiving
500 orders  100 components  ₦500 per order/50,000 units 500
500 orders  80 components  ₦500 per order/50,000 units 400
Quality assurance
10 hours  ₦800 per hour 8,000
6 hours  ₦800 per hour 4,800
Rework costs
10%  ₦10,000 1,000
5%  ₦10,000 500
Nonmanufacturing costs
Distribution 10,000 9,000
Warranty costs
10%  ₦15,000 1,500
5%  ₦13,000 650
91,000 78,350
The target cost is achieved.

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3 LIFE CYCLE COSTING

Section overview

 The nature of life cycle costing (LCC)

 Asset acquisitions
 Life cycle costing and building construction
 Life cycle costing and the product life cycle

3.1 The nature of life cycle costing (LCC)

Life cycle costing is sometimes called ‘whole life costing’ or ‘whole life cycle
costing’. It is a technique that attempts to identify the total cost associated with
the ownership of an asset so that decisions can be made about asset
acquisitions. It recognises that decisions made at the initial acquisition have the
effect of locking in certain costs in the future.
The principles of LCC can be applied to both complex and to simple acquisitions.
 As a simple example if a person buys a new printer that person is
committed to buying toner cartridges that are compatible to the printer.
Thus in choosing between two printers the initial cost of one might be less
than the other but its toner cartridges might be more expensive. Life cycle
cost analysis would allow a choice to be made based on the total life time
costs.
 A company will of course be concerned with cost when it buys a complex
asset of some kind but it will also be concerned with reliability, servicing
time, maintenance costs etc.
Life cycle costing can be applied to:
 Major asset acquisitions.
 Introduction of new products to the market.

3.2 Asset acquisitions

The cost of ownership of an asset is incurred throughout its life and not just at
acquisition. A decision made at the purchase stage will determine future costs
associated with an asset.

Life cycle costs

The costs of a product or asset over its life cycle could be divided into three
categories:
 Acquisition costs, set-up costs or market entry costs. These are costs
incurred initially to bring the product into production and to start selling it, or
the costs incurred to complete the construction of a building or other major
construction asset
 Operational costs or running costs throughout the life of the product or
asset

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 End-of-life costs. These are the costs incurred to withdraw a product from
the market or to demolish the asset at the end of its life.
Acquisition costs or set-up costs are usually ‘one-off’ capital expenditures and
other once-only costs, such as the costs of training staff and establishing systems
of documentation and performance reporting. Similarly, end-of-life costs are ‘one-
off’ items that occur just once.
Running costs or operational costs are regular and recurring annual costs
throughout the life of the product or asset. However, these may vary over time:
for example maintenance costs for an item of equipment, such as the
maintenance costs of elevators in a building, are likely to increase over time as
the asset gets older.
Although costs are incurred throughout the life of an asset, a large proportion of
these costs are committed at a very early stage in the product’s life cycle, when
the decision to develop the new product or construct the new building is made.

Example: Life cycle costing

A transport company wishes to buy a new heavy goods vehicle which will be run for
100,000 miles and then sold.
It is considering two types.
The following information is relevant:
Lorry A Lorry B
Initial cost ₦10,000,000 ₦15,000,000
Cost per service ₦500,000 ₦400,000
Service required every: 10,000 miles 25,000 miles
Running costs per mile ₦750 ₦500
Scrap value at end of life ₦1,000,000 ₦3,000,000

The life cycle cost of each lorry based on the above is as follows:
₦ ₦
Capital cost:
Initial cost 10,000,000 15,000,000
Scrap value (1,000,000) (3,000,000)
9,000,000 12,000,000
Service costs
Life time use (miles) 100,000 100,000
Service frequency (miles) 10,000 25,000
Number of services 10 4
Cost per service 500,000 400,000
5,000,000 1,600,000
Running costs
Number of miles 100,000 100,000
Cost per mile (₦) 750 500
75,000,000 50,000,000
Lifecycle cost 89,000,000 63,600,000

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Life cycle costing methodology

A proper purchasing decision requires that the costs of all available options
should be taken into account. This involves cost identification and estimation and
discounting. (Discounting is a technique that takes into account the time value of
money. That is to say it recognises that ₦1 today is worth more than ₦1 in the
future).

Benefits of LCC include:

 Improved evaluation of options
 Improved management awareness about the consequences of decisions
 Improved forecasting
 Improved understanding of the trade off between performance of an asset
and its cost.

Problems with using LCC

 Availability of data
 It is difficult and time consuming
 Often organisations are structured in a way that different managers are
responsible for the purchase decision and the future operation of the asset.
Thus, even though the purchase decision locks in future costs the manager
making the acquisition has no incentive to consider LCC.

3.3 Life cycle costing and building construction

Life cycle costing is relevant to the construction of buildings and other major
items of construction. An international standard on life cycle costing for buildings
was published in 2008.
When a building is planned, several different designs might be considered. Each
design will have different construction features and therefore a different initial
capital cost. Over the life of the building, annual running costs will vary according
to the design that is selected. For example:
 Energy-efficient buildings will incur lower energy costs each year
 The choice of construction materials will affect the life of the building and
the annual costs of repairs and maintenance
 The choice of design could affect the costs of demolition at the end of the
life of the building.
When two or more different building designs are considered, the preferred design
might be:
 the design that will achieve the lowest total cost over the life of the building,
or
 the design that will provide the most value for money (or benefits less
costs) over the life of the building.

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3.4 Life cycle costing and the product life cycle

Most products made in large quantities for selling to customers go through a life
cycle which consists of several stages:
 product development stage
 product introduction to the market
 a period of growth in sales and market size
 a period of maturity
 a period of decline.
 withdrawal from the market.
The diagram below indicates typical characteristics of sales revenue and profit at
each stage.

Illustration: Product life cycle

At each phase of a product’s life cycle:

 selling prices will be altered;
 costs may differ;
 the amount invested (capital investment) may vary; and
 spending on advertising and other marketing activities may change.
LCC can be important in new product launches as a company will of course want
to make a profit from the new product and the technique considers the total costs
that must be recovered. These will include:
 research and development costs;
 training costs;
 machinery costs;
 production costs;
 distribution and selling costs;

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 marketing costs;
 working capital costs;
 retirement and disposal costs.
Decisions made at the development phase impact later costs.

Stage Costs
Product R&D costs
development
Capital expenditure decisions
Introduction to the Operating costs
market
Marketing and advertising to raise product awareness
(strong focus on market share)
Set up and expansion of distribution channels
Growth Costs of increasing capacity
Maybe learning effect and economies of scale
Increased costs of working capital
Maturity Incur costs to maintain manufacturing capacity
Marketing and product enhancement costs to extend
maturity
Decline Close attention to costs needed as withdrawal decision
might be expensive
Withdrawal Asset decommissioning costs
Possible restructuring costs
Remaining warranties to be supported

Benefits of LCC
Life cycle costing compares the revenues and costs of the product over its entire
life. This has many benefits.
 The potential profitability of products can be assessed before major
development of the product is carried out and costs incurred. Non-profit-
making products can be abandoned at an early stage before costs are
committed.
 Techniques can be used to reduce costs over the life of the product.
 Pricing strategy can be determined before the product enters production.
This may lead to better control of marketing and distribution costs.
 Attention can be focused on reducing the research and development phase
to get the product to market as quickly as possible. The longer the
company can operate without competitors entering the market the more
revenue can be earned and the sooner the product will reach the
breakeven point.

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 By monitoring the actual performance of products against plans, lessons

can be learnt to improve the performance of future products. It may also be
possible to improve the estimating techniques used.
An understanding of the product life cycle can also assist management with
decisions about:
 Pricing
 Performance management
 Decision-making.
Pricing. As a product moves from one stage in its life cycle to the next, a change
in pricing strategy might be necessary to maintain market share. For example,
prices might be reduced as a product enters its maturity phases (and annual
sales volume stops rising).
In addition, an understanding of life cycle costs help with strategic decisions
about price. Over the entire life of the product, sales prices should be sufficiently
high to ensure that a profit is made after taking into account all costs incurred –
start-up costs and end-of-life costs as well as annual operating costs.
Performance management. As a product moves from one stage of its life cycle
to another, its financial performance will change. Management should understand
that an improvement or decline in performance could be linked to changes in the
life cycle and should therefore (to some extent at least) be expected.
Decision-making. In addition to helping management with decisions on pricing,
an understanding of life cycle costing can also help with decisions about making
new investments in the product (new capital expenditure) or withdrawing a
product from the market.

4 THROUGHPUT ACCOUNTING

Section overview

 The nature of throughput accounting

 Assumptions in throughput accounting
 Throughput, inventory and operating expenses
 Profit and throughput accounting
 The value of inventory in throughput accounting
 Comparing throughput accounting with absorption costing and marginal costing
 Constraints and bottlenecks in the system
 Dealing with constraints
 The relevance of constraints to throughput accounting
 Performance measurement ratios in throughput accounting

4.1 The nature of throughput accounting

Throughput accounting is not really a costing system at all, because with costing
no costs are allocated to units of production, with the exception of materials
costs.

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 With traditional costing systems, the main focus of attention is on costs and
how to control or reduce costs.
 With throughput accounting, the main focus of attention is on how to
achieve the goals of the entity successfully. For profit-making companies,
the goals of the entity are assumed to be the maximisation of profit.
Throughput accounting is also associated with the Theory of Constraints. This is
a theory that states that an entity always has a constraint that sets a limit on the
achievement of its goals. The task of management should therefore be to:
 identify what this effective constraint is
 maximise the performance of the entity in achieving its goals, within the
limits of this constraint
 look for ways of removing the constraint, so that performance can be
improved still further.
Although they are different, throughput accounting has some close similarities
with marginal costing and limiting factor analysis, which you should be familiar
with from your earlier studies.

4.2 Assumptions in throughput accounting

Throughput accounting is based on a number of assumptions.
 In traditional marginal costing, it is assumed that direct labour costs are a
variable cost, but in practice this is not usually correct. Employees are paid
a fixed weekly or monthly wage or salary, and labour costs are a fixed cost.
 The only variable cost is the purchase cost of materials and components
purchased from external suppliers.
 A business makes real profit by adding value. Value is added by selling
goods or services to customers whose market value is more than the cost
of the materials that go into making them. However, value is not added until
the sale is actually made.
 Value added should be measured as the value of the sale minus the
variable cost of sales, which is the cost of the materials.

4.3 Throughput, inventory and operating expenses

Throughput accounting is based on three concepts:
 throughput;
 inventory (investment); and
 operating expenses.

Throughput
Throughput can be defined as the rate at which an entity achieves its goals,
measured in ‘goal units’. In not-for-profit entities, the goal of the entity could be
measured in terms of a non-financial goal. For profit-making entities, the goal is
profit, and:
Contribution = Sales minus total variable costs
Throughput differs from contribution in traditional marginal costing because
variable costs consist only of real variable costs, which are (mainly or entirely)
materials costs.
It is therefore appropriate to define throughput as:
© Emile Woolf International 97 The Institute of Chartered Accountants of Nigeria
Throughput = Sales minus cost of raw materials and components

Inventory (or investment)

Inventory or investment is all the money that is tied up in a business, in
inventories of raw materials, WIP and finished goods. The term ‘investment’ is
normally preferred to ‘inventory’ because it includes the amount of capital tied up
in making the product and selling it to customers. Investment therefore includes
not only the amount invested in inventories but also investment in non-current
assets.
Inventory is eventually converted into throughput, but until it is sold it is capital
tied up earning nothing. When inventory is sold, throughput is created.
Throughput is not created until finished goods are sold. Creating finished goods
for inventory is therefore damaging to the entity’s goals, because it ties up
finance in investment and investment finance has a cost.

Operating expenses
Operating expenses are all the expenditures incurred to produce the throughput.
They consist of all costs that are not variable costs, and so include labour costs.

4.4 Profit and throughput accounting

Profit in throughput accounting is measured as throughput minus operating
expenses.

Example: Profit and throughput accounting

₦
Sales 800,000
Raw materials and components costs 350,000
Throughput 450,000
Operating expenses 340,000
Net profit 110,000

4.5 The value of inventory in throughput accounting

Inventories do not have value, except the variable cost of the materials and
components. Even for work-in-progress and inventories of finished goods, the
only money invested is the purchase cost of the raw materials. No value is added
until the inventory is sold.
 In throughput accounting, all inventories are therefore valued at the cost
of raw materials and components, and nothing more.
 It should not include any other costs, not even labour costs. No value is
added by the production process, not even by labour, until the item is sold.
 It is impossible to make extra profit simply by producing more output,
unless the extra output is sold.

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4.6 Comparing throughput accounting with absorption costing and marginal

costing
The difference between throughput accounting and the traditional methods of
accounting can be illustrated with an example.

Example: Comparing throughput accounting with absorption costing and

marginal costing
A company makes 1,000 units of a product during May and sells 800 units for
₦32,000. There was no inventory at the beginning of the month. Costs of production
were:
₦
Raw materials 6,000
Direct labour 8,000
Fixed production overheads 10,000
Other non-production overheads 5,000
Required
Calculate the profit for the period using:
(a) absorption costing
(b) marginal costing
(c) throughput accounting.
Assume for the purpose of absorption costing that budgeted and actual
production overheads were the same, and there are no under- or over-absorbed
overheads.

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Example (continued): Comparing throughput accounting with absorption costing

and marginal costing
Profit for the month using each costing method is therefore as follows:
Absorption Marginal Throughput
costing costing accounting
Sales 32,000 32,000 32,000
Production costs
6,000 6,000 6,000
Raw materials
8,000 8,000
Direct labour
10,000
Fixed overhead
24,000 14,000 6,000

Closing inventory
(4,800) (2,800) (1,200)
 200/1,000
Cost of sale (19,200) (11,200) (4,800)
Gross profit 12,800
Contribution 20,800
Throughput contribution 27,200
Less operating expenses
Other non-production
overheads 5,000 5,000 5,000
Fixed overheads 10,000 10,000
Labour costs 8,000
(5,000) (15,000) (23,000)
Net profit 7,800 5,800 4,200

The differences in profit are entirely due to the differences in inventory

valuations.

4.7 Constraints and bottlenecks in the system

Throughput accounting is derived from the Theory of Constraints, which is based
on the view that every system has a constraint. A constraint is anything that limits
the output from the system.
 If a system had no constraint, its output would be either zero or the system
would continue to produce more and more output without limit.
 Therefore for any system whose output is not zero, there must be a
constraint that stops it from producing more output than it does.
Constraints for a manufacturing company might be caused by any of the
following:
 external factors, such as a limit to customer demand for the products that
the company makes

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 weaknesses in the system itself, such as shortages of key resources and

capacity limitations
 weaknesses in the system’s controls, such as weak management.
In a manufacturing system, constraints can be described as bottlenecks in the
system. A bottleneck is simply a constraint that limits throughput. For example, a
bottleneck might be a shortage of materials, or a shortage of machine time.

4.8 Dealing with constraints

The management of business operations should focus on dealing with the key
constraints. The output of a system is restricted by its key constraint.
Management must identify what this is.
Action by management to improve operational efficiency is a waste of time and
effort if it is applied to any area of operations that is not a constraint. For
example, measures to improve labour efficiency are a waste of time if the key
constraint is a shortage of machine capacity.
The key constraint limits throughput. As stated earlier, the nature of the key
constraint might be:
 limitations on sales demand ;
 inefficiency in production, with stoppages and hold-ups caused by wastage,
scrapped items and machine downtime ;
 unreliability in the supplies of key raw materials, and a shortage of key
materials;
 a shortage of a key production resource, such as skilled labour.
Goldratt, argued that:
 Management should identify the key constraint and consider ways of
removing or easing the constraint, so that the system is able to produce
more output.
 However, when one constraint is removed, another key constraint will take
its place.
 The new key constraint must be identified, and management should now
turn its attention to ways of removing or easing the new key constraint.
 By removing constraints one after another, the output capacity of the
system will increase.
However, there will always be a key constraint.

4.9 The relevance of constraints to throughput accounting

Goldratt argued that if the aim of a business is to make money and profit, the
most appropriate methods of doing this are to:
 increase throughput;
 reduce operating expenses; or
 reduce investment, for example by reducing inventory levels (since there is
a cost to investment).

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Goldratt also argued that the most effective of these three ways of increasing
profit is to increase throughput.
Throughput can be increased by identifying the bottlenecks in the system, and
taking action to remove them or ease them.

4.10 Performance measurement ratios in throughput accounting

There are several key performance measurements in throughput accounting.
One of these is net profit, which is total throughput minus Operating expenses.
An objective is to increase net profit.
Performance can also be measured using ratios:
 Return on investment
 Throughput accounting productivity
 Throughput per unit of the bottleneck resource
 Operating expenses per unit of the bottleneck resource
 Throughput accounting ratio.

Return on investment

Formula: Return on investment

Net profit
=  100
Investment

An objective should be to increase the return on investment, either by increasing

net profit or reducing the size of the investment.

Throughput productivity
This is measured as:

Formula: Throughput productivity

Throughput
=  100
Operating expenses

An objective should be to increase throughput productivity, either by increasing

throughput or reducing operating expenses.

Throughput per unit of constraint

One of the advantages of throughput accounting is that it treats labour costs as a
fixed cost. In many manufacturing companies, where the production process has
been automated, direct labour costs are not a significant part of total production
costs.

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However traditional costing systems treat direct labour as a variable cost and
assume that variable overheads vary with labour hours. In addition, fixed
overheads might be absorbed on a labour hour basis. It is often assumed that
performance will be improved by improving labour efficiency.
Throughput accounting challenges this approach to costs and performance
measurement. Labour is a fixed cost and relatively small compared to other
costs. Improving labour efficiency will therefore do little to improve performance
and increase profits.
Net profit will be improved much more effectively by identifying the constraint on
activity and seeking to maximise throughput per unit of the constraint.
Throughput accounting ratio
The throughput accounting ratio is the ratio of [throughput in a period per unit of
bottleneck resource] to [operating expenses per unit of bottleneck resource].
Units of a bottleneck resource are measured in hours (labour hours or machine
hours). This means that the throughput accounting ratio can be stated as:

Formula: Throughput accounting ratio

Throughput per hour of bottleneck resource
=  100
Operating expenses per hour of bottleneck resource

Example: Throughput accounting ratio

A business manufactures product Z, which has a selling price of ₦20. The
materials costs are ₦8 per unit of Product Z. Total operating expenses each
month are ₦120,000.
Machine capacity is the key constraint on production. There are only 600
machine hours available each month, and it takes three minutes of machine time
to manufacture each unit of Product Z.
Required
(a) Calculate the throughput accounting ratio.
(b) How might this ratio be increased?

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Answer
(a) Throughput per unit = ₦(20 – 8) = ₦12
Throughput per machine hour = ₦12  (60 minutes/3 minutes) = ₦240
Operating expenses per machine hour = ₦120,000/600 hours = ₦200
Throughput accounting ratio = ₦240/₦200 = 1.2
(b) To increase the throughput accounting ratio, it might be possible to:
Raise the selling price for Product Z for each unit sold, to increase the
throughput per unit.
Improve the efficiency of machine time used, and so manufacture Product
Z in less than three minutes.
Find ways of reducing total operating expenses, in order to reduce the
operating expenses per machine hour.

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5 BACKFLUSH ACCOUNTING

Section overview

 JIT production and JIT purchasing

 Introduction to backflush accounting
 Backflush accounting with two ‘trigger points’
 Backflush accounting with one ‘trigger point’

5.1 JIT production and JIT purchasing

Just-in-Time (JIT) management methods originated in Japan in the 1970s. The
principle of JIT is that producing items for inventory is wasteful, because
inventory adds no value, and holding inventory is therefore an expense for which
there is no benefit.
If there is no immediate demand for output from any part of the system, a
production system should not produce finished goods output for holding as
inventory. There is no value in achieving higher volumes of output if the extra
output goes into inventory that has no immediate use.
Similarly, if there is no immediate demand for raw materials, there should not be
any of the raw materials in inventory. Raw materials should be obtained only
when they are actually needed.
It follows that in an ideal production system:
 there should be no inventory of finished goods: items should be produced
just in time to meet customer orders, and not before (just in time
production)
 there should be no inventories of purchased materials and components:
purchases should be delivered by external suppliers just in time for when
they are needed in production (= just in time purchasing).

Definition
Just-in-time purchasing is a purchasing system in which material purchases are
contracted so that the receipt and usage of the materials, to the maximum
extent, coincide
(CIMA Official Terminology).

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5.2 Introduction to backflush accounting

Backflush accounting is a method of cost accounting that is consistent with JIT
systems.
 Traditional cost accounting systems for manufacturing costs are ‘sequential
tracking’ systems. They track the costs of items as they progress through
the manufacturing process, from raw materials, through work in progress to
finished goods. At each stage of the manufacturing process, more costs are
added and recorded within the cost accounting system.
 The main benefit of sequential tracking costing systems is that they can be
used to put a cost to items of inventory. When inventory is large, there is a
need to measure inventory costs with reasonable ‘accuracy’.
 With a JIT philosophy, this benefit does not exist. Inventory should be
small, or even non-existent. The cost of inventory is therefore fairly
insignificant. A costing system that measures the cost of inventory is
therefore of little or no value, and is certainly not worth the time, effort and
expenditure involved.
 Backflush accounting is an alternative costing system that can be applied in
a JIT environment. It is ideally suited to a manufacturing environment
where production cycle times are fairly short and inventory levels are low.
As the term ‘backflush’ might suggest, costs are calculated after production has
been completed. They are allocated between the cost of goods sold and
inventories in retrospect. They are not built up as work progresses through the
production process.
It is important to recognise that the great advantage of backflush accounting is
that costs can be worked ‘backwards’, after the goods have been produced and
sold. There is no need for a complex cost accounting system that records costs
of production sequentially.

5.3 Backflush accounting with two ‘trigger points’

An event that leads to the recognition of costs is called a trigger point.
A backflush accounting system has one or two trigger points, when costs are
recorded. When there are two trigger points, these are usually:
 the purchase of raw materials; and
 the manufacture of completed products.
Trigger point 1
Direct material costs and other direct production costs are recorded in the usual
way by debiting the costs to the appropriate account. It is helpful to think of these
accounts as being like expense accounts where the costs are held until they can
be included into the cost of sales and to a much lesser extent into closing
inventory.
Trigger point 2
The cost of production is debited into finished inventory when production is
complete. The credit entries are to the suspense accounts at standard costs.

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Balances on the suspense accounts after these entries represent closing

inventory of finished goods or cost variances.
The debit recognised in the finished inventory account moved to a cost of goods
sold account almost immediately (remember what just in time manufacture
means).
A numerical example will be used to illustrate the costing method.

Example: Backflush accounting

A manufacturing company makes a single product (P), which has the following
standard cost:
₦
Raw materials 20
Direct labour 8
Overheads 22
50
During the period, it incurred the following costs:
Raw materials purchased ₦2,030,000
Conversion costs:
Direct labour costs incurred ₦775,000
Overhead costs incurred ₦2,260,000
₦3,035,000
The company made 100,000 units of Product P and sold 98,000 units.
The company uses a backflush costing system, with trigger points at raw
materials purchase and at completion of production.
Trigger point 1: Record the purchase of raw materials
Debit: Raw materials inventory ₦2,030,000
Credit: Creditors/payables ₦2,030,000

Other conversion costs are also recorded

Debit: Conversion costs ₦3,035,000
Credit: Creditors/payables ₦3,035,000

Raw materials inventory account

₦ ₦
Creditors 2,030,000

Conversion costs account

₦ ₦
Bank (labour cost) 775,000
Creditors (overheads) 2,260,000
3,035,000

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Performance management

Example (continued): Backflush accounting

Trigger point 2: Record the manufacture of the 100,000 units

Finished goods inventory account

₦ ₦
Raw materials
(100,000  20) 2,000,000
Conversion costs
(100,000  30) 3,000,000

Raw materials inventory account

₦ ₦
Creditors 2,030,000 Finished goods inventory 2,000,000
Closing balance c/f 30,000
2,030,000 2,030,000

Conversion costs account

₦ ₦
Bank (labour cost) 775,000 Finished goods inventory 3,000,000
Creditors (overheads) 2,260,000 Balance 35,000
3,035,000 3,035,000

The closing balance on the raw materials account may represent the cost of
closing inventory. If so, it is carried forward as an opening balance to the start of
the next period. However, any cost variance (difference between standard and
actual material cost) should be taken to the income statement for the period.

Similarly, the balance on the conversion costs account represents cost variances
for labour and overhead, and this should be written off to the income statement
for the period.
Almost immediate recognition of cost of sales
The cost of sales and closing inventory of finished goods are simply recorded as
follows:
Finished goods inventory account
₦ ₦
Raw materials 2,000,000 Cost of goods sold
(98,000  50) 4,900,000
Conversion costs 3,000,000 Closing inventory
(2,000  50) 100,000
5,000,000 5,000,000

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5.4 Backflush accounting with one ‘trigger point’

An even simpler backflush accounting system has just one trigger point, the
manufacture of finished units. In this system, the purchase of direct materials is
not recorded.
Conversion costs are debited, initially to a suspense account (or accounts as
before).
The cost of production is debited into finished inventory when production is
complete with the credit entries are to the suspense accounts at standard costs
and to payables for raw materials.

Example: Backflush accounting

A manufacturing company makes a single product (P), which has the following
standard cost:
₦
Raw materials 20
Conversion costs 30
50
During the period, it incurred the following costs:
Raw materials purchased ₦2,030,000
Conversion costs: ₦3,035,000
The company made 100,000 units of Product P and sold 98,000 units.
The company uses a backflush costing system trigger point at completion of
production.
Conversion costs account

₦ ₦
Bank (labour cost) 775,000 Finished goods inventory 3,000,000
Creditors (overheads) 2,260,000 Balance 35,000
3,035,000 3,035,000

Finished goods inventory account

₦ ₦
Raw materials Cost of goods sold
(payables) 2,000,000
(100,000  20) (98,000  50) 4,900,000
Conversion costs 3,000,000 Closing inventory
(100,000  30) (2,000  50) 100,000
5,000,000 5,000,000

The only difference is that there is no raw materials inventory account. The
₦30,000 of materials that has been purchased but not used is simply not
recorded in the costing system, and is therefore not included in closing inventory
at the end of the period.

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Performance management

6 ENVIRONMENTAL ACCOUNTING

Section overview

 The purpose of environmental management accounting

 A framework for environmental management accounting
 EMA techniques

6.1 The purpose of environmental management accounting

For some companies, environmental issues are significant, in terms of both
strategy and cost.
 Poor environmental behaviour can result in significant costs or losses, such
as fines for excessive pollution, environmental taxes, loss of land values,
the cost of law suits, and so on.
 Environmental behaviour can affect the perception of customers, and their
attitudes to a company and its products. Increasingly, consumers take
environmental factors into consideration when they make their buying
decisions.
Environmental management accounting can be used to provide information to
management to help with the management of environmental issues. Traditional
management accounting techniques can:
 under-estimate or even ignore the cost of poor environmental behaviour;
 over-estimate the costs of improving environmental practices; and
 under-estimate the benefits of improving environmental practices.
Environmental management accounting (EMA) provides managers with financial
and non-financial information to support their environmental management
decision-making. EMA complements other ‘conventional’ management
accounting methods, and does not replace them.
The main applications of EMA are for:
 estimating annual environmental costs (for example, costs of waste
control);
 budgeting;
 product pricing;
 investment appraisal (for example, estimating clean-up costs at the end of
a project life and assessing the environmental costs of a project); and
 estimating savings from environmental projects.

6.2 A framework for environmental management accounting

Burritt et al (2001) suggested a framework for EMA based on providing
information to management:
 from internal or external sources;

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Four of these elements of EMA are shown in the following table:

Environmental management accounting (EMA)

 that consists of routine reports or ad hoc information.

 where the focus is short-term or longer-term;
 as historical or forward-looking information;
 as monetary or physical measurements;
Monetary EMA Physical EMA

 Short-term focus Long-term focus Short-term focus Long-term focus


 Historical  Routine  Environmental  Analysis of  Material and  Accounting for
orientation reporting cost environmental energy flow environmental
accounting ly-induced accounting capital
capital impacts
expenditures
 Ad hoc (one-  Historical  Environmental  Historical  Post-
off) assessment of life cycle assessment of investment
information environmental costing, short-term assessment of
109

decisions environmental environmental environmental

target costing impacts, e.g. impacts of

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of a site or capital
product expenditures
The Institute of Chartered Accountants of Nigeria

 Future  Routine  Environmental  Environmental   Environmental

orientation reporting operational long-term  long-term
budgets and financial  physical
capital planning  planning

budgets 
(monetary 
 Ad hoc (one-  Relevant  Environmental  Assessment  Physical
off) environmental life cycle of environmental
information costing (e.g. budgeting and environmental investment
special target costing impacts appraisal.
orders) Specific
project life
cycle analysis
Performance management

6.3 EMA techniques

Environmental management accounting techniques include:
 re-defining costs;
 environmental activity-based accounting; and
 environmental life cycle costing.

Re-defining costs
The US Environmental Protection Agency (1998) suggested terminology for
environmental costing that distinguishes between:
 conventional costs: these are environmental costs of materials and
energy that have environmental relevance and that can be ‘captured’ in
costing systems;
 potentially hidden costs: these are environmental costs that might get
lost within the general heading of ‘overheads’;
 contingent costs: these are costs that might be incurred at a future date,
such as clean-up costs;
 image and relationship costs: these are costs associated with promoting
an environmental image, such as the cost of producing environmental
reports. There are also costs of behaving in an environmentally
irresponsible way, such as the costs of lost sales as a result of causing a
major environmental disaster.
In traditional management accounting systems, environmental costs (and
benefits) are often hidden. EMA attempts to identify these costs and bring them
to the attention of management.

Environmental activity-based accounting

Environmental activity based accounting is the application of environmental costs
to activity based accounting. A distinction is made between:
 environmental-related costs: these are costs that are attributable to cost
centres involved in environmental-related activities, such as an incinerator
or a waste recycling plant;
 environmental-driven costs: these are overhead costs resulting from
environment-related factors, such as higher costs of labour or depreciation.
The cost drivers for environment-related costs may be:
 the volume of emissions or waste;
 the toxicity of emissions or waste;
 ‘environmental impact added’ (units multiplied by environmental impact per
unit); or
 the volume of emissions or waste treated.

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Environmental life cycle costing

Life cycle costing is a method of costing that looks at the costs of a product over
its entire life cycle. Life cycle costing can help a company to establish how costs
are likely to change as a product goes through the stages of its life (introduction,
growth, maturity, decline and withdrawal from the market). This analysis of costs
should include environmental costs.

Illustration: Environmental life cycle costing

Xerox provides a good example of the environmental aspect of life cycle costing.
Xerox manufactures photocopiers, which it leases rather than sells. At the end of
a lease period, the photocopiers are returned from the customer to Xerox.
At one time, photocopiers were delivered to customers in packaging that could
not be re-used for sending the machines back at the end of the lease period.
Customers disposed of the old packaging and had to provide their own new
packaging to return the machines to Xerox. Xerox then disposed of this
packaging.
The company therefore incurred two costs: the cost of packaging to deliver
machines and the cost of disposal of the packaging for returned machines.
By looking at the costs of photocopiers over their full life cycle, Xerox found that
money could be saved by manufacturing standard re-usable packaging. The same
packaging could be used to deliver and return machines, and could also be re-
used.
At the same time, the company created benefits for the environment by reducing
disposals of packaging materials.

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Performance management

7 KAIZEN COSTING

Section overview

 An introduction to Kaizen costing

 Techniques for continuous improvement
 Kaizen costing compared with standard costing

7.1 An introduction to Kaizen costing

For companies that practise TQM and continuous improvement methods, Kaizen
costing takes over where target costing ends.
 Target costing is used in the design and development stage for a new
product.
 Kaizen costing is applied from the time that a product goes into full
production until the end of the product’s life.
Taken together, target costing and Kaizen costing are systems for life cycle
costing.
The philosophy of continuous improvement (Kaizen) is based on the view that
markets are highly competitive and industry must try to keep reducing costs in
order to reduce selling prices in order to maintain a competitive advantage.
Kaizen costing is a management accounting system that provides cost
information to help with achieving improvements without loss of product quality or
value.
Most of the costs of a product over its entire life cycle are committed during the
design and development stage. This is why target costing is a valuable technique
for the control of costs (without loss of value). However, there is still some scope
for further cost reduction after commercial production and marketing of the
product has begun.
A Kaizen costing system is therefore a costing system that is designed to help a
company to reduce product costs.
 A target for cost reductions is set. This target is below the current cost. The
cost reduction must be achieved without any loss of value for the customer.
For example, a target might be set to reduce unit costs of production by 5%
within two years.
 Teams are established to identify methods of making improvements.
 Kaizen focuses on making small improvements, as it is unlikely that a
single improvement will be sufficient to achieve the target cost reductions.
Many different improvements might be needed over a period of time.
 Actual costs are continually compared with the target costs, and progress
towards achieving the target cost is monitored through regular reporting.
 The project teams must continually review production conditions to find
ways of making more improvements and more cost reductions.
 Normally, teams are rewarded with bonuses if they achieve their cost
reduction targets.

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 When one cost reduction target is met, another cost reduction target takes
its place. With Kaizen, the process of seeking improvements never ends.

7.2 Techniques for continuous improvement

Teams that are given the responsibility for making improvements might use value
analysis (VA) methods. VA is similar to value engineering, except that VA is
applied to existing products and VE to products during their design and
development stage.
The types of questions that might be asked are as follows:
 Can common materials and parts be used? The same part might be used in
two or more parts of the product, or the same part might be used for
several different products that the company manufactures.
 How much of the cost consists of purchased materials and components?
Can major suppliers be persuaded to reduce their own costs and prices?
 Can improvements be made in logistics (distribution) or packaging?
 Can the investment in the product (for example, working capital) be
reduced?
 Can improvements be made in production systems or maintenance
methods?
 Can the work be organised in a different way?
 A system of value analysis must be supported by a management
accounting system that provides relevant cost data.

7.3 Kaizen costing compared with standard costing

It is useful to compare Kaizen costing with traditional standard costing.
 With standard costing, expected costs are established based on current
production methods. Variances between actual and standard costs are
calculated, and variance reports focus on significant variations between
actual costs and the current standard. There is no motivation to make
improvements and reduce costs below the existing standard.
 With Kaizen costing, actual costs are compared with the target, not an
existing standard. The variance reporting system is used to monitor
progress towards the target cost.
 With standard costing, managers are encouraged to prevent adverse
variances. For example, if there is an adverse material price variance, the
manager responsible might decide to buy materials at a lower price from a
different supplier. The result could be a loss of quality, a fall in value and a
reduction in customer satisfaction.
 With Kaizen costing, reductions in cost must be achieved without any loss
of value.
A 1993 article on Kaizen and Kaizen costing concluded: ‘In the US, changes in
the focus and methods of production need to be accompanied by changes in
management accounting systems. The Japanese have provided guidance on
how management accounting can play a significant role in creating sustainable

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Performance management

competitive advantage for a firm. The more organisations rid themselves of

traditional management accounting practices, the better is the chance that the
new ideas about manufacturing can take over and really show their worth. Old
ways of product costing blunt a firm’s ability to compete effectively and hinder
their ability to focus on world-class performance.’

8 PRODUCT PROFITABILITY ANALYSIS

Section overview

 Introduction
 Direct product profitability
 Problems with DPP

8.1 Introduction
It would be very unusual to find a company with a single product. Many
companies have wide product ranges.
Manufacturing companies often have complex costing systems to establish the
cost of production. Traditional accounting systems identify the direct costs
associated with a product and incorporate systems to apportion production
overheads into cost units. More modern techniques are discussed elsewhere in
this chapter. If cost allocation is reliable it is relatively helpful.

8.2 Direct product profitability

Retailers know how much units of inventory have cost them and how much they
are sold for. However, simply understanding the gross margin of different
products does not always indicate the true profitability of those products.
A retailer might be interested in understanding the impact that sales of individual
products and product lines have on profitability. Direct product profitability (an
approach developed by McKinsey & Co) is a technique which allows them to do
this. Direct product profitability attempts to attribute the purchase price and
indirect costs to individual products and product lines. This allows the
identification of a net profit for each of these.

Illustration: Direct product profitability

Direct product profitability of a given product for a given period is found as
follows.
₦
Sale revenue X
Purchase price (net of discounts received) (X)
Gross profit X
Less:
Ordering costs X
Storage costs X
Distribution costs X
Cost of obsolescence X

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(X)
The Institute of Chartered Accountants of Nigeria
Direct product profit X
Performance management

Notice that direct product profitability is expressed in profit per period rather than
per unit. Looking at unit profitability might be misleading as it would fail to take
sales volumes into account.

Example: Direct product profitability

A retailer sells two products (A and B) as follows:

A B
Sales price ₦4,000 ₦3,000
Purchase cost ₦3,000 ₦2,000
Gross profit per unit ₦1,000 ₦1,000
Gross margin 25% 33.33%
Shelf space per unit 20 cm2 10 cm2
Gross profit per unit of cm2 of shelf space ₦50 ₦100

It looks as if the retailer should be concentrating on selling B from the

above information. However, further data for weekly performance shows
that this is not the case.

A B
Gross profit per unit ₦1,000 ₦1,000
Unit sales 400 20
Gross profit ₦400,000 ₦20,000
Area used (cm2) 2,000 cm2 1,000 cm2
Cost per cm2 per week ₦50 ₦50
Storage cost ₦100,000 ₦50,000
Direct product profit ₦300,000 ₦(30,000)

Information about DPP implies that it is not worth selling B.

This assumes that the space currently used to sell B could be used to sell
more A. If this were not the case then the decision might be ill founded
as B is making a contribution towards the storage costs.
In practice, large retailers will have many hundreds (thousands) of
product lines. The space freed up from the discontinuation of a product
line would always be used to sell something else.

The above example demonstrates the importance of obtaining sufficient

information before meaningful analysis can be carried out.
DPP can be useful for a company that adopts a product based approach to
marketing. It suggests better results can be achieved by selling more of the
products which generate the highest product profitability.

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DPP analysis suggests ways of improving product profitability. For example,

moving items to more prominent positions to increase turnover or reducing the
size of product packaging. It might also be used to justify retailers seeking
product support from suppliers.

8.3 Problems with DPP

It depends on cost allocation and this might be difficult in practice.
It can be said to provide an incorrect marketing focus as it disregards the needs
of the customers.

9 SEGMENT PROFITABILITY ANALYSIS

Section overview

 Introduction to segmental profitability analysis

 Full cost approach
 Segment contribution approach
 Comparison of the two approaches

9.1 Introduction to segmental profitability analysis

All businesses exist to make profit. They do this by producing goods and
services and selling them for more than the cost of their production. The ability to
measure performance in terms of profitability is very important.
It is highly unlikely that a business will have only one product. Single product
businesses are useful to illustrate accounting principles but exist only in theory.
Many companies have hundreds of products which they sell in many regions.
Given the existence of many products and many different areas of operations, it
is unlikely that all products or areas will be profitable over time. Companies need
to evaluate profit performance systematically and regularly on a segmental basis
and unprofitable segments should be discontinued if they cannot be made
profitable.
A business can segment its operations in several ways, including:
 by product line;
 by geographical area (town, district, country)
There are two main ways of measuring segment profitability:
 the full cost approach; and
 the contribution approach.

9.2 Full cost approach

The full cost approach attempts to measure the total profit earned by each
segment.
The basic principles of this approach are as follows:
 The objective is to measure net profit of each operating segment.
 Overall net profit of a business is the sum of the net profit of the individual
segments.
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 All indirect expenses (common) must be allocated.
 Allocation of indirect expenses involves selecting bases of allocation.

Illustration: Segmental profit

₦
Segment sales X
Direct expenses
Variable segment costs (X)
Fixed segment expenses (X)
X
Allocated indirect expenses (X)
X

At first sight, this might look like a logical approach as a business cannot be
successful without profit (net income). However, measuring the profit of a
segment is more difficult than measuring the profit of a business in its entirety
due to the need to identify segment expenses.
From the segment’s point of view, there are two types of expenses:
 segment direct expenses; and
 segment indirect expenses.

Segment direct expenses

These are segment expenses that result from the existence and operation of the
segment. These expenses would be avoided by a company if it closed the
segment.
Examples of segment direct expenses include the following:
 direct costs (material, labour and variable overhead); and
 fixed costs that relate directly to a segment (e.g. factory rental).

Segment indirect expenses

These are segment expenses that are not directly caused by a particular
segment. They relate to the company as a whole but are shared to the segments
to which they relate in order to calculate segment profitability. These expenses
would not be avoided by a company if it closed the segment.
Examples of indirect expenses include the following:
 directors’ remuneration;
 head office expenses;
 costs of central functions (e.g. accounting, treasury, human resources etc.)
There are different methods that might be used for allocating expenses so it
might be said that the final allocation is somewhat arbitrary. An unfair allocation
method can cause one segment to appear to be more profitable than another
when in fact this is not the case.
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Performance management

9.3 Segment contribution approach

The segment contribution approach attempts to measure the contribution made
by each segment.
The basic principles of this approach are as follows:
 Only the contribution of each segment is computed. No attempt is made to
compute the net income of the segment.
 Indirect or common expenses of each segment are not allocated.
 Indirect or common expenses, however, are usually deducted from total
segmental contribution in order to arrive at overall business net income.
A segment is considered profitable if sales of the segment exceed the direct
expenses of the segment

Illustration: Segmental contribution

₦
Segment sales X
Direct expenses
Variable segment costs (X)
Fixed segment expenses (X)
X

The major problem of the full cost approach is that it is possible for a segment to
show an operating loss yet at the same time be making a positive contribution to
net income. In other words, if the seemingly unprofitable segment is closed, then
the overall net income of the business will decrease. This will be examined later
in this chapter.
To overcome this adverse feature of the full cost approach, many businesses
prefer to use the contribution approach to measuring segmental profitability.
The segmental contribution approach as indicated by its name measures
segmental contribution. Segmental contribution may simply be defined as sales
less direct expenses.
There is a difference between segmental contribution and contribution as
discussed in earlier chapters.
 Contribution (as discussed in earlier chapters) is sales less variable
expenses.
 Segmental contribution is segment sales less segment direct costs.
Segment direct costs might include fixed costs. This is because they would
vary if the segment was closed.

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Chapter 3: Modern management accounting techniques

9.4 Comparison of the two approaches

The indirect expenses of a segment will continue to be incurred regardless of
whether the segment is continued or not continued.
Therefore, as long as the segment is making a contribution towards indirect fixed
expenses, continuing operations at least in the short run makes the business
better off.
The following example illustrates the basic principles of the full cost and
segmental contribution approaches.

Example: Segment profitability

A company operates as two segments (X and Y).
The following results relate to the most recent accounting period.

X Y Total
₦000 ₦000 ₦000
Sales 300 200 500
Direct costs (215) (170) (385)
Segmental contribution 85 30 115
Indirect costs (60) (40) (100)
Segmental profit/(loss) 25 (10) 15

Analysis
The full cost approach shows that segment Y is operating at a net loss of
₦10,000. This makes it look as if the business would be better off by
₦10,000 if it were to close segment Y.
The segmental contribution approach shows that segment Y is making a
contribution of ₦30,000.
The contribution approach shows that segment Y actually makes a
contribution to the total fixed costs. If segment Y were closed this
contribution would be lost but the indirect costs would not be avoided.
Therefore, the company would be ₦30,000 worse off if segment Y were
closed and this would result in the company making a loss of ₦15,000.

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Performance management

10 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Describe target costing and how target cost is determined
 Apply the target costing tools to given scenarios
 Explain lifecycle costing
 Explain throughput accounting and solve throughput accounting problems
 Explain and apply backflush accounting
 Explain and apply environmental accounting
 Explain Kaizen costing
 Explain and calculate product profitability
 Explain and calculate segment profitability using full cost and contribution
approaches

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4
Skills level
Performance management

CHAPTER
Learning and experience curve theory

Contents
1 The learning curve
2 Other aspects
3 Chapter review

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Performance management

Detailed syllabus
The detailed syllabus includes the following:
A Cost planning and control
2 Overview of costs for planning and control
B Learning and experience curve theory
i Discuss and apply the learning and experience curve theory to pricing,
budgeting and other relevant problems.
ii Calculate and apply learning rate to cost estimation.

Exam context
This chapter explains each of the above topics in turn.

By the end of this chapter, you should be able to:

 Explain the learning effect
 Use a tabular approach to illustrate the learning effect
 Use the learning effect formula to calculate time required for units at a given point in
production as a basis for budgeting and pricing

© Emile Woolf International 124 The Institute of Chartered Accountants of Nigeria

Chapter 4: Learning and experience curve theory

1 THE LEARNING CURVE

Section overview

 The learning effect

 The learning curve model (tabular approach)
 Formula for the learning curve

1.1 The learning effect

When a team of workers begins a skilled task for the first time, and the task then
becomes repetitive, they will probably do the job more quickly as the workers
learn the task and so become more efficient. They will find quicker ways of
performing tasks, and will become more efficient as their knowledge and
understanding increase. This improvement in efficiency through experience is
called the learning effect.
When a skilled task is well-established and has been in operation for a long time,
the learning effect wears out, and the time to complete the task eventually
becomes the same every time the task is subsequently carried out.
When the average time to produce an additional unit becomes constant, a
‘steady state’ has been reached.
However, during the learning period, the time to complete each subsequent task
can fall by a very large amount and the learning effect can be substantial.
The learning effect (and learning curve) was first discovered in the US during the
1940s, in aircraft manufacture. It probably still applies today in aircraft
manufacture. Aircraft manufacture is a highly-skilled task, where:
 the skill of the work force is important; and
 the labour time is a significant element in production resources and
production costs.
Where the learning effect is significant, it has implications for:
 costs of completing the task;
 budgeting/forecasting production requirements and production costs; and
 pricing the output so as to make a profit.
Prices charged to the customer can allow for the cost savings that will be made
because of the learning effect

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Performance management

1.2 The learning curve model (tabular approach)

The learning effect can be measured mathematically, and shown as a learning
curve.
The learning curve is measured as a percentage learning effect. For example, for
a particular task, there might be an 80% learning curve effect, or a 90% learning
curve effect, and so on.

The learning effect

When there is a x% learning curve for the manufacture of a product, this means
that when cumulative output of the product doubles, the average time to produce
all the units made so far (the cumulative total produced to date) is x% of what it
was before. For example:
 when there is an 80% learning curve, every time output doubles the
cumulative average time to produce units falls to 80% of what it was before.
 The cumulative average time per unit is the average time for all the units
made so far, from the first unit onwards. For example if an 80% learning
effect applies:
 the average time for the first two units is 80% of the average time for
the first unit;
 The average time for the first four units is 80% of the average time for
the first two units and so on.

Example: The learning effect

The time to make a new model of a sailing boat is 100 days. It has been
established that in the boat-building industry, there is an 80% learning curve.
Calculate:
(a) the cumulative average time per unit for the first 2 units, first 4 units, first 8
units and first 16 units of the boat
(b) the total time required to make the first 2 units, the first 4 units, the first 8
units and the first 16 units
(c) the additional time required to make the second unit, the 3rd and 4th
units, units 5 – 8 and units 9 – 16.

These can be found by constructing the following table:

Cumulative Total time Incremental
average for all time for Average time
Total units time per units additional for additional
(cumulative) unit (days) (days) units (days) units (days)
1 100 100.00 100.00
2 ( 80%) 80 160.00 60.00 60.00
4 ( 80%) 64 256.00 96.00 48.00
8 ( 80%) 51.2 409.60 153.60 38.40
16 ( 80%) 40.96 655.36 245.76 30.72

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Chapter 4: Learning and experience curve theory

Practice question 1
The first unit of a new model of machine took 1,600 hours to make.
A 90% learning curve applies.
How much time would it take to make the first 32 units of this machine?
Calculate:
(a) the cumulative average time per unit for the first 2 units, first 4 units,
first 8 units and first 16 units.
(b) the total time required to make the first 2 units, the first 4 units, the
first 8 units and the first 16 units
(c) the additional time required to make the second unit, the 3rd and 4th
units, units 5 – 8 and units 9 – 16.
(d) the average time required to make the second unit, the 3rd and 4th
units, units 5 – 8 and units 9 – 16.

Problem with the tabular approach

It is easy to construct a table to show the learning effect and it provides useful
information. However, it can only be constructed to show doubling of the output.
The table can be used to calculate how many days it would take to construct
units 3 and 4 and the average time for each of these. However, it cannot be used
to calculate how long unit 3 actually took and how long unit 4 actually took. (We
know that boats 3 and 4 together took 96 days to make but not how long each
took as the learning effect means that boat 4 would have taken less time than
boat 3).
Similarly, the table can be used to calculate how many days it would take to
construct units 5 to 8 and the average time for each of these. However, it cannot
be used to calculate how long unit 5 actually took and how long unit 7 (say)
actually took. (We know that boats 5 to 8 together took 153.6 days to make but
not how long each took as the learning effect means that boat 8 would have
taken less time than boat 5 for example).
The way around this is to use the learning curve formula.

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Performance management

1.3 Formula for the learning curve

The learning curve is represented by the following formula (mathematical model):

Formula: Learning curve

y = axb
log of learning rate
b=
log 2
Where:
y = the cumulative average time per unit for all units made
x = the number of units made so far (cumulative number of units)
a = the time for the first unit
b = the learning factor.
The learning rate is expressed as a decimal – a learning rate of 80% is
expressed as 0.8

Logarithms (usually shortened to log) are different way to express a number.

Logs can have different bases. The most widely used logs are log10 (log to the
base 10 usually written simple as log) or natural logs (log to the base e but
written as written as ln).
The log of a number is number of times that you would have to multiply 10 by
itself to get that number. For example:
 the log of 100 is 2 meaning that you would have to multiply 10 by itself
twice to get a hundred.
 the log of 1,000 is 3 meaning that you would have to multiply 10 by itself
three times to get a thousand.
 the log of 80 is 1;90301 meaning that you would have to multiply 10 by
itself 1;90301 times to get 80.
 the log of 0.8 is 0.9691 meaning that you would have to multiply 10 by
itself 0.9691 times to get 0.8. (Note that the log of any number less than 1
is always negative).
Admittedly, this can be a little difficult to understand but modern calculators can
calculate log values easily.
The learning effect can be computed using the formula approach thus:
Y = axb
Where the above variables are explained above.

Y(x) = (axb) x

b= √ Y(x)
√ (axb)x

© Emile Woolf International 128 The Institute of Chartered Accountants of Nigeria

Example:
Determine the learning rate of a process where the first unit (a) uses 720 hours and and
the fourth unit is estimated to use an average of 405 hours per unit at a constant learning
rate.

Solution :
Using the formula approach:

Y = axb
Rate of learning = √y x = √405 x 4
√ axbx = √720 x 4

√0.5625 = 0.75 = 75%

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Chapter 4: Learning and experience curve theory

Example (continued): The learning effect

Returning to the earlier example:
The time to make a new model of a sailing boat is 100 days. It has been
established that in the boat-building industry, there is an 80% learning curve.
The cumulative average time per unit for the first 2 units, first 4 units, first 8 units
and first 16 units of the boat can be calculated as follows:
The learning factor:
log of learning rate log 0.8
b= b= = −0.32193
log 2 log 2

First 2 units
y = axb y = 100 days  20.32193 = 80 days

First 4 units
y = axb y = 100 days  40.32193 = 64 days

First 8 units
y = axb y = 100 days  80.32193 = 51.2 days

First 16 units
y = axb y = 100 days  160.32193 = 40.96 days

The formula can be used for any number of units.

Example (continued): The learning effect

Returning to the earlier example:
The time to make a new model of a sailing boat is 100 days. It has been
established that in the boat-building industry, there is an 80% learning curve.
The cumulative average time per unit for the first 9 units is as follows:
The learning factor:
log of learning rate log 0.8
b= b= = −0.32193
log 2 log 2

First 9 units
y = axb y = 100 days  90.32193 = 49.3 days

It is now a short step to work out how long any unit would take to build.

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Performance management

Example (continued): The learning effect

These can be found be constructing the following table:

Cumulative Total time Incremental

average for all time for
Total units time per units additional
(cumulative) unit (days) (days) units (days)
8 51.2 409.60
9 49.3 443.70 245.76

In other words, the 9th boat took 34.1 days to

build. mbuildcccomplete make.

This approach can be used to calculate the time taken to build any unit.

Example: The learning effect

It will take 500 hours to complete the first unit of a new product. There is a 95%
learning curve effect.
Calculate how long it will take to produce the 7th unit
The learning factor:
log of learning rate log 0.95
b= b= = −0.074
log 2 log 2

First 6 units
y = axb y = 500 hours  60.074 = 437.9 hours

First 7 units
y = axb y = 500 hours  70.074 = 432.9 hours

These can be used to find the incremental time as before.

Incremental
Cumulative Total time time for
average for all additional
Total units time per units units
(cumulative) unit (hours) (hours) (hours)
6 437.9 2,627.4
7 432.9 3,030.3 402.9

In other words, the 7th unit took 402.9 hours to build .

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Chapter 4: Learning and experience curve theory

2 OTHER ASPECTS

Section overview

 Graph of the learning curve

 Conditions for the learning curve to apply
 Implications of the learning curve
 Problems with the application of learning curve theory

2.1 Graph of the learning curve

The learning effect can be illustrated graphically.

Illustration: Learning effect

The cumulative average time per The total cost line curves
unit falls rapidly at first, but the upwards.
learning effect eventually ends and The slope decreases as more units
the average time for each are made implying that the cost
additional unit eventually becomes per unit falls as more and more
constant (a standard time). units are made.

2.2 Conditions for the learning curve to apply

The learning curve effect will only apply in the following conditions:
 There must be stable conditions for the work, so that learning can take
place. For example, labour turnover must not be high; otherwise the
learning effect is lost. The time between making each subsequent unit must
not be long; otherwise the learning effect is lost because employees will
forget what they did before.
 The activity must be labour-intensive and repetitive so that learning will
affect the time to complete the work.
 There must be no change in production techniques, which would require
the learning process to start again from the beginning.
 Employees must be motivated to learn.
The costs that are reduced as a result of the learning curve are those that vary
with labour time – labour costs and any overhead costs that vary with labour
time. The learning effect will not usually result in reductions in materials costs, for
example, because the usage of materials (ignoring losses through wastage) is
not related to labour efficiency.

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2.3 Implications of the learning curve

When a process benefits from a learning curve effect, there are implications for
budgeting and pricing.
 Budgets should allow for the reduction in the average labour time per unit.
Total labour requirements (the size of the work force required) will be
affected.
 If prices are calculated on a ‘cost plus’ basis, prices quoted to customers
should allow for future cost savings. The sales budget will be affected by
expected reductions in the sales price.
 Any system of budgetary control should make allowance for the expected
reduction in the production time per unit. Actual hours taken should be
compared with expected hours, allowing for the learning curve effect.

2.4 Problems with the application of learning curve theory

In practice, the learning curve effect is not used extensively for budgeting or
estimating costs (or calculating sales prices on a cost plus basis).
 It may be difficult to measure the learning rate with sufficient accuracy. It
also may be difficult to measure the time taken for the first unit accurately.
 In a modern manufacturing environment production is highly mechanised
and therefore the learning curve effect does not apply.
 Learning curve theory assumes that stable production conditions will exist,
and all subsequent units will be produced to the same specifications as the
original product. In practice, the product may go through several major
design changes after the first unit has been produced.
 For many products where skilled labour is required, production might have
reached a ’steady state’ so that there will be no further reductions in the
average times to produce the item.
 Even with skilled, labour-intensive work, if there is a high rate of labour
turnover, the work force might not gain enough collective experience for a
learning effect to apply.

Example: The learning effect

X Ltd has developed a new product. The process used to produce the new product
is repetitive, and around 60% automated.
Following reorganisation at X Ltd, the workforce is less motivated than it has
been in the past and the number of resignations has increased in recent months.
Required
Evaluate the extent to which you would expect a learning curve effect to occur in
respect of the new product at X Ltd.

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Chapter 4: Learning and experience curve theory

Answer
Learning curves only apply to repetitive processes.
The new product may experience a learning effect as it is to be produced using a
repetitive process.
The process is 60% automated, and learning curves can only be observed on a
process that is highly labour intensive. The 40% of the process that is not
automated could give rise to a learning curve, however the extent to which this
will impact on the process overall is unknown. It is possible that a learning curve
effect could occur, but it is unlikely to be significant.
Further, there are issues with motivation and staff turnover. Both of these factors
reduce the likelihood of a learning curve effect taking place.
If staff are not motivated, they will not be keen to learn and keen to work quickly
and so the learning curve will never arise.
Higher staff turnover prevents the learning curve taking place as staff are
replaced too frequently for the benefits to be observed as the workers will not
have sufficient time to learn the process and speed up.
Overall, the learning curve experienced in relation to the new product as X Ltd is
likely to be minimal.

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Performance management

3 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Explain the learning effect

 Use a tabular approach to illustrate the learning effect

 Use the learning effect formula to calculate time required for units at a given point
in production as a basis for budgeting and pricing

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Chapter 4: Learning and experience curve theory

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
Cumulative Total time Incremental
average time for all time for Average time
Total units per unit (90% units additional for additional
(cumulative) LF) (days) (days) units (days) units (days)
1 1,600 1,600 1,600
2 1,440 2880 1280 1280
4 1,296 5184 2304 1152.00
8 1,166.4 9331.20 4147.20 1036.80
16 1,049.76 16796.16 7464.96 933.12
32 944.78 30233.09 13436.93 839.81

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5
Skills level
Performance management

CHAPTER
Quality and quality costs

Contents
1 Quality management and quality costs
2 Costs of conformance
3 Costs of non-conformance
4 The significance of quality costs
5 Chapter review

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Performance management

INTRODUCTION
Aim
Performance management develops and deepens candidates’ capability to provide
information and decision support to management in operational and strategic contexts. This
has a focus on linking costing, management accounting and quantitative methods to critical
success factors and operational strategic objectives whether financial, operational or with a
social purpose. Candidates are expected to be capable of analysing financial and non-
financial data and information to support management decisions.

Detailed syllabus
The detailed syllabus includes the following:
A Cost planning and control
1 Overview of costs for planning and control
C Cost of quality
i Explain quality costs.
ii Analyse quality costs into costs of conformance and costs of non-
conformance.
iii Discuss the significance of quality costs for organisations.

Exam context
This chapter explains each of the above topics in turn.

By the end of this chapter, you should be able to:

 Explain the nature of quality costs
 Analyse quality costs into costs of conformance and costs of non-conformance
 Analyse costs of conformance into appraisal costs and prevention costs
 Analyse costs of non-conformance into internal and external failure costs
 Discuss the potential significance of quality costs, including reputation costs, for
organisations
 Explain approaches to the management of quality costs including the Total Quality
Management approach.

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Chapter 5: Quality and quality costs

1 QUALITY MANAGEMENT AND QUALITY COSTS

Section overview

 The importance of quality

 Quality-related costs
 Quality-related costs: costs of conformance and costs of non-conformance

1.1 The importance of quality

Success in business depends on satisfying the needs of customers and meeting
the requirements of customers. An essential part of meeting customers’ needs is
to provide the quality that customers require. Quality is therefore an important
aspect of product design and marketing.
Quality is also important in the control of production processes. Poor quality in
production will result in losses due to rejected items and wastage rates, sales
returns by customers, repairing products sold to customers (under warranty
agreements) and the damaging effect on sales of a loss of reputation.
An entity should seek to minimise quality-related costs. In order to do this,
quality-related costs should be measured, analysed and controlled. However in
many organisations the management accounting system does not capture,
analyse and report on quality cost data. This chapter indicates how quality-
related costs could be measured.

1.2 Quality-related costs

Quality-related costs can be defined as: ‘the expenditure incurred in defect
prevention and appraisal activities and the losses due to internal and external
failure of a product or service, through failure to meet the agreed specification’.
An organisation must incur costs to deal with quality.
 It incurs costs to maintain the required quality standards, and to prevent
poor quality, or detect poor quality items when they occur. These are costs
of conformance.
 It incurs costs in correcting the problem when poor quality does occur.
These are costs of non-conformance.
The cost of quality can be defined as: ‘The cost of ensuring and assuring
quality, as well as the loss incurred when quality is not achieved’. The aim should
be to minimise the total of quality-related costs.

1.3 Quality-related costs: costs of conformance and costs of non-conformance

Dr Armand Feigenbaum is considered a ‘quality guru’: he developed the concept
of total quality control (TQC) in the 1950s. The explanation of quality costs that
follows in the rest of this chapter is based on Feigenbaum’s analysis and
categorisation of quality costs.

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Performance management

The following formula sets out the total costs of quality, as defined by Dr Armand
Feigenbaum in the 1950s. This is now a well-established method of analysing
quality costs.

Formula: Quality costs

Costs of Costs of non-
Total costs of
= conformance + conformance
quality (costs of control) (costs of failure)

Costs of
= Prevention costs + Appraisal costs
conformance
and
Costs of non- External failure
= Internal failure costs +
conformance costs

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Chapter 5: Quality and quality costs

2 COSTS OF CONFORMANCE

Section overview

 Appraisal costs
 Prevention costs

2.1 Appraisal costs

No matter how much money is spent on preventing quality failures, some failures
will almost certainly occur. Prevention measures cannot provide a 100%
guarantee of quality. Consequently some inspection checks are needed to test
whether quality standards are being maintained, and if possible to identify
defective items that do occur.
Appraisal costs are the costs that are incurred to detect defective items before
they are delivered to customers and to deal with faults or defects that are
discovered. These costs are normally associated with inspection, and are the
costs incurred as part of the inspection process, in order to ensure that incoming
materials and other supplies – and outgoing finished products – are of the ‘right
quality’. They also include the costs of quality tests and quality audits.
Appraisal costs are incurred either after items have been supplied or produced,
or during the process of production.
Quality inspections may have the objective of identifying all defects, and rejecting
them as unacceptable. Defective materials or parts from a supplier are returned
to the supplier. Defective items that occur during production are either scrapped
or re-worked to eliminate the defect.
However, when an organisation is buying a large number of items and in large
quantities, inspecting 100% of items purchased would be a time-consuming and
expensive process, unless all items can be checked automatically within a fully-
automated production process.
For this reason, it is usual for quality inspections to be carried out on a sample of
items, not 100% of items. The results from the sample testing are used to assess
whether quality standards are on the whole within acceptable limits.
Here are some examples of appraisal costs.
 inspecting purchased items on delivery, to check whether they meet the
required specifications;
 in a manufacturing process, checking items as soon as possible during the
process, or checking finished items for defects;
 carrying out a quality audit from time to time, to assess whether quality
standards are up to the level required and the quality control system is
working as intended.

The costs incurred may consist of:

 the costs of labour time spent on inspecting;
 the costs of inspection equipment.

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Performance management

2.2 Prevention costs

Prevention costs are the costs of action to prevent defects (or reduce the number
of defects). They are costs incurred to prevent a quality problem from arising.
Quality problems can arise for a variety of reasons:
 The initial design of the product and the method of making it may be poor,
so that there will be a large number of sub-standard items produced.
 The raw materials used to make the product may be poor in quality, and
better-quality raw materials may reduce the wastage rate in production.
 The work force may be badly trained, and so may make a large number of
errors in production.
 Faulty output may occur when the production machinery is not in good
working order, which may be caused by insufficient maintenance and
repair work on the machines.
Prevention costs are the costs incurred in preventing these problems from
happening.
Investing in the prevention of quality failures will result in fewer failures and so
less need for inspections, and a reduction in appraisal costs and quality failure
costs. A solution to the problem of quality failures is to prevent them from
happening. Spending on prevention measures can be justified by much bigger
savings in appraisal costs and costs of quality failures.
Prevention costs are costs incurred in order to reduce appraisal costs and the
costs of quality failures, by preventing or reducing defects and failures produced
by the process, and to reduce the need to spend money on inspections and
testing for quality failures.

Examples of measures that might be taken to reduce quality failures are:

 Quality planning: establishing clear specifications for the quality standards
required in a product, service or process. By paying closer attention to
getting specifications ‘right’, particularly in product design, costs of
appraisal and quality failure costs can be reduced;
 Investing in systems and equipment to achieve the required quality
standard;
 Training staff to recognise the importance of quality and ‘getting things
right first time’;
 Choosing only those suppliers that can be expected to deliver supplies to
the required quality standard.

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Chapter 5: Quality and quality costs

3 COSTS OF NON-CONFORMANCE

Section overview

 Internal failure costs

 External failure costs

3.1 Internal failure costs

Internal failures are quality failures that:

 occur when products are defective because they do not conform to

requirements or specifications; but
 are discovered before the product is delivered to the customer.
They are failures that would otherwise have led to the external customer being
dissatisfied, if they had been delivered. Internal failures are caused either by
defects in products (failure of the product to meet specifications) and
inefficiencies in the production process.
Internal failures may be identified when defective items are found in the
inspection or testing process, or when there is a breakdown in the production
process. Items that are inspected and found to be faulty will be either:
 rejected and thrown out, or
 re-worked so that they meet the required quality standard.
Internal failure costs are costs incurred when defective production occurs. They
include:
 the variable cost of items that are scrapped when found to be sub-standard
in quality
 the incremental cost of re-working items to bring them to the required
quality standard
 the cost of production time lost due to failure and defects. If a factory is
working at full capacity and is unable to keep up with sales demand, this
cost would include the contribution lost as a consequence of producing
less finished output and so selling less.

3.2 External failure costs

External failure costs are costs incurred when the quality problem arises after the
goods have been delivered to the customer. They include the costs of:
 dealing with customers’ complaints
 carrying out repair work under a guarantee or warranty
 transport costs incurred when recovering faulty items from customers
 transport costs incurred in delivering repaired items or replacement items
to customers
 recalling all items from customers in order to correct a design fault
 legal costs, when a customer takes the organisation to court

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Performance management

 the cost of lost reputation: when an organisation gets a reputation for poor
quality, customers will stop buying from it.

Reputational costs
Corporate reputation can be defined as the overall estimation in which a
company is held by its customers. Reputations are built up over time, and it is
increasingly recognised that reputation is an important intangible asset. A strong
positive reputation can differentiate a company from its competitors, and help to
attract and retain customers. There is evidence that a good reputation enhances
profitability and contributes to the longer-term success of an organisation, by
maintaining customer and supplier loyalty, supporting the recruitment and
retention of high-quality personnel, and improving competitiveness.
Conversely, a negative reputation – or reputational damage – can erode
customer support for the company and its products.
‘Reputational risk’ is the risk of damage to reputation, and the resulting
consequences. The cost of a poor reputation (a failure to satisfy customers) is an
external failure cost.

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Chapter 5: Quality and quality costs

4 THE SIGNIFICANCE OF QUALITY COSTS

Section overview

 Managing quality costs

 Complications in the interpretation of quality costs
 Managing quality-related costs: Total Quality Management

4.1 Managing quality-related costs

The traditional approach to managing quality costs recognises that there is a
relationship between costs of conformance and costs of non-conformance.
The ‘traditional view’ of managing quality costs is that the total of all quality costs
should be minimised.
 An organisation should spend more money on prevention and detection
costs, if this reduces internal and external failure costs by a larger amount.
 On the other hand, there is no reason to spend more on preventing poor
quality if the benefits do not justify the extra cost.
The first step in reducing the costs of quality is to calculate the total cost the
organisation is incurring for quality.

Example: Calculating the costs of quality

X Limited has experienced quality issues with a new product.
Production information is as follows:
PRODUCTION DATA
Units manufactured and sold 20,000 units
Units requiring rework 3,000 units
Units requiring warranty repair service 4,000 units

The following information is available about the company’s efforts in

respect of quality:
Engineering hours 5,000 hours
Inspection hours (manufacturing) 32,000 hours

Engineering cost per hour ₦105

Inspection cost per hour ₦55
Rework cost per unit reworked ₦5,280
Customer support per warranty repair (per unit) ₦265
Warranty repairs per repaired unit ₦2,000
Staff training costs ₦195,000
Additional product testing costs ₦80,000

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Performance management

Example(continued): Calculating the costs of quality

A quality cost analysis can be prepared as follows:
₦,000 ₦,000
Prevention costs
Training 195
Engineering (5,000  105) 525
Appraisal costs 720
Inspection costs (32,000  55) 1,760
Product testing 80
1,840
Costs of conformance 2,560

Internal failure costs

Rework (3,000  5,280) 15,840
External failure costs
Repairs (4,000  (265 + 5050)) 21,260
Costs of conformance 37,100
Total cost of quality 39,660

In this case, the company’s costs of conformance are much smaller than its
costs of non-conformance. An investment in the costs of conformance might
result in savings in the costs of non-conformance so that overall the total cost of
quality would fall.

Example(continued): Calculating the costs of quality

Following on from the previous example, the company is considering investing in
costs of conformance as follows:
Training costs are to be doubled
Engineering hours are to be trebled
Inspection hours are to be increased five fold
Product testing cost to be trebled

Analysis has led the company to believe that the above measures would
result in the following:
Units requiring rework 2,000 units
Units requiring warranty repair service 2,000 units

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Chapter 5: Quality and quality costs

Example(continued): Calculating the costs of quality

A new quality cost analysis can be prepared as follows:
₦,000 ₦,000
Prevention costs
Training (195,000  2) 390
Engineering (5,000  3  105) 1,575
Appraisal costs 1,965
Inspection costs (32,000  5  55) 8,800
Product testing (80  3) 240
9,040
Costs of conformance 11,005

Internal failure costs

Rework (2,000  5,280) 10,560
External failure costs
Repairs (2,000  (265 + 5050)) 10,630
Costs of conformance 21,190
Total cost of quality 32,195

Therefore the initiative would reduce the total quality costs.

₦,000
Before the initiative 39,660s
After the initiative 32,195
Quality cost reduction 7,465

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Performance management

4.2 Complications in the interpretation of quality costs

Using percentages
Quality costs are often expressed as percentages of sales value. However, they
can also be expressed as a percentage of production costs. The distinction is
important to understand when analysing data.

Example: Calculating the costs of quality

The following information is available for a company.
₦,000
Revenue 1,000
Production costs (800)
Gross profit 200

a) If quality costs are 10% of revenue

The production costs can be analysed as follows:
Quality costs (10% of 1,000) 100
Other production costs (balancing figure) 700
Total production costs 800

a) If quality costs are 10% of production costs

The production costs can be analysed as follows:
Quality costs (10% of 800) 80
Other production costs (balancing figure) 720
Total production costs 800

A question might require you to calculate the number of units that need to be
produced in order to achieve a level of good output subject to a given failure rate.
In this case, the number produced can be found by grossing up the number
required to be sold to take account of the production failures.

Example
A company’s production process losses 20% of units input.
The number of units that must be input in order to achieve output of 100 good
units is:
100 units  100/80 = 125 units (or 100 units ÷ 0.8 = 125 units)
Proof Units
Units input to production 125
Losses in production (20% of 125) (25)
Good output 100

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Chapter 5: Quality and quality costs

Practice question 1
A company is considering investing in a new quality initiative.
It has made the following estimates of losses incurred in order to achieve
an output of 1,000 good units (i.e. free from defects).with and without this
initiative.
Before quality After quality
initiative initiative
Losses in production 5% 1%
Rejections on final inspection 10% 6%

Both units of good output and units lost and rejected costs ₦700 to
produce.
What is the maximum amount that the company should pay for the
quality improvement per batch of 1,000 units?

Timing of benefits
As stated above, the ‘traditional view’ of managing quality costs is that the total
of all quality costs should be minimised. When analysing the success or
otherwise of a change in policy to reduce total quality costs it is important to
understand that benefits resulting from increase spend on costs of conformance
may not be experienced instantly. There may be a delay as the result of the
changes work through the system.

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Example: Timing of changes in quality costs

A company has collected the following information:
Period 1 Period 2 Period 3 Period 4
₦,000 ₦,000 ₦,000 ₦,000
Appraisal costs 50 100 100 100
Prevention costs 60 65 100 120
110 165 200 220
Internal failure costs 250 300 220 180
External failure costs 300 240 180 150
550 540 400 330
Total quality costs 660 705 600 550

Analysis:
Period 1: 83.3% of the quality costs were the result of internal and
external failure.
Period 2: The company doubled spending on appraisal. This led to the
company identifying higher numbers of low quality items. This increased
the internal failure costs but resulted in a fall in the external failure costs
(as fewer flawed items were sent to customers).
Period 3: The information gathered in period 2 as a result of the
investment in appraisal costs allowed the company to identify quality
improvements leading to an increase in the prevention budget. This led
to a fall in internal failure costs and a continued fall in external failure
costs.
Period 4: The trends established in period 3 continued. Increased
prevention costs leads to further reductions in internal failure costs
and external failure costs.
The company has endured an increase in total quality costs from period
1 to period 2 but has benefited from the changes in periods 3 and 4.

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Chapter 5: Quality and quality costs

4.2 Total Quality Management

Customers’ needs can be satisfied to some extent by cutting costs and selling at
lower prices. However, strategies to achieve customer satisfaction must also
focus on three other critical success factors:
 quality;
 time; and
 innovation.
One approach to achieving improvements in these critical success factors is a
Total Quality Management programme.
Total Quality Management (TQM) is a philosophy of quality management with its
origins in Japan in the 1950s.

Definition: Total quality management

An integrated and comprehensive system of planning and controlling all business
functions so that products or services are produced which meet or exceed
customer expectations.
CIMA Official Terminology

TQM is a philosophy of business behaviour, embracing principles such as

employee involvement, continuous improvement at all levels and customer
focus, as well as being a collection of related techniques aimed at improving
quality such as full documentation of activities, clear goal-setting and
performance measurement from the customer perspective.
The ‘traditional view’ outlined above is rejected by supporters of TQM. The TQM
view is that it is impossible to identify and measure all quality costs. In particular,
it is impossible to measure the costs of lost reputation, which will lead to a
decline in sales over time. The aim should therefore always be to work towards
zero defects. To achieve zero defects, it will be necessary to spend more money
on prevention costs.
The TQM approach to quality costs is to ‘get things right the first time’.

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5 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Explain the nature of quality costs
 Analyse quality costs into costs of conformance and costs of non-conformance
 Analyse costs of conformance into appraisal costs and prevention costs
 Analyse costs of non-conformance into internal and external failure costs
 Discuss the potential significance of quality costs, including reputation costs, for
organisations.
 Explain approaches to the management of quality costs including the Total
Quality Management approach

Chapter 5: Quality and quality costs

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SOLUTIONS TO PRACTICE QUESTIONS
Solution 1
The number of units of input needed to produce 1,000 units of good output before and
after the quality initiative can be calculated as follows:

Units
Before the After the
initiative initiative

Desired good output 1,000 1,000

Losses at final inspection (balancing figure) 111 64
Units that reach final inspection
1,000  100/90 (or 1,000/0.9) 1,111
1,000  100/94 (or 1,000/0.94) 1,064
Losses during production (balancing figure) 58 11
Units that are input at the start
1,111  100/95 (or 1,000/0.95) 1,169
1,064  100/99 (or 1,000/0.99) 1,075

Proof
Input at the start 1,169 1,075
Losses during production (5%/1%) (58) (11)
Units that reach final inspection 1,111 1,064
Losses at final inspection (10%/6%) (111) (64)
Good output 1000 1,000

The maximum price that should be paid to achieve the quality

improvements (per batch of 1,000 units) is calculated as follows:
Units of input to achieve output of 1,000 units:
Before the initiative 1,169
After the initiative (1,075)
Units saved due to the initiative 94
Cost per unit (₦) 700
Saving per 1,000 units of good output (₦) 65,800

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6
Skills level

CHAPTER
Performance management

Budgetary control systems

Contents
1 The budgeting process
2 Budgetary systems
3 Dealing with uncertainty in budgeting
4 Behavioural aspects of budgeting
5 Beyond budgeting
6 Chapter review

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Performance management

INTRODUCTION

Detailed syllabus
The detailed syllabus includes the following:
B Planning and control
1 Budgetary system, planning and control
A Discuss and apply forecasting techniques to planning and control.
B Discuss budgetary system in an organization as an aid to performance
management.
C Evaluate the information used in budgetary system.
D Discuss the behavioural aspects of budgeting.
E Discuss the usefulness and problems associated with different types of
budget.
F Explain beyond budgeting models.

Exam context
This chapter explains the purpose of budgetary control systems and continues by explaining
different types of approaches to budgeting. Standard costing is of particular importance as it
is the foundation of variance analysis (covered in the next two chapters). The concluding
section of the chapter covers the behavioural aspects of budgeting.

By the end of this chapter, you should be able to:

 Explain the purposes of budgeting and the budgeting process
 Describe the main features of, and explain the differences between bottom-up and top-
down budgeting
 Explain incremental and zero-based budgeting
 Explain activity based budgeting (ABB)
 Recognise and explain the importance of the behavioural aspects of budgeting
 Discuss beyond budgeting as a concept
 Explain and apply forecasting techniques

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Chapter 6: Budgetary control systems

1 THE BUDGETING PROCESS

Section overview

 Introduction to budgeting
 Preparing the budget
 Principal budget factor
 Stages in the budgeting process

1.1 Introduction to budgeting

Planning framework
A business entity should plan over the long term, medium term and short term.
 Long term planning, or strategic planning, focuses on how to achieve the
entity’s long-term objectives.
 Medium-term or tactical planning focuses on the next year or two.
 Short-term or operational planning focuses on day-to-day and week-to-
week plans.
Budgets are medium-term plans for the business, expressed in financial terms. A
typical budget is prepared annually, and the overall budget is divided into control
periods for the purpose of control reporting.

The nature of budgets

Definition: Budget
A budget is a financial and/or quantitative statement prepared and approved
prior to a defined period of time for the purpose of attaining a set of given
objectives

A budget is a formal plan, expressed mainly in financial terms and covering all
the activities of the entity. It is for a specific period of time, typically one year.
When budgets are prepared annually, they are for the next financial year.
The total budget period (one year) may be sub-divided into shorter control
periods of one month or one quarter (three months).

Purposes of budgeting
Budgets have several purposes.
 To convert long-term plans (strategic plans) into more detailed shorter-term
(annual) plans.
 To ensure that planning is linked to the long-term objectives and strategies
of the organisation.
 To co-ordinate the actions of all the different parts of the organisation, so
that they all work towards the same goals. (This is known as ‘goal
congruence’). One of the benefits of budgeting is that is covers all activities,
so the plan should try to ensure that all the different activities are properly
co-ordinated and working towards the same objective.

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Performance management

 To communicate the company’s plans to the individuals (managers and

other employees) who have to put the plans into action.
 To motivate managers and employees, by setting targets for achievement,
and possibly motivating them with the incentive of bonuses or other
rewards if the targets are met.
 To provide guidelines for authorising expenditure. Expenditure might not be
permitted unless it has been planned in the budget or unless it is within the
budgeted expenditure limits for the department.
 To identify areas of responsibility for implementing the plans. For each part
of the budget, an individual manager should be made responsible for
achieving the budget targets for performance.
 To provide a benchmark against which actual performance can be
measured.
 To control costs. Costs can be controlled by comparing budgets with actual
results and investigating any differences (or variances) between the two.
This is known as budgetary control.

1.2 Preparing the budget

Preparing the annual budget is a major activity for many entities. In many
medium-sized and large companies, there is a well-defined process for budget
preparation, because a large number of individuals have to co-ordinate their
efforts to prepare the budget plans. The budgeting process may take several
months, from beginning to eventual approval by the board of directors.
The budgeting process might be supervised and controlled by a special
committee (the budget committee). This consists of senior managers from all
the main areas of the business. The committee co-ordinates the various
functional budgets submitted to it for review, and gives instructions for changes to
be made when the draft budgets are unsatisfactory or the functional budgets are
not consistent with each other.
Although the budget committee manages the budgeting process, the functional
budgets are usually prepared by the managers with responsibility for the
particular aspect of operations covered by that functional budget.

Budget manual
There should be a budget manual or budget handbook to guide everyone
involved in the budgeting process,. This should set out:
 the key objectives of the budget;
 budget planning procedures and budget timetables;
 the budget details that must be included in the functional budgets;
 responsibilities for preparing the functional budgets; and
 details of the budget approval process. The budget must be approved by
the budget committee and then by the board of directors.

The master budget

The ‘master budget’ is the final approved budget. It is usually presented in the
form of financial statements - a budgeted statement of profit or loss and a
budgeted statement of financial position for the end of the financial year.

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Chapter 6: Budgetary control systems

However the master budget is the result of a large number of detailed plans,
many of them prepared at a departmental or functional level. To prepare the
master budget, it is therefore necessary to prepare functional budgets first.

Functional budgets
A functional budget is a budget for a particular aspect of the entity’s operations.
The functional budgets that are prepared vary with the type of business and
industry. In a manufacturing company, functional budgets should include:
 a sales budget;
 a production budget;
 a budget for production resources and resource costs (such as a materials
cost budget and a labour cost budget);
 a materials purchasing budget; and
 an expenditure budgets for every overhead cost centre and general
overhead costs.

1.3 Principal budget factor

The budgeting process begins with the preparation of functional budgets, which
must be co-ordinated and consistent with each other. To make sure that
functional budgets are co-ordinated and consistent, the first functional budget
that should be prepared is the budget for the principal budget factor.
The principal budget factor (also called the key budget factor) is the factor in the
budget that will set a limit to the volume and scale of operations.

Sales demand (sales volume) as the principal budget factor

Normally, the principal budget factor is the expected sales demand. When this
happens, the expected sales demand should set a limit on the volume of
production (or volume of services). A company might have the capacity to
increase its production and output, but producing larger quantities has no
purpose unless the extra quantities can be sold.
A company will therefore prepare a budget on the basis of the sales volumes that
it hopes or expects to achieve. When sales demand is the principal budget factor,
the sales budget is the first functional budget that should be prepared.

A principal budget factor other than sales volume

Sometimes, there is a different limitation on budgeted activity. There might be a
shortage of a key resource, such as machine time or the availability of skilled
labour. When there is a shortage of a resource that will set a limit on budgeted
production volume or budgeted activity, the first functional budget to prepare
should be the budget for that resource.
In government, the principal budget factor for each government department is
often an expenditure limit for the department. The department must then prepare
a budget for the year that keeps the activities and spending plans of the
department within the total expenditure limit for the department as a whole.

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Performance management

1.4 Stages in the budgeting process

The budgeting process for a manufacturing company is probably more complex
than for many other types of organisation, and manufacturing company budgets
are more likely to be the subject of an examination question than budgets for
companies in other industries. This chapter therefore describes the budgeting
process for a manufacturing company.
The stages in setting the budget might be as follows.
 Stage 1: The provision and communication of budget guidelines to relevant
managers
 Stage 2: Identify the principal budget factor (or key budget factor). The
principal budget factor is often sales volume.
 Stage 3: Prepare the functional budget or plan for the principal budget
factor. Usually, this means that the first functional budget to prepare is the
sales budget.
 All the other functional budgets should be prepared within the limitation of
the principal budget factor. For example, even if the company has the
capacity to produce more output, it should not produce more than it can sell
(unless it formally decides to increase the size of the finished goods
inventory, in which case the production volume will be higher than the sales
volume).
 Stage 4: Prepare the other functional budgets, in logical sequence where
necessary. When the sales budget has been prepared, a manufacturing
organisation can then prepare budgets for inventories (= plans to increase
or reduce the size of its inventories), a production budget, labour usage
budgets and materials usage and purchasing budgets. Expenditure
budgets should also be prepared for overhead costs (production
overheads, administration overheads and sales and distribution
overheads). Overhead costs budgets are usually prepared for each cost
centre individually.
 Stage 5: Submit the functional budgets to the budget committee for review
and approval. The functional budgets are co-ordinated by the budget
committee, which must make sure that they are both realistic and
consistent with each other.
 Stage 6: Prepare the ‘master budget’. This is the budget statement that
summarises the plans for the budget period. The master budget might be
presented in the form of:
 a budgeted statement of profit or loss for the next financial year
 a budgeted statement of financial position as at the end of the next
financial year
 a cash budget or cash flow forecast for the next financial year.
 It should be possible to prepare the master budget statements from the
functional budgets.
 Stage 7: The master budget and the supporting functional budgets should
be submitted to the board of directors for approval. The board approves
and authorises the budget.
 Stage 8: The detailed budgets are communicated to the managers
responsible for their implementation.

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Chapter 6: Budgetary control systems

 Stage 9: Control process. After the budget has been approved, actual
performance should be monitored by comparing it with the budget. Actual
results for the period should be recorded and reported to management.
These results should be compared with the budget, and significant
differences should be investigated. The reasons for the differences
(‘variances’) should be established, and where appropriate control
measures should be taken. Comparing actual results with the budget
therefore provides a system of control. The managers responsible for
activities where actual results differ significantly from the budget will be held
responsible and accountable.
The planning process (budgeting) should therefore lead on to a management
monitoring and control process (budgetary control).
The next section describes the approach that can normally be used to prepare
functional budgets for a manufacturing organisation. In practice, budgets are
usually prepared with a computer model, such as a spreadsheet. However, you
need to understand the logic of budget preparation.

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Performance management

Practice question 1
X Limited makes and sells two products, Product X and Product Y.
Its sales budget for next year is to sell 2,500 units of Product X at a sales
price of ₦410 per unit and 3,200 units of Product Y at a sales price of
₦400 per unit.
The following cost information is expected to apply in the next year:
Product X Product Y
Cost per Cost per
Usage unit of X Usage unit of Y
Direct materials (kgs) (₦) (kgs) (₦)
Material A (₦30 per kg) 1.00 30 1.00 30
Material B (₦80 per kg) 0.75 60 0.50 40
Material C (₦30 per kg) 2.00 60 3.00 90
150 160
Usage Usage
Direct labour (hrs) (hrs)
Grade I (₦100 per hr.) 1.00 100 0.80 80
Grade II (₦80 per hr.) 1.50 120 1.00 80
220 160
Unit cost 370 320

The following opening and closing inventories are budgeted:

Opening Closing
Finished goods: Cost (₦) Units Total (₦) Units Total (₦)
X 370 300 111,000 200 74,000
Y 320 150 48,000 100 32,000
159,000 106,000
Materials: Cost kgs kgs
A 30 400 12,000 380 11,400
B 80 450 36,000 400 32,000
C 30 150 4,500 120 3,600
52,500 47,000

Total inventory 211,500 153,000

Required
a) Prepare functional budgets for sales, production units, material
usage, material purchases and labour usage.
b) Prepare a budgeted profit or loss account for the period.

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Chapter 6: Budgetary control systems

2 BUDGETARY SYSTEMS

Section overview

 Top-down budgeting and bottom-up budgeting

 Periodic budgets and rolling budgets (continuous budgets)
 Incremental budgeting and zero-based budgeting (ZBB)
 Activity based budgeting (ABB)
 Feed-forward control
 Difficulties in changing a budgetary system

A budgetary system is a system for preparing budgets (and producing control reports
for the purpose of budgetary control). There are several budgetary systems, and
entities will choose a system that is appropriate for their needs and circumstances.

2.1 Top-down budgeting and bottom-up budgeting

Top-down budgeting
In a system of top-down budgeting, the budget targets for the year are set at
senior management level, perhaps by the board of directors or by the budget
committee. Top-level decisions might be made, for example, about the amount of
budgeted profit that will be achieved, the growth in sales, reductions in production
costs and other functional department costs, and so on.
Divisions and departments are then required to prepare a budget for their own
operations that is consistent with the budget imposed on them from above.
For example, the board of directors might state that in the budget for the next
financial year, sales revenue will grow by 5% and profits by 8%. The sales
director would then be required to prepare a more detailed sales budget in which
the end result is a 5% growth in annual sales revenue. A production budget and
other functional budgets will then be prepared that is consistent with the sales
budget. The target for 8% growth in profits cannot be checked until all the
functional budgets have been prepared in draft form. If the initial draft budgets fail
to achieve 8% growth in profits, some re-drafting of the budgets will be required.
This process is called top-down budgeting because it starts at the top with senior
management and works its way down to the most detailed level of budgeting
within the management hierarchy. This might be departmental level or possibly
an even smaller unit level, such as budgets for each work section within each
department. A system of top-down budgeting would normally be associated with
an entity where management control is highly centralised.

Bottom-up budgeting
In a system of bottom-up budgeting, budgeting starts at the lowest level in the
management hierarchy where budgets are prepared. This may be at work section
level or departmental level. The draft lower-level budgets are then submitted to
the next level of management in the hierarchy, which combines them into a co-
ordinated budget, for example a departmental budget. Departmental budgets
might then be submitted up to the next level of management, which might be at
divisional level, where they will be combined and co-ordinated into a divisional
budget. Eventually budgets for each division will be submitted up to the budget
committee or board of directors.

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Performance management

The budget committee or board of directors will consider the draft budgets they
receive, and ask for changes to be made if the overall master budget is
unsatisfactory. Re-drafting of budgets will then go on until the master budget is
eventually approved.
In a system of bottom-up budgeting, lower levels of management are likely to
have more input to budget decision-making than in a top-down budgeting system,
and it is associated with budgeting in entities where management authority is
largely decentralised.

2.2 Periodic budgets and rolling budgets (continuous budgets)

Periodic budgets
A periodic budget is a budget for a particular time period, typically the financial
year. The budget is not changed or revised during the year, and it is a fixed
budget for the period. A company might therefore prepare a periodic budget for
its financial year 2010, which will then be replaced the next year by the periodic
budget for 2011, which will then be replaced the year afterwards by the periodic
budget for 2012, and so on.
Traditional budgeting systems are periodic budgeting systems. When periodic
budgets are used, an underlying assumption is that revenues and expenditure
within the financial year should be fairly predictable and that it is unlikely that any
unexpected events will occur during the year that will make the budget unrealistic
or irrelevant.
Periodic budgets are much less useful, however, when future events are
unpredictable and big changes might happen unexpectedly during the course of
the financial year. When events change rapidly, the original budget loses its
relevance because of the extent of the changes that have occurred. For example
an entity might operate in a country where the annual rate of inflation might be
anywhere between 200% and 400% during the year. Given the difficulty in
forecasting what the actual rate of inflation will be, but the probability that it will be
very high, it would make sense to review the budget regularly, and adjust it to
allow for revised estimates of what the rate of inflation will be.
When unexpected changes are likely to occur, or when future events are difficult
to predict with accuracy, it might be advisable for an entity to prepare revised
budgets much more frequently, as a matter of routine.

Rolling budgets
A rolling budget, also called a continuous budget, is a budget that is
continuously being updated. Each updated budget is for a given length of time,
typically 12 months. For example a new rolling budget may be prepared every
three months so that as one quarter of a 12-month budget ends, a new 12-month
budget is prepared with an additional quarter added at the end. In this way a new
12-month budget is prepared every three months.
A rolling budget can therefore be defined as ‘a budget continuously updated by
adding a further period, say a month or a quarter, and deducting the earliest
period’.

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Chapter 6: Budgetary control systems

Rolling budgets are most useful where future costs or activities cannot be
forecast reliably, so that it makes much more sense for planning purposes to
review the budget regularly, but to plan ahead for a full planning period each
time.

Example:
A company might prepare rolling annual budgets every three months. It will
prepare four annual budgets each year. If its year-end is 31st December, its
preparation of rolling budgets would be as follows:

Date of budget preparation Period covered by the budget

December Year 1 1st January – 31st December Year 2
March Year 2 1st April Year 2 – 31st March Year 3
June Year 2 1st July Year 2 – 30th June Year 3
September Year 2 1st October Year 2 – 30th September
Year 3
December Year 2 1st January – 31st December Year 3
and so on

Rolling budgets might be particularly useful for cash budgeting. An organisation

must ensure that it will always have sufficient cash to meet its requirements, but
actual cash flows often differ considerably from the budget. It might therefore be
appropriate to prepare a new annual cash budget every month, and so have 12
rolling cash budgets every year.

The main advantages of rolling budgets are as follows:

 Budgets are continually reviewed and revised in response to changes in
business conditions. The entity is not committed to a fixed annual budget
that is no longer relevant.
 Control can be exercised through comparisons between current forecasts
and strategic targets. This is a form of feedforward control. When the
business environment is continually changing, this may be a more effective
method of budgetary control than comparing actual results with the fixed
budget or standard costs.
The main disadvantages of rolling budgets are as follows:
 They can be time-consuming, and divert management attention from the
task of managing actual operations.
 Whenever a new rolling budget is prepared, the new plans must be
communicated to all managers affected by the changes. There is a risk that
some managers will not be informed about changes to plans and targets.

2.3 Incremental budgeting and zero-based budgeting (ZBB)

Incremental budgeting and zero-based budgeting are two different approaches to
estimating budgeted expenditure. The difference between them is most obvious
in budgeting for administrative activities (and other overhead activities) and
overhead costs.

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Performance management

Incremental budgeting
With incremental budgeting, the budgeted expenditure for the next financial
period is estimated by taking expenditure in the current period as a starting point.
An incremental amount is then added for:
 inflation in costs next year, and
 possibly, the cost of additional activities that will be carried out next year.
In its simplest form, incremental budgets for a financial period are prepared by
taking the expenditure in the current year, and adding a percentage to allow for
inflation next year.
This approach to budgeting is very common in practice because of its relative
simplicity. For example in order to prepare a labour cost budget, it might be
sufficient for the manager to make assumptions about (1) changes in staffing
levels and (2) the general level of pay rises, and apply these assumptions to the
actual labour costs for the current year that is just ending. If labour costs in the
current year are ₦2.4 million, and if it is assumed that the work force will increase
by 2% next year and that wages and salaries will increase by an average of 4%,
a labour cost budget can be prepared simply as: ₦2.4 million  102%  104% =
₦2.546 million.
A serious weakness of incremental budgeting, however, is that there is no
incentive to eliminate wasteful or unnecessary spending from the budget. For
example suppose that next year’s budget is based on this year’s actual spending
plus an allowance for inflation. If there has been wasteful spending in the current
year, next year’s budget will include an allowance for the wasteful spending, plus
inflation.
Incremental budgeting can also encourage more waste (sometimes called
‘budget slack’), because managers will try to spend up to their budget limit, so
that in the next financial year their budgeted spending allowance will not be
reduced.

Zero-based budgeting (ZBB)

Zero-based budgeting (ZBB) has a completely different approach to budgeting. It
aims to eliminate all wasteful spending (‘budget slack’) and only to budget for
activities that are worth carrying out and that the organisation can afford.
Planning starts from ‘zero’ and all spending must be justified.

Definition: Zero-based budgeting

A budget prepared from the “basement” or the “ground up” as if the budget were
being prepared for the first time.

ZBB can be particularly useful in budgeting for activities that are prone to
wasteful spending and budget slack, such as activities in a bureaucracy. ZBB
might be usefully applied, for example, to the budgets of government
departments.
The approach used in ZBB is as follows:
 The minimum level of operations in a department or budget centre is
identified. These are the essential things that the department will have to
do. A budget is prepared for this minimum essential level.

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 All other activities are optional additional activities that need to be justified,
in terms of the benefits obtained in return for the costs. Each additional
activity is called a decision package.
A decision package is a program of activities that will achieve a specific purpose
during the budget period. Each decision package must have a clearly-stated
purpose that contributes to the goals and objectives of the entity.
There are two types of decision package.
 Decision packages for a minimum level of operation. For example,
there may be a minimum acceptable level of training for a group of
employees. There may be several alternative decision packages for
providing the training – internal courses, external courses, or computer-
based training programmes. An expenditure estimate should be prepared
for each alternative basic decision package.
 Incremental decision packages. These are programmes for conducting a
more extensive operation than the minimum acceptable level. For example,
there may be incremental decision packages for providing some employees
with more training than the essential minimum, or for having more
extensive supervision, or more extensive quality control checks. For
incremental decision packages, an estimate should be made of the cost of
the incremental operation, and the expected benefits. Incremental decision
packages are optional activities: the entity need not include them in the
budget.
For each decision package, a budget decision must be made about whether to
include it in the budget and the following should be considered:
 Purpose of the activity (decision package)
 The likely results and benefits from the activity
 The resources required for the activity, and their cost
 Alternative ways of achieving the same purpose, but perhaps at a lower
cost
 A comparison of the costs and benefits of the activity.
A zero-based budget is then prepared as follows:
 A decision must be taken to provide for a minimum level of operation. This
means deciding for each basic operation:
 Whether or not to perform the operation at all – do the benefits justify
the costs?
 If the operation is performed at a basic level, which of the alternative
basic decision packages should be selected?
 Having decided on as basic level of operations, a basic expenditure budget
can be prepared.
 The next step is to consider each incremental decision package, and
decide whether this additional operation, or additional level of operations, is
justified. An incremental decision package is justified if the expected
benefits exceed the estimated costs.
 A budget can then be prepared consisting of all the selected basic decision
packages and incremental decision packages.

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 If the total expenditure budget is too high, when all these decision
packages are included, some incremental decision packages should be
eliminated from the budget. One method of doing this is to rank the
incremental decision packages in an order of priority (typically in order of
net expected benefits, which are the expected benefits minus the estimated
incremental costs). The decision packages at the bottom of the priority list
can then be eliminated from the budget, until total budgeted expenditure
comes within the maximum permitted spending limit.
Extensive use of value judgements by managers will be needed to rank decision
packages in a priority order. This is because the expected benefits from
incremental activities or incremental programmes are often based on guesswork
and opinion, or on forecasts that might be difficult to justify.

The advantages of zero-based budgeting

There are some obvious benefits from zero based budgeting
 All activities are reviewed and evaluated, and no activity is included in the
budget unless it appears to be worthwhile.
 Inefficiency in using resources and inefficiency in spending should be
identified and eliminated.
 A ZBB approach helps managers to question the reason for doing things
rather than simply accepting the current position.
 When total expenditure has to be reduced, ZBB provides a priority list for
activities and expenditures.
 ZBB encourages greater involvement by managers and might motivate
them to eliminate wasteful spending.

The disadvantages of zero-based budgeting

However, there are also some severe disadvantages to ZBB
 ZBB is a very time-consuming process, particularly if undertaken every
year.
 It is also costly, because it takes more time.
 Planners need to understand the principles of relevant costing and
decision-making, in order to compare properly the incremental costs and
incremental benefits of activities (decision packages).
 Managers might see ZBB as a threat, and an attempt by senior
management to cut back their expenditure allowances in the next budget
year.
 When incremental decision packages are ranked in priority order, there
may be disputes between managers of different decision units (budget cost
centres), as each tries to protect his own spending levels and argue that
budget cuts should fall on other cost centres.
In view of the large amount of management time that is required to prepare a
zero based budget, an entity may decide to produce a zero based budget
periodically, say every three years, and to prepare incremental budgets in the
intervening years.
In order to maintain the support of budget cost centre managers for a system of
ZBB, it is also necessary to make sure that any system of performance-based
rewards (such as annual bonuses for keeping spending within budget limits) is

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not affected by the use of ZBB. If managers feel that their rewards will be
threatened – for example because it will be difficult to keep spending within the
ZBB limits – they are unlikely to give their support to the ZBB system.
ZBB and performance monitoring
A successful system of ZBB requires methods for monitoring actual performance
and comparing actual performance with the budget.
 Each decision package must therefore have one or more measurable
performance objectives. The package must specify the objective or
objectives, and the activities or operations that will be required to achieve
those objectives.
 Actual performance should be measured and compared with the objectives.
Management must be informed whether or not the performance objectives
are achieved.

2.4 Activity based budgeting (ABB)

Background
Activity-based budgeting is a planning system under which costs are associated
with activities, and budgeted expenditures are then compiled based on the
expected activity level.
Activity based budgeting (ABB) is an extension of activity based costing (ABC)
which is an alternative approach to traditional absorption costing.
Traditional absorption accounting identifies overheads and absorbs them into
units of production or services using a volume based approach. For example,
overheads might be absorbed as an amount per direct labour hour or an amount
per unit of material used when making a product.
Traditional absorption costing has many weaknesses, especially in a ‘modern’
manufacturing environment where production overhead costs are often high
relative to direct production costs. Therefore, a system of adding overhead costs
to product costs by using time spent in production (direct labour hours or
machine hours) is difficult to justify.
Activity based costing assumes that overhead costs are caused by activities, and
the costs of activities are driven by factors other than production volume. For
each activity, there should be a cost driver. A cost driver is the factor that
determines the cost of the activity. It is something that will cause the costs for an
activity to increase as more of the activity is performed.
When an entity uses activity based costing, it should be able to prepare activity
based budgets. These are budgets prepared using activity based costing
methods, and budgets for overheads are therefore prepared as activity costs.

Definition: Activity-based budgeting

Activity-based budgeting (ABB) is a method of budgeting based on an activity
framework, using cost driver data in the budget setting and variance feedback
processes.
CIMA Official Terminology

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The preparation of an activity based budget requires the following steps:

Step Description
1 Identify activities and their cost drivers
2 Forecast the number of units of cost driver for the required activity
level
3 Calculate the cost driver rate (cost per unit of activity). for the coming
period

Example: Activity based budgeting

A company expects to process 50,000 sales orders in the coming budget
period.(NB this is not to sell 50,000 units but to make 50,000 sales with each
sales comprising a different number of units).
The forecast cost of processing a single sales order is ₦10 regardless of the
number of units to be sold in that order.
The budgeted cost of selling overhead is calculated as follows:
Step 1
Activity Sales
Cost driver Making a sale
Step 2: Number of units of cost driver 50,000
Step 3: Calculate the cost driver rate ₦10
Budgeted sales overhead ₦500,000

The above example provided a cost driver rate (₦10 per sale). It is important to
realise that the cost of an activity would have to be calculated and that might be
quite difficult to do.
The company would have to analyses its costs and identify those which related to
processing sales orders. This might be a little tricky. For example, part of the cost
of processing the order might involve the accounts department raising an invoice.
However, the person who raises the invoice will have other duties so not all of the
salary costs would necessarily relate to sales.
Advantages of activity-based budgeting
 It gives managers a much better understanding of the link between costs
and output of the business.
 It focuses attention on expensive activities and management might be able
to reduce the cost of these to increase profit.
 It might allow management to increase resource to eliminate bottlenecks
associated with an activity and allow business functions to run more
smoothly.
 It might also be possible to identify activities that do not add value, and their
associated costs. These activities can then be eliminated from the budget.
 Activities drive costs. By identifying cost drivers, it might be assumed that
Resources are clearly matched to its service provision

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Disadvantages of activity-based budgeting

 It is complex in nature and very difficult to set up.
 it requires a great deal of preliminary analysis and research to trace
costs back to activities; and
 accounting information systems would have to be modified to track
costs that relate to activities.
 As a result of the work necessary before it can be used it is expensive to
set up. (it is most useful to companies that have already introduced activity
based costing because they already have a strong insight into what is
needed to introduce activity-based budgeting).
 It is complex to operate.
 It is not practical for services where a flexible approach is required and/or
where resources need to be moved between activities in response to
demand.

2.5 Feed-forward control

Budgetary systems are systems of control as well as planning systems. In a
normal budgetary control system, actual results in each control period (month)
are compared with the budgeted results for the period. (Sometimes, cumulative
actual results for the year to date are also compared with budgeted results for the
year to date.)
Information that provides a comparison between budgeted results (planned
results) and actual results is called feedback.
Instead of basing budgetary control on feedback, there might be a system of
feed-forward control. With feed-forward control, control information is based on a
comparison with a revised up-to-date forecast of what is now expected to happen
in the budget year.
Feed-forward control involves a comparison between:
 a revised up-to-date forecast, and
 the original budget.
Within a budgetary control system, it should be possible in each control period to
compare:
 budgeted and actual results for the most recent control period (feedback
control)
 cumulative budgeted and actual results for the financial year to date
(feedback control)
 forecast results and the original budgeted results for the financial year
(feed-forward control).
A problem with feed-forward control, however, is that up-to-date forecasts of what
will happen in the rest of the financial year might not be reliable. The quality of
the control system depends on the quality (reliability) of the forecast information.

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2.6 Difficulties in changing a budgetary system

Each of the budgetary systems described in this section offers some benefits,
and one system is not necessarily better than another. The senior management
of an entity may decide that the budgetary system should be changed, and a new
system of budgeting (such as rolling budgets, zero-based budgets, or activity-
based budgets) should be introduced.
However, the practical difficulties of switching from one budgetary system to
another should be understood, and the benefits of using a new system might not
be sufficient to justify the problems in changing over. Difficulties that could arise
with the introduction of a new budgetary system include:
 Resistance of the managers responsible for budgeting: managers might be
reluctant to change to a new system from a system they understand and
are familiar with.
 Suspicion about the motives of senior management for wanting to make the
change.
 The time required to prepare the new system of budgeting, including the
time required to train managers in how to operate the new system.
 Practical difficulties with implementing the new system, such as difficulties
in calculating the relevant costs for a decision package (ZBB) or difficulties
in preparing reliable up-to-date forecasts (feed-forward control).

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3 DEALING WITH UNCERTAINTY IN BUDGETING

Section overview

 Limitations of a ‘fixed’ budget

 The nature of uncertainty in budgeting
 Flexible budgets
 Probabilities and expected values
 Spreadsheets and ‘what if’ analysis

3.1 Limitations of a ‘fixed’ budget

Weaknesses in the traditional budgeting process have been recognised, and
alternative budgeting models have been developed to improve the quality of
budgets and budgetary control.
A major weakness with an annual budget is that it is a fixed annual plan. Once it
has been prepared, it usually remains the ‘official’ plan until it is replaced by the
next annual budget 12 months later.
‘Fixed’ annual budgets are unsatisfactory for two important reasons.
 When a budget is prepared, there is a great deal of uncertainty about what
will happen, and the budget will be based on estimates. Even when
estimates are reasonable, there is no certainty that they will turn out to be
‘correct’.
 Unexpected events will happen during the year, and conditions in the
business environment will change. The changes might be significant, and
the ‘fixed’ budget will cease to be realistic and achievable. It might therefore
be appropriate to re-consider and revise the budget.

3.2 The nature of uncertainty in budgeting

There is uncertainty in budgeting because estimates and forecasts may be
unreliable. Information is almost never 100% reliable (or ‘perfect’), and some
uncertainty in budgeting is therefore inevitable.
Risk arises in business because actual events may turn out better or worse than
expected. For example, actual sales volume may be higher or lower than
forecast. The amount of risk in business operations varies with the nature of the
operations. Some operations are more predictable than others. The existence of
risk means that forecasts and estimates in the budget, which are based on
expected results, may not be accurate.
Both risk and uncertainty mean that estimates and forecasts in a budget are
unlikely to be correct.
Management must be aware of risk and uncertainty when preparing budgets and
when monitoring performance.
 When preparing budgets, it may be appropriate to look at several different
forecasts and estimates, to assess the possible variations that might occur.
In other words, managers should think about how much better or how much
worse actual results may be, compared with the budget.

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 When monitoring actual performance, managers should recognise that

adverse or favourable variances might be caused by weaknesses in the
original forecasts, rather than by good or bad performance.
Several approaches may be used for analysing risk and uncertainty in budgets.
These include:
 flexible budgets;
 using probabilities and expected values;
 use feed-forward control;
 using spreadsheet models and ‘what if’ analysis (sensitivity analysis); and
 stress testing.

3.3 Flexible budgets

Flexible budgets may be prepared during the budget-setting process. A flexible
budget is a budget based on an assumption of a different volume of output and
sales than the volume in the master budget or ‘fixed budget’.
An organisation might prepare several flexible budgets in addition to the main
budget (the master budget or fixed budget). If the actual level of activity differs
significantly from the expected level, the fixed budget can be substituted by a
suitable flexible budget.
For example, a company might prepare its master budget on the basis of
estimated sales of ₦100 million. Flexible budgets might be prepared on the basis
that sales will be higher or lower – say ₦80 million, ₦90 million, ₦110 million and
₦120 million. Each flexible budget will be prepared on the basis of assumptions
about fixed and variable costs, such as increases or decreases in fixed costs if
sales rise above or fall below a certain amount, or changes in variable unit costs
above a certain volume of sales.
During the financial year covered by the budget, it may become apparent that
actual sales and production volume will be higher or lower than the fixed budget
forecast. In such an event, actual performance can be compared with a suitable
flexible budget.
Flexible budgets can be useful, because they allow for the possibility that actual
activity levels may be higher or lower than forecast in the master budget. The
main disadvantage of flexible budgets could be the time and effort needed to
prepare them. The cost of preparing them could exceed the benefits of having
the information that they provide.

Flexible vs flexed
Note that a flexible budget is not the same as a flexed budget.
A flexible budget is prepared before the start of a budget period. It is described
as being ex-ante.
A flexed budget is prepared after the end of a budget period. It is described as
being ex-post. A flexed budget is one that is redrafted to actual levels of activity
for control purposes. The concept of a flexed budget is fundamental to variance
analysis which is covered in a later chapter.

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3.4 Probabilities and expected values

Estimates and forecasts in budgeting may be prepared using probabilities and
expected values. An expected value is a weighted average value calculated with
probabilities.

Example: Expected value

A company is preparing a sales budget. The budget planners believe that the
volume of sales next year will depend on the state of the economy.
State of the economy Sales for the year
₦ million
No growth 40
Low growth 50
Higher growth 70
It has been estimated that there is a 60% probability of no growth, a 30%
probability of low growth and a 10% probability of higher growth.
The expected value (EV) of sales next year could be calculated as follows:
Sales for EV of
State of the economy the year Probability sales
₦
₦ million million
No growth 40 0.6 24
Low growth 50 0.3 15
Higher growth 70 0.1 7
EV of sales 46
The company might decide to prepare a sales budget on the assumption that
annual sales will be ₦46 million.

The problems with using probabilities and expected values

There are two problems that might exist with the use of probabilities and
expected values.
 The estimates of probability might be subjective, and based on the
judgement or opinion of a forecaster. Subjective probabilities might be no
better than educated guesses. Probabilities should have a rational basis.
 An expected value is most useful when it is a weighted average value for
an outcome that will happen many times in the planning period. If the
forecast event happens many times in the planning period, weighted
average values are suitable for forecasting. However, if an outcome will
only happen once, it is doubtful whether an expected value has much
practical value for planning purposes.
This point can be illustrated with the previous example of the EV of annual sales.
The forecast is that sales will be ₦40 million (0.60 probability), ₦50 million (0.30
probability) or ₦70 million (0.10 probability). The EV of sales is ₦46 million.
 The total annual sales for the year is an outcome that occurs only once. It is
doubtful whether it would be appropriate to use ₦46 million as the budgeted
sales for the year. A sales total of ₦46 million is not expected to happen.

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 It might be more appropriate to prepare a fixed budget on the basis that

sales will be ₦40 million (the most likely outcome) and prepare flexible
budgets for sales of ₦50 million and ₦70 million.
When the forecast outcome happens many times in the planning period, an EV
might be appropriate.

Example: Expected value

A company is preparing a sales budget. The budget planners believe that the
volume of sales next year will depend on the state of the economy.
State of the economy Sales for the year
₦ million
No growth 40
Low growth 50
Higher growth 70
It has been estimated that there is a 60% probability of no growth, a 30%
probability of low growth and a 10% probability of higher growth.
The expected value (EV) of sales next year could be calculated as follows:
Sales for the year Probability EV of sales
₦ ₦ million
7,000 0.5 3,500
9,000 0.3 2,700
12,000 0.2 2,400
8,600

If the probability estimates are fairly reliable, this estimate of annual sales should
be acceptable as the annual sales budget.

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3.5 Spreadsheets and ‘what if’ analysis

Preparing budgets is largely a ‘number crunching’ exercise, involving large
amounts of calculations. This aspect of budgeting was made much easier,
simpler and quicker with IT and the development of computer-based models for
budgeting. Spreadsheet models, or similar planning models, are now widely used
to prepare budgets.
A feature of computer-based budget models is that once the model has been
constructed, it becomes a relatively simple process to prepare a budget. Values
are input for the key variables, and the model produces a complete budget.
Amendments to a budget can be made quickly. A new budget can be produced
simply by changing the value of one or more input variables in the budget model.
This ability to prepare new budgets quickly by changing a small number of values
in the model also creates opportunities for sensitivity analysis and stress
testing. The budget planner can test how the budget will be affected if forecasts
and estimates are changed, by asking ‘what if’ questions. For example:
 What if sales volume is 5% below the budget forecast?
 What if the sales mix of products is different?
 What if the introduction of the new production system or the new IT system
is delayed by six months?
 What if interest rates go up by 2% more than expected?
 What if the fixed costs are 5% higher and variable costs per unit are 3%
higher?
Sensitivity analysis and stress testing are similar.
 Sensitivity analysis considers variations to estimates and input values in the
budget model that have a reasonable likelihood of happening. For example,
variable unit costs might be increased by 5% or sales forecasts reduced by
5%.
 Stress testing considers the effect of much greater changes to the forecasts
and estimates. For example, what might happen if sales are 20% less than
expected? Or what might happen if the price of a key raw material
increases by 50%?
The answers to ‘what if’ questions can help budget planners to understand more
about the risk and uncertainty in the budget, and the extent to which actual
results might differ from the expected outcome in the master budget. This can
provide valuable information for risk management, and management can assess
the ‘sensitivity’ of their budget to particular estimates and assumptions.

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4 BEHAVIOURAL ASPECTS OF BUDGETING

Section overview

 Introduction
 Misunderstanding and worries about cost-cutting
 Opposition to unfair targets set by senior management
 Sub-optimisation
 Budget slack (budget bias)
 Participation in budget setting
 Other behavioural issues
 Management styles

4.1 Introduction

The effectiveness of budgeting and budgetary control depends largely on the

behaviour and attitudes of managers and (possibly) other employees.
 Budgets provide performance targets for individual managers. If managers
are rewarded for achieving or exceeding their target, budgets could provide
them with an incentive and motivation to perform well.
 It has also been suggested that budgets can motivate individuals if they are
able to participate in the planning process. Individuals who feel a part of the
planning and decision-making process are more likely to identify with the
plans that are eventually decided. By identifying with the targets, they might
have a powerful motivation to succeed in achieving them.
When budgeting helps to create motivation in individuals, the human aspect of
budgeting is positive and good for the organisation.
Unfortunately, in practice human behaviour in the budgeting process often has a
negative effect. There are several possible reasons why behavioural factors can
be harmful:
 misunderstanding and worries about cost-cutting;
 opposition to unfair targets set by senior management;
 sub-optimisation; or
 budget slack or budget bias.

4.2 Misunderstanding and worries about cost-cutting

Budgeting is often considered by the managers affected to be an excuse for
cutting back on expenditure and finding ways to reduce costs. Individuals often
resent having to reduce their spending, and so have a hostile attitude to the
entire budgeting process. This fear and hostility can exist even when senior
management do not have a cost-cutting strategy.

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4.3 Opposition to unfair targets set by senior management

When senior managers use the budgeting process to set unrealistic and unfair
targets for the year, their subordinates may unite in opposition to what the senior
managers are trying to achieve. Senior managers should communicate and
consult with the individuals affected by target-setting, and try to win their
agreement to the targets they are trying to set. Targets need to be reasonable.
A distinction can be made between:
 aspirational budgets, which are budgets based on performance levels
and targets that senior managers would like to achieve, and
 expectational budgets, which are budgets based on performance levels
and targets that senior managers would realistically expect to achieve.
Aspirational budgets might be considered unfair, especially if the individuals
affected have not been consulted. Expectational budgets, based on current
performance levels, do not provide for any improvements in performance.
Ideally perhaps, budgets might be set with realistic targets that provide for some
improvements in performance.

4.4 Sub-optimisation
There may be a risk that the planning targets for individual managers are not in
the best interests of the organisation as a whole. For example, a production
manager might try to budget for production targets that fully utilise production
capacity. However, working at full capacity is not in the best interests of the
company as a whole if sales demand is lower. It would result in a build-up of
unwanted finished goods inventories. The planning process must be co-ordinated
in order to avoid sub-optimal planning. In practice, however, effective co-
ordination is not always achieved.

4.5 Budget slack (budget bias)

Budget slack has been defined as ‘the intentional overestimation of expenses
and/or underestimation of revenue in the budgeting process’ (CIMA Official
Terminology). Managers who prepare budgets may try to overestimate costs so
that it will be much easier to keep actual spending within the budget limit.
Similarly, managers may try to underestimate revenue in their budget so that it
will be easier for them to achieve their budget revenue targets. As a result of
slack, budget targets are lower than they should be.
When managers are rewarded for achieving their budget targets, the motivation
to include some slack in the budget is even stronger.
An additional problem with budget slack is that when a manager has slack in his
spending budget, he may try to make sure that actual spending is up to the
budget limit. There are two reasons for this:
 If there is significant under-spending, the manager responsible might be
required to explain why.
 Actual spending needs to be close to the budget limit in order to keep the
budget slack in the budget for the next year.
The problem of budget slack is particularly associated with spending on
‘overhead’ activities and incremental budgeting. One of the advantages of zero
based budgeting is that it should eliminate a large amount of slack from
budgets.

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In some cases, budget bias operates the other way. Some managers might
prepare budgets that are too optimistic. For example, a sales manager might
budget for sales in the next financial year that are unrealistic and unachievable,
simply to win the approval of senior management.

4.6 Participation in budget setting

Rewards for performance are intended to motivate individuals to achieve the
targets they have been set.
Another view is that individuals can be motivated to improve their performance
and to set challenging budgets through their commitment to the work that they
do. If individuals enjoy their work and feel committed to performing as well as
possible, challenging budget targets can be agreed and better levels of actual
performance should be achieved.
Personal motivation to improve performance, it may be argued, can be achieved
if individuals are allowed to:
 participate meaningfully in the budget-setting or target-setting process; and
 be directly involved in negotiating performance targets for the budget
period.

Advantages and disadvantages of participation

The advantages of participative budgeting are as follows:
 Stronger motivation to achieve budget targets, because individuals are
involved in setting or negotiating the targets.
 There should be much better communication of goals and budget targets to
the individuals involved, and a better understanding of the target-setting
process.
 Involvement by junior managers in budgeting provides excellent experience
for personal development
 Better planning decisions – participation might lead to better planning
decisions, because ‘local’ managers often have a much better detailed
knowledge of operations and local conditions than senior managers.
However, there are significant disadvantages with participation.
 It might be difficult for junior managers to understand the overall objectives
of the organisation that budgets should be designed to meet.
 The quality of planning with participation depends on the skills, knowledge
and experience of the individuals involved. Participation is not necessarily
beneficial in all circumstances, particularly when individuals lack
experience.
 There might be a danger that budget targets will be set at a level that is not
ambitious. Participation on its own is not necessarily a sufficient incentive to
raise standards and targets for achievement. Individuals might try to argue
that performance targets should be set at current levels of achievement.
 Senior managers might pretend to be encouraging participation, but in
practice they might disregard all the proposals and ideas of their
subordinates. To be effective, participation must be ‘real’.

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 It is generally considered that participation is a good thing, but it needs to

be strictly managed by senior management to make sure optimum
decisions are taken that are in line with the company’s goals.

Factors affecting the impact of participation

The effect of participation on the motivation of subordinates will also depend on
circumstances. Hopwood suggested that the effectiveness of participation on
employee motivation depends on three key factors.

Factor Comments
The nature of the The effectiveness of participation will depend on the nature
task of the work, and the extent to which employees have
control over the way in which the work is done.
‘In highly-programmed … and technically constrained
areas, where speed and detailed control are essential for
efficiency, participative approaches have less to offer…. In
contrast, in areas where flexibility, innovation and the
capacity to deal with un-anticipated problems are
important, participation in decision-making may offer a
more immediate … payoff….’ (Hopwood).
Organisation Participation is likely to be more effective in an
structure organisation where management responsibilities are
decentralised, and local managers have more influence
over their own budgets.
Personality of the Some types of individual are more likely than others to be
employees motivated by participation in the budgeting process.

Imposed budgets
The opposite of a participative budget is an imposed budget, where senior
management dictates what the budget targets should be. Imposed budgets have
certain advantages:
 Less time consuming. Line managers do not have to spend time on
budgeting and so are not distracted from the task of running the business.
 Senior managers may have a greater appreciation of the constraints faced
by the business, such as restrictions on cash and other resources, and
shareholder expectations of profits and dividends.
 It may be easier to co-ordinate departmental budgets if they are prepared
together by senior management.
However the disadvantages of imposed budgets are that:
 Targets may be set at a challenging level and so are unachievable. If
unachievable targets are imposed, this will lead to de-motivation.
 Opportunities for exploiting the specialist knowledge of more junior
managers may be lost if they are excluded from the budget-setting process.

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Performance management

4.7 Other behavioural issues

Performance of operational managers may be measured by comparing actual
performance with the budget. The manager might be rewarded for achieving
budget targets but criticised for failing to meet the budget.
This tendency to ‘blame’ managers for failing to meet the budget targets will have
an adverse effect on the motivation and attitude of the operational managers in
the following circumstances:
 The budget might not make any distinction between costs that are
controllable and costs outside the manager’s control. The manager might
therefore be criticised for excess spending on items over which he has no
control.
 Circumstances might change and events might occur that make the original
budget unrealistic. Even so, the manager might be criticised for failing to
meet the budget targets, even when changed circumstances have made
the budget targets unrealistic.
If budgeting is used as a ‘performance contract’ between the company and its
managers, and provides a basis on which the actions by management are
assessed, this could lead to a number of problems. Managers will want to avoid
criticism, and so meet targets, but they have no obvious incentive to do better
than the targets in the budget plan.

Possible means of dealing with the

Factor
problem
Meeting only the lowest targets It may be appropriate to introduce an
Once a manager has agreed his incentive scheme, in which higher
budget targets for the year, his only bonuses are paid according to the
incentive is to achieve the budget amount by which the budget target is
target, and not to exceed it. exceeded. Higher bonuses can be
paid for better (budget-beating)
performance.
Using more resources than One possibility is to train management
necessary and staff in the application of Total
Once the budgeted utilisation of Quality Management techniques, so
resources has been agreed that managers and employees are
(materials, labour time, machine time actively looking for improvements.
and so on) a manager will be satisfied Another possibility is to provide
with using the full budgeted quantity of rewards for achieving variable costs
resources permitted. There is no per unit that are less than
incentive to improve on performance standard/budgeted.
and use fewer resources.
Earning the bonus – whatever it This is difficult problem to overcome.
takes to do this. The most effective solution may be to
Managers and employees who are amend the rewards system so that
incentivised by a bonus to achieve a there are a number of bonus
budget target will do whatever they incentives for achieving a number of
can to make the target – even if this different targets. However, this will be
means ignoring other aspects of difficult to design and implement.
performance for which there is no
bonus and even if it means ‘bending
the rules’ to make the target.

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Chapter 6: Budgetary control systems

Possible means of dealing with the

Factor
problem
Competing with other divisions and If there are disputes between different
departments in the same cost centres, or between cost centres
organisation and profit centres, it may be
There will be a tendency for cost necessary to refer the matter for
centres and profit centres to act resolution to the senior management
competitively towards each other, in at head office.
order to achieve their own budget
target. This may be evident in
attitudes to transfer pricing, which are
described in another chapter.
Making sure that all the expenditure Rewarding employees and managers
allocation in the budget is actually for achieving lower fixed costs than
spent budgeted may be a solution to this
Managers often see budgeting as a problem.
competition for resources and
spending allocations. If a cost centre
or profit centre does not spend up to
its permitted limit in one year, it is at
risk of having some of the spending
allowance removed the next year.
Managers will try to avoid this by
making sure that their full budgeted
spending allocation is actually spent.
Providing forecasts that are A change in management culture may
inaccurate be necessary to overcome this
Managers may try to provide forecasts problem. It is an almost unavoidable
that are (deliberately) not accurate in feature of management behaviour that
order to gain an advantage and forecasts will be presented in the most
misrepresent future expectations. favourable light possible. It is the task
There are various reasons why this of top management to establish a
may be done – for example to culture of ‘no blame’ within the
persuade senior management to organisation, so that managers may
make a decision that is favourable to be willing to provide information that is
the forecast provider in order to win a more ‘honest’.
bigger allocation of resources in the
budget.
Meeting the budget target, but not As suggested above, it may be
beating it. appropriate to have an incentive
If there is no incentive to beat a scheme in which higher bonuses are
budget target, managers will be available according to the amount by
satisfied with simply achieving the which the budget target is exceeded.
target. They may then prefer not to
exceed the target so that their target
for the following year may not be as
challenging as it otherwise might be.

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Performance management

Possible means of dealing with the

Factor
problem
Avoiding risks A bonus system that rewards
Managers will be tempted to stick to managers and employees for beating
the agreed plans in the budget and a range of budget targets may be
will be reluctant to take unplanned effective, so that managers are
initiatives that could result in a failure prepared to take risks to improve
to meet budget targets. Managers performance. However, as the crisis in
may prefer to do nothing wrong than the banking system (2007 – 2009)
to take risks in order to improve showed, managers should never be
performance. encouraged to take on excessive
risks.

4.8 Management styles

In the 1970s, research was carried out by Anthony Hopwood into performance
evaluation by managers, and how the performance of managers with cost centre
responsibility is judged. He identified three types of management style:
 a budget-constrained style;
 a profit-conscious style; and
 a non-accounting style

Budget-constrained style
With this style of management, the performance of managers is based on their
ability to meet budget targets in the short term. With this style of performance
evaluation, the focus is mainly on budgeted costs actual costs and variances.
Managers are under considerable pressure to meet their short-term budget
targets. Stress in the job is high. Managers might be tempted to manipulate
accounting data to make actual performance seem better in comparison with the
budget.

Profit-conscious style
The performance of managers is evaluated on the basis of their ability to increase
the general effectiveness of the operations under their management. Increasing
general effectiveness means being more successful in achieving the longer-term
aims of the organisation. For example, success in reducing costs in the long term
would be considered an increase in general effectiveness.
With a profit-conscious style, budgets and variances are not ignored, but they are
budgetary control information which is treated with caution, and variances are not
given the same importance as with a budget-constrained style.
Hopwood found that with this style of management evaluation, costs remain
important, but there is much less pressure and stress in the job. As a
consequence, there was a good working relationship between managers and
their subordinates. In addition, there was less manipulation of accounting data
than with a budget-constrained style.

Non-accounting style
With this style, budgetary control information plays a much less important part in
the evaluation of managers’ performance. Other (non-accounting) measures of
performance were given greater prominence.

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Chapter 6: Budgetary control systems

Closing comment
The results of empirical research by Hopwood and others (notable David Otley)
seem to suggest that the most appropriate approach to the evaluation of
performance depends on the circumstances and conditions in which the
organisations and their managers operate.

5 BEYOND BUDGETING

Section overview

 Origins of ‘beyond budgeting’

 Weaknesses in traditional budgeting
 The ‘beyond budgeting model’
 Performance management in the ‘beyond budgeting’ model
 Beyond budgeting: concluding comments

5.1 Origins of ‘beyond budgeting’

The Beyond Budgeting Round Table (BBRT) was set up in 1998. It is a
European-wide research project investigating whether entities would benefit from
the abolition of budgets and budgeting. The BBRT claims that several successful
European companies have stopped preparing budgets. Instead, they use a
‘responsibility model’ for decision-making and performance measurement. As a
result, their performance has improved.
In the UK, the ideas of ‘beyond budgeting’ are associated with the writing of
Jeremy Hope and Robin Fraser.

5.2 Weaknesses in traditional budgeting

Hope and Fraser have argued that the traditional budgeting system is inefficient
and inadequate for the needs of modern businesses. In a continually-changing
business world, traditional budgeting systems can have the effect of making
business organisations fixed and rigid in their thinking, and unable to adapt. As a
result, business organisations may be much too slow and inflexible in reacting to
business developments.
The budgeting system establishes ‘last year’s reality’ as the framework for the
current year’s activities. When the business environment is changing rapidly, this
approach is inadequate. Managers should respond quickly to changes in the
environment, but traditional budgeting and budgetary control systems act as a
restraint on innovation and initiative.
Consequences of the inadequacy of the traditional budgeting system are that:
 operational managers regard the budgeting process as a waste of their
time and resent having to prepare and then continually revise budget plans
 management accountants are involved in the budgetary planning and
control system, but their work adds little or no value to the business. As a
result, it may be difficult to justify the existence of the management
accounting function.
According to the Beyond Budgeting Round Table, there are ten major problems
with the traditional budgeting and budgetary control system.
© Emile Woolf International 186 The Institute of Chartered Accountants of Nigeria
 Budgets are time-consuming and expensive. In spite of computer
technology and the use of budget models, it can take four to five months in
a large company to prepare the annual budget for next year. The work on
budget preparation has been found to use over 20% of the time of senior
managers and financial controllers.
 Traditional budgeting adds little value and uses up valuable
management time that could be used better in other ways. Preparing a
budget does nothing, or very little, to add value to the entity. Budgets ‘are
bureaucratic, time-consuming exercises, and the time taken would be
better deployed in more value-creating activities’ (Hope and Fraser).
 Fails to consider shareholder value. The traditional budgeting process
focuses too much on internal matters and not enough on external factors
and the business environment, and it fails to focus on shareholder value.
 Rigid and inflexible: budgeting systems prevent fast response.
Managers concentrate on achieving ‘agreed’ budget targets, which may not
be in the best interests of the organisation as a whole, particularly when
circumstances change after the budget has been agreed. Budgets are
therefore ‘rigid’ and prevent fast and flexible responses to changing
circumstances and unexpected events.
 Budgets ‘protect’ spending and fail to reduce costs. In many entities,
managers are expected to spend their entire budget allowance. If they
don’t, money will be taken away from their budget allowance next year.
This is certainly no incentive to cut costs.
 Traditional budgeting and budgetary control discourages innovation.
Managers are required to achieve fixed budget targets, and the fixed
budget does not encourage continuous improvement. Managers will be
reluctant to exceed their budgeted spending limits, even though extra
spending would be necessary to react to events, possibly because
spending above budget will put their bonus at risk. In a dynamic business
environment, business organisations should be seeking continuous
improvement and innovation.
 Budgets focus on sales targets, not customer satisfaction. This will
possibly increase sales in the short-term, even if the products are not as
good as they should be, but long-term success depends on satisfying
customers.
 In practice, it has been found that although most companies have a
budgeting system, they are poor at executing strategy. This suggests that
budgeting systems are not effective systems for implementing strategy.
 Budgeting systems encourage a culture of ‘dependency’, in which junior
managers do what they are told by their boss, and do not argue. ‘They
reinforce the “command and control” management model and … undermine
attempts at organisational change, such as team working, delegation and
empowerment’ (Hope and Fraser).
 Budgets can lead to ‘unethical’ behaviour, such as including ‘slack’ within
the budgeted spending allowance.
 There are other major criticisms of budgeting systems.
 Traditional budgeting is seen as a method of imposing financial control, by
comparing actual results with budget. Budgeting should be a system for
communicating corporate goals – setting objectives and improving
performance.
 Budgets are also plans that focus on financial numbers. ‘They fail to deal
with the most important drivers of shareholder value … - knowledge or
intellectual capital. Strong brands, skilled people, excellent management
processes, strong leadership and loyal customers are assets that are
outside the … accounting system’ (Hope and Fraser).
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Performance management

 In many cases, budget plans are not the result of a rational decision-
making process. Often, budgets are a political compromise between
different departments and managers, and budgeted spending limits for
each manager are the outcome of a bargaining process.
 Traditional budgetary control encourages managers to achieve fixed budget
targets, but does not encourage continuous improvement. Managers will be
reluctant to exceed their budgeted spending limits, even though extra
spending would be necessary to react to events, possibly because
spending above budget will put their bonus at risk. In a dynamic business
environment, business organisations should be seeking continuous
improvement and innovation.
 Traditional budgeting shows the costs of departments and functions, but
not the costs of activities that are performed by employees. The traditional
budget figures do not give managers information about the cost drivers in
their business. In addition, traditional budgets do not help managers to
identify costs that do not add value.

5.3 The ‘beyond budgeting model’

The Beyond Budgeting view is that budgeting, as practised by most companies,
should be abolished. The traditional hierarchical form of management structure
should also be abolished. In its place, there should be a system in which
authority and responsibility is given to operational managers, who should work
together to achieve the strategic objectives of the entity.
Traditional budgeting is based on a ‘dependency model’ of management and
organisation culture. It is a system for centralised control by senior management.
Control is exercised by requiring operational managers to meet (or exceed)
budget targets.
The ‘Beyond Budgeting’ alternative is a ‘responsibility model’ in which decision-
making and performance management are delegated to ‘line managers’
(operating managers). Instead of having fixed annual plans, these managers
agree performance targets: these targets are reviewed regularly and amended as
necessary in response to changing circumstances and unexpected events.
A solution to the lack of flexibility in traditional budgeting may be continuous
rolling forecasting (or even continuous budgets), so that the business
organisation can adapt much more quickly to changes in its environment and to
new events.
Responsibility should be delegated to operational managers, who should be
empowered to take decisions in response to changing circumstances, that the
managers believe would be in the best interests of the organisation.
 Goals should be agreed by reference to external benchmarks (such as
increasing market share, or beating the competition in other ways) and
targets should not be fixed and internally-negotiated.
 Operational managers should be motivated by the challenges they are
given and by the delegation of responsibility.
 Operational managers can use their direct knowledge of operations to
adapt much more quickly to changing circumstances and new events.
 Operational managers may be expected to work within agreed parameters,
but they are not restricted in their spending by detailed line-by-line budgets.

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Chapter 6: Budgetary control systems

 Delegated decision-making should encourage more transparent and open

communication systems within the organisation. Managers need
continuous rolling forecasts to make decisions and apply control. Efficient
IT systems are therefore an important element in the ‘beyond budgeting’
model.

5.4 Performance management in the ‘beyond budgeting’ model

In the Beyond Budgeting model of performance management, there are 12 basic
principles.
 Governance. The basis for taking action should be a set of clear values.
Mission statements and plans should not be used to guide action.
 Responsibility for performance. Managers should be responsible for
achieving competitive results, not for meeting the budget target.
 Delegation. People should be given the ability and the freedom to act.
They should not be controlled and constrained by senior managers.
 Structure. Operations should be organised around processes and
networks, and should not be organised on the basis of departments and
functions.
 Co-ordination. There should be effective co-ordination between people
within the company, and this should be achieved by process design and
fast information systems.
 Leadership. Senior managers should challenge and ‘coach’. They should
not command and control.
 Setting goals. The goal should be to beat competitors, not meet budget.
 Formulating strategy. Formulating and implementing strategy should be a
continuous process, not an annual event imposed by senior management.
 Anticipatory management. Management should use anticipatory systems
for managing strategy. (Anticipatory systems are systems that provide
information about events that are anticipated in the future.)
 Resource management. Resources should be made available to
operational managers at a fair cost, when they are required. Resources
should not be allocated to departments in a fixed budget.
 Measurement and control. Performance measurement and control should
be based on a small number of key performance indicators, not a large
number of detailed reports.
 Motivation and rewards. Rewards, at a company level and a business unit
level, should be based on competitive performance, not meeting
predetermined budget targets.
 Principles (1) to (6) are concerned with establishing an effective
organisation and culture of behaviour. Principles (7) to (12) are concerned
with establishing an effective system of performance measurement.
 ‘Beyond Budgeting entails a shift from a performance emphasis based on
numbers to one based on people. It assumes that performance
improvement is more likely to come from giving capable people control over
decisions (and making them accountable for results), than simply from
adopting different measures and incentives’ (Hope and Fraser).
 Hope and Fraser set out the 12 principles, and their effect, as follows:

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Performance management

Effective organisation Effective performance Management of

and behaviour competitive
success
Clear values Relative targets Fast response
Responsibility for Adaptive strategies Best people
results
Freedom and Anticipatory Innovative
capability to act × management = strategies
Fast networks and Internal market for Low costs
processes resources
Co-ordination Fast, distributed Loyal customers
controls
Challenge and stretch Relative team rewards Satisfied customers

To compete successfully, management has to be very good at the six issues in

the box on the right-hand side of this diagram.
 They must create a climate and culture for fast response. An ability to
respond quickly to unexpected changes and events will mean that the
company can deal with uncertainty successfully. Change should be seen as
an opportunity, not a threat.
 Managers must be given responsibility for strategy, and they should
monitor strategy continuously, not just once a year (as in the traditional
budget model).
 If new initiatives are needed, managers should be able to obtain the
resources they need quickly. ‘They need, for example, the authority to
acquire key people when they are available (not when there is room in the
budget); to react to competitive threats and opportunities as they arise (not
as predicted in an outdated plan); and to acquire and deploy resources
when necessary (not as allocated by head office)’ (Hope and Fraser).
 They must employ the best people. A challenging environment to work in is
likely to attract and retain top-quality employees.
 They must innovate and generate new business ideas. Bureaucracy does
not encourage innovation and creativity. The ‘Beyond Budgeting’ model
does.
 They must operate with low costs. Competitive pressures in markets are
forcing down prices. In the ‘Beyond Budgeting’ model managers will adapt
strategies to the requirements of the competitive environment, and will find
ways to reduce costs if this is appropriate. The traditional budgeting model
does not encourage effective cost reduction.
 They must create and retain loyal customers. The ‘Beyond Budgeting’
model encourages managers to focus on satisfying customer needs.
Satisfied customers are likely to be loyal customers.
 They must create value for shareholders. The ‘Beyond Budgeting’ model
should help a company to improve its profitability and create additional
value for its shareholders.

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Chapter 6: Budgetary control systems

5.5 Beyond budgeting: concluding comments

Hope and Fraser have argued that traditional budgeting systems are weak and
should not be used. However, in practice most companies and other
organisations continue to use them.
It has been argued that the ‘beyond budgeting’ model is much more easily
applied in the private sector than in the public sector. Government activity is
managed through expenditure budgets and spending controls, and there is
accountability for spending to politicians (government ministers and elected
representatives) and to the general public. There may also be uncertainty about
the objectives of particular government activities or departments. In such
circumstances, it is difficult to apply a flexible system of decision-making or to
devolve decision-making to lower levels of management.
There have been attempts to improve traditional budgeting systems: for example,
zero based budgeting, continuous budgets and activity based budgeting are all
attempts to improve the budgeting system. Hope and Fraser argue, however, that
these are ‘valiant efforts to update the process, but they only deal with part of the
[problem] and are both time-consuming and complicated to manage.’

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Performance management

6 FORECASTING

Section overview

 The nature of a time series

 Analysing a time series
 Moving averages
 Centred moving averages
 Line of best fit
 Seasonal variations

6.1 The nature of a time series

A time series is a record of data over a period of time, for example, sales revenue
per month or revenue per quarter. The time series is a convenient way of
representing historical information but more importantly it might be used to make
predictions about the future. This is done by continuing the series forward in time.
In order to do this, the time series must be analysed into its component parts.

Components of a time series

A change in value of an observed variable in a time series might be due to a
combination of factors. These are described as the components of the time
series. There are two models of a time series which differ in how these
components are linked together.

Formula: Time series models

Additive model:
YA = T + S + C + R

Proportional (multiplicative model)

YM = T  S  C  R

Where:
T = Trend – the overall direction of change in the data.
S = Seasonal variation – differences between the actual data observed
for a time period and the amount predicted by the trend for that period.
C = Cyclical variation – Longer term variations which might cause
changes over longer periods.
R = Random fluctuations

Note that the term “seasonal variation” has a specific meaning in time series
analysis. It relates to the variation in each period covered in the analysis.
Therefore it could mean a daily, weekly, quarterly or annual variation depending
on the analysis.

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Chapter 6: Budgetary control systems

Questions requiring analysis of a time series will require the identification of a

trend and seasonal variations.
 Random fluctuations cannot be predicted. The usual assumption made is
that they are negligible and can be ignored in any analysis.
 Also, there is usually insufficient data to identify cyclical variations.
The plot of a time series as a graph is called a historigram.
The diagram below shows a trend line with seasonal variations above and below
the trend line. The general trend in this diagram is up and the trend can be shown
as a straight line. However, the actual value in each time period is above or
below the trend, because of the seasonal variations.

Illustration: Historigram of a time series

6.2 Analysing a time series

There are two aspects to analysing a time series from historical data:
 estimating the trend line; and
 calculating the amount of the seasonal variations (monthly variations or
daily variations).
The time series can then be used to make estimates for a future time period, by
calculating a trend line value and then either adding or subtracting the
appropriate seasonal variation for that time period.
Two methods of calculating a trend line are:
 Moving averages.
 Linear regression analysis.
Linear regression analysis is a technique that produces a line of best fit for
observed data. This was covered in an earlier chapter (along with the high/low
method which can also be used in forecasting). Note that both might be used
together. Moving averages might be used to identify the underlying trend and

Performance management

then linear regression might be used to identify a line of best fit for the moving
averages identified.
Methods of calculating seasonal variations are explained later.

6.3 Moving averages

Moving averages can be used to estimate a trend line, particularly when there
are seasonal variations in the data.
The technique involves smoothing out fluctuations in the underlying observed
data by calculating averages for small groups of observations from that data. The
size of the small group is related to the type of data. If the data is quarterly then a
group of 4 would be used or if the data was monthly a group of 12 would be
used.
Moving averages are calculated as follows:
Step 1: Decide the length of the cycle. The cycle is a number of days or weeks,
or seasons or years.
 The cycle might be seven days when historical data is collected daily for
each day of the week or perhaps six days if the business is closed for one
day per week.
 The cycle will be one year when data is collected monthly for each month of
the year or quarterly for each season.
Step 2: Use the historical data to calculate a series of moving averages. A
moving average is the average of all the historical data in one cycle.
For example, suppose that historical data is available for daily sales over a period
Day 1 – Day 21, and there are seven days of selling each week.
 A moving average can be calculated for Day 1 – Day 7. This represents an
amount for the middle day in the data i.e. day 4.
 Another moving average can be calculated for Day 2 – Day 8. . This
represents an amount for the middle day in the data i.e. day 5.
This process continues until all of the data have been included. Note that as this
is an averaging process it results in a figure related to the mid-point of the overall
period for which the average has been calculated.
Note that it is easier to number each day, month or quarter in a cycle starting
from 1 rather than retain actual day names, dates etc.
Step 3: If there is an even number of items of data in the moving average
calculation, then the average will correspond to a point between the middle two
time periods. A second average is calculated for each pair of values in the
moving average column. This is done to centre the observation and align it with a
time period.
For example:
 A moving average for Quarter 1 – Quarter 4 gives a value which represents
the mid-point of the range. This is Quarter 2.5.
 A moving average for Quarter 2 – Quarter 5 gives a value which represents
the mid-point of the range. This is Quarter 3.5.
 Quarters 2.5 and 3.5 do not exist so the values are averaged to give a
value which is taken to represent Quarter 3.

Chapter 6: Budgetary control systems

Step 4: Use the moving averages (and their associated time periods) to calculate
a trend line.
The following example illustrates the calculation of moving average in detail to
ensure that you understand what it means before moving on to produce a
complete trend.

Example: Calculating moving averages

A company operates for five days each week. Sales data for the most recent
three weeks are as follows:
Sales Monday Tuesday Wednesday Thursday Friday
units units units units units
Week 1 78 83 89 85 85
Week 2 88 93 99 95 95
Week 3 98 103 109 105 105

Moving averages are calculated as follows:

Day Sales
1 78
2 83
3 89 = 420 ÷ 5 days = 84 per day
4 85
5 85
84 represent the sales on the middle day of
the period (day 3)

Day Sales
2 83
3 89
4 85 = 430 ÷ 5 days = 86 per day
5 85
6 88
86 represents the sales on the middle day
of the period (day 4)

The example is continued to complete the trend on the next page.

Performance management

Example: Constructing a trend line with moving averages

For convenience, it is assumed that Week 1 consists of Days 1 – 5, Week 2

consists of Days 6 – 10, and Week 3 consists of Days 11 – 15.
This sales data can be used to estimate a trend line. A weekly cycle in this
example is 5 days. Moving averages are calculated for five-day periods, as
follows:
Moving average (trend
5 day found by dividing the 5
Day Sales total day total by 5)
Day 1 78
Day 2 83
Day 3 89 420 84
Day 4 85 430 86
Day 5 85 440 88
Day 6 88 450 90
Day 7 93 460 92
Day 8 99 470 94
Day 9 95 480 96
Day 10 95 490 98
Day 11 98 500 100
Day 12 103 510 102
Day 13 109 520 104
Day 14 105 530
Day 15 105 540

Note that this process always results in a loss of values for points in time at the
start and at the end of the range.

Chapter 6: Budgetary control systems

Line of best fit

The trend is an indication of the general movement in a set of data. In order to
make predictions, the trend must be expressed as a straight line.
In the above example, the trend increases by 2 each day. This means that each
moving average actually lies on a straight line. An equation can be found for this
trend line by taking the first sales figure as a starting point and then adjusting it
by the number of days multiplied by 2 per day to give the following formula:
Daily sales = 78 + 2x.
This trend line can be used to forecast a trend value for any day in the future. For
example, the forecast for sales on day 50 is:
Daily sales = 78 + 50x = 178
This of course assumes that sales will continue to grow at 2 per day on average.
This trend line can also be used to calculate the ‘seasonal variations’ (in this
example, the daily variations in sales can be above or below the trend).
In turn, these can be used to adjust the forecast value of the trend line to take
account of whether day 50 is a Monday, Tuesday, Wednesday, Thursday or
Friday.
This is explained later.

6.4 Centred moving averages

When there is an even number of seasons in a cycle, the moving averages will
not correspond to an actual season. When this happens it is necessary to take
moving averages of the moving averages in order to arrive at a value which
corresponds to an actual season of the year.

Performance management

Example: Constructing a trend line with centred moving averages

The following quarterly sales figures have been recorded for a company.
Sales Quarter 1 Quarter 2 Quarter 3 Quarter 4
₦000 ₦000 ₦000 ₦000
Year 1 20 24 27 31
Year 2 35 39 44 47
Year 3 49 56 60 64

In the following analysis, the quarters are numbered from 1 to 12 for ease
of reference. (Thus year 1: Q1 is numbered Q1 and year 3: Q4 is numbered
Q12).
Moving average values for each quarter are calculated as follows:
Moving average (trend found
4 quarter by dividing the 4 quarter total
Quarter Sales total by 4)

1 20

2 24
102 25.5
3 27
117 29.25
4 31
132 33.00
5 35
149 37.25
6 39
165 41.25
7 44
179 44.75
8 47
196 49.00
9 49
212 53.00
10 56
229 57.25
11 60

12 64

Chapter 6: Budgetary control systems

Each of the moving average figures above line up opposite a point between two
quarters (seasons). For example, the average for quarters 1 to 4 sits between
quarter 2 and quarter 3 at quarter 2.5.
Analysing seasonal variation requires the figures in the trend to be lie opposite an
actual season (quarter). This is achieved by carrying out a second averaging for
each adjacent pair of numbers. The resultant numbers are called centred moving
averages

Example: Constructing a trend line with centred moving averages (continued)

Centred
Moving Centre total (of 2 moving
Quarter Sales average moving averages) average (÷2)

1 20

2 24
25.5
3 27 25.5 + 29.25 = 54.75 27.38
29.25
4 31 29.25 + 33.00 = 62.25 31.13
33.00
5 35 33.00 + 37.25 = 70.25 35.13
37.25
6 39 37.25 + 41.25 = 78.50 39.25
41.25
7 44 41.25 + 44.75 = 86.00 43.00
44.75
8 47 44.75 + 49.00 = 93.75 46.88
49.00
9 49 49.00 + 53.00 = 102 51.00
53.00
10 56 53.00 + 57.25 =
55.13
57.25 110.25
11 60

12 64

The moving averages in the right hand column correspond to an actual season
(quarter). These moving averages are used to estimate the trend line and the
seasonal variations.

Performance management

6.5 Line of best fit

As explained earlier, the trend is an indication of the general movement in a set
of data but in order for it to be used to make predictions, it must be expressed as
a straight line.
The first moving average value can be used as a starting point in the equation of
a straight line. One way of identifying the slope is to subtract the lowest moving
average from the highest and divide the figure by the number of periods between
those two figures.

Example: Line of best fit

From the previous example

Moving
average
Quarter 10 55.13
Quarter 3 (27.38)
27.75
Number of periods between Q10 and Q3 ÷7
3.96

The equation of the line of best fit is:

y (Sales) = 27.38 + 3.96x

Care must be taken in using this equation. Remember the starting point for the
equation is Q3 so any value must be calculated in reference to Q3.

Example: Line of best fit

From the previous example estimate the trend sales figure for Q4 in year 4.
This corresponds to Q16 in the example which is 13 quarters after the starting
point.
y (Sales) = 27.38 + 3.96x
y (Sales in Q4 of year 4) = 27.38 + 3.96 (13) = 78.86

Chapter 6: Budgetary control systems

6.6 Seasonal variations

The trend line on its own is not sufficient to make forecasts for the future. We
also need estimates of the size of the ‘seasonal’ variation for each of the different
seasons.
Consider the two examples above:
 In the first example, we need an estimate of the amount of the expected
daily variation in sales, for each day of the week.
 In the second example, we need to calculate the variation above or below
the trend line for each season or quarter of the year.
A ‘seasonal variation’ can be measured from historical data as the difference
between the actual historical value for the time period, and the corresponding
trend value.
The seasonal variation is then used to adjust a forecast trend value.
There are two models used to estimate seasonal variation:
 The additive model;
 The proportional model.

The additive model

This model assumes that seasonal variations above and below the trend line in
each cycle adds up to zero. Seasonal variations below the trend line have a
negative value and variations above the trend line have a positive value.
The seasonal variation for each season (or daily variation for each day) is
estimated as follows, when the additive assumption is used:
 Calculate the difference between the moving average value and the actual
historical figure for each time period.
 Group these seasonal variations into the different seasons of the year
(days of the week; months or quarters of the year).
 Calculate the average of these seasonal variations for each season (or day;
month; quarter).
 if the total seasonal variations for the cycle do not add up to zero the
difference is spread evenly across each season (or day; month; quarter).
 This adjusted figure is the seasonal variation.

Performance management

Example: Additive model

Using the previous example for quarterly sales, actual sales and the
corresponding moving average value were as follows:
Variation
(Actual –
Actual sales Moving
Quarter Trend in the quarter average)
Year 1: Q3 27.375 27 0.375
Year 1: Q4 31.125 31 0.125
Year 2: Q1 35.125 35 0.125
Year 2: Q2 39.250 39 0.250
Year 2: Q3 43.000 44 1.000
Year 2: Q4 46.875 47 0.125
Year 3: Q1 51.000 49 2.000
Year 3: Q2 55.125 56 0.875

The seasonal variation (daily variation) is now calculated as the average

seasonal variation for each day, as follows:
Variation Q1 Q2 Q3 Q4 Total
Year 1 0.375 0.125
Year 2 0.125 0.250 1.000 0.125
Year 3 2.000 0.875
Average 1.063 0.313 0.313 0.0 0.437
Adjustment: 0.10925 0.10925 0.10925 0.10925 0.437
Seasonal
adjustment 0.95375 0.42225 0.42225 0.10925 0

The seasonal variations can then be used, with the estimated trend line, to make
forecasts for the future.

Example: Forecast sales

The forecast for the trend value of sales in Q4 in year 4 is 78.86.

The estimated sales in this quarter are:

Trend value 78.86
Quarter 4 adjustment (rounded) 0.11
Sales forecast 78.97

Chapter 6: Budgetary control systems

The proportional model

This model expresses the actual value in each season as a proportion of the
trend line value.
When a proportional model is used to calculate seasonal variations, rather than
the additive model, the seasonal variations for each time period are calculated by
dividing the actual data by corresponding moving average or trend line value.
The sum of the proportions for each time period must add up to 1. This means
that the total of the proportions quarterly data must sum to 4. If this is not the
case the difference is spread evenly over each quarter

Example: Proportional model

Using the previous example for quarterly sales, actual sales and the
corresponding moving average value were as follows:

Seasonal
variation: actual
sales as a
Actual sales in proportion of the
Quarter Trend the quarter moving average
Year 1: Q3 27.375 27 0.986
Year 1: Q4 31.125 31 0.996
Year 2: Q1 35.125 35 0.996
Year 2: Q2 39.250 39 0.994
Year 2: Q3 43.000 44 1.023
Year 2: Q4 46.875 47 1.003
Year 3: Q1 51.000 49 0.961
Year 3: Q2 55.125 56 1.016

The seasonal variation (daily variation) is now calculated as the average

seasonal variation for each day, as follows:

Variation Q1 Q2 Q3 Q4 Total
Year 1 0.986 0.996
Year 2 0.996 0.994 1.023 1.003
Year 3 0.961 1.016
Average 0.978 1.004 1.004 0.999 3.985
0.00375 0.00375 0.00375 0.00375 0.015
0.98175 1.00775 1.00775 1.00275 4.000

Performance management

Example: Forecast sales

The forecast for the trend value of sales in Q4 in year 4 is 78.86.

The estimated sales in this quarter are:

Trend value 78.86
Quarter 4 adjustment (rounded) 1.003
Sales forecast 79.01

7 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to:
 Explain the purposes of budgeting and the budgeting process

 Describe the main features of, and explain the differences between bottom-up
and top-down budgeting
 Explain incremental and zero-based budgeting
 Explain activity based budgeting (ABB)
 Recognise and explain the importance of the behavioural aspects of budgeting
 Discuss beyond budgeting as a concept
 Explain and apply forecasting techniques

Performance management

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
Sales budget
Budgeted
Budgeted Budgeted sales
Product sales quantity sales price revenue
units ₦ ₦
X 2,500 410 1,025,000
Y 3,200 400 1,280,000
Total 2,305,000

Production budget
Product X Product Y
units units
Sales budget 2,500 3,200
Budgeted closing inventory 200 100
2,700 3,300
Opening inventory 300 150
Production budget 2,400 3,150

Material usage budget

A (kgs) B (kgs) C (kgs)
Usage to make 2,400 units of X
2,400 units  1 kgs 2,400
2,400 units  0.75 kgs 1,800
2,400 units  2 kgs 4,800

Usage to make 3,150 units of Y

3,150 units  1 kgs 3,150
3,150 units  0.5 kgs 1,575
3,150 units  3 kgs 9,450
Usage in kgs 5,550 3,375 14,250
Cost per kg ₦30 ₦80 ₦30
Usage in naira 166,500 270,000 427,500

Total cost ₦864,000

Chapter 6: Budgetary control systems

Solution (continued) 1
Material purchases budget
A (kgs) B (kgs) C (kgs)
Usage 5,550 3,375 14,250
Closing inventory 380 400 120
5,930 3,775 14,370
Opening inventory (400) (450) (150)
Purchases (kgs) 5,530 3,325 14,220
Cost per kg (₦) ₦30 ₦80 ₦30
Purchases (₦) 165,900 266,000 426,600

Total cost ₦858,500

Labour usage budget

Grade I (hrs) Grade II (hrs)
Usage to make 2,400 units of X
2,400 units  1 hr 2,400
2,400 units  1.5 hrs 3,600

Usage to make 3,150 units of Y

3,150 units  0.8 hrs 2,520
3,150 units  1 hr 3,150
Usage in kgs 4,920 6,750
Cost per kg (₦) 100 80
Usage in naira 492,000 540,000

Total cost(₦) 1,032,000

Performance management

Solution (continued) 1
Budgeted profit or loss account
₦ ₦
Sales budget 2,305,000
Cost of sales:
Opening inventory 211,500
Purchases 858,500
Labour usage 1,032,000
2,102,000
Closing inventory (153,000)
(1,949,000)
Budgeted gross profit 356,000

The budgeted gross profit can be checked as follows:

(Units  (Sales price – Unit cost) ₦
Profit from selling X (2,500 units  (410  370)) 100,000
Profit from selling Y (3,200 units  (400  320)) 256,000

356,000

7
Skills level
Performance management

CHAPTER
Variance analysis

Contents
1 Standard costs

2 Introduction to variance analysis

3 Direct materials variances
4 Direct labour variances
5 Variable production overhead variances
6 Fixed production overhead cost variances:
absorption costing
7 Sales variances
8 Interrelationships between variances
9 Reconciling budgeted and actual profit: standard
absorption costing
10 Standard marginal costing
11 Productivity, efficiency and capacity ratios
12 Chapter review

Performance management

INTRODUCTION

Detailed syllabus
The detailed syllabus includes the following:
B Planning and control
2 Variance analysis
A Explain the uses of standard cost and types of standard.
B Discuss the methods used to derive standard cost.
C Explain and analyse the principle of controllability in the performance
management system.
D Calculate and apply the following variances:
i Material usage and price variances;
iii Labour rate, efficiency and idle time variances;
iv Variable overhead expenditure and efficiency variances;
v Fixed overhead budget, volume, capacity and productivity variances;
vi Sales volume variance;
E Identify and explain causes of various variances and their inter-relationship.
F Analyse and reconcile variances using absorption and marginal costing
techniques

Exam context
This chapter explains the techniques of variance analysis.
The chapter explains that a flexed budget shows what would have been achieved based on
the actual level of activity but assuming revenue per unit and all costs per unit have been the
same as budgeted. It is a new budget drawn up for the actual levels of unit sales and unit
output.
Variance analysis reconciles the difference between the budgeted profit figure and that
actually achieved. This reconciliation occurs in two steps. The difference between the original
budgeted profit and the flexed budgeted profit is shown as a volume variance. The
differences between the flexed budget and the actual results are shown in detail.
By the end of this chapter, you should be able to:
 Explain standard costing using examples
 Explain and construct a flexed budget
 Calculate sales volume variance

 Calculate, analyse and interpret various variances relating to material, labour and
factory overhead(both variable and fixed)
Prepare an operating statement reconcile budgeted profit to actual profit using total
absorption costing (TAC) and marginal costing (MC)

1 STANDARD COSTS

Section overview

 Standard units of product or service

 Standard cost
 Standard costing
 The uses of standard costing
 Deriving a standard cost
 Types of standard
 Reviewing standards

1.1 Standard units of product or service

Standard costing involves using an expected cost (standard cost) as a substitute
for actual cost in the accounting system. Periodically the standard costs are
compared to the actual costs. Differences between the standard and actual are
recorded as variances in the costing system.

When is standard costing appropriate?

Standard costing can be used in a variety of situations.
It is most useful when accounting for homogenous goods produced in large
numbers, when there is a degree of repetition in the production process.
A standard costing system may be used when an entity produces standard units
of product or service that are identical to all other similar units produced.
Standard costing is usually associated with standard products, but can be applied
to standard services too.
A standard unit should have exactly the same input resources (direct materials,
direct labour time) as all other similar units, and these resources should cost
exactly the same. Standard units should therefore have the same cost.

1.2 Standard cost

Definition: Standard cost and standard costing

Standard cost is an estimated or predetermined cost of performing an operation or
producing a good or service, under normal conditions
Standard costing is a control technique that reports variances by comparing actual
costs to pre-set standards so facilitating action through management by exception.

A standard cost is a predetermined unit cost based on expected direct

materials quantities and expected direct labour time, and priced at a
predetermined rate per unit of direct materials and rate per direct labour hour and
rate per hour of overhead.
 Standard costs of products are usually restricted to production costs only,
not administration and selling and distribution overheads.
© Emile Woolf International 211 The Institute of Chartered Accountants of Nigeria
 Overheads are normally absorbed into standard production cost at an
absorption rate per direct labour hour.

Example: Standard cost card

The standard cost of a Product XYZ might be:

₦ ₦
Direct materials:
Material A: 2 litres at ₦4.50 per litre 9.00
Material B: 3 kilos at ₦4 per kilo 12.00
21.00
Direct labour
Grade 1 labour: 0.5 hours at ₦20 per hour 10.00
Grade 2 labour: 0.75 hours at ₦16 per hour 12.00
22.00
Variable production overheads: 1.25 hours at ₦4 per hour 5.00
Fixed production overheads: 1.25 hours at ₦40 per hour 50.00
Standard (production) cost per unit 98.00

Who sets standard costs?

Standard costs are set by managers with the expertise to assess what the
standard prices and rates should be. Standard costs are normally reviewed
regularly, typically once a year as part of the annual budgeting process.
 Standard prices for direct materials should be set by managers with
expertise in the purchase costs of materials. This is likely to be a senior
manager in the purchasing department (buying department).
 Standard rates for direct labour should be set by managers with expertise
in labour rates. This is likely to be a senior manager in the human
resources department (personnel department).
 Standard usage rates for direct materials and standard efficiency rates for
direct labour should be set by managers with expertise in operational
activities. This may be a senior manager in the production or operations
department, or a manager in the technical department.
 Standard overhead rates should be identified by a senior management
accountant, from budgeted overhead costs and budgeted activity levels that
have been agreed in the annual budgeting process.

1.3 Standard costing

Standard costing is a system of costing in which:
 all units of product (or service) are recorded in the cost accounts at their
standard cost, and
 the value of inventory is based on standard production cost.
Differences between actual costs and standard costs are recorded as variances,
and variances are reported at regular intervals (typically each month) for the
purpose of budgetary control.
Standard costing may be used with either a system of absorption costing or a
system of marginal costing.

Performance management

1.4 The uses of standard costing

Standard costing has four main uses.
 It is an alternative system of cost accounting. In a standard costing system,
all units produced are recorded at their standard cost of production.
 When standard costs are established for products, they can be used to
prepare the budget.
 It is a system of performance measurement. The differences between
standard costs (expected costs) and actual costs can be measured as
variances. Variances can be reported regularly to management, in order to
identify areas of good performance or poor performance.
 It is also a system of control reporting. When differences between actual
results and expected results (the budget and standard costs) are large, this
could indicate that operational performance is not as it should be, and that
the causes of the variance should be investigated. Management can
therefore use variance reports to identify whether control measures might
be needed, to improve poor performance or continue with good
performances.
When there are large adverse variances, this might indicate that actual
performance is poor, and control action is needed to deal with the weaknesses.
When there are large favourable variances, and actual results are much better
than expected, management should investigate to find out why this has
happened, and whether any action is needed to ensure that the favourable
results will continue in the future.

Variances and controllability

The principle of controllability should be applied in any performance management
system
When variances are used to measure the performance of an aspect of
operations, or the performance of a manager, they should be reported to the
manager who is:
 responsible for the area of operations to which the variances relate, and
 able to do something to control them.
There is no value or practical purpose in reporting variances to a manager who is
unable to do anything to control performance by sorting out problems that the
variances reveal and preventing the variances from happening again.
It is also unreasonable to make a manager accountable for performance that is
outside his control, and for variances that he can do nothing about.

1.5 Deriving a standard cost

A standard variable cost of a product is established by building up the standard
materials, labour and production overhead costs for each standard unit.
In a standard absorption costing system, the standard fixed overhead cost is a
standard cost per unit, based on budgeted data about fixed costs and the
budgeted production volume.

Chapter 7: Variance analysis

Companies can often measure the standard quantities with a high degree of
confidence. Remember that standard costing is appropriate in conditions of high
production numbers and a lot of repetition. Companies might make thousands of
items and this experience leads to knowledge of the process.

Deriving the standard usage for materials

The standard usage for direct materials can be obtained by using:
 historical records for material usage in the past, or
 the design specification for the product

Deriving the standard efficiency rate for labour

The standard efficiency rate for direct labour can be obtained by using:
 historical records for labour time spent on the product in the past, or
 making comparisons with similar work and the time required to do this
work, or
 ‘time and motion study’ to estimate how long the work ought to take

Deriving the standard price for materials

The standard price for direct materials can be estimated by using:
 historical records for material purchases in the past, and
 allowing for estimated changes in the future, such as price inflation and any
expected change in the trade discounts available

Deriving the standard rate of pay for labour

Not all employees are paid the same rate of pay, and there may be differences to
allow for the experience of the employee and the number of years in the job.
There is also the problem that employees may receive an annual increase in pay
each year to allow for inflation, and the pay increase may occur during the middle
of the financial year.
 The standard rate of pay per direct labour hour will be an average rate of
pay for each category or grade of employees.
 The rate of pay may be based on current pay levels or on an expected
average pay level for the year, allowing for the expected inflationary pay
rise during the year.

Performance management

Example: Deriving a standard cost

A company manufactures two products, X and Y. In Year 1 it budgets to make
2,000 units of Product X and 1,000 units of Product Y. Budgeted resources per
unit and costs are as follows:
Product X Product Y
Direct materials per unit:
Material A 2 units of material 1.5 units of material
Material B 1 unit of material 3 units of material
Direct labour hours per unit 0.75 hours 1 hour

Costs
Direct material A ₦40 per unit
Direct material B ₦30 per unit
Direct labour ₦200 per hour
Variable production overhead ₦40 per direct labour hour
Fixed production overheads per unit are calculated by applying a direct labour
hour absorption rate to the standard labour hours per unit, using the budgeted
fixed production overhead costs of ₦120,000 for the year.

Required
Calculate the standard full production cost per unit of:
(a) Product X, and
(b) Product Y

Chapter 7: Variance analysis

Answer
First calculate the budgeted overhead absorption rate.
Budgeted direct labour hours hours
Product X: (2,000 units  0.75 hours) 1,500
Product Y (1,000 units  1 hour) 1,000
2,500

Budgeted fixed production overheads ₦120,000

Fixed overhead absorption rate/hour ₦48

Product X Product Y
₦ ₦
Direct materials
Material A (2 units  ₦40) 80 (1.5 units  ₦40) 60
Material B (1 unit  ₦30) 30 (3 units  ₦30) 90
Direct labour (0.75 hours  ₦200) 150 (1 hour  ₦200) 200
Variable
production
overhead (0.75 hours  ₦40) 30 (1 hour  ₦40) 40
Standard variable
prod’n cost 290 390
Fixed production
overhead (0.75 hours  ₦48) 36 (1 hour  ₦48) 48
Standard full
production cost 326 438

Performance management

Practice question 1
A company manufactures two products, L and H. In Year 1, it budgets
to make 6,000 units of Product L and 2,000 units of Product H.
Budgeted resources per unit and costs are as follows:
L H
Direct materials per unit:
Material X 3 kg 1kg
Material Y 2 kg 6 kg
Direct labour hours per unit 1.6 hours 3 hours

Costs
Direct material X ₦30 per unit
Direct material Y ₦40 per unit
Direct labour ₦250 per hour
Variable production overhead ₦50 per direct labour hour

Fixed production overheads per unit are calculated by applying a direct

labour hour absorption rate to the standard labour hours per unit, using
the budgeted fixed production overhead costs of ₦1,800,000 for the
year.
Required
Calculate the standard full production cost per unit of:
(a) Product L, and
(b) Product H

Chapter 7: Variance analysis

1.6 Types of standard

Standards are predetermined estimates of unit costs but how is the level of
efficiency inherent in the estimate determined? Should it assume perfect
operating conditions or should it incorporate an allowance for waste and idle
time? The standard set will be a performance target and if it seen as unattainable
this may have a detrimental impact on staff motivation. If the standard set is too
easy to attain there may be no incentive to find improvements.
There are four types of standard, and any of these may be used in a standard
costing system:
 Ideal standards. These assume perfect operating conditions. No
allowance is made for wastage, labour inefficiency or machine breakdowns.
The ideal standard cost is the cost that would be achievable if operating
conditions and operating performance were perfect. In practice, the ideal
standard is not achieved.
 Attainable standards. These assume efficient but not perfect operating
conditions. An allowance is made for waste and inefficiency. However the
attainable standard is set at a higher level of efficiency than the current
performance standard, and some improvements will therefore be necessary
in order to achieve the standard level of performance.
 Current standards. These are based on current working conditions and
what the entity is capable of achieving at the moment. Current standards do
not provide any incentive to make significant improvements in performance,
and might be considered unsatisfactory when current operating
performance is considered inefficient.
 Basic standards. These are standards which remain unchanged over a
long period of time. Variances are calculated by comparing actual results
with the basic standard, and if there is a gradual improvement in
performance over time, this will be apparent in an improving trend in
reported variances.
When there is waste in production, or when idle time occurs regularly, current
standard costs may include an allowance for the expected wastage or expected
idle time. This is considered in more detail later.

Types of standard: behavioural aspects

One of the purposes of standard costing is to set performance standards that
motivate employees to improve performance. The type of standard used can
have an effect on motivation and incentives.
 Ideal standards are unlikely to be achieved. They may be very useful as
long term targets and may provide senior managers with an indication of
the potential for savings in a process but generally the ideal standard will
not be achieved. Consequently the reported variances will always be
adverse. Employees may become de-motivated when their performance
level is always worse than standard and they know that the standard is
unachievable.
 Current standards may be useful for producing budgets as they are based
on current levels of efficiency and may therefore give a realistic guide to
resources required in the production process. However current standards
are unlikely to motivate employees to improve their performance, unless
there are incentives for achieving favourable variances (for achieving
results that are better than the standard), such as annual cash bonuses.

Performance management

 Basic standards will not motivate employees to improve their performance

as they are based on achievable conditions at some time in the past. They
are also not useful for budgeting because they will often be out of date. In
practice, they are the least common type of standard.
 Attainable standards are the most likely to motivate employees to improve
performance as they are based on challenging but attainable targets. It is
for this reason that standards are often based on attainable conditions.
However, a problem with attainable standards is deciding on the level of
performance that should be the target for achievement. For example, if an
attainable standard provides for some improvement in labour efficiency,
should the standard provide for a 1% improvement in efficiency, or a 5%
improvement, or a 10% improvement?

1.7 Reviewing standards

How often should standards be revised? There are several reasons why
standards should be revised regularly.
 Regular revision leads to standards which are meaningful targets that
employees may be motivated to achieve (for example, through incentive
schemes).
 Variance analysis is more meaningful because reported variances should
be realistic.
 In practice, standards are normally reviewed annually. Standards by their
nature are long-term averages and therefore some variation is expected
over time. The budgeting process can therefore be used to review the
standard costs in use.

Chapter 7: Variance analysis

2 INTRODUCTION TO VARIANCE ANALYSIS

Section overview

 Standard cost cards

 Fixed budget
 Flexed budget
 Comparison of actual results to the flexed budget
 Cost variances

2.1 Standard cost cards

Standard costs are constructed by estimating the quantities of standard amounts
of input (for example materials and labour) and estimating the cost of buying
these over the future period covered by the standard.
Standard costs for a unit are often set out in a record called a standard cost card.
A typical standard cost card is as follows.

Example: Standard cost card (Lagos Manufacturing Limited)

₦
Direct materials 5 kg @ ₦1,000 per kg 5,000
Direct labour 4 hours @ ₦500 per hour 2,000
Variable overhead 4 hours @ ₦200 per hour 800
Marginal production cost 7,800
Fixed production overhead 4 hours @ ₦600 per hour 2,400
Total absorption cost 10,200

The above standard costs will be used in examples throughout this chapter to
illustrate variance analysis.
Standard costs link to the budget through activity levels.
For example, if a company wanted to make 1,200 of the above units the budget
would show a material cost of ₦6,000,000 (1,200  ₦5,000)

Example: Fixed budget for a period

Lagos Manufacturing Limited has budgeted to make 1,200 units.
Cost budget ₦‘000
Materials (1,200 units ₦5,000 per unit) 6,000
Labour (1,200 units  ₦2,000 per unit) 2,400
Variable overhead (1,200 units  ₦800 per unit) 960
Fixed overhead (1,200 units  ₦2,400 per unit) 2,880

Performance management

2.2 Fixed budget

The original budget prepared at the beginning of a budget period is known as the
fixed budget. A fixed budget is a budget for a specific volume of output and sales
activity, and it is the ‘master plan’ for the financial year that the company tries to
achieve.

Example: Fixed budget for a period

Lagos Manufacturing Limited has budgeted to make 1,200 units and sell 1,000
units in January.
The selling price per unit is budgeted at ₦15,000.
The standard costs of production are as given in the previous example.
The budget prepared for January is as follows:

Unit sales 1,000

Unit production 1,200

Budget ₦‘000
Sales (1,000 units  15,000) 15,000
Cost of sales:
Materials (1,200 units ₦5,000 per unit) 6,000
Labour (1,200 units  ₦2,000 per unit) 2,400
Variable overhead (1,200 units  ₦800 per unit) 960
Fixed overhead (1,200 units  ₦2,400 per unit) 2,880
12,240
Closing inventory (200 units  ₦10,200 per unit) (2,040)
Cost of sales (1,000 units  ₦10,200 per unit) (10,200)
Profit 4,800

Note:
Budgeted profit = 1,000 units  (₦15,000  ₦10,200 per unit) =
₦4,800,000

One of the main purposes of budgeting is budgetary control and the control of
costs. Costs can be controlled by comparing budgets with the results actually
achieved.
Differences between expected results and actual results are known as variances.
Variances can be either favourable (F) or adverse (A) depending on whether the
results achieved are better or worse than expected.

Chapter 7: Variance analysis

Consider the following:

Example: Fixed budget and actual results for a period.

At the end of January Lagos Manufacturing Limited recorded its actual results as
follows.
Budget Actual
Unit sales 1,000 900
Unit production 1,200 1,000

Budget Actual
Budget ₦‘000 ₦‘000
Sales 15,000 12,600
Cost of sales:
Materials 6,000 4,608
Labour 2,400 2,121
Variable overhead 960 945
Fixed overhead 2,880 2,500
12,240 10,174
Closing inventory (2,040) (1,020)
Cost of sales (10,200) (9,154)
Profit 4,800 3,446

Note:
The actual closing inventory of 100 units is measured at the standard cost
of ₦10,200 per unit. This is what happens in standard costing systems.

What does this tell us?

The actual results differ from the budget. The company has not achieved its plan
in January. Profit is less than budgeted. The company would like to understand
the reason for this in as much detail as possible.
The technique that explains the difference between actual results and the budget
is called variance analysis. This technique identifies the components of the
difference between the budgeted profit and the actual profit in detail so that they
can be investigated and understood by the company.
The sales figure is less than budgeted but why? The sales figure is a function of
the quantity sold and the selling price per unit. The quantity sold is 100 units less
than budgeted but what about the impact of any difference in the sales price?
At first sight it looks as if the company has made savings on every cost line. For
example budgeted material cost was ₦6,000,000 but actual spend was only
₦4,608,000. However, this is not a fair comparison because the budgeted cost
was to make 1200 units whereas the company only made 1,000 units.

Performance management

2.3 Flexed budget

Variances are not calculated by comparing actual results to the fixed budget
directly because the figures relate to different levels of activity and the
comparison would not be like to like. A second budget is drawn up at the end of
the period. This budget is based on the actual levels of activity and the standard
revenue and standard costs. This budget is called a flexed budget.

Example: Flexed budget for a period

The flexed budget prepared by Lagos Manufacturing Limited at the end of January
(based on actual levels of activity and standard revenue per unit and standard cost
per unit) is as follows:

Unit sales 900

Unit production 1,000

Budget ₦‘000
Sales (900 units  15,000) 13,500
Cost of sales:
Materials (1,000 units ₦5,000 per unit) 5,000
Labour (1,000 units  ₦2,000 per unit) 2,000
Variable overhead (1,000 units  ₦800 per unit) 800
Fixed overhead (1,000 units  ₦2,400 per unit) 2,400
10,200
Closing inventory (100 units  ₦10,200 per unit) (1,020)
Cost of sales (900 units  ₦10,200 per unit) (9,180)
Profit 4,320

This shows the amount that the company would have received for the actual
number of units sold if they had been sold at the budgeted revenue per item.
It shows what the actual number of units produced (1,000 units) would have cost
if they had been made at the standard cost.
The flexed budget is a vital concept. It sits at the heart of variance analysis.

Chapter 7: Variance analysis

2.4 Comparison of actual results to the flexed budget

All three statements can be combined as follows:

Example: Fixed budget, flexed budget and actual results for a period.
At the end of January, Lagos Manufacturing Limited has recorded its actual results
as follows (together with the original fixed budget and the flexed budget for the
month).
Fixed Flexed
budget budget Actual
Unit sales 1,000 900 900
Unit production 1,200 1,000 1,000

Budget Actual Actual

Budget ₦‘000 ₦‘000 ₦‘000
Sales 15,000 13,500 12,600
Cost of sales:
Materials 6,000 5,000 4,608
Labour 2,400 2,000 2,121
Variable overhead 960 800 945
Fixed overhead 2,880 2,400 2,500
12,240 10,200 10,174
Closing inventory (2,040) (1,020) (1,020)
Cost of sales (10,200) (9,180) (9,154)
Profit 4,800 4,320 3,446

Note:
The actual closing inventory of 100 units is measured at the standard total
absorption cost of ₦10,200 per unit. This is what happens in standard
costing systems.

The information for Lagos Manufacturing Limited’s performance in January will

be used throughout this chapter to illustrate variance analysis.
Note that the above example is unlikely to be something that you would have to
produce in the exam. It is provided to help you to understand what variance
analysis is about.

Commentary
Variance analysis explains the difference between the fixed budget profit and the
actual profit in detail. This paragraph provides an initial commentary before
looking at the detailed calculations in later sections of this chapter.
Both the fixed budget and the flexed budget are based on the standard revenue
per unit and the standard costs per unit. Therefore, the difference between the
fixed budget and the flexed budget is caused only by difference in volume. This
figure of ₦480,000 (₦4,800,000  ₦4,320,000) is called the sales volume
variance. This is revisited in detail later in this chapter.

Performance management

Revenue is sales quantity  sales price per unit. The revenue in the flexed budget
and the actual revenue are both based on the actual quantity sold. Therefore the
difference between the two figures of ₦900,000 (₦13,500,000  ₦12,600,000) is
due to a difference in the selling price per unit. This difference is called the sales
price variance. This is revisited in detail later in this chapter.
The difference between each variable cost line in the flexed budget and the
equivalent actual figure is a total cost variance for that item. For example the
actual results show that 1,000 units use material which cost ₦4,608,000. The
flexed budget shows that these units should have used material which cost
₦5,000,000. The difference of ₦392,000 is due to a combination of the actual
material used being different to the budgeted usage of 5kgs per unit and the
actual price per kg being different to the budgeted price per kg. In other words,
the total variance can be explained in terms of usage and price. This is explained
in detail later in this chapter.
Variable cost variances can be calculated for all items of variable cost (direct
materials, direct labour and variable production overhead). The method of
calculating the variances is similar for each variable cost item.
 The total cost variance for the variable cost item is the difference between
the actual variable cost of production and the standard variable cost of
producing the items.
 However, the total cost variance is not usually calculated. Instead, the total
variance is calculated in two parts, that add up to the total cost variance:
 a price variance or rate variance or expenditure per hour variance.
 a usage or efficiency variance.
The difference between the fixed overhead in the flexed budget and the actual
fixed overhead is over absorption. This was covered in an earlier chapter but will
be revisited in full later in this chapter.

2.5 Cost variances

Adverse and favourable cost variances

In a standard costing system, all units of output are valued at their standard cost.
Cost of production and cost of sales are therefore valued at standard cost.
Actual costs will differ from standard costs. A cost variance is the difference
between an actual cost and a standard cost.
 When actual cost is higher than standard cost, the cost variance is adverse
(A) or unfavourable (U).
 When actual cost is less than standard cost, the cost variance is favourable
(F).
Different variances are calculated, relating to direct materials, direct labour,
variable production overhead and fixed production overhead. (There are also
sales variances. These are explained in a later section.)
In a cost accounting system, cost variances are adjustments to the profit in an
accounting period.
 Favourable variances increase the reported profit.
 Adverse variances reduce the reported profit.

Chapter 7: Variance analysis

The method of calculating cost variances is similar for all variable production cost
items (direct materials, direct labour and variable production overhead).
A different method of calculating cost variances is required for fixed production
overhead.

Variances and performance reporting

Variance reports are produced at the end of each control period (say, at the end
of each month).
 Large adverse variances indicate poor performance and the need for
control action by management.
 Large favourable variances indicate unexpected good performance.
Management might wish to consider how this good performance can be
maintained in the future.
Variances might be reported in a statement for the accounting period that
reconciles the budgeted profit with the actual profit for the period. This statement
is known as an operating statement.

Performance management

3 DIRECT MATERIALS VARIANCES

Section overview

 Direct materials: total cost variance

 Direct materials price variance
 Direct materials usage variance
 Alternative calculations
 Direct materials: possible causes of variances

3.1 Direct materials: total cost variance

The total direct material cost variance is the difference between the actual
material cost in producing units in the period and the standard material cost of
producing those units.

Illustration: Direct materials – total cost variance

₦
Standard material cost of actual production:
Actual units produced  Standard kgs per unit  Standard price per kg X

Actual material cost of actual production:

Actual units produced  Actual kgs per unit  Actual price per kg (X)
X

The variance is adverse (A) if actual cost is higher than the standard cost, and
favourable (F) if actual cost is less than the standard cost.

Example: Direct material – Total cost variance (Lagos Manufacturing Limited)

Standard material cost per unit: (5kgs  ₦1,000 per kg) = ₦5,000 per unit

Actual production in period = 1,000 units.

Materials purchased and used: 4,850 kgs at a cost of ₦4,608,000

Direct materials total cost variance is calculated as follows:

₦‘000
Standard: 1,000 units should cost (@ ₦5,000 per unit) 5,000
Actual: 1,000 units did cost (4,608)
Total cost variance 392 F

Chapter 7: Variance analysis

The direct materials total cost variance can be analysed into a price variance and
a usage variance.
 A price variance measures the difference between the actual price paid for
materials and the price that should have been paid (the standard price).
 A usage variance measures the difference between the materials that were
used in production and the materials that should have been used (the
standard usage).

Practice question 2
A unit of Product P123 has a standard cost of 5 litres of Material A at ₦3 per
litre. The standard direct material cost per unit of Product P123 is therefore
₦15.
In a particular month, 2,000 units of Product P123 were manufactured.
These used 10,400 litres of Material A, which cost ₦33,600.
Calculate the total direct material cost variance.

3.2 Direct materials price variance

The price variance may be calculated for the materials purchased or materials
used. Usually it is calculated at the point of purchase as this allows the material
inventory to be carried at standard cost.

Illustration: Direct materials – price variance

₦
Standard material cost of actual production:
Actual kgs purchased  Standard price per kg X

Actual material cost of actual purchases

Actual kgs purchased  Actual price per kg (X)
X

Example: Direct materials – price variance (Lagos Manufacturing Limited)

Standard material cost per unit: (5kgs  ₦1,000 per kg) = ₦5,000 per unit

Actual production in period = 1,000 units.

Materials purchased and used: 4,850 kgs at a cost of ₦4,608,000

Direct materials price variance is calculated as follows:

₦‘000
Standard: 4,850 kgs should cost (@ ₦1,000 per kg) 4,850
Actual: 4,850 kgs did cost (4,608)
Materials price variance 242 F

Performance management

If there are two or more direct materials, a price variance is calculated separately
for each material.

Practice question 3
A unit of Product P123 has a standard cost of 5 litres of Material A at ₦3 per
litre. The standard direct material cost per unit of Product P123 is therefore
₦15. In a particular month, 2,000 units of Product P123 were manufactured.
These used 10,400 litres of Material A, which cost ₦33,600.
Calculate the direct material price variance.

3.3 Direct materials usage variance

The usage variance is calculated by comparing the actual quantity of material
used to make the actual production to the standard quantity that should have
been used to produce those units. In other words, the actual usage of materials is
compared with the standard usage for the actual number of units produced,
The difference is the usage variance, measured as a quantity of materials. This is
converted into a money value at the standard price for the material.

Illustration: Direct materials – Usage variance

Kgs
Standard quantity of material needed to make the actual production X
Actual quantity of material used to make the actual production (X)
Usage variance (in kgs) X
Standard cost per kg (multiply by) X
Usage variance (₦) X

Example: Direct materials – Usage variance (Lagos Manufacturing Limited)

Standard material cost per unit: (5kgs  ₦1,000 per kg) = ₦5,000 per unit

Actual production in period = 1,000 units.

Materials purchased and used: 4,850 kgs at a cost of ₦4,608,000

Direct materials usage variance is calculated as follows:

Kgs
Standard:
Making 1,000 units should have used (@ 5 kgs per unit) 5,000
Actual: Making 1,000 units did use (4,850)
Usage variance (kgs) 150 F
Standard cost per kg ₦1,000
Usage variance (₦) ₦150,000 F

Chapter 7: Variance analysis

Practice question 4
A unit of Product P123 has a standard cost of 5 litres of Material A at ₦3 per
litre.
The standard direct material cost per unit of Product P123 is therefore ₦15.
In a particular month, 2,000 units of Product P123 were manufactured.
These used 10,400 litres of Material A, which cost ₦33,600.
Calculate the direct materials usage variance.

3.4 Alternative calculations

Variances can be calculated in a number of ways. A useful approach is the
following line by line approach.

Formula: Alternative method for calculating material variances

AQ purchased  AC X
X Price variance
AQ purchased  SC X
X Inventory movement
AQ used  SC X
X usage variance
SQ used  SC X

Where:
AQ = Actual quantity
AC = Actual cost per kg
SC = Standard cost per kg
SQ = Standard quantity needed to make actual production

Performance management

Example: Alternative method for calculating material variances (Lagos

Manufacturing Limited)
Standard material cost per unit: (5kgs  ₦1,000 per kg) = ₦5,000 per unit
Actual production in period = 1,000 units.
Materials purchased and used: 4,850 kgs at a cost of ₦4,608,000

₦‘000 ₦‘000
AQ purchased  AC
4,850 kgs  ₦X per kg 4,608
AQ purchased  SC 242 (F) Price variance
4,850 kgs  ₦1,000 per kg 4,850
AQ used  SC nil inventory movement
4,850 kgs  ₦1,000 per kg 4,850
SQ used  SC 150 (F) Usage variance
5,000 kgs  ₦1,000 per kg 5,000

SQ = 1,000 units  5 kgs per unit = 5,000 kgs

Practice question 5
A unit of Product P123 has a standard cost of 5 litres of Material A at ₦3 per
litre.
The standard direct material cost per unit of Product P123 is therefore ₦15.
In a particular month, 2,000 units of Product P123 were manufactured.
These used 10,400 litres of Material A, which cost ₦33,600.
Calculate the direct materials price and usage variances using the alternative
approach.

Chapter 7: Variance analysis

3.5 Direct materials: possible causes of variances

When variances occur and they appear to be significant, management should
investigate the reason for the variance. If the cause of the variance is something
within the control of management, control action should be taken. Some of the
possible causes of materials variances are listed below.

Materials price variance: causes

Possible causes of favourable materials price variances include:
 Different suppliers were used and these charged a lower price (favourable
price variance) than the usual supplier.
 Materials were purchased in sufficient quantities to obtain a bulk purchase
discount (a quantity discount), resulting in a favourable price variance.
 Materials were bought that were of lower quality than standard and so
cheaper than expected.
Possible causes of adverse materials price variances include:
 Different suppliers were used and these charged a higher price (adverse
price variance) than the usual supplier.
 Suppliers increased their prices by more than expected. (Higher prices
might be caused by an unexpected increase in the rate of inflation.)
 There was a severe shortage of the materials, so that prices in the market
were much higher than expected.
 Materials were bought that were better quality than standard and more
expensive than expected.

Materials usage variance: causes

Possible causes of favourable materials usage variances include:
 Wastage rates were lower than expected.
 Improvements in production methods resulted in more efficient usage of
materials (favourable usage variance).
Possible causes of adverse materials usage variances include:
 Wastage rates were higher than expected.
 Poor materials handling resulted in a large amount of breakages (adverse
usage variance). Breakages mean that a quantity of materials input to the
production process is wasted.
 Materials used were of cheaper quality than standard, with the result that
more materials had to be thrown away as waste.

Performance management

4 DIRECT LABOUR VARIANCES

Section overview

 Direct labour: total cost variance

 Direct labour rate variance
 Direct labour efficiency variance
 Idle time variance
 Alternative calculations
 Idle time variance where idle time is included in standard cost
 Direct labour: possible causes of variances

4.1 Direct labour: total cost variance

The total direct labour cost variance is the difference between the actual labour
cost in producing units in the period and the standard labour cost of producing
those units.

Illustration: Direct labour – total cost variance

₦
Standard labour cost of actual production:
Actual units produced  Standard hrs per unit  Standard rate per hr X

Actual labour cost of actual production:

Actual units produced  Actual hours per unit  Actual rate per hour (X)
X

The variance is adverse (A) if actual cost is higher than the standard cost, and
favourable (F) if actual cost is less than the standard cost.

Example: Direct labour – Total cost variance (Lagos Manufacturing Limited)

Standard labour cost per unit: (4 hrs  ₦500 per hr) = ₦2,000 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000

Direct labour total cost variance is calculated as follows:

₦‘000
Standard: 1,000 units should cost (@ ₦2,000 per unit) 2,000
Actual: 1,000 units did cost (2,121)
Total cost variance (121) A

Chapter 7: Variance analysis

The direct labour total cost variance can be analysed into a rate variance and an
efficiency variance. These are calculated in a similar way to the direct materials price
and usage variances.
 A rate variance measures the difference between the actual wage rate paid per
labour hour and the rate that should have been paid (the standard rate of pay).
 An efficiency variance (or productivity variance) measures the difference between
the time taken to make the production output and the time that should have been
taken (the standard time).

4.2 Direct labour rate variance

The direct labour rate variance is calculated for the actual number of hours paid
for.
The actual labour cost of the actual hours paid for is compared with the standard
cost for those hours. The difference is the labour rate variance.

Illustration: Direct labour – rate variance

₦
Standard labour cost of actual production:
Actual hours paid for  Standard rate per hour X

Actual labour cost of actual production

Actual hours paid for  Actual rate per hour (X)
X

Example: Direct labour – rate variance (Lagos Manufacturing Limited)

Standard labour cost per unit: (4 hrs  ₦500 per hour) = ₦2,000 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000

Direct labour rate variance is calculated as follows:

₦‘000
Standard: 4,200 hours should cost (@ ₦500 per hour) 2,100
Actual: 4,200 hours did cost (2,121)
Labour rate variance (21) A

If there are two or more different types or grades of labour, each paid at a
different standard rate per hour, a rate variance is calculated separately for each
labour grade.

Performance management

4.3 Direct labour efficiency variance

The direct labour efficiency variance is calculated for the hours used on the units
produced.
For the actual number of standard units produced, the actual hours worked is
compared with the standard number of hours that should have been worked to
produce the actual output. The difference is the efficiency variance, measured in
hours. This is converted into a money value at the standard direct labour rate per
hour.

Illustration: Direct labour – Efficiency variance

Hours
Standard labour hours used to make the actual production X

Actual labour hours used to make the actual production (X)

Efficiency variance (hours) X
Standard rate per hour (multiply by) X
Efficiency variance (₦) X

Example Direct labour – Efficiency variance (Lagos Manufacturing Limited)

Standard labour cost per unit: (4 hrs  ₦500 per hour) = ₦2,000 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000

Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 4 hours per unit) 4,000
Actual: Making 1,000 units did use (4,200)
Efficiency variance (hours) (A) (200) A
Standard rate per hour ₦500
Efficiency variance (₦) (A) (₦100,000) A

Practice question 6
Product P234 has a standard direct labour cost per unit of:
0.5 hours × ₦12 per direct labour hour = ₦6 per unit.
During a particular month, 3,000 units of Product P234 were manufactured.
These took 1,400 hours to make and the direct labour cost was ₦16,200.
Calculate the total direct labour cost variance, the direct labour rate variance
and the direct labour efficiency variance for the month.

Chapter 7: Variance analysis

4.4 Idle time variance

Idle time was explained in the previous chapter. Part of this explanation is
repeated here for your convenience.
Idle time occurs when the direct labour employees are being paid but have no
work to do. The causes of idle time may be:
 A breakdown in production, for example a machine breakdown that halts
the production process
 Time spent waiting for work due to a bottleneck or hold-up at an earlier
stage in the production process
 Running out of a vital direct material, and having to wait for a new delivery
of the materials from a supplier.
 A lack of work to do due to a lack of customer orders.
A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are
measured. Idle time variance is part of the efficiency variance.
Sometimes idle time might be a feature of a production process for example
where there may be bottlenecks in a process that might lead to idle time on a
regular basis. In this case the expected idle time might be built into the standard
cost.
 If idle time is not built into the standard cost the idle time variance is always
adverse.
 If it is built into the standard cost the idle time variance might be favourable
or adverse depending on whether the actual idle time is more or less than
the standard idle time for that level of production.

Idle time not part of standard cost

As stated above if the idle time is not included in the standard cost, any idle time
is unexpected and leads to an adverse variance.

Illustration: Direct labour – idle time variance

Hours
Actual hours paid for X(X
Actual hours worked )X
Idle time (hours) X
Standard rate per hour (multiply by) X
Idle time (₦)

Calculating the idle time variance will affect the calculation of the direct labour
efficiency variance. If idle time occurs but is not recorded the idle time variance is
part of the direct labour efficiency variance.

Performance management

Example: Direct labour – idle time variance (Lagos Manufacturing Limited)

Standard labour cost per unit: (4 hours  ₦500 per kg) = ₦2,000 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000
Labour hours worked: 4,100 hours

Direct labour idle time variance is calculated as follows:

Hours
Actual hours paid for 4,200
Actual hours worked (4,100)
Idle time (hours) (100) A
Standard rate per hour (multiply by) ₦500
Idle time (₦) (₦50,000) A

Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 4 hours per unit) 4,000
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (100) A
Standard rate per hour ₦500
Efficiency variance (₦) (₦50,000) A

Chapter 7: Variance analysis

4.5 Alternative calculations

The following shows the line by line approach for labour variances.

Formula: Alternative method for calculating labour variances

AH paid for  AR X
X Rate variance
AH paid for  SR X
X Idle time variance
AH worked  SR X
X Efficiency variance
SH worked  SR X

Where:
AH = Actual hours
AR = Actual rate per hour
SR = Standard rate per hour
SH = Standard hours needed to make actual production

Example: Alternative method for calculating labour variances (Lagos

Manufacturing Limited)
Standard labour cost per unit: (4 hours  ₦500 per kg) = ₦2,000 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000
Labour hours worked: 4,100 hours

₦‘000 ₦‘000
AH paid for  AR
4,200 hours  ₦X per hour 2,121
AH paid for  SR 21 (A) Price variance
4,200 hours  ₦500 per hour 2,100
AH worked  SR 50 (A) Idle time
4,100 hours  ₦500 per hour 2,050
SH worked  SR 50 (A) Efficiency
4,000 hours  ₦500 per hour 2,000

SQ = 1,000 units  4 hours per unit = 4,000 hours

Performance management

Practice question 7
Product P234 has a standard direct labour cost per unit of:
0.5 hours × ₦12 per direct labour hour = ₦6 per unit.
During a particular month, 3,000 units of Product P234 were manufactured.
These took 1,400 hours to make and the direct labour cost was ₦16,200.
Calculate the direct labour rate variance and the direct labour efficiency
variance for the month using the alternative approach.

4.6 Idle time variance where idle time is included in standard cost

Methods of including idle time in standard costs

There are different ways of allowing for idle time in a standard cost.
 Method 1. Include idle time as a separate element of the standard cost, so
that the standard cost of idle time is a part of the total standard cost per
unit.
 Method 2. Allow for a standard amount of idle time in the standard hours
per unit for each product. The standard hours per unit therefore include an
allowance for expected idle time.

Example: Idle time in standard (Lagos Manufacturing Limited)

Standard labour rate = ₦500 per hour
A unit of production should take 3.6 hours to produce.
Expected idle time is 10% of total time paid for.
Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).

Idle time can be built into the standard as follows:

Method 1 ₦
Labour 3.6 hours  ₦500 per hour 1,800
Idle time 0.4 hours  ₦500 per hour 200
2,000

Method 2 ₦
Labour 4 hours  ₦500 per hour 2,000

Chapter 7: Variance analysis

The two methods will result in the identification of the same overall variance for
idle time plus labour efficiency but the split of the number may differ.

Example: Method 1 – idle time variance (Idle time included in standard as a

separate element) (Lagos Manufacturing Limited)
Standard labour rate = ₦500 per hour
A unit of production should take 3.6 hours to produce.
Expected idle time is 10% of total time paid for.
Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).

Idle time can be built into the standard as follows:

Method 1 ₦
Labour 3.6 hours  ₦500 per hour 1,800
Idle time 0.4 hours  ₦500 per hour 200
2,000

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000
Labour hours worked: 4,100 hours

Direct labour idle time variance is calculated as follows:

Hours
Expected idle time (1,000 units  0.4 hours per unit) 400
Actual idle time (4,200 hours  4,100 hours) (100)
Idle time (hours) 300 F
Standard rate per hour (multiply by) ₦500
Idle time (₦) ₦150,000 F

Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 3.6 hours per unit) 3,600
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (500) A
Standard rate per hour ₦500
Efficiency variance (₦) (₦250,000) A

Performance management

Example: Method 2 – idle time variance (Idle time allowed for as a standard
amount of idle time in the standard hours per unit for each product) (Lagos
Manufacturing Limited)
Standard labour rate = ₦500 per hour
A unit of production should take 3.6 hours to produce.
Expected idle time is 10% of total time paid for.

Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).
Idle time can be built into the standard as follows:
Method 2 ₦
Labour 4 hours  ₦500 per hour 2,000

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of ₦2,121,000
Labour hours worked: 4,100 hours

Direct labour idle time variance is calculated as follows:

Hours
Expected idle time (10% of 4,200 hours paid for) 420
Actual idle time (4,200 hours  4,100 hours) (100)
Idle time (hours) 320 F
Standard rate per hour (multiply by) ₦500
Idle time (₦) ₦160,000 F

Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (4 hours per unit
less10% of the hours paid for = 4,000 – (10% of 4,200)) 3,580
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (520) A
Standard rate per hour ₦500
Efficiency variance (₦) (₦260,000) A

In summary the idle time variance is part of the efficiency variance. Different
methods result in a different split of the idle time variance and efficiency variance
but the figures always sum to the same total.

Chapter 7: Variance analysis

Revisiting the previous examples:

Example: Sum of idle time and efficiency variances (Lagos Manufacturing Limited)
Idle time Efficiency
variance variance Total
Idle time not recorded  100 (A) 100 (A)
Idle time recorded:
not part of standard cost 50 (A) 50 (A) 100 (A)
part of standard cost
(method 1) 150 (F) 250 (A) 100 (A)
part of standard cost
(method 2) 160 (F) 260 (A) 100 (A)

4.7 Direct labour: possible causes of variances

When labour variances appear significant, management should investigate the
reason why they occurred, and take control measures where appropriate to
improve the situation in the future. Possible causes of labour variances include
the following.
Possible causes of favourable labour rate variances include:
 Using direct labour employees who were relatively inexperienced and new
to the job (favourable rate variance, because these employees would be
paid less than ‘normal’).
 Actual pay increase turning out to be less than expected.
Possible causes of adverse labour rate variances include:
 An increase in pay for employees.
 Working overtime hours paid at a premium above the basic rate.
 Using direct labour employees who were more skilled and experienced
than the ‘normal’ and who are paid more than the standard rate per hour
(adverse rate variance).
Possible causes of favourable labour efficiency variances include:
 More efficient methods of working.
 Good morale amongst the workforce and good management with the result
that the work force is more productive.
 If incentive schemes are introduced to the workforce, this may encourage
employees to work more quickly and therefore give rise to a favourable
efficiency variance.
 Using employees who are more experienced than ‘standard’, resulting in
favourable efficiency variances as they are able to complete their work
more quickly than less-experienced colleagues.
Possible causes of adverse labour efficiency variances include:
 Using employees who are less experienced than ‘standard’, resulting in
adverse efficiency variances.
 An event causing poor morale.

Performance management

5 VARIABLE PRODUCTION OVERHEAD VARIANCES

Section overview

 Variable production overhead: total cost variance

 Variable production overhead expenditure variance
 Variable production overhead efficiency variance
 Alternative calculations
 Variable production overheads: possible causes of variances

5.1 Variable production overhead: total cost variance

The total variable production overhead cost variance is the difference between
the actual variable production overhead cost in producing units in the period and
the standard variable production overhead cost of producing those units.

Illustration: Variable production overhead – total cost variance

₦
Standard variable production overhead cost of actual production:
Actual units produced  Standard hrs per unit  Standard rate per hr X

Actual variable production overhead cost of actual production:

Actual units produced  Actual hours per unit  Actual rate per hour (X)
X

The variance is adverse (A) if actual cost is higher than the standard cost, and
favourable (F) if actual cost is less than the standard cost.

Example: Variable production overhead – Total cost variance (Lagos Manufacturing

Limited)
Standard variable production overhead cost per unit: (4 hrs  ₦200 per hr) =
₦800 per unit

Actual production in period = 1,000 units.

Variable production overhead = ₦945,000.
Labour hours paid for: 4,200 hours

Direct variable production overhead total cost variance is calculated as

follows:
₦‘000
Standard: 1,000 units should cost (@ ₦800 per unit) 800
Actual: 1,000 units did cost (945)
Total cost variance (145) A

Chapter 7: Variance analysis

The variable production overhead total cost variance can be analysed into an
expenditure variance (spending rate per hour variance) and an efficiency variance.
 The expenditure variance is similar to a materials price variance or a labour rate
variance. It is the difference between actual variable overhead spending in the
hours worked and what the spending should have been (the standard rate).
 The variable overhead efficiency variance in hours is the same as the labour
efficiency variance in hours (excluding any idle time variance), and is calculated
in a very similar way. It is the variable overhead cost or benefit from adverse or
favourable direct labour efficiency variances.

5.2 Variable production overhead expenditure variance

It is normally assumed that variable production overheads are incurred during
hours actively worked, but not during any hours of idle time.
 The variable production overhead expenditure variance is calculated by
taking the actual number of hours worked.
 The actual variable production overhead cost of the actual hours worked is
compared with the standard cost for those hours. The difference is the
variable production overhead expenditure variance.
A variable production overhead expenditure variance is calculated as follows.
Like the direct labour rate variance, it is calculated by taking the actual number of
labour hours worked, since it is assumed that variable overhead expenditure
varies with hours worked.

Illustration: Variable production overhead expenditure variance

₦
Standard variable production overhead cost of actual production:
Actual hours worked  Standard rate per hour X

Actual variable production overhead cost of actual purchases

Actual hours worked  Actual rate per hour (X)
X

Performance management

Example: Variable production overhead expenditure variance (Lagos Manufacturing

Limited)
Standard variable production overhead cost per unit: (4 hrs  ₦200 per hr) =
₦800 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours
Labour hours worked: 4,100 hours at a variable overhead cost of ₦945,000.

Variable production overhead rate variance is calculated as follows:

₦‘000
Standard: 4,100 hours should cost (@ ₦200 per hour) 820
Actual: 4,100 hours did cost (945)
Variable production overhead rate variance (125) A

5.3 Variable production overhead efficiency variance

The variable production overhead efficiency variance in hours is exactly the same
as the direct labour efficiency variance in hours.
It is converted into a money value at the standard variable production overhead
rate per hour.

Illustration: Variable production overhead – Efficiency variance

Hours
Standard hours used to make the actual production X

Actual hours used to make the actual production (X)

Efficiency variance (hours) X
Standard rate per hour (multiply by) X
Efficiency variance (₦) X

Chapter 7: Variance analysis

Example Variable production overhead efficiency variance (Lagos Manufacturing

Limited)
Standard variable production overhead cost per unit: (4 hrs  ₦200 per kg) =
₦800 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours
Labour hours worked: 4,100 hours at a variable overhead cost of ₦945,000.

Variable production overhead efficiency variance is calculated as follows:

Practice question 8
Product P123 has a standard variable production overhead cost per unit of:
1.5 hours × ₦2 per direct labour hour = ₦3 per unit.
During a particular month, 2,000 units of Product P123 were manufactured.
These took 2,780 hours to make and the variable production overhead cost
was ₦6,550.
Calculate the total variable production overhead cost variance, the variable
production overhead expenditure variance and the variable production
overhead efficiency variance for the month.

Performance management

5.4 Alternative calculations

The following shows the line by line approach for variable production overhead
variances.

Formula: Alternative method for calculating variable production overhead

variances
AH worked  AR X
X Rate variance
AH worked  SR X
X Efficiency variance
SH worked  SR X

Where:
AH = Actual hours
AR = Actual rate per hour
SR = Standard rate per hour
SH = Standard hours needed to make actual production

Example: Alternative method for calculating variable production overhead

variances (Lagos Manufacturing Limited)
Standard variable production overhead cost per unit: (4 hrs  ₦200 per kg) =
₦800 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours
Labour hours worked: 4,100 hours at a variable overhead cost of ₦945,000.

₦‘000 ₦‘000
AH worked  AR
4,100 hours  ₦X per hour 945
AH worked  SR 125 (A) Expenditure
4,100 hours  ₦200 per hour 820
SH worked  SR 20 (A) Efficiency
4,000 hours  ₦200 per hour 800

SH = 1,000 units  4 hours per unit = 4,000 hours

Chapter 7: Variance analysis

Practice question 9
Product P123 has a standard variable production overhead cost per unit of:
1.5 hours × ₦2 per direct labour hour = ₦3 per unit.
During a particular month, 2,000 units of Product P123 were manufactured.
These took 2,780 hours to make and the variable production overhead cost
was ₦6,550.
Calculate the variable production overhead expenditure variance and the
variable production overhead efficiency variance for the month using the
alternative approach.

5.5 Variable production overhead: possible causes of variances

Possible causes of favourable variable production overhead expenditure
variances include:
 Forecast increase in costs not materialising
Possible causes of adverse variable production overhead variances include:
 Unexpected increases in energy prices
Anything that causes labour efficiency variance will have an impact on variable
production overhead efficiency variances as variable production overhead is
incurred as the labour force carries out production.
Possible causes of favourable variable production overhead efficiency variances
include:
 More efficient methods of working.
 Good morale amongst the workforce and good management with the result
that the work force is more productive.
 If incentive schemes are introduced to the workforce, this may encourage
employees to work more quickly and therefore give rise to a favourable
efficiency variance.
 Using employees who are more experienced than ‘standard’, resulting in
favourable efficiency variances as they are able to complete their work
more quickly than less-experienced colleagues.
Possible causes of adverse variable production overhead efficiency variances
include:
 Using employees who are less experienced than ‘standard’, resulting in
adverse efficiency variances.
 An event causing poor morale.

Performance management

6 FIXED PRODUCTION OVERHEAD COST VARIANCES: ABSORPTION

COSTING

Section overview

 Over/under absorption
 Total fixed production overhead cost variance
 Fixed production overhead expenditure variance
 Fixed production overhead volume variance
 Fixed production overhead efficiency and capacity variances
 Fixed production overheads: possible causes of variances

6.1 Over/under absorption

Variances for fixed production overheads are different from variances for variable
costs.
With standard absorption costing, the standard cost per unit is a full production
cost, including an amount for absorbed fixed production overhead. Every unit
produced is valued at standard cost.
This means that production overheads are absorbed into production costs at a
standard cost per unit produced. This standard fixed cost per unit is derived from
a standard number of direct labour hours per unit and a fixed overhead rate per
hour.
The total fixed overhead cost variance is the total amount of under-absorbed or
over-absorbed overheads, where overheads are absorbed at the standard fixed
overhead cost per unit.
It was explained in an earlier chapter that the total under- or over-absorption of
fixed overheads can be analysed into an expenditure variance and a volume
variance.
The total volume variance can be analysed even further in standard absorption
costing, into a fixed overhead capacity variance and a fixed overhead efficiency
variance.
Fixed overhead variances are as follows:

Illustration: Analysis of fixed production overhead variances

Chapter 7: Variance analysis

6.2 Total fixed production overhead cost variance

The total fixed overhead cost variance is the amount of:
 under-absorbed fixed production overhead (= adverse variance) or
 over-absorbed fixed production overhead (= favourable variance).
Overheads are absorbed at a standard fixed cost per unit produced, not at
standard rate per hour.

Illustration: Fixed production overhead – total cost variance (over/under

absorption)
₦
Fixed production overhead absorbed in the period:
Actual units produced  Fixed production overhead per unit X
Actual fixed production overhead incurred in the period (X)
Total fixed production overhead variance (Over/(under) absorption) X

The total fixed production overhead cost variance can be analysed into an
expenditure variance and a volume variance. Together, these variances explain
the reasons for the under- or over-absorption.

Example: Fixed production overhead – total cost variance (over/under absorption)

(Lagos Manufacturing Limited)
Budgeted fixed production overhead ₦2,880,000
Budgeted production hours:
= Budgeted production volume  Standard hours per unit
= 1,200 units  4 hours per unit 4,800 hours
Overhead absorption rate ₦2,880,000/4,800 hours ₦600 per hour
Standard fixed production overhead per unit
= 4 hours  ₦600 per hour ₦2,400 per unit

Actual fixed production overhead ₦2,500,000

Actual production 1,000 units

The total cost variance for fixed production overhead (over/under absorption)
is calculated as follows:
₦‘000
Fixed production overhead absorbed in the period:
= Actual units produced  Fixed production overhead per unit
= 1,000 units  ₦2,400 per unit 2,400
Actual fixed production overhead incurred in the period (2,500)
Under absorption (100) A

The amount of fixed production overhead absorption rate is a function of the

budgeted fixed production overhead expenditure and the budgeted production
volume.
The total variance can be explained in these terms.

Performance management

6.3 Fixed production overhead expenditure variance

A fixed production overhead expenditure variance is very easy to calculate. It is
simply the difference between the budgeted fixed production overhead
expenditure and actual fixed production overhead expenditure.

Illustration: Fixed production overhead – expenditure variance

₦
Budgeted fixed production overhead X
Actual fixed production overhead incurred (X)
Fixed production overhead expenditure variance X

An adverse expenditure variance occurs when actual fixed overhead expenditure

exceeds the budgeted fixed overhead expenditure.
A favourable expenditure variance occurs when actual fixed overhead
expenditure is less than budget.

Example: Fixed production overhead – expenditure variance (Lagos Manufacturing

Limited)
₦‘000
Budgeted fixed production overhead 2,880
Actual fixed production overhead (2,500)
Fixed production overhead expenditure variance 380 F

Fixed overhead expenditure variances can be calculated, for control reporting, for
other overheads as well as production overheads. For example:
 an administration fixed overheads expenditure variance is the difference
between budgeted and actual fixed administration overhead costs
 a sales and distribution fixed overhead expenditure variance is the
difference between budgeted and actual fixed sales and distribution
overhead costs

6.4 Fixed production overhead volume variance

The fixed production overhead volume variance measures the amount of fixed
overheads under- or over-absorbed because of the fact that actual production
volume differs from the budgeted production volume.
The volume variance is measured first of all in either units of output or standard
hours of the output units.
The volume variance in units (or standard hours of those units) is converted into
a money value, as appropriate, at the standard fixed overhead cost per unit (or
the standard fixed overhead rate per standard hour produced).

Chapter 7: Variance analysis

Illustration: Fixed production overhead – volume variance

Units
Actual number of units produced X(X
Budgeted production )X
Fixed production overhead volume variance (units) X
Standard absorption rate per unit X
Fixed production overhead volume variance (₦)

Example Fixed production overhead – volume variance (Lagos Manufacturing

Limited)
Budgeted fixed production overhead ₦2,880,000
Budgeted production hours:
= Budgeted production volume  Standard hours per unit
= 1,200 units  4 hours per unit 4,800 hours
₦2,880,000
Overhead absorption rate /4,800 hours ₦600 per hour
Standard fixed production overhead per unit
= 4 hours  ₦600 per hour ₦2,400 per unit

Actual fixed production overhead ₦2,500,000

Actual production 1,000 units

The volume variance is calculated as follows:

Units
Actual number of units produced 1,000
Budgeted production (1,200)
Fixed production overhead volume variance (units) (200) A
Fixed production overhead per unit ₦2,400
Fixed production overhead volume variance (₦) ₦480,000 A

Practice questions 10
A company budgeted to make 5,000 units of a single standard product in
Year 1.
Budgeted direct labour hours are 10,000 hours.
Budgeted fixed production overhead is ₦40,000.
Actual production in Year 1 was 5,200 units, and fixed production overhead
was ₦40,500.
Calculate the total fixed production overhead cost variance, the fixed
overhead expenditure variance and the fixed overhead volume variance for
the year.

Performance management

6.5 Fixed production overhead efficiency and capacity variances

Any volume variance might be due to two reasons:
 The company has worked a different number of hours than budgeted. They
have operated at a different capacity.
 During the hours worked the company has operated at a different level of
efficiency to that budgeted.
The fixed production overhead volume variance can be analysed into a fixed
overhead efficiency variance and a fixed overhead capacity variance.

Fixed production overhead efficiency variance

This is exactly the same, in hours, as the direct labour efficiency variance and the
variable production overhead efficiency variance.
It is converted into a money value at the standard fixed overhead rate per hour.

Illustration: Fixed production overhead – Efficiency variance

Hours
Standard hours used to make the actual production X
Actual hours used to make the actual production (X)
Efficiency variance (hours) X
Standard rate per hour (multiply by) X
Efficiency variance (₦) X

Example: Fixed production overhead efficiency variance (Lagos Manufacturing

Limited)
Standard fixed production overhead cost per unit: (4 hrs  ₦600 per hr) =
₦2,400 per unit

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours
Labour hours worked: 4,100

Fixed production overhead efficiency variance is calculated as follows:

Chapter 7: Variance analysis

Fixed production overhead capacity variance

This is the difference between the budgeted and actual hours worked (excluding
any idle time hours). It is converted into a money value at the standard fixed
overhead rate per hour.

Illustration: Fixed production overhead – Capacity variance

Hours
Actual number of hours worked X
Budgeted hours to be worked (X)
Capacity variance (hours) X
Standard rate per hour (multiply by) X
Capacity variance (₦) X

Example: Fixed production overhead capacity variance (Lagos Manufacturing

Actual fixed production overhead ₦2,500,000

Actual production 1,000 units

The fixed production overhead capacity variance is calculated as follows:

Hours
Actual number of hours worked 4,100
Budgeted hours to be worked (4,800)
Capacity variance (hours) (700) A
Standard rate per hour (multiply by) ₦600
Capacity variance y variance (₦) (₦420,000) A

Performance management

Practice questions 11
A company budgeted to make 5,000 units of a single standard product in
Year 1.
Budgeted direct labour hours are 10,000 hours.
Budgeted fixed production overhead is ₦40,000.
Actual production in Year 1 was 5,200 units in 10,250 hours of work, and
fixed production overhead was ₦40,500.
Calculate the fixed overhead efficiency variance and the fixed overhead
capacity variance for the year.

6.6 Fixed production overheads: possible causes of variances

Some of the possible causes of fixed production overhead variances include the
following.

Fixed overhead expenditure variance

 Poor control over overhead spending (adverse variance) or good control
over spending (favourable variance).
 Poor budgeting for overhead spending. If the budget for overhead
expenditure is unrealistic, there will be an expenditure variance due to poor
planning rather than poor expenditure control.
 Unplanned increases or decreases in items of expenditure for fixed
production overheads, for example, an unexpected increase in factory rent.

Fixed overhead volume variance

A fixed overhead volume variance can be explained by anything that made actual
output volume different from the budgeted volume. The reasons could be:
 Efficient working by direct labour: a favourable labour efficiency variance
results in a favourable fixed overhead efficiency variance.
 Working more hours or less hours than budgeted (capacity variance).
 An unexpected increase or decrease in demand for a product, with the
result that longer hours were worked (adverse capacity variance).
 Strike action by the workforce, resulting in a fall in output below budgeted
output (adverse capacity variance).
 Extensive breakdowns in machinery, resulting in lost production (adverse
capacity variance).

Chapter 7: Variance analysis

7 SALES VARIANCES

Section overview

 Sales variances: Introduction

 Sales price variance
 Sales volume variance
 Sales: possible causes of variances

7.1 Sales variances: Introduction

Sales variances, unlike cost variances, are not recorded in a standard costing
system of cost accounts (in the cost ledger). However, sales variances are
included in variance reports to management.
They help to reconcile actual profit with budgeted profit.
They help management to assess the sales performance.
There are two sales variances:
 a sales price variance; and
 a sales volume variance

7.2 Sales price variance

A sales price variance shows the difference between:
 the actual sales prices achieved for items that were sold, and
 their standard sales price
To calculate this variance, you should take the actual items sold, and compare
the actual sales revenue with the standard selling prices for the items. This
compares the revenue actually generated to the revenue that should have been
generated if the items were sold at the standard selling price per unit.

Illustration: Sales price variance

₦
Standard revenue for actual sales
Actual sales  Standard selling price per unit X

Actual revenue
Actual sales  Actual selling price per unit (X)
X

There is a favourable sales price variance if units were sold for more than their
standard sales price, and an adverse variance if sales prices were below the
standard price.

Performance management

Example: Sales price variance (Lagos Manufacturing Limited)

Budgeted sales volume 1,000 units

Budgeted selling price per unit ₦15,000

Actual sales volume 900 units

Actual revenue ₦12,600,000

Sales price variance is calculated as follows:

₦‘000
Standard revenue for actual sales
900 units  ₦15,000 per unit 13,500

Actual revenue
Actual sales  Actual selling price per unit (12,600)
Sales price variance 900 A

7.3 Sales volume variance

A sales volume variance shows the effect on profit of the difference between the
actual sales volume and the budgeted sales volume.
In a standard absorption costing system, the sales volume variance might be
called a sales volume profit variance.
The variance is calculated by comparing the actual number of units sold (actual
sales volume) to the number of units expected to be sold when the original
budget was drafted (budgeted sales volume).
This is then expressed as a money value by multiplying it by the standard profit
per unit.

Illustration: Sales volume variance

Units
Budgeted sales volume X
Actual sales volume (X)
Sales volume variance (units) X
Standard profit per unit (multiply by) X
Sales volume variance (₦) X

Chapter 7: Variance analysis

Example: Sales volume variance (Lagos Manufacturing Limited)

Budgeted sales volume 1,000 units

Budgeted selling price per unit ₦15,000
Standard cost per unit (from the standard cost card) ₦10,200
Therefore, standard profit per unit ₦4,800

Actual sales volume 900 units

Actual revenue ₦12,600,000

Sales volume variance is calculated as follows:

Units
Budgeted sales volume 1,000
Actual sales volume 900
Sales volume variance (units) (100) A
Standard profit per unit (multiply by) ₦4,800
Sales volume variance (₦480,000) A

The volume variance is favourable if actual sales volume is higher than the
budgeted volume and adverse if the actual sales volume is below budget.
There is an alternative method of calculating the sales volume variance, which
produces exactly the same figure for the variance.

Practice question 12
A company budgets to sell 7,000 units of Product P456. It uses a standard
absorption costing system. The standard sales price of Product P456 is
₦50 per unit and the standard cost per unit is ₦42.
Actual sales were 7,200 units, which sold for ₦351,400.
Calculate the sales price variance and sales volume variance.

7.4 Sales: possible causes of variances

Possible causes of sales variances include the following:

Sales price variance

 Actual increases in prices charged for products were higher or less than
expected due to market conditions.
 Actual sales prices were less than standard because major customers were
given an unplanned price discount.
 Competitors reduced their prices, forcing the company to reduce the prices
of its own products.

Performance management

Sales volume variance

 Actual sales demand was more or less than expected.
 The sales force worked well and achieved more sales than budgeted.
 An advertising campaign had more success than expected.
 A competitor went into liquidation, and the company attracted some of the
former competitor’s customers.
 The products that the company makes and sells are going out of fashion
earlier than expected; therefore the sales volume variance was adverse.

8 INTERRELATIONSHIPS BETWEEN VARIANCES

Section overview

 The nature of interrelationships between variances

 Sales price and sales volume
 Materials price and usage
 Labour rate and efficiency
 Labour rate and variable overhead efficiency
 Capacity and efficiency
 Footnote: the importance of reliable standard costs

8.1 The nature of interrelationships between variances

Some causes of individual variances have already been listed.
The reasons for variances might also be connected, and two or more variances
might arise from the same cause. This is known as an interrelationship between
two variances.
For example, one variance might be favourable and another variance might be
adverse. Taking each variance separately, the favourable variance might suggest
good performance and the adverse variance might suggest bad performance.
However, the two variances might be inter-related, and the favourable variance
and the adverse variance might have the same cause. When this happens,
management should look at the two variances together, in order to assess their
significance and decide whether control action is needed.
Examples of interrelationships between variances are given below.

8.2 Sales price and sales volume

A favourable sales price variance and an adverse sales volume variance might
have the same cause. If a company increases its selling prices above the
standard price, the sales price variance will be favourable, but sales demand
might fall and the sales volume variance would be adverse.
Similarly, in order to sell more products a company might decide to reduce its
selling prices. There would be an adverse sales price variance due to the
reduction in selling prices, but there should also be an increase in sales and a
favourable sales volume variance.

8.3 Materials price and usage
A materials price variance and usage variance might be inter-related. For
example, if a company decides to use a material for production that is more
expensive than the normal or standard material, but easier to use and better in
quality, there will be an adverse price variance. However a consequence of
using better materials might be lower wastage. If there is less wastage, there will
be a favourable material usage variance. Therefore, using a different quality of
material can result in an adverse price variance and a favourable usage variance.

8.4 Labour rate and efficiency

If there is a change in the grade of workers used to do some work, both the rate
and efficiency variances may be affected.
For example, if a lower grade of labour is used instead of the normal higher
grade:
 there should be a favourable rate variance because the workers will be paid
less than the standard rate
 however the lower grade of labour may work less efficiently and take longer
to produce goods than the normal higher grade of labour would usually
take. If the lower grade of labour takes longer, then this will give rise to an
adverse efficiency variance.
Therefore the change in the grade of labour used results in two ‘opposite’
variances, an adverse efficiency variance and a favourable rate variance.
When inexperienced employees are used, they might also waste more materials
than more experienced employees would, due to mistakes that they make in their
work. The result might be not only adverse labour efficiency, but also adverse
materials usage.

8.5 Labour rate and variable overhead efficiency

When a production process operates at a different level of efficiency the true cost
of that difference is the sum of any costs associated with labour hours. Therefore,
the issues described above also affect the variable overhead efficiency variance.

8.6 Capacity and efficiency

If a production process operates at a higher level of efficiency that might mean
that it does not have to operate for as long to produce the budgeted production
volume. The favourable fixed production overhead efficiency variance would
cause an adverse fixed production overhead capacity variance.
The reverse is also true. If a production process operates at a lower level of
efficiency that might mean that it has to operate for longer than was budgeted.
The adverse efficiency fixed production overhead variance would cause a
favourable fixed production overhead capacity variance.

8.7 Footnote: the importance of reliable standard costs

It is important to remember that the value of variances as control information for
management depends on the reliability and accuracy of the standard costs. If the
standard costs are inaccurate, comparisons between actual cost and standard
cost will have no meaning. Adverse or favourable variances might be caused by
inaccurate standard costs rather than by inefficient or efficient working.

Chapter 7: Variance analysis

9 RECONCILING BUDGETED AND ACTUAL PROFIT: STANDARD

ABSORPTION COSTING

Section overview

 Purpose of an operating statement

 Format of an operating statement

9.1 Purpose of an operating statement

A management report called an operating statement migh