PERFORMANCE MANAGEMENT

TOPIC ONE:

INTRODUCTION & ADVANCED MANAGEMENT ACCOUNTING TECHNIQUES.

Part one.
Performance can be a measure of attainment achieved by an individual, team or organization. Performance
management may refer to a task of ensuring that resources in the organization provide the best possible
value for money and that they are behaving in the manner assumed or described in the integration of
performance measures, benchmarks, and goals in order to achieve optimal results.
In a HR perspective, performance management could be summarized as a systematic process of planning
work and setting expectations, developing the capacity to perform, periodically rating performance in a
summary fashion and rewarding good performance.
NB; performance management is closely connected to performance measurement. They are sometimes
mistaken for each other. In careful usage, performance management is the larger domain and includes
performance measurement as a component:
Performance measurement: a process of assessing the achievement of pre-determined goals and
objectives through the measurement of the following types of indicators( points of performance
measurement):
a) Inputs, this indicates the inputs required of an activity to produce an output.
b) Processes of delivery; indicate the transformation produced by an activity (i.e., some form of work).
It also involves the mechanism that enables an activity to work (a performer), either human or system.
It also involves control as an object that controls the activity's production through compliance.
c) Service and product outputs and outcomes. This captures the outcome or results of an activity or group of
activities.
Performance management always differs among organizations and departments within such organizations
and revolves around 3 steps;
a) Design of the performance measures / standards i.e. the ways in which to measure the desired behaviors
and achievements.
b) Measure/assess the results/outcomes vs the preset standards (KPIs and CSFs)
c) Provide suitable feedback and manage any variances.
NB: Examples of CSFs may include profitability, market position, reputation, market share, productivity,
product leadership, personnel development & employee attitudes.
Effective performance management will always need a clear understanding of an organization’s vision,
mission, goals and objectives amidst existence of well managed stakeholders as was thoroughly discussed in
lectures
However, goals and objectives;
● Goals; are statements of general intentions (not that much different to a mission).
● Objectives; are more specific.
NB: good objectives should be smart; these core objectives are normally converted into critical success
factors (CSFs).
Performance management has two main concepts i.e. Performance and management. Performance is the
outcome or output, or results. On the other hand, management is the procedure or assessment or method or
approach.
Note
Critical success factor (CSF) is a management term for an element that is necessary for an organization or
project to achieve its mission. To achieve their goals they need to be aware of each key success factor (ksf)
and the variations between the keys and the different roles key result area (kra).
KPI stands for key performance indicator, a quantifiable measure of performance over time for a specific
objective. KPIs provide targets for teams to shoot for, milestones to gauge progress, and insights that help
people across the organization make better decisions.
KPIs evaluate the success of an organization or of a particular activity (such as projects, programs, products
and other initiatives) in which it engages
Johnson and Scholes suggested a six step process for developing CSFs
❖ Identify the success factors that are critical for profitability.
❖ Identify what is necessary (the ‘critical competencies’) in order to achieve a superior performance in the
critical success factors.
❖ Develop the level of critical competence so that a competitive advantage is obtained.
❖ Identify appropriate key performance indicators for each critical competence.
❖ Give emphasis to developing critical competencies that competitors will find it difficult · to match.
❖ Monitor the firm’s and competitors’ achievement.

Stakeholders' effect in performance management

A stakeholder is anyone, or any organization, affected by an organization. Stakeholders include;
shareholders, employees, suppliers, customers, the local populace, government. Stakeholders have different
requirements and these will affect what is meant by performance.
NB; what the principal stakeholders & what the stakeholders will tolerate.
The Mendlow’s matrix model can explain how to address the various stakeholder concerns through
understanding their differing interests and power on the operations of the business. This is illustrated below;

Interest

High low
Power
Key players Keep satisfied
High

low Keep informed Minimum effort

High low
NB;
Power = the amount of influence a stakeholder can exercise on the organization.
Interest = how likely a stakeholder is to take action.

The four categories of stakeholders and their respective needs from a given company.
● Key players: these people have both high power and high interest and can take action. Therefore
management needs to keep them happy. These include the directors, partners, senior staff, upper tier
sponsors.etc
● Keep satisfied: these have high power but are reluctant to exercise it provided they are kept satisfied. If
kept unhappy, they might turn into key players. These include; lower tier sponsors, shareholders, local
community residents, competitors, researchers (supporters) etc.
● Keep informed: low power, but lots of interest through noise. Management should aim to keep them
informed as a matter of politeness and recognition. E.g. the banks, MUBS police station for the sake of
MUBS.
● Minimal effort: this group (low power & low interest) is at the back of the queue when management is
making. For example, broadcasters
In brief
Mendelow’s matrix is a tool that is used to analyze stakeholders and their attitudes. This will consider factors
such as the level of interest a stakeholder has in a project or organization’s chosen strategies and whether
they are likely to use their power to influence this.
This is what to expect from each segment:

Minimal effort

The stakeholders in this group are the type that are not interested in the organization and do not have much
power either. An example here could be the suppliers with whom the organization only does a small volume of
business. The decisions relating to these stakeholders have a low impact. What you want to do here is ensure
that you do not waste resources taking these stakeholders goals or potential responses into account.

Keep informed

These stakeholders have high level of interest in your organization but lower power. They are important
because if these are not kept on the-know about decisions they may seek additional power and influence the
running of the organization. Some of your workers could be in this category or imagine running a hospital and
having volunteer groups, these groups provide services that are “nice to have” but are not necessarily
essential so the volunteers have high interest but less power. The recommended strategy is to keep these
stakeholders informed of plans and outcomes through communication and stakeholders marketing.

Keep satisfied
Here you find stakeholders with high power, basically high ability to influence what the organization is up to,
but currently have low interest in the organization. This group is important because if dissatisfied or gets
concerned their interest level may arouse. Examples here could include governmental agencies and
regulatory bodies, large suppliers, or even senior management from other departments. The strategy to use
with these is to keep them satisfied so that they do not exert their influence.

Key players

In this quadrant you end up with stakeholders who have lots of influence and are highly motivated to
express their own interest. These could be your major customers, your key suppliers, senior procurement
managers etc. What can you do here? The strategy to use with these stakeholders is one of early involvement
and participation, this way their goals can be integrated with organizational goals ensuring their support.

Importance of performance management;

❖ Working towards common goals; individual performance drives organizational performance. It is important
to ensure everyone understands this agency's vision and goals, how their work fits into the organization,
and how they contribute to the mission accomplishment. Doing this increases engagement and improves
program delivery.
❖ A clear understanding of job expectations (through kpis & csfs); when employees and supervisors have a
clear understanding of their specific job duties, each individual is held accountable for their own duties
and responsibilities.
❖ Regular feedback about performance; regular feedback facilitates better communication in the workplace.
Performance management helps you to identify your strengths and weaknesses of different responsibility
centers.
❖ Performance management can be a motivational tool by use of budget bonuses, rewarding favorable
variances fostering you to not only feel more satisfied, but to go beyond the expected especially through
use of bonuses and other incentives given to the managers.
❖ Basis for improving performance. Performance management will help you to gain any additional training
or mentoring which can act as a basis for developing future succession plans etc. And by looking at
arising variances.
❖ Rewards for good performance. Outstanding efforts do not go unnoticed. Performance management
offers a variety of awards that show gratitude for a job well done, such as time off and bonuses.

Limitations of performance management systems and procedures.

1. Lengthy and complex:
In performance management it is suggested that the managers spend more time with each employee to
evaluate their performance; so if the company or team consists of a large number of people, the process of
performance appraisal becomes extremely hectic and difficult. It will take long hours to evaluate the whole
department’s pa; then there has to be hours of discussions in the meetings to get solutions for the difficulties
and errors of the employees.

2. Become a hindrance in the employee’s progress:

Sometimes the experience of performance management is unpleasant and stressful; it becomes an obstacle
to the progress of the employee. The managers may discourage and dissuade the employees through
performance management if overemphasize is done on the errors and mistakes of the employees and the
achievements and often overlooked. Then the employees will feel that they are not given enough due for their
hard work, their achievements; the company only highlights their failures without praising them for their
achievements. Performance management should always be a process of constructive support,
encouragement and a celebration of the achievements; the mistakes and errors should be subtly pointed out
and solutions also should be provided to the employees.

3. Contradictory and misleading opinions in the performance management file:

Often the situation is that the manager is insincere and does not keep proper records and notes on the
performance of the employees; this will create a gap between the actual performance of the workers and the
report of the manager. The manager will make the wrong performance management reports; this will create
contradictory and misleading performance management reports of the employees by the company. It is
important that performance appraisals and documentation are done timely and regularly; so that a faulty
appraisal can be avoided. So one of the disadvantages of performance appraisals is that a faulty review in
appraisal can turn out very negative for you.

4. Partialities and favoritism:

The company managers are often partial and favoritism is also practiced; this hampers the process of
performance management. This partiality can be counted as a benefit of performance management or during
this process. Hence to keep away partiality from the pa is difficult as it is solely dependent on the senior and
manager to remain impartial and unbiased to conduct a proper performance appraisal. A faulty performance
evaluation is the outcome of a manager who has preconceived notions and evaluates the performance of
employees based on biases.

5. Flawed conditions and standards:

Many companies commit errors while creating the guidelines and directives of evaluating the performance of
their employees; these faults will make the performance management systems of the company insignificant
and meaningless. Standards which do not properly reflect the actual performance of the workers are futile.
Thus if the system tracks the goods without evaluating the quality of the products then the whole thing is
rendered meaningless. If there are any norms or conditions that allow the employees to take unethical
advantages and achieve success; then the performance management is ineffective and the company will
suffer a set-back for this.

6. Employees may suffer from low self-esteem:

The ethical workers may be frustrated and lose their sense of worth when working under a faulty performance
management system; and where unethical means are undertaken to succeed. Even when the company’s
performance management is mostly unbiased; if the unethical employees achieve more success than the real
hard working ones; then people will get disillusioned and lose their faith in the company.

7. Demeaning the communication system between employer and employee:

Performance management involves a two-way communication system between the employers and the
employees. So if the managers neglect the evaluations and are irregular in doing the performance evaluations
then it will have a negative effect on the performance history of the employee and also his career success; if
the employee feels that over-emphasis is given on his mistakes and errors and his achievements are
overlooked; then he will lose the incentive to work hard and progress. Also, too much praise and celebration
for success will also make the workers arrogant and over-confident; so a balance should be created and the
co. Should function accordingly.

8. Deficient in management expertise:

In spite of giving enough thought and time to the directives of the company; they often have some drawbacks
and when the rules are implemented in reality the negative aspects come to the fore. This happens due to the
lack of management commitment and management understanding. The way to be successful in implementing
effective performance management requires the sponsor of top management workers and line management
workers; so that the workers feel that the co is committed to the benefits of the employees only. Also, bonuses
and incentives should be there in all organizations to encourage the employees for hard work and growth of
the company.

Part two.
A review of advanced management accounting techniques.
MGT accounting techniques
● ABC
● Throughput accounting ( t a ). Here we look at the concept of limited resources or factors.
● Target costing. This looks at setting the selling price in addition to profit planning.
● Life cycle costing;
● Environmental and social accounting; (the environmental accounting techniques and the methods to
be used)
Activity based costing (ABC)
It is an accurate technique that assigns costs to activities rather than products or services.

It enables more accurate allocation of costs to products and services.

Unlike TPC, ABC generates useful information on how money is spent on different activities to make a
product or service.

Note that ABC is generally an improvement of the tpc as far as the allocation or absorption of overheads is
concerned

ABC involves the identification of the factors (cost drivers) which cause the change of the costs of an
organization’s major activities.
NB: A cost driver (cost causal) is a factor which causes a change in the cost of an activity.
● Support/service overheads are charged to products on the basis of their usage of an activity.
● For costs that vary with production level in the short term, the cost driver will be volume related (labor or
machine hours).
● Overheads that vary with some other activity (and not volume of production) should be traced to products
using transaction-based cost drivers such as production runs or number of orders received.
NB: traditional systems measure accurately volume-related resources that are consumed in proportion to the
number of units produced of the individual products. Such resources include direct materials, direct labour,
energy, and machine-resources exist for activities that are unrelated related costs.
However, many organizational to physical volume. Non-volume related activities consist of support activities
such as materials handling, material procurement, set-ups, production scheduling and first item inspection
activities.
Traditional product-cost systems, which assume that products consume all activities in proportion to their
production volumes, thus report distorted product costs. So, although both traditional absorption costing and
activity-based costing systems adopt a two-stage allocation process, the differences can be listed as follows:
(1) For overhead allocation, ABC establishes separate cost pools for support activities such as material
handling.as the costs of these activities are assigned directly to products through cost driver rates, re
apportionment of service department costs is avoided. Overhead absorption into products is where the main
difference lies between ABC and traditional costing. Traditional absorption costing uses two absorption bases,
(labour hours or machine hours) to charge overhead to products, whereas ABC uses many cost drivers as
absorption bases (e.g. The number of orders, or the number of despatches.)
(2) The use of cost drivers is the main idea behind ABC as they highlight what causes costs to increase – for
example, the number of orders to suppliers each product incurs. Overheads that do not vary with
volume/output, but with some other activity, should be traced to products using ABC cost drivers. Traditional
absorption costing, on the other hand, allows overheads to be related to products in more arbitrary ways –
therefore producing less accurate product costs.
TPC steps:
● Identification of the products or services dealt in.
● Aggregate overhead total costs to be estimated or identified.
● Choose a blanket rate. A blanket rate is a production overhead absorption rate used for a factory as a
whole; it is sometimes used as an alternative to calculating a rate for each individual cost centre.
● Estimate a blanket overhead absorption rate.
● Apportion the overheads to the cost centres.

General rule:
The costing technique that attaches a lower full unit cost would bring about a good performance in terms of
increased profits or reduced losses where as a technique that attaches a relative high full cost to products or
services is associated with poor performance results in terms of reduced profits or increased losses.
Calculating the full production cost per unit using ABC
There are five basic steps:
Step 1: Group production overheads into activities, according to how they are driven. A cost pool is an activity
which consumes resources and for which overhead costs are identified and allocated. For each cost pool,
there should be a cost driver. The terms ‘activity’ and ‘cost pool’ are often used interchangeably.
Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred. A cost driver
is a factor that influences (or drives) the level of cost.
Step 3: Calculate an oar for each activity. The oar is calculated in the same way as the absorption costing
oar. However, a separate oar will be calculated for each activity, by taking the activity cost and dividing by the
total cost driver volume.
Step 4: Absorb the activity costs into the product. The activity costs should be absorbed back into the
individual products.
Step 5: Calculate the full production cost and/ or the profit or loss.

Illustration one;
Saturn, a chocolate manufacturer, produces three products. Information relating to each of the products is as
follows;
The sky bar, a bar of solid milk chocolate.
The moon egg, a fondant filled milk chocolate egg.
The sun bar, a biscuit and nougat based chocolate bar.

Sky bar Moon egg Sun bar

Direct labour cost per unit(shs) 70 140 120
Direct material cost per unit(shs) 170 190 160
Actual production/sales (units) 500,000 150,000 250,000
Direct labour hours per unit 1 0.5 2
Direct machine hours per unit 1 4 2
Selling price per unit(shs) 500 450 430

Some supplementary data is further available for Saturn company;

Machining costs 45,000,000

Component costs 15,000,000
Set-up costs 30,000,000
Packing costs 30,000,000
Annual production overhead 120,000,000

Cost driver data;

Cost driver Sky bar Moon egg Sun bar

Machine hours per unit 1 4 2
Number of production set-ups 3 1 15
Number of components 4 6 20
Number of customer orders 21 4 25

Required;
a) Using TPC, calculate the full production cost per unit and the profit per unit for each product. Comment on
the implications of the figures calculated.
b) Using ABC, calculate the full production cost per unit and the profit per unit for each product. Comment on
the implications of the figures calculated.
c) Comment on the reasons for the differences in the production cost per unit between the two methods.

Illustration two:
Naaks ltd makes and sells two items, plus and double plus. The direct costs of production are $18 for one unit
of plus and $2 per unit of double plus. Information relating to annual production and sales is as follows;

Plus Double plus

Annual production and sales units 24,000 15,000
Direct labour hours per unit 1.0 1.5
Number of orders 10 140
Number of batches 12 240
Number of setups per batch 1 3
Special parts per unit 1 4

Information relating to production overhead costs is as follows;

Cost driver Annual cost

Set up costs Number of setups 73,200
Special parts handling Number of special parts 60,000
Other materials handling Number of batches 63,000
Order handling Number of orders 19,800
Other overheads - 26,000
Total 242,000

Other overhead costs do not have an identifiable cost driver, and in an abc system, these overheads would be
recovered on a direct labour hours basis.
Required;
a) Calculate the production cost per unit of plus and of double plus if the company uses traditional
absorption costing and the other overheads are recovered on a direct labour hours basis.
b) Calculate the production cost per unit of plus and of double-plus if the company uses ABC.
c) Comment on the reasons for the differences in the production cost per unit between the two methods.
d) What are the implications for management of using an ABC system instead of an absorption costing
system?

Solution
a) Calculate the production cost per unit of plus and of double plus if the company uses traditional
absorption costing (TPC)
Computation of the overhead absorption rate (oar)
OAR = total budgeted overheads/total budgeted absorption units
But total budgeted absorption units (direct labour hours) = direct labour hours per unit * the annual production
or sales units for both products as done below.
= (1*24,000) + (1.5*15,000)
= 24,000 + 22,500
= 46,500 direct labour hours

OAR = $242,000/46,500 dlh

OAR = $5.2/dlh

Unit cost statement using TPC

Details Plus Double plus

Direct production cost per unit($) 18 2
Overhead (indirect cost) per unit($) 5.2*1 = 5.2 5.2*1.5 = 7.8
Full production cost per unit($) 23.2 9.8

b) Calculate the production cost per unit of plus and of double plus if the company uses abc.
Computation of cost driver rates (CDRs/OARs)

Overhead cost Cost driver Budgeted annual Cost driver units b Cost driver rate
(activity) cost($) a (cdrs/oars)=(a/b)
Set up costs Number of setups 73,200 732 $ 100 per set up
Special parts Number of special 60,000 84,000 $ 0.71 per special part
handling parts
Other materials Number of batches 63,000 252 $ 250 per batch
handling
Order handling Number of orders 19,800 150 $ 132 per order
Other overheads Direct labour hours 26,000 46,500 $ 0.56 per dlh

Unit cost statement using ABC

Details Plus Double plus

Direct production costs($) 18*24,000 = 432,000 2*15,000 = 30,000
Overhead costs($)
Set up costs 1,200 72,000
Special parts handling 17,040 42,600
Other materials handling 3,000 60,000
Order handling 1,320 18,480
Other overheads 13,440 12,600
Total costs(a) 468,000 235,680
Annual production and sales units24,000 15,000
(b)
Full production cost per unit(a/b) $ 19.5 $ 15.7

Merits of ABC
❖ It provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management
and decision making should be improved.
❖ It provides much better insight into what drives overhead costs.
❖ ABC recognizes that overhead costs are not all related to production and sales volume.
❖ In many businesses, overhead costs are a significant proportion of total costs, and management needs to
understand the drivers of overhead costs in order to manage the business properly. Overhead costs can
be controlled by managing cost drivers.
❖ It can be applied to derive realistic costs in a complex business environment.
❖ ABC can be applied to all overhead costs, not just production overheads.
❖ ABC can be used just as easily in service costing as in product costing.
Demerits of ABC.
ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small
proportion of the overall cost.
 It is impossible to allocate all overhead costs to specific activities.
 The choice of both activities and cost drivers might be inappropriate.
 ABC can be more complex to explain to the stakeholders of the costing exercise.
 The benefits obtained from ABC might not justify the costs.
 In some situations, ABC does not provide very different information from traditional absorption costing
 It’s initially time-consuming to collect a large amount of data concerning the activities relating to each job
undertaken.
 Difficulty of identifying real cost-drivers within the system otherwise inaccurate results would be derived
leading to incorrect decisions by management.
ABC in the public sector
The austerity measures introduced by many governments have meant that the public sector is under
increasing pressure to deliver more services, for less money, and with greater transparency. Public sector
organizations thus need to identify, allocate and control costs more than ever before. ABC is seen as one
possible tool to help with this.
Reasons for introducing ABC
The main drivers for introducing ABC are;
❖ Public responsibility – responsible public organisations must have tight control of running costs at a time
when resources provided by the central government are strictly limited.
❖ Public accountability – many organisations are being challenged as to whether or not they spend taxpayer
money wisely and feel a need to demonstrate this when the questions are asked.
❖ Resource allocation within organisations - there have been concerns in many organisations as to whether
the services provided had an equitable distribution of scarce resources – or whether those who shouted
loudest got the most resource.
❖ Helping managers to manage – managers need a better awareness of what activities actually cost to
provide before they can think which to cut
ABC resistance in public sector
However, many public sector organisations have resisted the introduction of abc. To measure the cost of a
service and take into account resource costs, the resource used must be measured – which often means
recording time spent.
Timesheets allow accountability for what people are actually doing, and for this cost then to be allocated to
services. This is a challenge for the public sector, and for those that wish to use abc or take a similar
approach, a culture change is definitely required.

THROUGH PUT ACCOUNTING (TA)

TA background
There are two aspects of modern manufacturing that you need to be familiar with i.e. total quality
management (TQM) and just in time (JIT).
Total quality management; TQM is the continuous improvement in quality, and effectiveness through a
management approach focusing on both the process and the product. Fundamental features include;
Key characteristics for successfully operating such a system are:
● High quality: possibly through deploying TQM systems.
● Prevention of errors before they occur
● Importance of total quality in the design of systems and products
● Real participation of all employees
● Commitment of senior management to the cause
● Recognition of the vital role of customers and suppliers
● Recognition of the need for continual improvement

Just-in-time (JIT)
Jit is a pull-based system of production, pulling work through the system in response to customer demand.
This means that goods are only produced when they are needed, eliminating large stocks of materials and
finished goods.
a) Speed: rapid throughput to meet customers’ needs.
b) Reliability: computer-aided manufacturing technology will assist.
c) Flexibility: small batch sizes and automated techniques are used.
d) Low costs: through all of the above.
Standard product costs are associated with traditional manufacturing systems producing large quantities of
standard items. Key features of companies operating in a JIT and TQM environment are:
1) High level of automation
2) High levels of overheads and low levels of direct labour costs
3) Customized products produced in small batches
4) Low stocks
5) Emphasis on high quality and continuous improvement
Throughput accounting aims to make the best use of a scarce resource (bottleneck) in a JIT environment.
Throughput is a measure of profitability and is defined by the following equation: throughput = sales
revenue – direct material cost.
The aim of throughput accounting is to maximize this measure of profitability, whilst simultaneously reducing
operating expenses and inventory (money is tied up in inventory).
The goal is achieved by determining what factors prevent the throughput from being higher. This constraint is
called a bottleneck, for example there may be a limited number of machine hours or labour hours. In the
short-term the best use should be made of this bottleneck. This may result in some idle time in non-bottleneck
resources, and may result in a small amount of inventory being held so as not to delay production through the
bottleneck.
In the long-term, the bottleneck should be eliminated. For example a new, more efficient machine may be
purchased. However, this will generally result in another bottleneck, which must then be addressed.
Main assumptions of TA
These include the following;
i. The only totally variable cost in the short-term is the purchase cost of raw materials that are bought
from external suppliers.
ii. Direct labour costs are not variable in the short-term. Many employees are salaried and even if paid
at a rate per unit, are usually guaranteed a minimum weekly wage.
NB; given these assumptions, throughput is effectively the same as contribution.
Goldratt and cox describe the process of identifying and taking steps to remove the constraints that restrict
output as the theory of constraints (TOC). The process involves five steps;
NB: Step 3 requires that the optimum production of the bottleneck activity determines the production schedule
of the non-bottleneck activities. There is no point in a non-bottleneck activity supplying more than the
bottleneck activity can consume. This would result in increased work-in-progress (WIP) inventories with no
increased sales volume.
The TOC is a process of continuous improvement to clear the throughput chain of all the constraints. Thus,
step 4 involves taking action to remove, or elevate, the constraint. This may involve replacing the bottleneck
machine with a faster one, providing additional training for a slow worker or changing the design of the
product to reduce the processing time required on the bottleneck activity. Once a bottleneck has been
elevated it will generally be replaced by a new bottleneck elsewhere in the system. It then becomes
necessary to return to step 1.
What is the theory of constraints(TOC)?
The theory of constraints is a methodology for identifying the most important limiting factor (i.e., constraint)
that stands in the way of achieving a goal and then systematically improving that constraint until it is no longer
the limiting factor. In manufacturing, the constraint is often referred to as a bottleneck.
The theory of constraints takes a scientific approach to improvement. It hypothesizes that every complex
system, including manufacturing processes, consists of multiple linked activities, one of which acts as a
constraint upon the entire system (i.e., the constraint activity is the “weakest link in the chain”).
A successful theory of constraints implementation will have the following benefits:
❖ Increased profit: the primary goal of toc for most companies
❖ Fast improvement: a result of focusing all attention on one critical area – the system constraint
❖ Improved capacity: optimizing the constraint enables more product to be manufactured
❖ Reduced lead times: optimizing the constraint results in smoother and faster product flow
❖ Reduced inventory: eliminating bottlenecks means there will be less work-in-process

The five focusing steps are further described in the following table.

Step Objective
Identify Identify the current constraint (the single part of the process that limits the rate at which
the goal is achieved).
Exploit Make quick improvements to the throughput of the constraint using existing resources
(i.e., make the most of what you have).
Subordinate Review all other activities in the process to ensure that they are aligned with and truly
support the needs of the constraint.
Elevate If the constraint still exists (i.e., it has not moved), consider what further actions can be
taken to eliminate it from being the constraint. Normally, actions are continued at this
step until the constraint has been “broken” (until it has moved somewhere else). In some
cases, capital investment may be required.
Repeat The five focusing steps are a continuous improvement cycle. Therefore, once a
constraint is resolved the next constraint should immediately be addressed. This step is a
reminder to never become complacent – aggressively improve the current
constraint…and then immediately move on to the next constraint.

In addition, throughput accounting has four derived measures and these are; net profit, return on investment,
productivity and investment turns.
Net profit = throughput - operating expenses
Return on investment = net profit ÷ investment
Productivity = throughput ÷ operating expenses.
Illustration three
Hard tiles recorded a profit of Ugx 120,000,000 in the accounting period just ended, using marginal costing.
The contribution/sales ratio was 75%. Material costs were 10% of sales value and there were no other
variable production overhead costs. Fixed costs in the period were ugx 300,000,000.
Required:
What was the value of throughput in the period?
Solution
Profit (π) = ugx 120,000,000 and c/s ratio = 75%

From marginal costing principles

120,000,000 = 75% sales
Sales = 120,000,000/75%
Sales = ugx 160,000,000
Therefore material costs = 10%*160,000,000
= ugx 16,000,000
Throughput for the period = sales revenue – material costs
Throughput for the period = 160,000,000 – 16,000,000
Throughput (return) = Ugx 144,000,000

THE THROUGHPUT ACCOUNTING RATIO.

When there is a bottleneck resource, performance can be measured in terms of throughput for each unit of
bottleneck resource consumed. There are three inter-related ratios;
.
Return per factory hour = OR .

Cost per factory hour = OR

! "( )
Throughput accounting ratio (TAR) = OR

NB; the total factory cost is the fixed production cost, including labour. The total factory cost may be
referred to as 'operating expenses'.
Interpretation of TPAR
TPAR>1 would suggest that throughput exceeds operating costs so the product should make a profit.
Priority should be given to the products generating the best ratios.
TPAR<1 would suggest that throughput is insufficient to cover operating costs, resulting
at a loss.
TPAR = 1 would mean that there is a breakeven point, no loss and no profit, profit would equal to loss
Decision making in a throughput accounting environment
● When ranking products made within the same factory it is sufficient to look at their respective return per
hour figures.
● However, if ranking products or divisions across the company it would be suitable to look at tpar figures to
reflect differences in costs between factories.
Criticisms of TPAR
● It concentrates on the short-term, when a business has a fixed supply of resources (i.e. A
bottleneck) and operating expenses are largely fixed.
● However, most businesses can't produce products based on the short term only.
● It is more difficult to apply throughput accounting concepts to the longer-term, when all costs are variable,
and vary with the volume of production and sales or another cost driver. The business should consider
this long-term view before rejecting products with a tpar < 1.

Note:
In the longer-term an ABC approach might be more appropriate for measuring and controlling performance.

Illustration four;
A business manufactures a single product that it sells for $10 per unit. The materials cost for each unit of
product sold is $3. Total operating expenses are $50,000 each month. Labour hours are limited to 20,000
hours each month. Each unit of product takes 2 hours to assemble.
Required; calculate the throughput accounting ratio (TPAR).

Solution
SP per unit = $ 10
MC per unit = $ 3

TFC (operating expenses) = $ 50,000

Labour hours/ factory hours per unit = 2
TPAR =?
! " !
TPAR = !

Note: Return is the same as the throughput and return per unit is the same as the throughput per unit.
The total throughput is used in situations of multi-product.

So return /FH = return per unit ÷ FHs per unit.

But return per unit = 10 - 3 = $ 7

Return per FH = 7 ÷ 2 = $ 3.5 per FH

Cost per FH = total factory cost ÷ total factory hours

Cost per FH = $ 50,000 ÷ 20,000
Cost per FH = $ 2.5 per FLHs

Therefore TPAR will be:

TPAR = $ 3.5 per FH ÷ $ 2.5 per FH

TPAR = 1.4

TPAR = 140%
Illustration five;
Xeen limited manufactures a product that requires 1.5 hours of machining. Machine time is a bottleneck
resource, due to the limited number of machines available. There are 10 machines available, and each
machine can be used for up to 40 hours per week. The product is sold for $85 per unit and the direct material
cost per unit is $42.50. Total factory costs are $8,000 each week.

Calculate
(a) The return per factory hour
(b) The TPAR.

Improving the TPAR

Options to increase the TPAR include the following:
● Increase the sales price for each unit sold, to increase the throughput per unit
● Reduce material costs per unit (e.g. by changing materials or switching suppliers), to increase the
throughput per unit.
● Reduce total operating expenses, to reduce the cost per factory hour
● Improve the productivity of the bottleneck, e.g. the assembly workforce or the bottleneck machine, thus
reducing the time required to make each unit of product. Throughput per
factory hours would increase and therefore the TPAR would increase.

Multi-product decision making

Throughput accounting may be applied to a multi-product decision making problem in the same way as
conventional key factor analysis.
The usual objective in questions is to maximise profit. Given that fixed costs are unaffected by
the production decision in the short run, the approach should be to maximise the throughput
earned.
Step 1: Identify the bottleneck constraint.
Step 2: Calculate the throughput per unit for each product.
Step 3: Calculate the throughput per unit of the bottleneck resource for each product.
Step 4: Rank the products in order of the throughput per unit of the bottleneck resource. If all products are
made in the same factory, then the ranking can be done on return/hour as the cost/hour will be the same;
however if not the ranking is done on TPAR.
Step 5: Allocate resources using this ranking and answer the question

Illustration .six;
Just in time manufactures four products, A, B, C and D. Details of sales prices, costs and resource
requirements for each of the products are as follows.

Product A B C D

Sales price ( $ ) 1.4 0.8 1.2 2.8

Material cost ( $ ) 0.6 0.3 0.6 1

Direct labour cost ( $ ) 0.4 0.2 0.4 1

Machine time per unit (minutes) 5 2 3 6

Labour time per unit ( minutes ) 2 1 2 5

Weekly sales demand ( units ) 2000 2000 2500 1500

Machine time is a bottleneck resource and the maximum capacity is 400 machine hours each week.
Operating costs, including direct labour costs, are $5,440 each week. Direct labour costs are $12 per hour.
Required;
(a) Determine the quantities of each product that should be manufactured and sold each week to maximise
profit and calculate the weekly profit.
(b) Calculate the throughput accounting ratio at this profit-maximising level of output and sales

Solution
A) Determine the quantities of each product that should be manufactured and sold each week to maximize
profit and calculate the weekly profit.

Throughput = sales price per unit - material cost per unit

Product A B C D

Sales price per unit ( $ ) 1.4 0.8 1.2 2.8

Material cost per unit ( $ ) 0.6 0.3 0.6 1

Throughput ( return ) per unit ( $ ) 0.8 0.5 0.6 1.8

(a )

Machine minutes per unit ( $ ) ( 5 2 3 6

bottleneck resource) ( b )

Throughput per machine minutes 0.16 0.25 0.2 0.3

($) ( a ) ÷ ( b )

Ranks 4 2 3 1

NB: Total available machine minutes (bottleneck resource ) = 400 MHs * 60 minutes = 24,000
machine minutes.

Production and sales schedule:

Product Prod'n & M.minutes Total Throughput Total

sales units (a) per unit machine per unit ( b ) throughput
minutes (a*b)

D 1,500 6 9,000 1.8 2,700

B 2,000 2 4,000 0.5 1,000

C 2,500 3 7,500 0.6 1,500

A 700 5 3,500 0.8 560

Total 24,000 $ 5,760

For product A is a balancing figure obtained from:
24,000 - (9,000+4,000+7,500)
24,000-20,500 = 3,500/5 = 700 units.

Weekly profit
WP = total throughput - total operating costs
WP = $ 5,760 - $ 5,440
WP = $ 320

(b) Calculate the throughput accounting ratio at this profit maximizing level of output and sales.
TPAR = return per FH ÷ cost per FH

Return per FH= total throughput ÷ total FHs

Return per FH = $ 5,760 / 24,000 m.minutes
Return per FH = $ 0.24/m.minute

Cost/FH = total factory costs ÷ total FHs

Cost/FH = $ 5,440 / 24,000m.mimutes
Cost/FH = $ 0.23/m.minute

TPAR = 0.24 ÷ 0.23 = 1.04

OR
TPAR = total throughput ÷ total factory expenses
TPAR = 5,760 ÷ 5,440 = 1.06

Conclusion: Performance is just average or at breakeven level and hence efforts to improve the tpar should
be put in place such as………..

TA in the public sector

Throughput accounting principles can be applied in both the private and public sectors. Take the
following example:

Scenario
A not-for-profit organisation performs a medical screening service in three sequential stages: 1)take
an x-ray, 2) interpret the result and 3) recall patients who need further investigation/tell others that all is
fine.
The ‘goal unit’ of this organisation will be to progress a person through all three stages. The number of
people who complete all the stages is the organisation’s throughput, and the organisation should seek to
maximize its throughput. The duration of each stage, and the weekly resource available, is as follows;

Process Time per patient ( hours) Total hours available per week

Take an x-ray 0.5 80

Interpret the result 0.2 40

Recall patients who need further 0.4 60

investigation/tell others that all is
fine.
From the above table, the maximum number of patients (goal units) who can be dealt with in each
process is as follows;

Process Time per patient( Total hours available No. Of patients

hours) per week

Take an x-ray 0.5 80 160

Interpret the result 0.2 40 200

Recall patients who 0.4 60 150

need further
investigation/tell others
that all is fine

Here, the recall procedure is the bottleneck resource, or constraint.

Throughput, and thereby the organisation’s performance, cannot be improved until that part of the
process can deal with more people.
Therefore, to improve throughput, the following steps can be taken.
● Ensure there is no idle time in the bottleneck resource, as that will be detrimental to overall
performance (idle time in a non-bottleneck resource is not detrimental to overall performance).
● See if less time could be spent on the bottleneck activity.
● Finally, increase the bottleneck resource available.

In this example, increasing the bottleneck resource, or the efficiency with which it is used, might be
relatively cheap and easy to do because this is a simple piece of administration while the other stages
employ expensive machinery or highly skilled personnel. There is certainly no point in improving the first
two stages if things grind to a halt in the final stage; patients are helped only when the whole process is
completed, and they are recalled if necessary.

TARGET COSTING
Target costing involves setting a target cost by subtracting a desired profit from a competitive
market price. Real world users include sony, toyota and the swiss watchmakers, swatch. In
effect it is the opposite of conventional 'cost plus pricing. However, cost-plus pricing ignores;
★ The price that customers are willing to pay
★ The price charged by competitors for similar products
★ Cost control
Target costing is a cost management process which involves setting a target cost by subtracting a desired
profit margin from a competitive market price.

A target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from
a competitive market price. This target cost may be less than the planned initial product cost but it is expected
to be achieved by the time the product reaches the maturity stage of the product life cycle.

Implementing target costing

The steps in the implementation of the target costing process;
★ Set a selling price at which the organization will be able to achieve a desired market share.
★ Estimate the required profit based on return on sales or return on investment.
★ Calculate the target cost = target selling price - target profit.
★ Compile an estimated cost for the product based on the anticipated design specification and current cost
levels.
★ Calculate the target cost gap = estimated cost (currently attainable cost) - target cost.
★ Make efforts to close the gap. This is more likely to be successful if efforts are made to design out' costs
prior to production, rather than to 'control out' costs during the production phase.

This therefore calls for the target costing process which could be as below;

Closing the target cost gap

The target cost gap is established in step 4 of the target costing process. Target cost gap =
estimated product cost - target cost. It is the difference between what an organization thinks it can currently
make a product for, and what it needs to make it for, in order to make a required profit. Alternative product
designs should be examined for potential areas of cost reduction that will not compromise the quality of the
products. Questions that a manufacturer may ask in order to close the gap include;
❖ Can any materials be eliminated, e.g. Cut down on packing materials?
❖ Can a cheaper material be substituted without affecting quality?
❖ Can labour savings be made without compromising quality, for example, by using
lower skilled workers?
❖ Can productivity be improved, for example, by improving motivation?
❖ Can production volume be increased to achieve economies of scale?
❖ Could cost savings be made by reviewing the supply chain?
❖ Can part-assembled components be bought in to save on assembly time?
❖ Can the incidence of the cost drivers be reduced?
❖ Is there some degree of overlap between the product-related fixed costs that could be eliminated by
combining service departments or resources?

★ NB; a key aspect of this is to understand which features of the product are essential to
customer perceived quality and which are not. This process is known as value analysis. Attention should
be focused more on reducing the costs of features perceived by the customer not to add value.
★ Closing the cost gap by increasing the selling price is not a viable option as the price is determined by
market forces rather than the company.

Various techniques can be employed to close a target cost gap;

● Reducing the number of components
● Using cheaper staff
● Using standard components wherever possible.
● Acquiring new, more efficient technology.
● Training staff in more efficient techniques.
● Cutting out non-value-added activities.

Illustration seven
Rilac plc is considering whether or not to launch a new product. The sales department has determined that a
realistic selling price will be ugx 82,000 per unit. Packard have a requirement that all products generate a
gross profit of 40% of selling price.
Required; calculate the target cost.
Illustration eight
Company cee is currently considering expansion into manufacturing two new products, a printer
and a digital camera. Company cee normally uses a pricing policy of a 10% mark-up on
standard prime cost on its products. However, as both the printing and camera markets are highly
competitive, the finance director is considering using a target costing approach but wants to retain the same
mark-up.

Printers
The maximum price the market will support is $200 per unit of the new printer. 60% of the direct cost of each
printer is expected to be polymer.

Digital cameras
40% of the direct cost of each digital camera is expected to be software. The minimum price
company cee can source the software necessary to make one digital camera is currently $76, which has been
built into the budget. On this basis, company cee has determined that the cost gap between the budgeted
cost per digital camera and the target cost per digital camera is $23.70.

Required:
(a) What is the target cost of the polymer used in the manufacture of printers?
(b) Assuming that target costing principles are adopted, what is the maximum selling price that company cee
can charge per digital camera?

Value analysis,
This is otherwise known as ‘cost engineering’ and ‘value engineering. It is a technique in which a firm’s
products, and maybe those of its competitors, are subjected to a critical and systematic examination by a
small group of specialists. They can be representing various functions such as design, production, sales and
finance. Value analysis seeks to close the cost gap by asking of a product the following questions;
Does it need all of its features? Can a usable part be made better at a lower cost?
A cost advantage may be obtained in many ways, e.g. Economies of scale, the experience curve, product
design innovations and the use of no-frills’ product offering. Each provides a different way of competing on the
basis of cost advantage.

Types of value
★ Cost value: this is the cost incurred by the firm dealing in the product.
★ Exchange value: the amount of money that consumers are willing to part with so as to obtain ownership
of the product, i.e. Its price.
★ Use value: this is related entirely to function, i.e. The ability of a product to perform its specific intended
purpose. For example, a basic small car provides personal transport at a competitive price and is
reasonably economic to run.
★ Esteem value: this relates to the status or regard associated with ownership. Products with high esteem
value will often be associated with premium or even price-skimming prices.

NB:'value' is a function of both 'use' and 'esteem'. Value analysis aims to maintain the esteem value in a
product, but at a reduced cost value. The result of value analysis is to achieve an improved value/cost
relationship.
Target costing in service organisations
Target costing is as relevant to the service sector as the manufacturing sector. Key issues are similar in both:
the needs of the market need to be identified and understood as well as its customers and users; and
financial performance at a given cost or price (which does not exceed the target cost when resources are
limited) needs to be ensured. For example, if a firm of accountants was asked to bid for a new client contract,
the partners or managers would probably have an idea of what kind of price is likely to win the contract. If staff
costs are billed out at twice their hourly salary cost, say, this would help to determine a staff budget for the
contract. It would then be necessary to work out the hours needed and play around with the mix of
juniors/senior staff to get to that target cost.

There are ways in which target costing can be applied to service-oriented businesses, and the focus of target
costing shifts from the product to the service delivery system.

Problems with target costing in service industries

Unlike manufacturing, service industries have the following characteristics which could make target costing
more difficult;

(1) The intangibility of what is provided means that it is difficult to define the ‘service’ and
attribute costs; in the nhs, it is challenging to define what a ‘procedure’ is. Clinical specialties cover a wide
range of disparate treatments, and services include high levels of indirect cost.
Consistent methods of cost attribution are needed, and this is not always straightforward. Direct charging is
not always possible and there are different configurations of cost centers across providers. This may limit the
consistency which can be achieved.

(2) Inseparability/simultaneity of production and consumption: although the manufacturer of a tangible good
may never see the actual customer, customers often must be present during the production of a service, and
cannot take the service home. No service exists until it is actually being experienced/ consumed by the
person who has brought it.

(3) Heterogeneity/variability - the quality and consistency varies, because of an absence of

standards or benchmarks to assess services against. In the nhs, there is no indication of what an excellent
performance in service delivery would be, or any definition of unacceptable performance.

(4) Perishability - the unused service capacity from one time period cannot be stored for future use. Service
providers and marketers cannot handle supply-demand problems through production scheduling and
inventory techniques.

(5) No transfer of ownership - services do not result in the transfer of property. The purchase of a service only
confers on the customer access to or a right to use a facility.

LIFE-CYCLE COSTING
Traditional costing techniques based around annual periods may give a misleading impression of the costs
and profitability of a product. This is because systems are based on the financial accounting year, and dissect
the product's lifecycle into a series of annual sections. Usually, therefore, the management accounting
systems would assess a product's profitability on a periodic basis, rather than over its entire life.

Lifecycle costing, however, tracks and accumulates costs and revenues attributable to each product over its
entire product lifecycle;
LCC = total life cycle costs ÷ total life cycle units.

Justification for LCC.

The costs involved in making a product, and the sales revenues generated, are likely to be
different at different stages in the life of a product. For example, during the initial development of the product
the costs are likely to be high and the revenue minimal - i.e. The product is likely to be loss-making.
● The product life cycle may be divided into five phases (to illustrate with a graph). According to Berliner
and Brimson (1988), companies operating in an advanced manufacturing environment are finding that
about 90% of a product's lifecycle costs are determined by decisions made early in the cycle. In many
industries, a large fraction of the life-cycle costs consists of costs incurred on product design, prototyping,
programming, process design and equipment acquisition. This had created a need to ensure that the
tightest controls are at the design stage, i.e. before a launch, because most costs are committed, or
'lockedin', at this point in time. Management accounting systems should therefore be developed that aid
the planning and control of product lifecycle costs and monitor spending and commitments at the early
stages of a product's life cycle.

Illustration 9
The following details relate to a new product that has finished development and is about to be launched.

Development Launch Growth Maturity Decline

Time period Finished 1 year 1 year 1 year 1 year

R &d 20

Marketing costs - 5 4 3 0.9

Production cost - 1.00 0.9 0.8 0.9

per unit($)

Production 1m 5m 10m 4m
volume

The launch price is proving a contentious issue between managers. The marketing manager is keen to start
with a low price of around $8 to gain new buyers and achieve target market share. The accountant is
concerned that this does not cover costs during the launch phase and has produced the following schedule
to support this;

Launch phase $ million

Amortized r & d costs ( 20 ÷ 4 ) 5

Marketing costs 5

Production costs ( 1m * $ 1 per unit ) 1

Total 11

Total production units 1m units

Cost per unit 11

Required; prepare a revised cost per unit schedule looking at the whole lifecycle and comment on the
implications of this cost with regards to the pricing of the product during the launch phase.

Illustration ten;
Natural power specializes in the manufacture of solar set-ups. It is planning to introduce a new solar panel
specifically designed for small houses. Development of the new panel is to begin shortly and natural power
is in the process of determining the price of the panel. It expects the new product to have the following costs.

Year 1 Year 2 Year 3 Year 4

Units manufactured 8,000 15,000 20,000 5,500

and sold

$ $ $ $

R&d costs 1,900,000 100,000 _ _

Marketing costs 100,000 75,000 50,000 10,000

Production cost per 500 450 400 450

unit

Customer service 50 40 40 30
cost per unit

Disposal of _ _ _ 300,000
specialist
equipment.

The marketing director believes that customers will be prepared to pay $570 for a solar panel
but the financial director believes this may not cover all of the costs throughout the lifecycle.
Required;
Calculate the cost per unit looking at the whole life cycle and comment on the above suggested
price.

NB: specific costs may be associated with each stage a product’s life cycle;

1) Pre-production/product development stage; a high level of setup costs will be incurred in this stage
(preproduction costs), including research and development (R&D), product design and building of production
facilities.

2) Launch/market development stage; success depends upon awareness and trial of the product by
consumers, so this stage is likely to be accompanied by extensive marketing and promotion costs. Production
costs per unit will be extremely high due to the low volumes involved.

3) Growth stage; marketing and promotion will continue through this stage. In this stage sales volume
increases dramatically, and unit costs fall as fixed costs are recovered over greater volumes and variable
production costs per unit fall due to economies of scale.
4) Maturity stage; initially profits will continue to increase, as initial setup and fixed costs are
recovered. Marketing and distribution economies are achieved but overall marketing costs may increase to
respond to increased competition. Variable production costs per unit fall further due to economies of scale
and learning effects. However, price competition and product differentiation will start to erode profitability as
firms compete for the limited new customers remaining.

5) Decline stage; marketing costs are usually cut as the product is phased out. Production
economies may be lost as volumes fall. Meanwhile, a replacement product will need to have been developed,
incurring new levels of R&D and other product setup costs. Alternatively additional development costs may be
incurred to refine the model to extend the life-cycle (this is typical with cars where ‘product evolution’ is the
norm rather than ‘product revolution’).

Factors that need to be managed in order to maximise a product’s return over its lifecycle
★ Design costs out of the product; it was stated earlier that around 90% of a product’s costs were often
incurred at the design and development stages of its life. Decisions made then commit the organisation to
incurring the costs at a later date, because the design of the product determines the number of
components, the production method, etc. It is absolutely vital therefore that design teams do not work
in isolation but as part of a cross functional team in order to minimise costs over the whole life cycle.
★ Minimize the time to market; in a world where competitors watch each other keenly to see what new
products will be launched, it is vital to get any new product into the marketplace as quickly as possible.
The competitors will monitor each other closely so that they can launch rival products as soon as possible
in order to maintain profitability. It is vital, therefore, for the first organisation to launch its product as
quickly as possible after the concept has been developed, so that it has as long as possible to establish
the product in the market and to make a profit before competition increases. Often it is not so much costs
that reduce profits as time wasted.
★ Minimize the break-even point; firms may wish to try to minimise the time taken to achieve break-even for
a new project. Leaving aside the cost aspects already discussed, this turns the focus to pricing strategies
at launch: such factors would have to be considered within the wider context of issues such as product
strategy and objectives. For example, is the main objective to penetrate a market and gain market share,
or to establish a high quality image?
★ Maximize the length of the life cycle itself: generally, the longer the life cycle, the greater the profit that will
be generated, assuming that production ceases once the product goes into decline and becomes
unprofitable.
★ One way to maximise the life cycle is to get the product to market as quickly as possible because this
should maximise the time in which the product generates a profit.
★ Another way of extending a product’s life is to find other uses, or markets, for the product. Other product
uses may not be obvious when the product is still in its planning stage and need to be planned and
managed later on. On the other hand, it may be possible to plan for a staggered entry into different
markets at the planning stage. Many organisations stagger the launch of their products in different world
markets in order to reduce costs, increase revenue and prolong the overall life of the product. For
example, initiatives could be taken to reduce testing costs and therefore the 'research and development'
category. Likewise, proper planning and a tight control on transportation & handling costs could minimise
distribution costs.
★ These opportunities for cost reduction are unlikely to be found when management focuses on maximising
profit in a period-by-period basis. Only on knowing the lifecycle costs of a product can a business decide
appropriately on its price. This, coupled with planning of the different phases of the product's life, could
give rise to the following tactics as tabulated below;
 Introduction Growth Maturity Decline

High prices to recoup Competition increases; Sales slowdown and Superior products
high development costs; reduce price to remain level off; the market appear - our prices must
high returns before competitive price is maintained. be cut to maintain sales.
competitors enter the Upgrades and/or new
market markets should be
considered.

Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire
product life cycle.

Benefits of LCC.
a) With life cycle costing, non-production costs are traced to individual products over complete life cycles.
b) The total of these costs for each individual product can therefore be reported and compared with
revenues generated in the future.
c) The visibility of such costs is increased.
d) Individual product profitability can be better understood by attributing all costs to products.
e) As a consequence, more accurate feedback information is available on the organisation's success or
failure in developing new products.
f) In today's competitive environment, where the ability to produce new or updated versions of products is
paramount to the survival of an organization, this information is vital.

ENVIRONMENTAL & SOCIAL MGT ACCOUNTING (EMA)

EMA focuses on the efficient use of resources and the disposal of waste and effluent by businesses. EMA is
concerned with the accounting information needs of managers in relation to corporate activities that affect the
environment as well as environment-related impacts on the corporation. This includes;

★ Identifying and estimating the costs of environment-related activities

★ Identifying and separately monitoring the usage and cost of resources such as water, electricity and fuel
and to enable costs to be reduced.
★ Ensuring environmental considerations form a part of capital investment decisions
★ Assessing the likelihood and impact of environmental risks including environment-related indicators as
part of routine performance monitoring.
★ Benchmarking activities against environmental best practice.

Environmental concern and business performance

Martin Bennett and peter James (the green bottom line: management accounting for environmental
improvement and business benefit’, management accounting, November 1998), looked at the ways in which a
company's concern for the environment can impact on its performance;
★ Short-term savings through waste minimization and energy efficiency schemes can be substantial.
★ Companies with poor environmental performance may face increased cost of capital because investors
and lenders demand a higher risk premium.
★ There are a number of energy and environmental taxes, such as the landfill tax in the UK.
★ Pressure group campaigns can cause damage to reputation, or additional costs.
★ Environmental legislation may cause the 'sunsetting' of products and opportunities for 'sunrise'
replacements.
★ The cost of processing input which becomes waste is equivalent to 5-10% of some organizations'
revenue.
Bennett and James ('the green bottom line' 1998) went on to suggest six main ways in which business and
environmental benefits can be achieved;

(a) Integrating the environment into capital expenditure decisions by considering environmental opposition to
projects which could affect cash flows.

(b) Understanding and managing environmental costs. Environmental costs are often hidden in overheads
and environmental and energy costs are often not allocated to the relevant budgets.

(c) Introducing waste minimization schemes.

(d) Understanding and managing life cycle costs. For many products, the greatest environmental impact
occurs upstream (such as mining raw materials) or downstream from production (such as energy to operate
equipment.) This has led to producers being made responsible for dealing with
the disposal of products such as cars, and government and third party measures to influence raw material
choices. Organisations therefore need to identify, control and make provision for environmental life cycle
costs and work with suppliers and customers to identify environmental cost reduction opportunities.

(e) Measuring environmental performance. Business is under increasing pressure to measure all aspects of
environmental performance, both for statutory disclosure reasons and due to demands for more
environmental data from customers.

(f) Involving management accountants in a strategic approach to environment-related

management accounting and performance evaluation. A 'green accounting team' incorporating the key
functions should analyse the strategic picture and identify opportunities for practical initiatives. It should
analyse the short-medium-and long term impact of possible changes in the following;
(1) Government policies, such as transport.
(2) Legislation and regulation.
(3) Supply conditions, such as fewer landfill sites.
(4) Market conditions, such as changing customer views.
(5) Social attitudes, such as factory farming.
(6) Competitor strategies.

EMA and effect on financial performance

There are a number of ways in which environmental issues can have an impact on the financial performance
of organisations.
● Improving revenue; producing new products or services which meet the environmental needs or concerns
of customers can lead to increased sales. It may also be possible to sell such products for a premium
price. Improved sales may also be a consequence of improving the reputation of the business. It is
possible that in the future, rather than good environmental management resulting in improved sales, poor
management will lead to losses. All businesses will be expected to meet a minimum standard
related to environmental issues.
● Cost reductions; paying close attention to the use of resources can lead to reductions in cost. Often
simple improvements in processes can lead to significant costs savings.
• Increases in costs; there may be increases in some costs, for example the cost of complying with legal
and regulatory requirements, and additional costs to improve the environmental image of the
organisation. However some of these costs may be offset by government grants and this expenditure
may save money in the long-term as measures taken may prevent future losses.
● Costs of failure; poor environmental management can result in significant costs, for example the cost of
clean-up and fines following an environmental disaster.

Identifying and accounting for environmental costs

Management is often unaware of the extent of environmental costs and cannot identify opportunities for cost
savings. Environmental costs can be split into two categories;

Internal costs; these are costs that directly impact on the income statement of a company.
There are many different types, for example;
● Improved systems and checks in order to avoid penalties/fines
● Waste disposal costs
● Product take back costs (i.e. in the EU, for example, companies must
provide facilities for customers to return items such as batteries, printer
cartridges etc. For recycling. The seller of such items must bear the cost of
these "take backs")
● Regulatory costs such as taxes (e.g. Companies with poor environmental management policies often
have to bear a higher tax burden)
● Upfront costs such as obtaining permits (e.g. For achieving certain levels of emissions)
● Back -end costs such as decommissioning costs on project completion

External costs; these are costs that are imposed on society at large, but not borne by the company that
generates the cost in the first instance. For example,
● Carbon emissions
● Usage of energy and water
● Forest degradation
● Health care costs
● Social welfare costs.

Other classifications include;

a) Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
Examples include the costs of the design and operation of processes to reduce contaminants, training
employees, recycling products and obtaining certification relating to meeting the requirements of national
and international standards.

b) Environmental detection costs: costs incurred to ensure that the organisation complies with regulations
and voluntary standards. Examples include performing contamination tests and inspecting products to
ensure regulatory compliance.

c) Environmental internal failure costs: costs incurred from performing activities that have produced
contaminants and waste that have not been discharged into the environment. Recycling scrap, or
disposing of toxic materials, are examples.

d) Environmental external failure costs: costs incurred on activities performed after discharging waste into
the environment. Examples include the costs of cleaning up contaminated soil, oil spills, or restoring land
to its natural state.
The US environmental protection agency makes the following categories of environmental costs;

Conventional costs;
These have environmental relevance. They are the costs that management is aware of but not typically
described as environmental in the traditional management accounts. Examples are energy and other non-
renewable resources used by the organisation.

Potentially hidden costs;

These are environmental costs hidden within general overheads in the traditional MGT accountants
and hence management is not aware of them. Examples are fines for non-compliance with environmental
regulations, costs of monitoring and compliance costs.

Contingent costs;
These are liabilities which an organization may incur in future due to current activities. For
example decontamination costs to be incurred at the end life of a factory/ cleaning up pollution.

Image /relationship/reputational costs;

Costs for maintaining a good environmental image such as advertising and public assurance of the
environment responsible to the public and publication of external environmental reports.

BUSINESS SUSTAINABILITY AND TRIPLE BOTTOM LINE (TBL)

From a business and accounting perspective, sustainability relates to the expansion of the
Traditional financial bottom line (profit or loss). Broader definition of the bottom line to include full cost of
operations.

PLANET
Envirmental performance

PEOPLE PROFIT
Social performance Economic performance

The intersection for all is the sustainability section

The triple bottom line (TBL) is an accounting framework with three components, which are
known as the three pillars of sustainability. The first bottom line or pillar of sustainability is social
responsibility (people); environment (planet) is the second bottom line; and economic (profit) is the third
bottom line. Triple bottom line accounting is of interest to ‘for-profit’ and ‘not-for-profit’ organisations, as
well as government sectors: federal, state and local governments.
The theoretical underpinning of business and social responsibility is linked to four conceptual pillars:
● First, development necessary to meet the needs of the present and future generations.
● Second, two arguments of the stakeholder concept are (a) the recognition that the global impact of
businesses on climate and cultural changes is of concern to all stakeholders, and (b) the acceptance by
businesses that each stakeholder group has different goals, priorities and demands.
● Third, the corporate social responsibility concept is based on the ethical responsibility argument that
businesses should consider the needs of all stakeholders, not just shareholders or business owners.
This ethical responsibility argument is drawn from four theories:
○ Social contract theory (the contract extends beyond the physical parties to the contract to other
members of society for their approval)
○ Social justice theory (the needs of all members of society should be considered and goods
or services distributed fairly in society)
○ Rights theory (businesses need to comply with basic human rights of stakeholders in their
operations)
○ Deontological theory (a moral duty to treat others with respect).
● Finally, the concept of business accountability relates to a legal and ethical responsibility by business to
all stakeholders. This concept demands transparency of information that communicates,
explains, justifies and reports business activities and the outcomes of these activities to all stakeholders

Reasons why firms choose to be sustainable businesses:

★ To help reduce the impact of climate change and conserve limited natural resources
★ To enhance the competitiveness and reputation of the business
★ Gaining customer loyalty by limiting any possible negative corporate image
★ Regulatory compliance to avoid the financial risk of fines or higher interest rates
★ Risk management of potential environmental and health and safety or social issues in order to
minimise operational risk such as shut-downs.

Key considerations about systems and processes to be a sustainable business;

★ The sources of raw materials: need to know the sustainability of the supply of raw materials
★ Production : savings in energy and reducing waste
★ The use of recycled packaging and ‘greener’ vehicles for product distribution
★ Employee acceptance and commitment: provide training and development programs for employees,
with the focus on management systems and procedures
★ Building stronger relationships with the local community.
EMA techniques
The most appropriate management accounting techniques for the identification and allocation of
environmental costs are those identified by the united nations division for sustainable development.
These include;

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

Flow cost accounting

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

The importance/benefits of accounting for environmental costs;

● Organizations which adopt EMA have greater awareness of the impact of environmental-related activities
on their income statements and balance sheets.
● The organizations are likely to identify and take advantage of cost-reduction and other improvement
opportunities.
● It also reduces chances of taking the wrong product mix options and other development decisions.
● Also, it reduces chances of employing incorrect pricing of products and services by incorporating
environmental costs.
● Yields enhanced customer value.
● Reduces reputational risk because an organisation looks to operate in an environmentally responsible
manner.
● Better /fairer product costs
● Improved pricing - so that products that have the biggest environmental impact reflect this by having
higher selling prices better environmental cost control facilitates the quantification of cost savings from
"environmentally-friendly" measures
● Should integrate environmental costing into the strategic management process
● Reduces the potential for cross subsidization of environmentally damaging products.

Disadvantages
★ Time consuming
★ Expensive to implement
★ Determining accurate costs and
★ Appropriate costs drivers is difficult
★ External costs not experienced by the company (e.g. Carbon footprint) may still be
ignored/unmeasured.
★ Some internal environmental costs are intangible (e.g. Impact on employee health) sand these are still
ignored
★ A company that incorporates external costs voluntarily may be at a competitive disadvantage
to rivals who do not do this.

TOPIC.2: ADVANCED BUDGETING & CONTROL

A recap;
Budgeting is an essential tool for management in both planning and controlling future activities. An ideal
budgeting process;

● Communication of details of the budget policy.

● Determination of the factor that restricts performance
● Preparation of the sales/revenue budget.
● Extraction of other budgets.
● Negotiation of budgets
● Coordination and review of budgets
● Final acceptance and implementation of the budgets.
● Continued monitoring & evaluation.

Purpose of budgeting;

● Planning; a budgeting process forces a business to look to the future. This is essential for survival since
it stops management from relying on ad hoc or poorly coordinated planning.
● Controlling; involves controlling actual outcomes with preset targets.
● Coordination; the budget allows coordination of all parts of the business towards a common corporate
goal.
● Communication; the budget is a formal communication channel that allows junior and
senior managers to converse.
● Evaluation; responsibility accounting divides the organisation into budget centres, each of which has a
manager who is responsible for its performance. The budget may be used to evaluate the actions of a
manager within the business in terms of the costs and revenues over which they have control.
● Motivation; the budget may be used as a target for managers to aim for. Reward should be given for
operating within or under budgeted levels of expenditure. This acts as a motivator for managers.
● Authorization; the budget acts as a formal method of authorization to a manager for expenditure,
hiring staff and the pursuit of plans contained within the budget
● Delegation; managers may be involved in setting the budget. Extra responsibility may motivate the
managers. Management involvement may also result in more realistic targets.

Budgets and performance management

Budgets contribute to performance management by providing benchmarks against which to compare actual
results (variance analysis), and to develop corrective measures. They take many forms and serve many
functions, but most provide the basis for;
(a) Detail sales targets
(b) Staffing plans
(c) Production planning
(d) Cash investment and borrowing
(e) Capital expenditures.

Budgets give managers "pre-approval" for execution of spending plans, and allow them to provide forward
looking guidance to investors and creditors. For example, budgets are necessary to convince banks and other
lenders to extend credit to a given entity.

Even in a small business, a robust business plan/budget can often result in anticipating and avoiding
disastrous outcomes. Medium and larger organizations invariably rely on budgets. This is equally true in
businesses, government, and not-for-profit organizations (NPOs). Without a budget, an organization will be
highly inefficient and ineffective.

THE PLANNING/PERFORMANCE HIERARCHY

 Strategic performance

tactical performance

operational peformance

Strategic planning and performance

● Responsible for the sources of finance

● Form a vision & mission etc.

Tactical planning and performance

● Involves capital expenditures

● Goals and objectives
● Forming of strategies.

Operational planning and performance

● Functional budget formulations and implementation.

The aim is that if a manager achieves short-term budgetary targets (operational plans) then there
is more chance of meeting tactical goals and ultimately success for strategic plans.

● Strategic planning is long term, looks at the whole organization and defines resource requirements. For
example, to develop new products in response to changing customer needs.

● Tactical planning is medium term, looks at the department/divisional level and specifies how to use
resources. For example, to train staff to deal with the challenges that this new product presents.

● Operational planning is very short term, very detailed and is mainly concerned with control. Most
budgeting activities fall within operational planning and control. For example, a budget is set for the new
product to include advertising expenditure, sales forecasts, labor and material expenditure etc.

The achievement of budgetary plans will impact on the eventual achievement of the tactical and strategic
plans.
NB; however, budgets should also be flexible in order to meet the changing needs of the
business.

Behavioral aspects of budgeting vs management styles (Hopwood)

Individuals react to the demands of budgeting and budgetary control in different ways and their behavior can
damage the budgeting process.

In accordance with Hopwood (1973), his research into the manufacturing division of a us steelworks, and
identified three distinct styles of using budgetary information to evaluate management performance as
summarized below;
Management style Performance evaluation Behavioral aspects
criteria

Budget constrained style ● Manager evaluated on ● Job related pressure.

ability to achieve budget in ● May result in short term
the short term. decision making at the
● Manager will be criticized expense of long term
for poor results. For goals.
example, if spending ● Can result in poor working
exceeds the limit set. relations with colleagues.
● Can result in manipulation
of data

Profit conscious style ● Manager evaluated on ● Less job related pressure

ability to reduce costs and ● Better working relations
increase profit in the long with colleagues.
term. ● Less manipulation of data.
● For example, a manager
will be prepared to exceed
the budgetary limit in the
short term if this will result
in an increase in long term
profit.

Non accounting style ● Manager evaluated mainly • Similar to profit conscious

on non accounting style but there is less
performance indicators concern for accounting
such as quality and information.
customer satisfaction. • Requires significant and
stringent monitoring of
performance against
budget.

Review question
A manager is awarded a bonus for achieving monthly sales budget targets. State down possible behavioral
implications of such a policy. What should be done to try to improve the process?

Question
A sales manager has achieved ugx 6,550,000 of sales in the current year. Business is expected to grow by
8% and price inflation is expected to be 3% in the next year. Required; suggest a suitable budget target for
the forthcoming year and any other necessary reservations to be considered.

Dealing with uncertainty in budgeting

Budgets are open to a range of risks and uncertainty. For example, non-controllable factors such as a
recession or a change in prices charged by suppliers will contribute to uncertainty in the budget setting
process.
Uncertainty arises largely because of changes in the external environment, over which a company will have
little or no control.

Reasons include;
● Social or political unrest could affect productivity (e.g. through industrial action), as could natural disasters
like earthquakes and storms.
● Machines may break down unexpectedly, and the business may fail to meet production schedules.
● Customers may decide to buy more or less goods or services than originally forecast. For example, if a
major customer goes into liquidation, this has a huge effect on a company and could also cause them to
go into liquidation.
● The workforce may not perform as well as expected because of a lack of motivation, illness, etc. On the
other hand, they may perform better than thought.
● Competitors may strengthen or emerge, and take some business away from a company. On the other
hand, a competitor's position may weaken, leading to increased business.
● Technological advances may take place which lead a company's products or services to become
outdated and therefore less desirable.
● Materials may increase in price because of global changes in commodity prices.
● Inflation, as well as movement in interest rates, can cause the price of all inputs to increase or decrease.

TECHNIQUES TO DEAL WITH RISK AND UNCERTAINTY IN BUDGETING.

These may include;
FLEXIBLE BUDGETS: these are budgets which, by recognizing different cost behavior patterns are
designed to change as the volume of activity changes. Flexible budgets are prepared under marginal costing
principles, and so mixed costs are split into their fixed and variable components. This is useful at the control
stage: it is necessary to compare actual results to the actual level of activity achieved against the results that
should have been expected at this level of activity which is shown by a flexed budget.

Question
PQR ltd has prepared the following fixed budget for the coming year;

Ugx

Direct materials 50,000,000

Direct labour 25,000,000

Variable overheads 12,500,000

Fixed overheads 10,000,000

97,500,000

Budgeted selling price will be ugx 10,000 per unit.

At the end of the year, the following costs had been incurred for the actual production of 12,000 units.

Ugx

Direct materials 60,000,000

Direct labour 28,500,000

Overheads 26,000,000

114,500,000

● The actual sales were 12,000 units for ugx 122,000,000.

● Direct labour will be only 60% variable based on past experience and current economic conditions.
● Actual overheads also comprise of 45% fixed while the rest vary in accordance with activity level in the
period.

Required; prepare PQR LTD’s flexed budget for the actual activity for the year and comment on the arising
variances for management analysis.

DETAILS FIXED FLEXED ACTUAL VARIANCE STATUS

BUDGET BUDGET

Production 10,000 - 12,000 2,000

and sales
units

SALES 100,000,000 120,000,000 ( 122,000,000 2,000,000 F

W1 )

DM 50,000,000 60,000,000 60,000,000 - _

(W2)

DL 25,000,000 28,000,000 28,500,000 500,000 A

(W3)

V.OHs 12,500,000 15,000,000 14,300,000 700,000 F

(W4) (W4)

F OHs 10,000,000 10,000,000 11,700,000 1,700,000 A

(W4)

Total costs 97,500,000 113,000,000 144,500,000

Profit / loss 2,500,000 7,000,000 7,500,000 500,000 F

WORKINGS
Flexing ratio = actual units ÷ budgeted units
Flexing ratio = 12,000 ÷ 10,000
Flexing ratio = 1.2 OR 120%

FLEXED
SALES(W1) = 1.2 × 100,000,000 = 120,000,000
DM(W2) = 1.2 × 50,000,000 = 60,000,000

DIRECT LABOUR (W3)

Variable = 60 % * 25,000,000 = 15,000,000
FLEXED = 1.2 × 15,000,000 = 18,000,000

FIXED ( 40 % ) = 10,000,000
Total flexed = 10,000,000 + 18,000,000
Total flexed = 28,000,000

OVERHEADS ( W4 )
FLEXED variable = 1.2 × 12,500,000
FLEXED variable = 15,000,000

Actual = 55% × 26,000,000 = 14,300,000

Fixed = 10,000,000 ( NOT FLEXED )
Actual = 45% * 26,000,000
Actual = 11,700,000
ROLLING BUDGETS (CONTINUOUS BUDGETS): The budget is updated regularly on short-term
intervals and, as a result uncertainty is reduced. Also called a perpetual budget.
NB: the above two have already been covered in the previous paper …hence a recap should be
made.
ADVANTAGES.
 Avoids wasting management efforts in deriving detailed targets over long periods, which will probably not
happen. They concentrate on short term accuracy instead.
 It forces regular re appraisal of the budget to ensure that it is up to date.
 It ensures planning and control is based on the most up to date information available.
 It avoids the de-motivational effects of unrealistic and unattainable budgets.
 It overcomes the annual disruption of the budget round. There is always a budget covering the next few
months.
 It can be used to communicate changes in the organization strategy to management.

Draw backs
 Increases the time and effort put into budgeting
 Constantly changing targets my make managers cynical or dispirited
 May lead to careless budgeting if managers know that targets can be changed later.
 It may slip into incremental budgeting
 May reduce control and increase bargaining if managers know that they can hide poor performance
behind changed targets.

Example
A co uses a rolling budgeting and has a sales budget as follows:

Qtr 1 Qtr. 2 Qtr 3 Qtr. 4 Total

Sales ($) 125,500 132,300 138,400 145,200 536,400

Actual sales for quarter 1 were $ 123,450. The adverse variance is fully explained by competition being more
intense than expected and growth being lower than anticipated. The budget committee has proposed that the
revised assumption for sales growth should be 3% per quarter.
Required: update the budget as appropriate.

SENSITIVITY ANALYSIS: variables can be changed one at a time and a large number of budgets
produced.

SIMULATION: this is similar to sensitivity analysis but it is possible to change more than one variable at a
time. It's normally computerized though specialized computerized packages and spreadsheets.

SPREADSHEETS: a spreadsheet is a computer package which stores data in a matrix format where the
intersection of each row and column is referred to as a cell. These are used to assist in the budgeting
process. When producing a master budget manually the major problem is ensuring that any initial entry in the
budget or any adjustment to a budget item is dealt with in every budget that is relevant - in effect, budgets
need to comply with normal double entry principles to be consistent. This is useful for carrying out sensitivity
analysis & simulation modeling.

Advantages
● Large enough to include a large volume of information.
● Formulate and look up tables can be used so that if a figure is amended, all the figures will be
recalculated.
● The results can be printed out or distributed to other users electronically quickly & easily.
● Most programs can also represent the results graphically e.g. Balances can be summarized in a bar
chart.

Disadvantages of spreadsheets
● Spreadsheets for a particular budgeting application will take time to develop. The benefit of the
spreadsheet must be greater than the cost of developing and maintaining it.
● Data can be accidentally changed (or deleted) without the user being aware of this occurring.
● Errors in design, in the use of formulae, can produce invalid output.
● Due to complexity of the model, these design errors can be difficult to locate.
● Data used will be subject to a high degree of uncertainty. This can be forgotten and the data used to
produce what is considered to be an accurate report.
● Security issues, such as risk unauthorized access (e.g. hacking) or a loss of data (e.g. due to fire or theft).
● Version control issues can arise.
● Educating staff to use spreadsheets/ models and which areas/cells to use as inputs can be time
consuming.

FEEDBACK & FEED FORWARD CONTROL

Feedback control
It is defined as 'the measurement of differences between planned outputs and actual outputs achieved, and
the modification of subsequent action and/or plans to achieve future required results'. This is the most
common type of control system. It can be both positive feedback is feedback taken to reinforce a deviation
from standard. The inputs or processes would not be altered and negative feedback is feedback taken to
reverse a deviation from standard. This could be by amending the inputs or process, so that the system
reverts to a steady state. For example, a machine may need to be reset over time to its original settings.

Feed forward control

A feed forward control system operates by comparing budgeted results against a forecast. Control action is
triggered by differences between budgeted and forecasted results. Feed forward control is control based on
forecasted results. In other words, if the forecast is bad, control action is taken before the actual results come
through.
NB: the use of a feed-forward control system means that corrective action can be taken to avoid expected
adverse variances.

QUANTITATIVE ANALYSIS IN BUDGETING

This is concerned with numerical techniques that can be useful in the preparation of budgets. These include;

A. High/low analysis.
B. The learning curve.
C. Expected values.( probabilities)

HIGH / LOW ANALYSIS

A method of analyzing a semi-variable cost into its fixed and variable elements based on an analysis of
historical information about costs at different production levels. The fixed and variable costs can then be
used to forecast the total cost at any level of production. The approach is as follows;

Step 1; select the highest and lowest activity levels, and their costs.

Step 2; find the variable cost/unit.

Variable cost/unit = (cost at high level of production - cost at low level production) ÷ (high level production-
low level production)

Step 3; find the fixed cost, using either the high or low production level. Fixed
cost = total cost at that production level - total variable cost

Step 4; use the variable and fixed cost to forecast the total cost for a specified level of production.

Illustration
You have been availed the following information from the period just ended;

Month Batches Inspection costs ( ugx )

July 340 2,240,000

August 300 2,160,000

September 380 2,320,000

Oct 420 2,400,000

Nov 400 2,360,000

Dec 360 2,280,000

Required
1) Use the high / low analysis to find the variable cost per batch and the total fixed cost.
2) Forecast the total cost when 500 batches are produced and assembled

Advantages of high/low analysis

● The high-low method has the enormous advantage of simplicity.
● It is easy to understand and easy to use.

Disadvantages of high/low analysis

● The high-low method has the enormous advantage of simplicity.
● It is easy to understand and easy to use.
● It assumes that production is the only factor affecting costs.
● It assumes that historical costs reliably predict future costs.
● It uses only two values, the highest and the lowest, so the results may be distorted due to random
variations in these values.

COMPREHENSIVE QUESTION ( 1 )
Gameez designs is a co. That deals in a variety of digital games. Their products normally last for 3 years only.
Performance is measured by reference to the profits made in each of the expected three years of popularity in
the market. Gameez generally accepts a net profit of 35% of turnover as reasonable. A rate of contribution
(selling price less variable cost) of 75% is also considered acceptable. The co has a large development
department which carries out all the design work before it passes the completed game to the sales and
distribution department to market and distribute the product.
Gameez co has come up with a new product “donjon” with the following budgeted performance figures.
The budgeted sales volume (units) will be 8,000, 16,000 and 4,000 in years 1, 2 and 3 resp.
The selling price will be $ 50 per unit in year 1 & 2 and to be revised down by 5% in year 3. A detailed
analysis of the costs show that for a volume of 10,000units, a total cost of $130,000 will be incurred while at
14,000 units, a total cost of $ 150,000 will be incurred and any volume above 15,000 units will cause fixed
costs to increase by 50%. The marketing costs will be $ 60,000 in year 1, and $ 40,000 in year 2.
Design & development costs are incurred before the game is launched and will cost $300,000 and planned to
be recovered in the ratios 2:1 in year 1 and 2 respectively as the product picks the market.

Required;
01. Produce the budgeted results for the game “donjon” and briefly comment on the game‟s expected
performance, taking into account the whole life cycle of the game.
02. Explain the concept of feedback and forward control as budget monitoring.

COMPREHENSIVE QUESTION ( 2 )
Gameez designs is a co. That deals in a variety of digital games. Their products normally last for 3 years only.
Performance is measured by reference to the profits made in each of the expected three years of popularity in
the market. Gameez generally accepts a net profit of 35% of turnover as reasonable. A rate of contribution
(selling price less variable cost) of 75% is also considered acceptable. The co has a large development
department which carries out all the design work before it passes the completed game to the sales and
distribution department to market and distribute the product. Gameez co has come up with a new product
“donjon” with the following budgeted performance figures.
The budgeted sales volume (units) will be 8,000, 16,000 and 4,000 in years 1, 2 and 3 resp.
The selling price will be $ 30 per unit. A detailed analysis of the costs show that for a volume of 10,000units, a
total cost of $130,000 will be incurred while at 14,000 units, a total cost of $ 150,000 will be incurred and any
volume above 15,000 units will cause fixed costs to increase by 50%. The marketing costs will be $ 60,000 in
year 1, and $ 40,000 in year 2.
Design & development costs are incurred before the game is launched and will cost $300,000. These costs
are written off to the income statement before year one commences.

Required;
03. Produce the budgeted results for the game “donjon” and briefly comment on the game’s expected
performance, taking into account the whole life cycle of the game.
04. Explain why incremental budgeting is a common method of budgeting and outline any problems
associated with it.

Solution;
Gameez designs
Budgeted performance results for donjon over a 3 year period.

Year 1 Year 2 Year 3 Total

Sales volume 8,000 16,000 4,000 28,000

Selling price per unit ( $ ) 30 30 30 30

Sales revenue ( sp * volume ) ( $ ) 240,000 480,000 120,000 840,000

Variable costs (w1.) = vc/unit * volume (40,000) (80,000) (20,000) (140,000)

($)

Total contribution ( $ ) 200,000 400,000 100,000 700,000

Marketing costs ( $ ) (60,000) (40,000) - (100,000)

Fixed costs ( $ ) - w2 (80,000) (120,000) (80,000) (280,000)

Net profit ( $ ) 60,000 240,000 20,000 320,000

W1. Analysis of variable costs; (using high low analysis)

Vc/unit = (highest cost - lowest cost)/ (highest units - lowest
units)
Vc/unit = (150,000 - 130,000)/14,000 - 10,000
Vc/unit = 20,000/4,000
Vc/unit = $ 5/unit

W2. Fc = TC - VC
Using 10,000 units;
Fc = 130,000 - 5*10,000
Fc = 80,000

And for year.2

= (150/100)*80,000 = $ 120,000
● The overall net profit margin (NPM) =(320,000/840,000)*100%
= 38% vs co. Target of 35%.
● The overall contribution margin (cm) =(700,000/840,000)*100%
= 83% vs co. target of 75%

Comment/conclusion;
The donjon product will yield good performance for the co averaging all the three years as can be
evidenced from the above resultant NPM & cm that are both above company target. Therefore it’s a
worthwhile product to deal in over the planned 3 yr period.

LEARNING CURVE
This is useful in labor budgeting taking into consideration the learning effect as a result of repetitively doing
the same work.
The learning curve is 'the mathematical expression of the commonly observed effect that, as complex and
labor-intensive procedures are repeated, unit labor times tend to decrease.'

Wright's law
Wright's law states that as cumulative output doubles, the cumulative average time per unit falls to a fixed
percentage (the 'learning rate') of the previous average time.
Wright's law aims to provide a reliable framework for forecasting cost declines as a function of cumulative
production. It states that for every cumulative doubling of units produced, costs will fall by a constant
percentage.

The learning process starts from the point when the first unit comes off the production line. From then on,
each time cumulative production is doubled, the cumulative average time per unit is a fixed percentage of its
previous level.
For example, a 90% learning curve means that each time cumulative output doubles the cumulative average
time per unit falls to 90% of its previous value.

The theory of learning curve only holds if the following conditions (assumptions) apply;
1) There is a significant manual element (labor intensive) in the task being considered.
2) The task must be repetitive.
3) Production must be at an early stage so that there is room for improvement.
4) There must be consistency in the composition of the workforce.
5) There must not be extensive breaks in production, or workers will „forget‟ the skill.
6) Workforce should be motivated.

The methods for learning curve are;

These are two i.e;
The tabular approach (calculates the average times when cumulative output doubles and time required for
all units produced).

Example 1.on tabular approach;

Consider the following example of the time taken to make the first four units of a new product.

No. Of units Time to taken

(hours)
 01 10

02 8

03 7.386

04 7.014

Required; compute the total time for making the next 4 units to double output to the 8th unit of this product.
Solution;

Serial number of units Time to make the Total cumulative time Cumulative average
units concerned to make all units so far time per unit
(hours)

01 10 10 10

02 8 18 9

03 7.386 25.386 8.462

04 7.014 32.4 8.1

In this example, wright's law is verified as the cumulative average decreases to 90% of the previous average
every time we double the cumulative output, such as from 1 to 2 or from 2 to 4 units. We therefore say that
the process demonstrates a 90% learning rate.

Hence, the total time for making the 8th unit of this product is derived as follows;

Step 1: Calculate the cumulative average time for the target production units (8)
Here, the cumulative average for the first 8 units = 8.100 × 90% = 7.29 hours per unit

Step 2: Calculate the total cumulative time for the first 8 units = 7.29 × 8 = 58.32 hours

Step 3: Time to make the next 4 units = the cumulative time to make 8 units in total - the cumulative time to
make 4 units in total.
Time to make the next 4 units = 58.32 - 32.4 = 25.920 hours.

Example 2.on tabular approach

The first unit of output of a certain new product requires 100 hours and an 80% learning curve
applies. Required; compute the total time of producing the 4th and 8th unit of this same product.

Solution:
 Units Cumulative average time per unit Cumulative total time for units
produced so far

1 100 100

2 80 160

4 64 256

8 51.2 409.6

The algebraic approach

The problem with tabular approach is that we cannot calculate averages for all levels of
production. For example, how would we go about calculating how long the fifth unit should take to make?
The learning curve table in the tabular approach is useful if output keeps doubling, but for intermediate output
levels we can obtain the information we need with the following formula;
y = axb
Whereby;
Y = cumulative average time per unit x =
cumulative output
A = time taken for 1st unit
B = a learning factor which is given from the formula log
r/log 2
R = learning rate expressed as a % or decimal.

Example.1 (Algebraic method)

Xyz has anticipated a 95% learning curve towards production of a new item. The 1st item will cost $ 2,000 in
materials, and will take 400 labour hours. The cost per labour is $ 5. Overheads are 50% of labour. Required;
compute the total cost for the first item and the first 8 items.

Solution;
Total cost for the first item;
Cumulative average time per unit
Y1 = 400
cumulative total time = 1* 400 = 400 hours
labor cost = 400*$5 = $ 2,000
Materials cost = $ 2,000
Overheads. = $ 1,000
Total $ 5,000

Total cost for the first 8 items;

but Y8 = 400*8^ (log0.95/log2)
= 400 * 0.8574
= 342.96 hours

And cumulative total time for 8 items = 342.96*8 = 2,743.68 hours

Labor cost = 2,743.68 *$5 = $ 13,718.4
Materials cost = $ 2,000
Overheads
(50% *$ 13,718.4) = $ 6,859.2
Total $ 22,577.6

Example .2 (Algebraic method)

The first unit of a new product is expected to take 100 hours. An 80% learning curve is known to apply.
Calculate;
a) The average time per unit for the first 16 units.
b) The average time per unit for the first 25 units
c) The time it takes to make the 20th unit.

Solution;
(a) a = 100 b = -0.3219 x = 16
Y16 = 100 × 16-0.3219
= 40.96 hours

(b) x = 25
Y25 = 100 × 25-0.3219
Y25 = 35.48 hours

(c)
X = 20
Y20 = 100 × 20-0.3219
Y20 = 38.12 hours

Cumulative total time for 20 units = 38.12 × 20 = 762.42

X = 19
Y19 = 100 × 19-0.3219 = 38.76 hours

Cumulative total time for 19 units = 38.76 × 19 = 736.35

Hence time it takes to make the 20th unit = cumulative total time for 20 units -cumulative total time for 19 units
= 762.42 - 736.35 = 26.07 hours

Example
Locus cars are a couple set up in london to build mass-produced sports cars. 5 skilled work men working a
standard 35 hour week will build these cars. Production has only just started but the workforces are keen to
learn so fast. The first prototype was built however; the time taken had not been recorded. The third unit
however did record that the average time for all units at this point was 11.36 hours. Based on previous
knowledge, management believes there is a 70% learning rate of the new workmen.
a) Calculate the time taken for the first prototype.
b) Calculate the total time taken for the 12th car only.
c) Calculate the total time for the 14th to the 15th car only
d) How many cars can locus build in the first 2 months assuming the learning effect ceases at 200 cars?
e) Locus cars have also built tractors in the past, and had built 8 of them. The first tractor took 17 hours of
labour time and the total time for the first 8 tractors was 100 hours. Calculate the learning curve to the
nearest 1%
Solution
a) calculate the time taken for the first prototype
Log 0.7/log 2 = -0.5146
11.36 hours = a × 3 ^ -0.5146
11.36 = a * 0.5682
A = 11.36/0.5682
A = 20 hours

b)
Method one:
Time for the first 12 units (20 * 12^-0.5146)*12
= 66.81 hours

Time for the first 11 units (20 * 11^-0.5146)*11

= 64.05 hours

So therefore time for the 12th unit = time for the first 12 units - time for the first 11 units
= 66.81 hours - 64.81 hours = 2.76 hours.

Method two:
Cumulative average unit time for 12 units
= 20 * 12^-0.5146 = 5.5678

Cumulative average unit time for 11 units

= 20 * 11^-0.5146 = 5.8228

Total time for 12 units = 12 * 5.5678 = 66.81

Total time for 11 units = 11 * 5.8228 = 64.05
So therefore time for the 12th unit = time for the first 12 units - time for the first 11 units
= 66.81 hours - 64.81 hours = 2.76 hours.

c)
Time for the first 15 units = (20 * 15^-0.5146) * 15 = 74.46 hours
Time for the first 13 units = (20 * 13^-0.5146) * 13 = 69.46 hours.
So therefore time for the 14th to 15th unit = the time for the first 15 units - time for the first 13 units = 74.46 -
69.46 = 5.00 hours.

d)
Time for the first 200 units = (20 * 200^-0.5146) * 200 = 261.8
Time for the first 199 units = (20 * 199^-0.5146) * 199 = 261.2
So time for the 200th unit = time for the first 200 units - time for the first 199 units = 261.8 - 261.2 = 0.6

Workmen work in 2 months ( 8 weeks * 5 men * 35 hours ) = 1,400 hours

The first 200 units take 261.8 hours as above.

1,400 hours - 261.8 hours = 1,138.2 hours remaining.

1,138.2 hours / 0.6 hours (time for the 200th unit & beyond) = 1,897 units.
Therefore, 200 units + 1,897 units = 2,097 cars built in the first 2 months.

e)
A = 17 hours, Y = 100 hours ÷ 8 tractors = 12.5 hours on average for 8 tractors.

If we assume that r represents the learning rate, then:

Tractors Average hours per

unit

1 17

2 17 * r

4 17 * r * r

8 17 * r * r * r

Therefore for 8 tractors:

17 r³ = 12.5

R³ = 12.5 / 17

R³ = 0.735294117

R = (0.735294117) ^⅓

R = 0.90

Therefore the learning rate is 90%

STEADY STATE
Eventually, the time per unit reaches a steady state where no further improvement can be made.

Cessation of learning effect

Practical reasons for the learning effect to cease are:
(a) When machine efficiency restricts any further improvement.
(b) The workforce reaches their physical limits.
(c) If there is a „go-slow‟ agreement among the workforce

Example .3
Pax ltd has just produced the first full batch of a new product taking 200 hours. Pax has a learning curve
effect of 85%.
a)How long will it take to produce the next 15 batches?
b)Pax expects that after the 30th batch has been produced, the learning effect will cease. From the 31st batch
onwards, each batch will take the same time as the 30th batch. What time per batch should be budgeted?

Relevance of learning curve in budgeting;

● The LC data can be used in projecting realistic production budgets.
● Preparation of realistic standard costs for cost control purposes.
● Computation of incremental costs to be incurred on extra units of output.
● Used in quoting profitable selling prices aimed at a given market share esp. With cost-plus pricing
technique.
● Facilitates budgetary control especially with labor variances
● Useful in cash flow projection/cash budgets.

Limitations of the learning curve;

● This is not always present in every time of an organization.

● Assumes stable conditions at work that can be affected by labor turnover.
● Long breaks or stopovers in between work can make workers forget so that learning begins afresh.
● Use of inaccurate data in estimating the learning rate.
● Production methods or product designs can change necessitating a change in the learning rate.
● Workforce can demand bonuses, in return for achieving time reductions as production increases or
doubles.

EXPECTED VALUES IN BUDGETING

These are useful in determining the best combination of expected profit and risk. It assigns probabilities to
different conditions so as to derive an EV of budgeted profit.

Importance of probabilistic budgets.

● Helps in assessing the risks associated with different types of budgets.

● Helps in resource allocation to products and services based on their respective expected values.

Illustration (expected values)

a) Rooqs ltd has recently developed a new product in a certain market niche of kafumbe mukasa area and is
planning a marketing strategy for it so as to slowly penetrate a wider common market in a reasonably short
time. A choice must be made as to whether the unit selling price should be set at ushs 5,500 or ushs 6,800.
Below are the estimated sales volumes for the planned product;

At a price of ushs 5,500 At a price of ushs 6,800

Sales units Probability Sales units Probability

2,000 0.1 8,000 0.1

3,000 0.6 1,600 0.3

4,000 0.3 2,000 0.3

4,000 0.3

More information to note;

● Advertising will cost ushs 8,500,000 at a price of ushs 5,500 and ushs 14,400,000 at a price of ushs
 6,800.
● Materials costs will be ushs 29,600 per unit.
● Labor and production overheads will be ushs 18,500 per unit.
● Period production costs will be ushs 40,600,000
● The management would like to allow for some risk of each pricing decision before choosing a selling
price of either ushs 5,500 or ushs 6,800.

Required; advise management of Rooqs ltd on which selling price to be selected if the co wishes to;
(a) Minimize the worst possible outcome of profit.
(b) Maximize the best possible outcome of profit.

Required; advise management on which selling price to be selected if the co wishes to;
(a) Minimize the worst possible outcome of profit.
(b) Maximize the best possible outcome of profit.

Solution;
At a price of ushs 5,500 At a price of ushs 6,800

Sales units Probability Expected sales Sales units Probability Expected sales
units units

2,000 0.1 200 8,000 0.1 800

3,000 0.6 1,800 1,600 0.3 480

4,000 0.3 1,200 2,000 0.3 1,200

4,000 0.3 600

Total expected sales units 3,200 3,080

To advise on the appropriate selling price to be taken, there is a need to compute expected profits for
each of these selling prices.

Particulars At a price of ushs At a price of ushs 6,800

5,500

Sales revenue 17,600,000 20,944,000

Advertising costs 8,500,000 14,400,000

Material costs ( unit cost*units ) 94,720,000 91,168,000

Labor and production ohs ( unit 59,200,000 56,980,000

cost * units )

Period production costs 40,600,000 40,600,000

Expected profits / loss -185,420,000 -182,204,000

Hence which selling price to be selected if the co wishes to;

(a) Minimize the worst possible outcome of profit; it would be the selling price of ushs 5,500 that is associated
with a higher expected loss of ushs 185,420,000 as can be seen from the table above.
(b) Maximize the best possible outcome of profit; here the selling price would be ushs 6,800 that is
associated with a lower expected loss of ushs 182,204,000 as per the table above.

Problems with expected values in budgeting

● It can be more time-consuming than preparing a single fixed budget.
● A probabilistic budget represents a weighted average of expectations and may therefore not reflect an
outcome that is actually expected to happen.
● They possess little practical value for purposes of planning and control hence costs of preparation may
exceed the benefits derived.

BEYOND BUDGETING (BB)

The whole concept of budgeting turns around the idea that the operation of an organisation can be
meaningfully planned for in some detail over an extended period into the future. Further, this plan can be used
to guide, control and coordinate the activities of numerous departments and individuals within the
organisation.

Hope and R Fraser (2000), beyond budgeting‟ (bb) is the generic name given to a body of
practices intended to replace budgeting as a management model. The core concept is the need to move from
a business model based on centralized organizational hierarchies to one based on devolved networks.
The modern economic environment is associated with a rapidly changing environment, flexible manufacturing,
short product life-cycles and products/services which are highly customized. The "lean business‟ and the
„virtual businesses'' are responses to this. Such businesses own limited assets of the traditional kind but
assemble resources as and when needed to meet customer demand. The keys to their operation are flexibility
and speed of response. They are able to move quickly to exploit opportunities as they arise and do not
operate according to elaborate business plans.
In an age of discontinuous change, unpredictable competition, and fickle customers, few companies can plan
ahead with any confidence - Yet most organizations remain locked into a "plan-make-and-sell‟ business
model that involves a protracted annual budgeting process based on negotiated targets and that assumes
that customers will buy what the co decides to make. Such assumptions are no longer valid in an age when
customers can switch loyalties at the click of a mouse.

Beyond budgeting is defined in CIMA's official terminology as 'the idea that companies need to move beyond
budgeting because of the inherent flaws in budgeting esp when used to set incentive contracts. It is argued
that a range of techniques, such as rolling forecasts and market related targets, can take the place of
traditional budgets.'
BB is intended to be an exercise in mobilizing competent managers, skilled workers and loyal customers.
However, traditional budgeting still has its defenders. Such defenders claim that while budgeting may be
associated with a „command and control‟ management style, it is the management style that is the problem
and not budgeting.

6 PRINCIPLES OF BEYOND BUDGETING.

Any bb implementation should incorporate the following six main principles;
★ An organisation structure with clear principles and boundaries; a manager should have no doubts over
what he/she is responsible for and what he/she has authority over; the concept of the internal market for
business units may be relevant here.
★ Managers should be given goals and targets which are based on relative success and linked to
shareholder value; such targets may be based on key performance indicators and benchmarks following
the balanced scorecard principle.
★ Managers should be given a high degree of freedom to make decisions; this freedom is consistent with
the total quality management and business process reengineering concepts; a bb organization chart
should be „flat‟.
★ Responsibility for decisions that generate value should be placed with „front line teams‟; again, this is
consistent with TQM and BPR concepts.
★ Front line teams should be made responsible for relationships with customers, associate businesses and
suppliers; direct communication between all the parties involved should be facilitated.
★ Information support systems should be transparent and ethical; an activity based accounting
system which reports on the activities for which managers and teams are responsible is likely to be of use
in this regard.

Benefits of beyond budgeting

All the cases studied are different, but the following general benefits for bb are claimed:
● Faster response time - operating within a flexible organizational network and with strategy as an „adaptive
process‟ allows managers to respond quickly to customer requests.
● Better innovation - managers working within an environment wherein performance is judged on the basis
of team and business unit results encourages the adoption of new innovations. Relations with customers
and suppliers through SCM may facilitate the adoption of new working methods and technologies.
● Lower costs - in the context of bb, managers are more likely to perceive costs as scarce resources which
have to be used effectively than as a budget „entitlement‟ that has to be used. Bb is also likely to promote
an awareness of the purposes for which costs are being incurred and thereby the potential for reductions.
● Improved customer and supplier loyalty - the leading role of front line teams in dealing with customers and
suppliers is likely to deepen the relevant relationships.

TOPIC 3. DECISION MAKING TECHNIQUES

RELEVANT COST ANALYSIS.

DECISION -MAKING;

This refers to a process of estimating the consequences of alternative actions that the decision maker can
take.
A relevant cost; is a future cash flow arising as a direct consequence of a decision.

Relevant costs for short-term special decisions:

Decision making: refers to a process of evaluating two or more alternatives leading to a final choice which is
known as alternative choice decision. This is a fundamental exercise of management in the managerial
process. It's concerned with the future and involves a choice between alternatives. Successful decision
making involves the following steps:

● Problem identification.
 ● Identification of objectives.
● Search for alternative courses of action.
● Gathering data about the alternatives.
● Evaluation and selection of a course of action.
● Implementing the decision.
● Monitoring the results to ensure that the desired values are achieved.

1. Identification of the problem:

To make a decision, you must first identify the problem you need to solve or the question you need to answer.
Clearly define your decision. If you misidentify the problem to solve, or if the problem you’ve chosen is too
broad, you’ll knock the decision train off the track before it even leaves the station. If you need to achieve a
specific goal from your decision, make it measurable and timely.
2. Identification of objectives
Once you have identified your decision, it’s time to gather the information relevant to that choice. Do an
internal assessment, seeing where your organization has succeeded and failed in areas related to your
decision. Also, seek information from external sources, including studies, market research, and, in some
cases, evaluation from paid consultants.
3. Search for alternative course of action.
With relevant information now available, identify possible solutions to your problem. There is usually more
than one option to consider when trying to meet a goal. For example, if your co is trying to gain more
engagement on social media, your alternatives could include paid social advertisements, a change in your
organic social media strategy, or a combination of the two.
4. Gathering data about the alternatives
Once you have identified multiple alternatives, weigh the evidence for or against said alternatives. See what
companies have done in the past to succeed in these areas, and take a good look at your organization’s own
wins and losses. Identify potential pitfalls for each of your alternatives, and weigh those against the possible
rewards.
5. Evaluation and selection of a course of action
Here is the part of the decision-making process where you actually make the decision. Hopefully, you’ve
identified and clarified what decision needs to be made, gathered all relevant information, and developed and
considered the potential paths to take. You should be prepared to choose.
6. Implementing the decision
Once you’ve made your decision, act on it! Develop a plan to make your decision tangible and achievable.
Develop a project plan related to your decision, and then assign tasks to your team.

7. Monitoring the results to ensure that the desired results are achieved
After a predetermined amount of time which you defined in step one of the decision-making process, take an
honest look back at your decision. Did you solve the problem? Did you answer the question? Did you meet
your goals? If so, take note of what worked for future reference. If not, learn from your mistakes as you begin
the decision-making process again.

Fundamental features of relevant cost;

❖ It’s a cash flow; only cash flow information is required for decision- making. This excludes items like
depreciation, bad debts, and notional costs.
❖ It’s a future cost; these must be forward looking based on expected factor prices for the planning
period. This therefore excludes past costs, sunk costs and committed costs as
irrelevant costs.
❖ Differential costs/revenues; these differ among decision alternatives. These can include both
incremental and opportunity costs.
❖ Opportunity cost; this is a benefit foregone by choosing one option instead of the next best
other.
❖ Incremental cost; these are avoidable or escapable costs which are incurred only when the activity is
extended beyond its present range. Hence variable costs are incremental costs.

Summary of relevant costs for some cost elements

Cost element Relevant cost Irrelevant cost

Materials ● Current replacement

cost/purchase cost.
● Current resale value.
● Opportunity cost i.e. when put
to alternative use.

Labor ● Replacement cost

● Incremental cost.
● Hiring cost.
● Lost contribution from labor
transfer

Overheads ● Directly attributable OHS ● Fixed OHS

● Cash overheads ● General OHS

Note

● Irrelevant costs are costs that won't be affected by a managerial decision.

● Relevant costs are costs that will be affected by a managerial decision.
● Irrelevant costs are those that will not change in the future when one decision is made versus another.
● Examples of irrelevant costs are sunk costs, committed costs, or overheads as these cannot be avoided.
● It can be noted that fixed costs are often irrelevant because these cannot be altered in any given
situation
● Sunk costs are expenditures which have already been incurred; committed costs are future costs which
cannot be altered; non-cash expenses like depreciation and amortization; and overheads like general
and administrative overheads are all examples of irrelevant costs.
● Examples of relevant costs include; future cash flows (cash expenses which will be incurred in the
future); avoidable costs (those costs which can be avoided in a certain decision); opportunity costs
(cash inflows which would have to be sacrificed); incremental costs (those incremental or differential
costs related to the different alternatives).

Example one; the managing director of parser ltd, a small business, is considering undertaking a one off
contract and has asked her inexperienced accountant to advise on what costs are likely to be incurred so that
she can price at a profit. The following schedule has been prepared:
Costs for special order:

Notes $

Direct wages 1 28,500

Supervisor costs 2 11,500

General overheads 3 4,000

Machine depreciation 4 2,300

Machine overheads 5 18,000

Materials 6 34,000

98,300

Notes:
1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this
job, who could be transferred from another department to undertake work on the special order. They
are fully occupied in their usual department and sub-contracting staff would have to be bought-in to
undertake the work left behind. Subcontracting costs would be $32,000 for the period of the work.
Different subcontractors who are skilled in the special order techniques are available to work on the
special order and their costs would amount to $31,300.

2. A supervisor would have to work on the special order. The cost of $11,500 is comprised of $8,000
normal payments plus $3,500 additional bonus for working on the special order. Normal payments
refer to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in
his normal work amounting to $2,500. It is not anticipated that any replacement costs relating to the
supervisor’s work on other jobs would arise.

3. General overheads comprise an apportionment of $3,000 plus an estimate of $1,000 incremental

overheads.

4. Machine depreciation represents the normal period cost based on the duration of the contract. It is
anticipated that $500 will be incurred in additional machine maintenance costs.

5. Machine overheads (for running costs such as electricity) are charged at $3 per hour. It is estimated
that 6000 hours will be needed for the special order. The machine has 4000 hours available
 capacity. The further 2000 hours required will mean an existing job is taken off the machine resulting
in a lost contribution of $2 per hour.

6. Materials represent the purchase costs of 7,500 kg bought some time ago. The materials are no longer
used and are unlikely to be wanted in the future except on the special order. The complete inventory of
materials (amounting to 10,000 kg), or part thereof, could be sold for $4.20 per kg. The replacement
cost of material used would be $33,375. Because the business does not have adequate funds to
finance the special order, a bank overdraft amounting to $20,000 would be required for the project
duration of three months. The overdraft would be repaid at the end of the period. The bank‟s overdraft
rate is 18%. The managing director has heard that, for special orders such as this, relevant costing
should be used that also incorporates opportunity costs. She has approached you to create a revised
costing schedule based on relevant costing principles.

Required; adjust the schedule prepared by the accountant to a relevant cost basis, incorporating appropriate
opportunity costs.

Solution
Notes $
Subcontractor costs 1 31,300
Supervisor costs 2 1,000
General overheads 3 1,000
Machine maintenance 4 500
Machine overheads 5 22,000
Materials 6 31,500
Interest costs 7 900
Total 88,200

Notes to the above figures;

1. The choice lies between the two subcontractor costs that have to be employed because of the
shortage of existing labour. The minimum cost is to have subcontractors employed who are
skilled in the special process.
2. Only the difference between the bonus and the incentive payment represents an additional cost
that arises due to the special order. Fixed salary costs do not change.
3. Only incremental costs are relevant.
4. Depreciation is a period cost and is not related to the special order. Additional maintenance costs
are relevant.
5. The relevant costs are the variable overheads ($3 × 6000 hours) that will be incurred, plus the dis
placement costs of $2 × 2000 hours making a total of $22,000.
6. Since the materials are no longer used the replacement cost is irrelevant. The historic cost of
$34,000 is a sunk cost. The relevant cost is the lost sale value of the inventory used in the special
order which is: 7,500 kg × $4.20 per kg = $31,500.
7. Full opportunity costing will also allow for imputed interest costs on the incremental loan. The
correct interest rate is the overdraft rate since this represents the incremental cost the company
will pay. Simple interest charges for three months are therefore: (3/12) × $20,000 × 18% =
$900.

LIMITING FACTOR ANALYSIS

Limiting factor : this is a resource in limited SS that can stop the organization from maximizing benefit from
a given production plan.
Such limited resources must be used to maximize output.

NOTE:
In case of one limiting factor, products have to be ranked in order of their contribution per
limiting factor. Such priority is given to products with a higher contribution per unit down wards.

What is a limiting factor and how can we solve limiting factor

questions?
A limiting factor is any resource that is in scarce ss. It's also known
as a key factor.
When a co. manufactures more than one product, a problem is faced by the management as to which product
mix (product composition) will give the maximum profits. If there is demand for all the products that can be
produced, the co may at times find it difficult to meet the needs of the customers especially if demand is in
excess of its productive capacity.

The level output of the co. May be restricted by shortage of resources known as limiting factors. A limiting
factor is an element that restricts the output and the profit potential earning capacity of the firm. Limiting
factors could be shortage of labour, materials, equipment or factory space.

The contribution approach to limiting factors:

In making the product mix decision, the following steps are followed:

● Determine the contribution per product.(i.e. Unit selling price - variable cost )
● Determine the contribution per limiting factor. This gives the measure of profitability for a unit of a limiting
factor. This can be calculated using the formula:

Contribution per limiting factor = unit contribution ÷units of scarce resources to make complete unit

● Rank the products by contribution per limiting factor by assigning one to the product with highest
contribution per limiting factor and in that order.
● Produce to full satisfaction of each product following the ranking order until the limiting factor units are
used up.

Example:

A company produces three products and is reviewing the production and sales budgets for the next
accounting period.

The following information is available for the three products:

Oranges Passion fruits Apples

Unit selling price 200 150 800

Variable cost per unit 140 70 600

Fertilizers per unit in ¼ ½ 2

kgs
 Estimated sales 500 units 10,000 units 600 units
Demand

Amount of fertilizers is limited to 1,700 kilograms for the period and is insufficient to meet total sales demand

Required:

(a) Determine the product mix a co can produce and sell in order to maximize returns during the period.
(b) Total contribution to be gained and lost because of the optimum mix selected.

Solution

a)

Oranges Passion fruits Apples

Selling price per unit 200 150 800

Variable cost per unit (140) (70) (600)

Contribution per 60 80 200

unit

Fertilizers per ¼ ½ 2
unit(kgs)

Contribution per 240 160 100

limiting factor

Rank 1st 2nd 3rd

Amount of fertilizers needed to meet the demand.

Product Units Fertilizers per unit(kgs) Total kilograms of

fertilizers

Orange 500 ¼ 125

Passion fruits 10,000 ½ 500

Apples 600 2 1,200

Total 1,825

Product Units Fertilizer required Fertilizers available

 Oranges 500 125 1575(1,700-125)

Passion fruits 10,000 500 1075(1,700-500-125)

Apples 538(k) 1075

600 units = 1,200kgs

k units = 1075kgs

Rule of cross multiplication:

1,200k = 1075 × 600

k = 538

Note: the co should produce 500 units of oranges, 10,000 units of passion fruits, and 538 units of apples.

b) total contribution gain

Product Units produced Unit contribution margin Total contribution

Oranges 500 60 30,000

Passion fruits 10,000 80 800,000

Apples 538 200 107,600

Totals 937,600

Contribution lost = units not produced (i.e. 600 - 538) * unit contribution margin

Contribution lost = 62 * 200/=

Contribution lost = shs 12,400

Example

The following data has been prepared for a co that manufactures three products.

Product A B C

Maximum demand 20,000 units 15,000 units 18,000 units

Sales price $40 $39 $53

 Material 2 kg at $5 per kg 2.4 kg at $5 per kg 1.6 kg at $5 per kg

Labour 2 hours at $10 per hour 1.5 hours at $10 per hour 1.8 hours at $10 per hour.

Total fixed costs = $ 150,000

Maximum available materials = 106,000 kg

Maximum available labour hours = 80,000 hours.

Required: Calculate the optimum production plan and the maximum profit using limiting factor analysis.

Solution

Step one: We need to establish which of the resources, if any, is scarce. To this end, we calculate the total amount of
materials and labor hours needed.

Total amount of materials needed:

= (20,000 * 2) + (15,000 * 2.4) + (18,000 * 1.6)

= 104,800 kgs.

Total labour hours needed:

= (20,000 * 2) + (15,000 * 1.5) + (18,000 * 1.8)

= 94,900 hours.

As we have 106,000 kg of materials available, materials are not a scarce resource.

But the required labour hours (94,900 hours) are more than the available labour hours (80,000) so labour hours is a
limiting factor.

Step two: we find the contribution per labour hours for each product and then we rank products in the order of
contribution earned per labour hours:

Product A B C

Sales price $40 $39 $53

Materials ( 2 * $5 ) = $10 ( 2.4 * $5 ) = $12 ( 1.6 * $5 ) = $8

 Labour hours ( 2 * $10 )=$20 ( 1.5 *$10) = $15 ( 1.8 *$10) = $18

Contribution ( a ) $ 10 $ 12 $ 27

Labour hours per unit

(b) 2 1.5 1.8

Contribution per labour $ 15

hours ( a ÷ b ) $5 $8

Rank 3 2 1

Why do we rank the products in such an order?

It is because our aim or objective is to maximize contribution. So in order to achieve our aim, we must first
produce the product that earns the greatest contribution per hour. In our example, that is product c.

Total hours needed to produce the product c are : ( 18,000 * 1.8 ) = 32,400 hours.

Now we have 47,600 hours ( 80,000 - 32,400 ) left. So this means that we have enough labour hours to
manufacture all units of the product b, which will take another 22,500 hours ( 15,000 * 1.5 )

The remaining hours are 25,100 (47,600 - 22,500 ) , so we can produce just 12,550 units of product a (
25,100 ÷ 2 )

So our optimum product mix is 12,550 units of a, 15,000 units of b and 18,000 units of c. Now we can find the
maximum profit by calculating total contribution and deducting fixed cost.

Total contribution

= ( 12,550 * $10 ) +( 15,000 * $12 ) + ( 18,000 * $27 )

= $ 791,500

Maximum profit

= $ 791,500 - $ 150,000

= $ 641,500

Example three

If a company makes 2 products i.e. P & Q and their corresponding cost data is as below;
Cost element P Q

Direct materials 1 3

Direct labour 6 3

Variable overheads 1 1
Moreso;
The selling price per of p & q is $14 and $ 11 resp. Also during this month, the d.l.hs available are only
8,000

The sales demand is anticipated as P = 3000 units and Q = 5,000 units.

Required; draft a production budget that maximizes profit on assumption that period costs are $ 20,000.

Example four: Lax manufactures and sells 3 products X, Y and Z with the following budgeted information.

Product X Y Z

Sales demand 550 500 400

S.P.U 16 18 14

V.Cs

Materials 8 6 2

Labour 4 6 9

Additional information;
● The organization has existing inventory of 250 units of x and 200 units of z that can be used to
meet sales demand.
● It has been also anticipated that ss of materials will be restricted to $4,800and ss of labour to $6,600.

Required; determine the product mix and sales that would maximize the organizations profits in that period.

LINEAR PROGRAMMING (FOR A SITUATION OF TWO LIMITING FACTORS)

In this chapter we will look at the situation where there is more than one limited resource, and a technique
known as linear programming is applied. If there are two or more scarce resources then we are unable to
use the key factor approach. Instead, we use linear programming (using the graphical method or
simultaneous equations)

The steps are as follows;

● Define the unknowns in terms of symbols

● Formulate equations for the constraints
● Formulate an equation for theobjective
● Graph the constraints and the objective
● Find the optimum solution.

SPARE CAPACITY/SLACK
In the previous example, there were limits on the resources available. However, there was no
requirement to use all of the resources - only that we could not use more than the maximum
 available.

● If the optimum solution results in using less than the maximum available of a particular
resource, then we have spare capacity of that resource or slack.
● A slack occurs when maximum availability of a resource or other constraining factor is not used ie if at
the optimal solution, the amount of resource used is less than the amount of the resource available,
then a slack is said to have arisen. It occurs when the maximum availability of a resource or other
factor is not used.

Surplus; this occurs when more than a minimum requirement is used . It is the excess over the minimum
amount of a constraint. It is normally where the constraint is more or equal to constraint.

Shadow prices

In real life there are unlikely to be any truly limited resources - it will almost always be possible to get more,
but we are likely to have to pay a premium for it. For example, the SS of labour may be limited by the length of
the normal working week, but we can get more hours if we are prepared to pay overtime.

Definition
● It is the increase in value which would be created by having one additional unit of the limiting
factor at its original cost.
● The shadow price (also known as the dual price) of a limited resource is the most extra that we
would be prepared to pay for one extra unit of the limited resource. We calculate it by calculating
the extra profit that would result if we have one extra unit of the limited resource.

Example five;
Peter makes two types of chairs - the ‘executive’ and the ‘standard’.
The data relating to each is as follows:

Standard Executive

Materials 2 kg 4 kg

Labour 5 hours 6 hours

Contribution $6 $9

There is a maximum of 80 kg of material available each week and 180 labour hours per week. Demand for
‘standard’ chairs is unlimited, but maximum weekly demand for ‘executive’ chairs is 10.

Required;
(a) Find the optimal production plan and the maximum contribution that this will generate.
(b) Calculate the slack for each of the constraints i.e. for materials, for labour, and for demand for ‘executive’
chairs.
(c) Calculate the shadow price of each of the constraints i.e. for materials, for labour, and for demand for
 ‘executive’ chairs.

Example six
A machine shop makes boxes (b) and tins (t). Contribution per box is $5 and $7. Each box requires 3 hours
of processing time , 16kg of raw materials and 6 labour hours. Each tin on the other hand requires 10 hours
of processing time, 4kg of raw materials and 6 labour hours. In a given month, 330 hours of processing time
have been availed, 400kg of raw materials and 240 labour hours. The manufacturing technology used means
that at least 12 tins must be made per month. It has also targeted to maximize contribution for that month by
obtaining $12 from each box and $8 from each tin.
Required;
a) Derive the objective and constraints functions for the above manufacturing set-up.
b) The optimal number of boxes and tins for that month.
c) Determine any available slacks for processing time, raw materials, labour, and tins produced for that
month.
d) Compute the shadow price for labour.

PRICING DECISIONS
Price; this refers to a value attached to something i.e. A product or service at a specified time.

It is the quantity of payment or compensation given by one party to another in return for one unit of goods or
services. A price is influenced by production costs, ss of the desired item, and demand for the
product/service.

Pricing; pricing is a process of fixing the value that a manufacturer/seller will receive in the exchange of
services and goods. The pricing depends on the Co’s average prices, and the buyer’s perceived value of an
item, as compared to the perceived value of competitors’ product.

Every business person starts a business with a motive and intention of earning profits. This ambition can be
acquired by the pricing method of a firm. While fixing the cost of a product and services the following points
should be considered.

● The identity of the goods and services.

● The cost of similar goods and services in the market.
● The target audience for whom the goods and services are produced.
● The total cost of production (raw material, labor cost, machinery cost, transit, inventory cost etc).
● External elements like government rules and regulations, policies, economy, etc.

Objectives of pricing

• Revenue & profit maximization; usually the objective of any business is to maximize the profit. During the
short run, a firm can earn maximum profit by charging high prices. However, during the long run, a firm
reduces price per unit to capture a bigger share of the market and hence earn high profits through
increased sales.
• Obtaining market share leadership; if the firm’s objective is to obtain a big market share, it keeps the price
per unit low so that there is an increase in sales.
• Surviving in a competitive market; the objective of pricing for any company is to fix a price that is
reasonable for the consumers and also for the producer to survive in the market. Every company is in
danger of getting ruled out from the market because of rigorous competition, change in customer’s
 preferences and taste. Therefore, while determining the cost of a product all the variable and fixed costs
should be taken into consideration. Once the survival phase is over the company can strive for extra
profits.
• Attaining product quality leadership; generally, firm charges higher prices to cover high quality and high
cost if it’s backed by above objective.
• Ruling the market; firms impose low figures for the goods and services to get hold of large market size.
The technique helps to increase the sale by increasing the demand and leading to low production cost.
• Markets for an innovative idea; here, the company charges a high price for their product and services that
are highly innovative and use cutting-edge technology. The price is high because of the high production
cost. Mobile phone, electronic gadgets are a few examples.

Factors to consider in fixation of a selling price

● Costs; these give a basis for the profit component to be charged. An important factor which is kept in
mind while fixing the price is the cost of the product or service. The price of the product must be able to
cover the total cost of the product. Total cost means fixed cost and variable cost. Fixed costs are fixed
irrespective of production level for example; rent of the factory, cost of machinery, etc. while a variable
cost varies with production e.g. Cost of raw materials, wages of labour etc.

● Competitors (the extent of competition in the market). When a firm doesn't face any competition then it
cannot enjoy complete freedom in fixing the price. But when competition is more than price is fixed
keeping in mind the price of competitor's product for example; pepsi co cannot fix the price of its drinks
without considering the price of coke and other cold drinks available in the market.

● Customers demand and utility; when demand of the product is inelastic i.e. no or less substitutes are
available then the co. Can fix up a high price. While when demand is elastic i.e. more substitutes are
available then the price has to be brought down.

● The bargaining power of customers in the target market.

● Price sensitivity; is the measurement of how the price of goods and services affects customer's
willingness to buy them. This would help determine the amount of value that one creates in his or her
product in a way of revealing the customer's willingness to pay.

● Price perception. This refers to the value of money (monetary) and the sacrifice (non-monetary) given by
customers to get a product.

● Quality; good quality products are always associated with high prices while the poor quality products are
always associated with low prices.

● More factors include the following; intermediaries; suppliers, inflation, level/trend of incomes, product
range, and ethics etc.
PRICING METHODS /APPROACHES.

The pricing methods are divided into three parts.

A) Cost oriented/based pricing methods

It is the basis for evaluating the price of the finished goods, and most of the companies apply this method to
calculate the price of the product. This method is divided further into the following ways.

Cost-plus pricing; in this pricing, the manufacturer calculates the cost of production sustained and includes a
fixed percentage (also known as markup) to obtain the selling price. The mark up of profit is evaluated on the
total cost (fixed and variable cost).

1. Full cost plus;

Full cost includes a share of overheads and also often includes nonproduction costs like administration,
selling and distribution.

Advantages include;
-It’s a logical approach that seeks to ensure an organization makes a profit.
-It's quick, simple and cheap that can be delegated to lower level managers. -
-The profit mark-up added ensures that fc for the period are covered.

Disadvantages
-Ignores the effect of demand and other market conditions on the level of prprice
-Could be affected by over or under absorption of overheads causing too low or too high costs.

2. Marginal cost plus pricing;

This involves adding a profit mark-up to the marginal costs of a product. It draws attention to gross profit and
GP margin. It’s normally a profit maximizing price.

3. Opportunity cost pricing; here prices are based on the costs arising from undertaking alternative courses
of action in terms of products & services to deal in.

Advantages of cost plus pricing approaches;

-Widely used and acceptable.
-Simple & easy to calculate if costs are known.
-May encourage price stability – if all competitors have similar cost structures and use similar mark-up.
-selling price decisions can be delegated to management.

Disadvantages of cost-plus pricing

● Ignores the economic relationship between price and demand
● Different absorption methods give rise to different costs and hence different selling prices.
● Does not guarantee profit-if sales volumes are low fixed costs may not be recovered.
● This structured method fails to recognize the manager’s need for flexibility in pricing

4. Target-return pricing; here the company or a firm fixes the cost of the product to achieve the rate of return
on investment (RRR).

Example one;
A new product is being launched, and the following costs have been estimated;

Materials Ugx 35,000 per unit

Labour Ugx 28,000 per unit
Variable overheads Ugx 17,500 per unit
Fixed overheads Ugx 175,000,000 per year
Production 10,000 units per year.
Required; calculate the selling price based on;
a) Full cost plus 20%
Solution;
Full costs = MC + LC + VOHS + FOHS = 35,000 + 28,000 + 17,500+ (175,000,000/10,000) =
98,000 +20% (98,000) = 98,000 + 19,600 = 117,600

Therefore selling price is ugx 117,600 per unit.

(b) Marginal cost plus 40%

Marginal/variable cost plus = MC + LC + VOHS
= 35,000+28,000+17,500 = 80,500 + 40 %( 80,500)
=112,700
Therefore selling price is given as ugx 112,700 per unit

B) Market-oriented pricing methods: under this category, the price is determined on the basis of market
demand. They include the following;

a) Price skimming method.

Involves charging high prices when a product is first launched in order to maximize short-term profitability.
Initially high prices may be charged to take advantage of the newness appeal of a new product when demand
is initially inelastic. Once the market becomes saturated the price can be reduced to attract that part of the
market that has not been exploited.

Conditions suitable for a market-skimming strategy

1. Where products have a short life cycle, and there is a need to recover their developments costs quickly
and make a profit.
2. Where the strength of demand and the sensitivity of demand to price are unknown. From a psychological
point of view it is far better to begin with a high price, which can then be lowered if the demand for the
product appears to be more price sensitive than at first thought.
3. A firm with liquidity problems may use market-skimming in order to generate high cash flows earlier.

NB; with high prices being charged potential competitors will be tempted to enter the market. For skimming to
be sustained one or more significant barriers to entry must be present to deter these potential competitors.
For example, patent protection, strong brand loyalty.

Discussion question; suggest products and services that may be priced using a market-skimming strategy?
B) Penetration pricing method
Penetration pricing is the charging of low prices when a new product is initially launched in order to gain rapid
acceptance of the product. Once market share is achieved, prices are increased. It is an alternative to market
skimming when launching a new product.

Circumstances which favor a penetration policy

i. If the firm wishes to increase market share.
ii. A firm wishes to discourage new entrants from entering the market.
iii. If there are significant economies of scale to be achieved from high volume output, and so a quick
penetration into the market is desirable.
iv. If demand is highly elastic and so would respond well to low prices

C) Price-discrimination method
A price-discrimination strategy is where a company sells the same product or services at different prices in
different markets, for reasons not associated with costs.

Conditions required for a price discrimination strategy

i. The seller must have some degree of monopoly power, or the price will be driven down. Customers
can be segregated into different markets. Customers cannot buy at the lower price in one market and
sell at the higher price in the other market.
ii. Price discrimination strategies are particularly effective for services.
iii. There must be different price elasticity of demand in each market so that prices can be raised in one
and lowered in the other to increase revenue.

Dangers of price-discrimination as a strategy

i. A black market may develop allowing those in a lower priced segment to resell to those in a higher
priced segment.
ii. Competitors join the market and undercut the firm's prices.
iii. Customers in the higher priced brackets look for alternatives and demand becomes more elastic over
time. Others may include;

Perceived-value pricing- in this method, the producer establishes the cost taking into consideration the
customer’s approach towards the goods and services, including other elements such as product quality,
advertisement, promotion, distribution, etc. That impacts the customer’s point of view.

Value pricing- here, the company produces a product that is high in quality but low in price.

Going-rate pricing- in this method, the company reviews the competitor’s rate as a foundation in deciding the
rate of their product. Usually, the cost of the product will be more or less the same as the competition.

Auction type pricing-

With more usage of the internet, this contemporary pricing method is blooming day by day. Many online
platforms like OLX, quicker, EBay, etc. Use online sites to buy and sell the product to the customer.
Differential pricing- this method is applied when the pricing has to be different for different groups or
customers. Here, the pricing might differ according to the region, area, product, time etc.

DEMAND BASED PRICING METHODS

This is based on the price function and also the cost function.

The price function

It is given as; p = a – bQ where;
P = selling price
Q = quantity demanded at a specified price
a = theoretical maximum price (.i.e. If the price is set at ‘a’ or above, then the demand will be zero)
b = the change in price required to change demand by 1 unit (the gradient of the line)

Example two
A company sells an article at $12 per unit and has a demand of 16,000 units at this price. If the selling price
were to be increased by $1 per unit, it is estimated that demand will fall by 2,500 units. Required; on the
assumption that the price/demand relationship is linear, derive the equation relating the selling price to the
demand.

Example three
A company currently has a demand for one of its products of 2000 units at a selling price of ugx 30 per unit. It
has been determined that a reduction in selling price of ugx 1 will result in additional sales of 100 units. The
costs of production are ugx 1000 (fixed) together with a variable cost of ugx 20 per unit.
Required; calculate the selling price per unit at which the profit will be maximized.

OPTIMAL SELLING PRICE

This is the price that maximizes profit. It is at a point where MC = MR.

Example. A company sells an article at $12 per unit and has a demand of 16,000 units at this price. If the
selling price were to be increased by $1 per unit, it is estimated that demand will fall by 2,500 units.

Required; on the assumption that the price/demand relationship is linear, derive the equation relating the
selling price to the demand.

Example: the demand schedule for abc co is given below.

Price( $) Quantity demanded(piece)

1.00 200

1.50 150

2.00 100

2.50 50

Based on the schedule, answer the following questions:

1. Draw a demand curve for ABC
2. Derive a demand function for ABC.
Solution for (2)
Q = a + bp
Step one: find the slope 'b'
B = change in Q ÷ change in price
B = Q1 – Q 0 ÷ P1 – P0
B = ( 150 - 200 ) / ( 1.50 - 1.00)
B = -100

Step 2: find 'a'

Q = a + (-100)p
Choose any level of price and amount ( q )
Q = a - 100p
150 = a - 100 (1.50)
150 = a - 150
A = 150 + 150
A = 300

Therefore the demand function for ABC is

Q = 300 - 100p

Example:
A company currently has a demand for one of its products of 2000 units at a selling price of ugx 30 per unit. It
has been determined that a reduction in selling price of ugx 1 will result in additional sales of 100 units. The
costs of production are ugx 1000 (fixed) together with a variable cost of ugx 20 per unit.
Required; calculate the selling price per unit at which the profit will be maximized.

Example
A certain division of ABC limited sells a single product. Fixed costs for the period are shs 700,000 and
variable shs 70 per unit. The current selling price for the product is shs 160 and at this price they normally sell
10,000 units as demanded. The management has been able to establish over time that for each successive
increase in price by shs 2, annual demand will fall by 500 units. Required; calculate the optimal output and
price for the product assuming that if prices are set within each shs 2 there will be a proportionate change in
demand.

RISK AND UNCERTAINTY IN DECISION MAKING

Risk; this is said to exist where a decision maker has knowledge that several possible outcomes are possible
- usually due to past experience of similar circumstances. This past experience enables the decision maker to
estimate the probability or the likely occurrence of each potential future outcome.
Uncertainty; exists when the future is unknown and the decision maker has no past
Experience on which to base predictions. Due to insufficient information, there are no probability estimates for
the different possible outcomes.
NB; the approach taken to make a decision will normally depend on the decision-makers attitude to
risk/ risk preference i.e.
● A risk seeker (optimist); will be interested in the best possible outcome, no matter how small the
change that they may occur. They try to make decisions that balance risk and return.

● A risk neutral; will be concerned with the most likely or „average‟ outcome.

● A risk avoider (pessimist); makes decisions on the basis of the worst possible outcomes that may
occur. This takes a decision that limits or minimizes the risk.

The decision rules;

● Maxi-min rule; here a decision maker selects the alternative that offers the least unattractive worst
outcomes i.e. The alternative that maximizes the minimum profits/outcome. This rule is
defensive and conservative since it avoids the worst outcomes without taking into account opportunities
for maximizing profits.

Maximin (pessimist): the maximin person looks at the worst that could happen under each action and
then chooses the action with the largest payoff. These assume that the worst that can happen, and then
take the action with the best worst case scenario. The maximum of the minimums or the "best of the
worst". This is the person who puts their money into a savings account because they could lose money at
the stock market.

● Maxi maxi rule; this looks at the best possible results i.e. Maximize the maximum profits. Aims at the
option that could provide the maximum outcome. This rule ignores the outcomes that are less than the
best possible outcome. It’s a decision for risk seekers.

● Minimax regret rule; this aims at minimizing the regret from making the wrong decision. A regret is an
opportunity lost by making a wrong decision. It involves measuring the amount of the regret for each
decision option. I.e. Regret for each decision option = profit from the best decision option - profit from the
decision option undertaken given the outcome e circumstances or situation. It is the amount by which the
profits are worse than if the best decision option had been taken. These are normally recorded in a payoff
table such as below:

Project profit (return) in dollars

Season A B C

Rainy 200 120 95

Windy 120 150 85

Sunshine 90 100 130

The regret (opportunity loss) table would be as below;

Project choice (return) in dollars

 Season A B C

Rainy 0 30 35

Windy 80 0 45

Sunshine 110 50 0

From the above table, the maximum regrets include $ 110 for a, $ 50 for b, and $ 45 for c.
Hence choose c with the lowest maximum regret of $ 45

● Expected values; this is a weighted average value of different possible outcomes from a given
decision and such weightings are based on probability on the basis of historical experience of such
similar circumstances. They are normally used to support a risk-neutral attitude that normally ignores
any variability in the range of possible outcomes but focuses on EV of outcomes.
NB: the EV decision will be that decision option with the highest EV of benefit or lowest EV of cost.

Limitations of expected values;

● EV is a weighted average outcome that will occur in the long run if events occur many times over. It is
a long run average.
● The EV of a given decision can be a value that will never occur.
● Since it's an average value, it ignores the extreme outcomes.
● The expected value is not usually ‘expected‟.
● The expected value gives no indication of the risk.
● The estimation of the probabilities is very unreliable.
Example
A) Michael sells lunches and snacks in a cafeteria. The lunch menu is freshly prepared each
morning and he has to decide how many meals to SS each day. As the office block is located in
the city centre, there are several other places situated around the building where staff can buy
their lunch, so the level of demand for lunches in the cafeteria is highly uncertain. Michael has
analyzed daily sales over the previous six months and established four possible demand levels
and their associated probabilities. He has produced the following payoff table to show the daily
profits which could be earned from the lunch sales in the cafeteria.

Demand level Probability SS level SS level ( SS level ( SS Level

( snacks ) (snacks ) snacks) snacks ) snacks
450 ( shs) 620 ( shs ) 775 ( shs ) 960 ( shs )

450 0.15 1,170,000 980,000 810,000 740,000

620 0.3 1,170,000 1,612,000 1,395,000 1,290,000

775 0.4 1,170,000 1,612,000 2,015,000 1,785,000

960 0.15 1,170,000 1,612,000 2,015,000 2,496,000

Required: advise Michael on which SS level to focus using the following decision criterion;
1) max-min
2) Expected value.
3) max-max
4) Mini-max regret.
Solution
1) max-min
Minimum or the lowest payoff at the ss level of :
450 snacks = shs 1,170,000
620 snacks = shs 980,000
775 snacks = shs 810,000
960 snacks = shs 740,000
Therefore, i advise Michael to focus on the SS level of 960 snacks since it gives the minimum
payoff.

2) expected values
Expected value at SS of:
450 snacks
= (1,170,000*0.15) + (1,170,000 * 0.3) + (1,170,000 * 0.4) + (1,170,000 * 0.15 )
= shs 1,170,000

620 snacks
= (980,000 * 0.15) + (1,612,000 * 0.85)
= shs 1,517,200.

775 snacks
=( 810,000 * 0.15 )+ ( 1,395,000 * 0.3 ) + ( 2,015,000 * 0.55 )
= shs 1,648,250

960 snacks
=( 740,000 * 0.15 )+ ( 1,290,000 * 0.3 ) + ( 1,785,000 * 0.4) + ( 2,496,000 * 0.15 )
= shs.1,586,400

Advise: he should SS 775 snacks since it has the highest EV of benefit

3)max-max rule:
We choose the maximum or highest pay-offs at SS level of:
450 snacks = shs 1,170,000
620 snacks = shs 1,612,000
775 snacks = shs 2,015,000
960 snacks = shs 2,496,000
Advise: choose a SS level of 960 snacks because these are associated with the maximum or
the highest pay-off.

4) mini-max regret rule

Step one: we come up with the regret matrix table as shown below:

Demand level SS level

450 620 775 960

450 0 190,000 360,000 430,000

620 442,000 0 217,000 322,000

775 845,000 403,000 0 230,000

960 1,326,000 884,000 481,000 0

Step two: we spot out the highest maximum regrets as shown below:
450 snacks = shs 1,326,000
620 snacks = shs 884,000
775 snacks = shs 481,000
960 snacks = shs 430,000

Step three: we now select the SS level with the lowest maximum regret.
In this case, i advise Michael to focus on the SS of 960 snacks since it has the lowest maximum
regret.

Note: the minimax regret always takes the form of a diagonal regret matrix.
(b) Upet co ltd ( UCL ) sells a certain garment at Ushs 45,000 per pack and has a demand of
300,000 packs at this price under usual business circumstances. If the selling price was to be
increased by shs 1, the customer demand would fall by 200 packs. On the assumption that a
linear price/demand relationship exists between the demand and price of this garment, derive a
price function for this garment.

Example
The makindan co has estimated that the demand for one of its products is either 100, 200 or
300 units a month. The production sold for $ 15 per item and the total variable costs amount to
$ 7 per item. If demand is less than supply, the product may be sold off cheaply for $ 5 per item.
There is no penalty cost for not meeting demand.
a) A payoff matrix to represent the above information concisely.
b) Determine what demand should be satisfied under each of the following decision rules;
expected value if the probabilities are 0.3, 0.5, and 0.2 for demand of 100,200, and 300
items respectively; maxi-mim, maxi-maxi; and; minimax regret.

Solution
Selling price per item = $ 15
Variable cost per item= $ 7

Selling price per item $ 15

Less : variable cost per item ($7)

Contribution per item $8

Rules as per the question

(a) DD < SS = we sell at $ 5

Price when DD < SS $5

Less: variable cost per item ($7)

Lost contribution per item $2

Note: that the $ 2 is for the excess SS

So therefore:
For DD > SS, we sell $ 8 per item which is the excess DD and the lost contribution is $ 0

For DD = SS, we sell at $ 8 per item which is perfect because what is demanded is consumed.

(a)Pay-off matrix

Demand SS
 100 200 300

100 800 ( w1 ) 600 ( w4 ) 400 ( w7 )

200 800 ( w2 ) 1, 600 ( w5 ) 1,400 ( w8 )

300 800 ( w3 ) 1,600 ( w6 ) 2,400 ( w9 )

W1
DD = 100 & SS = 100, so DD = SS
Payoff = $ 8 * 100 = $ 800

W2
DD = 200 & SS = 100, so DD > SS
We have an excess of 200 units that doesn't affect the SS side.
Payoff = $ 8 * 100 = 800

W3
DD = 300 & SS = 100, so DD > SS
We have an excess of 200 units that doesn't affect the supply side.
Payoff = $ 8 * 100 = $ 800

W4
DD = 100 & SS = 200, so DD < SS
We have an excess supply of 100 units which affects the demand side.
Payoff = ($ 8 * 100) - ($ 2 * 100)
Payoff = $ 600

W5
DD = 200 & SS = 200, so DD = SS
We have no excess in SS & no excess in dd.
Payoff = ($ 8 * 200) = $ 1,600

W6
DD = 300 & SS = 200, so DD > SS
Payoff = ($ 8 * 200) = $ 1,600

W7
DD = 100, & SS = 200, so DD < SS. Excess SS of 200 units
Payoff = ($ 8 * 100) - ($ 2 * 200)
Payoff = $ 800 - $ 400
Payoff = $ 400

W8
DD = 200 & SS = 300, DD < SS
Excess of 100 units
Payoff = ($ 8 * 200) - ($ 2 * 100)
Payoff = $ 1,600 - $ 200
Payoff = $ 1,400
W9
DD = 300 & SS = 300
So which means DD = SS
Payoff = $ 8 * 300
Payoff = $ 2,400

B)
Prob. Demand. Supply
100. 200. 300

0.3. 100. 800. 600. 400

0.5. 200. 800 1,600 1,400

0.2. 300. 800. 1,600. 2,400

Expected value at SS level

100 units = $ 800 * 1 = 800

200 units = ( $ 600 * 0.3 )+( $ 1,600 * 0.7 )

= $ 1,300

300 units = ($ 400 * 0.3) + ($ 1,400 * 0.5) +

($ 2,400 * 0.2) = $ 1,300

Using the expected value criteria choose either 200 units or 300 units to ss since both have the
highest expected value.

Max min
We determine the minimum pay-offs at demand of:
100 units = $ 400
200 units = $ 800
300 units = $ 800

The decision maker would choose either 200 units or 300 units since both have the minimum
pay-offs.

Max-max
We choose the maximum pay-offs at the demand of:
100 items = $ 800
200 items = $ 1,600
300 items = $ 2,400

The decision maker would choose 300 items since it's associated with the maximum payoff of $
2,400.
Example:
John has a factory capacity of 1,200 units per month. Units cost him $ 6 each to make and his
normal selling price is $ 11 each. However, the demand per month is uncertain and is as
follows:

Demand Probability

400 0.2

500 0.3

700 0.4

900 0.1

He has been approached by a customer who is prepared to contract to a fixed quantity per month at a
price of $9 per unit. The customer is prepared to sign a contract to purchase 300, 500, 700 or 800 units
per month. The co can vary production levels during the month up to the maximum capacity, but cannot
carry forward any unsold units in inventory.

(a) Calculate all possible profits that could result

(b) Determine for what quantity john should sign the contract, under each of the following criteria:
I) expected value
ii) maximin
Iii) maximax
Iv) minimax regret
(c) What is the most that john would be prepared to pay in order to obtain perfect
information as to the level of demand?

VALUE OF PERFECT AND IMPERFECT INFORMATION

Perfect information; is that information that can predict the future 100% accurately. This gets rid of all
uncertainty from a given decision and normally leads to the best decision option.

Imperfect information; it’s that information that can’t predict the future reliably and it's normally better
than no information.

Value of information; this is the difference between the EV of a decision if no information is available and EV
of a decision if information is available.

Value of perfect information; this is the difference between the EV of profit with perfect information
and the EV of profit without perfect information.
Value of imperfect information; this is the difference between the EV of profit with imperfect
information and the EV of profit without the information.

The value of information is calculated based on its EV.

Illustration; XML plc is faced with a decision of the level at which to market its new product “lilix”. This
product can be sold nationally, within a single region or single area. This decision is complicated by
uncertainty about the general strength of consumer demand for the product and the conditional profit table
has been constructed and availed;

Market level Weak demand (ugx 000 Moderate demand ( ugx Strong demand ( ugx
) 000 ) 000 )

Nationally (14,000) 7,000 35,000

One region 0 12,250 14,000

One area 3,500 5,250 7,000

Probability 0.3 0.5 0.2

Required;
i. What is the best market level for marketing the lilix product?
ii. What is the value of perfect information about the state of demand?

DECISION TREE ANALYSIS

A decision tree is a diagrammatic representation of the various alternatives and outcomes. It is relevant
when using an expected value approach and where there are several decisions to be made - it makes the
approach more understandable.

It involves roll back analysis that evaluates the EV of each decision option from right to left. They are
useful means of analyzing a given probability problem.

Decision tree analysis involves visually outlining the potential outcomes, costs, and consequences of a
complex decision. These trees are particularly helpful for analyzing quantitative data and making a decision
based on numbers.

Example;
Fairlooks ltd, a manufacturing plant of cosmetics, is faced with a decision regarding whether or not to
expand and build small or large premises at a prime location. Small premises would cost 300 million while
large premises would cost 500 million to build.
The co segments its market according to low, medium and high demand levels. The chance of
experiencing a low demand level is 25%, medium 40% and high 35%.
Below is the estimated income for each demand level in shs million;

Premises Low demand Medium demand High demand

Small 456 585 262

Large 215 525 855

The managing director has suggested that the co should hire the leading market research firm in uganda to
provide the most reliable estimates of demand levels. This firm normally charges shs 90 million for such an
assignment. Required;
a) Using decision tree analysis, advise the co whether it should hire the market research firm.
b) Explain the concept of “value of perfect information”

Another example;
Combi plc is having problems with one of their offices and has decided that there are three courses of
action available to them:
★ Shut down the office, raising proceeds of $5 million
★ Have an expensive refurbishment of the office costing $4,000,000
★ Have a cheaper refurbishment of the office at a cost of $2,000,000
If they do the expensive refurbishment, then a good result will yield a return of $13,500,000 whereas a
poor result will yield a present value of only $6,500,000.

If they alternatively decide to do the cheaper refurbishment, then a good result will yield a return of
$8,500,000 whereas a poor result will yield $4,000,000.

In either case, the probability of the refurbishment achieving a good result has been estimated to be 2/3.

An independent company has offered to undertake market research for them in order to identify in advance
whether the result of refurbishment is likely to be good or poor. The research will cost $200,000 and there is
a 68% probability that it will indicate a good result. Unfortunately, the research cannot be guaranteed to be
accurate. However, if the research indicates a good result, then the probability of the actual result being good
is 91%.

If the survey indicates a poor result, then the probability of the actual result being good is 13%. Combi has
already decided that if they do have market research, and if the research indicates a poor result, then they
will only be prepared to consider the cheaper refurbishment.

Required; use a decision tree to recommend what actions should be taken.

Solution (to be given in class)

RESEARCH / QUALITATIVE TECHNIQUES TO REDUCE UNCERTAINTY IN DECISION

MAKING.

This is normally focused on customer habits, attitudes or intentions in the market.

Market research; this involves gathering, analyzing, and reporting data about markets so as to investigate,
describe, measure and explain a given situation facing a co. Specifically helps;
● Understanding the needs and opinions of customers and other stakeholders.
● Managerial information for further competitive advantage.
● To reduce risk and uncertainty and monitor performance of products and services in those specific
markets.

Focus groups; this is used to obtain views and opinions from a small group of individuals about a given
product and service. These avail qualitative data about customer attitudes.
● They are normally used in early stages of product development.
● The members of the group are based on similar demographics, lifestyles, buying attitudes, income levels
etc.
● They are normally part of the target market of a given product.
● Such groups also reduce uncertainty by providing information which influences decisions about designing
and marketing a product.

Other methods of analyzing uncertainty in decisions can include;

Simulation models; used in a situation of a large number of uncertain variables in a given situation. Involves
use of random numbers to assign values to the uncertain variables. It’s a computer based modeling used in
inventory, queuing, scheduling and forecasting problems.

Sensitivity analysis; this measures the effect of changes in the estimated value of a key factor on a given
future outcome. Here decision options are tested for their vulnerability to changes in any variable like sales
volume, price, material cost or labour cost.

Note: the above models use spreadsheets as a computerized package for checking for the effect changes in
variables on the overall co performance.

TOPIC 4:

PERFORMANCE MEASUREMENT AND CONTROL

Definition:
Performance measurement is generally defined as regular evaluation of outcomes and results, which
generates reliable data on the effectiveness and efficiency of programs /targets /objectives.
If you want people to work towards several objectives, then you need to measure their performance in terms
of achieving those objectives. This is because people act in accordance with the way their actions are
measured.
NB: The calculation of a particular indicator of performance will probably mean very little, unless it is set in
some context of comparison. Establishing the value of a particular indicator will add little benefit until it is;
● Compared with a budget
● Set in a trend
● And / or set against a best practice benchmark within a given industry.
Financial performance measurement and ratio analysis
A key aspect of performance measurement is ratio analysis. Specific ratios are discussed below but some
general considerations need to be taken into account with all ratio analysis;
● Many ratios use figures at a particular point in time and thus may not be representative of the position
throughout a period. For example, seasonal trade or large one-off items may make year-end figures
uncharacteristic.
● Ratios are of little use in isolation. Comparisons could be made to last year’s figures to identify trends or
competitors’ results and/or industry averages to assess performance.
● Ratios can be manipulated by management. A well known example of ‘window dressing’ is to issue
spurious invoices before the year end and then issue credit notes just after.

Ideal features of a good performance measure.

● Availability of resources; i.e. People, equipment and time to collect and analyze information. Weigh costs
and benefits of producing performance indicators.
● Set objectives; these enable comparison with actual performance. This is then followed by identifying
key/critical factors to success of these objectives.
● Relevant i.e. Measures must reflect what actually the company does.
● Appropriateness; i.e.to the organizational level to which it is at which it is used
● Timeliness; the sooner the results of measurements are available for use, the better they will serve their
control purpose. This calls for delegation of some decisions to operational levels.
● Understandability; the most effective measures are those that are easy to comprehend and direct such as
percentages rather than use of indices of performance.
● Level of achievements; short-term measures are valuable but may limit an organization from long-term
opportunities.
● Fair; i.e. Free from bias and errors
● A variety/range /different perspectives of measuring performance. E.g. In a balanced scorecard.
● Cost effectiveness; the cost implementing the measure should not be prohibitive of the benefits.

The performance measures;

These take financial/quantitative and non- financial/qualitative performance measures.

Performance indicator Possible performance measure

Profitability ROI, RI, NPM, GPM, cost reductions etc.
Market share Percentage share, units sold, changes in revenue,
Innovation New products, investments in new processes,
Customer satisfaction Customer surveys, customer retention, complaints.

The financial measures may include;

Under this financial statements are prepared to assist users in making decisions. They therefore need
interpreting, and the calculation of various ratios makes it easier to compare the state of a company with
previous years and with other companies. Common ratios may include G.P, N.P, ROCE, gearing, quick acid
test ratios) etc.
The detailed areas of analysis may include;

● Profitability ratios; explain how well a company performs given its assets base.
Gross profit margin = gross profit x 100%
Turnover
This ratio shows the profit earning capacity of the business and its ability to pay salaries, interest and
dividends.
Net profit margin = ((profit before interest & taxation (operating profit) ÷ turnover)) x 100%

The ratio shows what can be paid as dividends and reinvested for business growth.

Return on capital employed (ROCE/ROI) =

Profit before interest & taxation x 100%
capital employed (net assets)

Where capital employed = total assets less current liabilities or total equity plus long term debt.
ROCE is sometimes calculated using operating profit (profit before finance charges and tax) instead of net
profit. If net profit is not given in the question, use operating profit instead.
A high ROCE is desirable. An increase in ROCE could be achieved by; increasing net profit, e.g. through an
increase in sales price or through better control of costs.
Reducing capital employed, e.g. through the repayment of long term debt.
This ratio shows the return on capital in the business and can be compared with the returns from other
investments. It is useful where there are several investments.

Asset turnover = turnover x 100%

Capital employed
It measures management’s efficiency in generating revenue from the net assets at its disposal.
Capital employed = shareholders’ funds plus ‘creditors amounts falling due after more than one year’ plus
long term provisions for liabilities and charges i.e. equity + loans.

● Liquidity ratios; explain the short-term financial position of a company i.e. ability of an entity to pay its
short term debts and meet unexpected cash needs.

Current ratio = current assets

Current liabilities
The ratio shows the ability of an entity to pay its current liabilities using its current assets.

Quick/acid test ratio = current assets less stock

Current liabilities
This ratio provides an acid test of whether the firm has sufficient resources to settle its liabilities.

Inventory days = average inventory x 365 days

Cost of sales
The ratio shows how many days’ worth of sales are tied up in stock.

Receivables days = average debtors x 365 days

Credit sales
The ratio shows how quickly or slowly the business is collecting its debts from customers.

Payables days = average creditors x 365 days

Purchases
The ratio shows how long the business is taking to pay its suppliers.

● Gearing/ leverage ratios; explain the long-term financial position of a company. They indicate the degree
of financial risk attached to the company, and the sensitivity of earnings and dividends to changes in
profitability and activity level.
Debt: equity ratio = prior charge capital (long term debt).
Long term debt + equity (shareholders’ funds)

Interest cover ratio = profit before interest & taxation

Interest
The ratio shows the ability of a business to pay interest out of its profits generated. Interest cover of less than
two is usually considered unsatisfactory.

● Investor ratios; focus on how well investors will appraise the company. These are measures of returns to
shareholders on their investment in the business.
- Eps (earnings per share) = earnings (profit) available for distribution to equity holders.
Number of shares in issue
This shows the profit earned per share in the period.

- P/e ratio = market price per share

EPS
- DPS(dividend per share) = dividends/ number of shares

Bases for comparison

Most measures mean little on their own, and are only really useful when compared with something. Any
comparison is likely to be with one of the following:
● Previous years for the same company.
● Other similar companies.
● Industry average.

Illustration one;
(In pdf)

Illustration two
Jump has a network of sports clubs which is managed by local managers reporting to the main board. The
local managers have a lot of autonomy and are able to vary employment contracts with staff and offer
discounts for membership fees and personal training sessions. They also control their own maintenance
budget but don’t have control over large amounts of capital expenditure.
A local manager’s performance and bonus is assessed relative to three targets. For every one of these three
targets that is reached in an individual quarter, $400 is added to the manager’s bonus which is paid at year
end. The maximum bonus that can be earned is $4,800(12*$400) that represents 40% of the basic salary of a
local manager. Jump co has a 31 march year end.
The performance data for one of the sports clubs for the last four quarters is as follows;
Qtr to 30 June Qtr to 30 sept 2018 Qtr to 30 Dec 2018 Qtr to 31 mar
2018 2019
No. Of members 3,000 3,200 3,300 3,400
Member visits 20,000 24,000 26,000 24,000
Personal training sessions 310 325 310 339
booked.
Staff days 450 480 470 480
Staff lateness days 20 28 28 20
Days in quarter 90 90 90 90
Agreed targets are;
1. Staff must be on time over 95% of the time (no penalty is made when staff are absent from work).
2. On average 60% of members must use the club’s facilities regularly by visiting at least 12 times per
quarter.
3. On average 10% of members must book a personal training session each quarter.
Required;
a) Calculate the amount of bonus that the manager should expect to be paid for the latest financial year.
b) Discuss to what extent the targets set are controllable by the local manager (argue based on set
targets).
c) Describe two methods as to how a manager with access to the accounting and other records could
un-ethically manipulate the situations so as to gain a greater bonus.

Illustration three
Jungle co is a very successful multinational retail company. It has been selling a large range of household and
electronic goods for some years. One year ago, it began using new suppliers from the country of Yemen,
where labor is very cheap, for many of its household goods. In 2015, jungle co also became a major provider
of ‘cloud computing’ services, investing heavily in cloud technology. These services provide customers with a
way of storing and accessing data and programs over the internet rather than on their computers’ hard drives.
All jungle co customers have the option to sign up for the company’s ‘gold’ membership service, which
provides next day delivery on all orders, in return for an annual service fee of ugx 4000. In September 2016,
jungle co formed its own logistics company and took over the delivery of all of its parcels, instead of using the
services of international delivery companies. Over the last year, there has been worldwide growth in the
electronic goods market of 20%. Average growth rates and gross profit margins for cloud computing service
providers have been 50% and 80% respectively in the last year. Jungle Co’s prices have remained stable
year on year for all sectors of its business, with price competitiveness being crucial to its continuing success
as the leading global electronic retailer.
The following information is available for jungle co for the last two financial years;
Notes 30/June/2017(ugx 000’s) 30/June/2016(ugx 000’s)
Revenue 1 94,660 82,320
Cost of sales 2 (54,531) (51,708)
Gross profit 40,129 30,612
Administration expenses 3 (2,760) (1,720)
Distribution expenses (13,420) (13,180)
Other operating expenses (140) (110)
Net profit 23,809 15,602

Notes;
1. Breakdown of revenue
30/June/2017(ugx 000’s) 30/June/2016(ugx 000’s)
Household goods 38,990 41,160
Electronic goods 41,870 32,640
Cloud computing services 12,400 6,520
Gold membership fees 1,400 2,000
94,660 82,320

2. Breakdown of cost of sales

30/June/2017(ugx 000’s) 30/June/2016(ugx 000’s)
Household goods 23,394 28,812
Electronic goods 26,797 21,216
Cloud computing services 4,240 1,580
Gold membership fess 100 100
54,531 51,708

3. Administration expenses included in these costs are the costs of running the customer service department
(ugx 860,000 in 2016 and ugx 1,900,000 in 2017.) This department deals with customer complaints.

4. Non-financial data
30/June/2017(ugx 000’s) 30/June/2016(ugx 000’s)
Percentage of orders delivered on time 74% 92%
Number of customer complaints 1,400,000 320,000
Number of customers 7,100,000 6,500,000
Percentage of late gold member 14% 2%
deliveries

Required: discuss the financial and non-financial performance of jungle co for the year ending 30 june, 2017.

Benefits of performance measures

i. Clarifying the objectives of the organization.
ii. Developing agreed measures of activity
iii. Greater understanding of the processes.
iv. Facilitating comparison of performance in different organizations.
v. Facilitating the selling of targets for the organization and its managers.
vi. Promotion of accountability of the organization to its shareholders.

Problems of performance measures

i. Tunnel vision. In due focus on performance measures to the detriment of other areas.
ii. Management myopia – short-sightedness leading to neglect of long-term objectives.
iii. Misrepresentation. Creative reporting to support that the measure is acceptable whereas not.
iv. Misinterpretation. Failure to recognize the complexity of the environment in which the organization
operates.
v. Ossification. Unwillingness to change the performance measure scheme once it has been set up.

How to cope up with the use of performance measures.

The issue is to acknowledge that imperfections will exist in any scheme.
● Involve staff at all levels to the development and implementation of the scheme.
● Be flexible in the use of performance measures. It’s best to acknowledge that they should but be
relied on exclusively for control.
● Keep the performance measurement system under review and this should help to overcome the
ossification and gaining problems
● Audit the system
● Seek expert interpretation
● Maintain careful audit of the data used.
Non-financial performance measures
Fitzgerald and moon building blocks model
Fitzgerald and moon focused on performance measurement in service businesses. They suggested the
following areas needing measures of performance.
Dimensions of performance; these are the aspects of performance that are measured. They include;
● Financial performance i.e. Profitability, sales growth, ROI, cash flow, etc.
● Competitive performance i.e. Sales growth, proportion of contracts won, customer assessment/feedback,
and market share.
● Quality i.e. rejects/reworks, customer complaints/feedback, claims for compensation, peer review
assessments.
● Flexibility i.e. spare capacity, time order to delivery, set up time, % of work declined.
● Resource utilization i.e. idle time, machine utilization and wastage.
● Innovation i.e. new products brought to market, r & d spend.

Standards
Once the measures for the dimensions of performance have been selected, then the second thing is to set the
standards or targets of performance.
● Individuals should own the standards and be responsible for them.
● Realistic and achievable.
● Fair and equitable for all managers.
Rewards;
This refers to the structure of the rewards system, and how individuals will be rewarded for the successful
achievement of performance targets.
● Clear
● Improve performance/motivation.
● Suitable/equitable to work done.
● Made according to control levels.

The balanced scorecard. (4 perspectives)

A balanced scorecard is a performance metric used in strategic management to identify and improve various
internal functions of a business and their resulting external outcomes. It is used to measure and provide
feedback to organizations. The information gathered using a balanced scorecard is interpreted by managers
and executives, and used to make better decisions for the organization.
The balanced scorecard (developed by Kaplan and Norton 1992) views the business from four perspectives
and aims to establish goals for each together with measures which can be used to evaluate whether these
goals have been achieved.
The balanced scorecard is used to attain objectives, measurements, initiatives and goals that result from
these four primary functions of a business. With the balanced scorecard, they look at the company as a whole
when viewing company objectives.

Perspective Assessment question Possible measures

Customer perspective What do existing and potential % sales from new customers
customers value from us?
% on time deliveries
% orders from enquiries
customers survey analysis

Internal business perspective What process must we excel at to Unit cost analysis
achieve our customer and Efficiency
financial objectives? Value analysis
 Process/cycle time

Learning and growth How can we continue to improve Number of new products
and create future value? introduced
Time to market for new products.

Financial persp’ How do we create value for our Profitability

shareholders? Sales growth
ROI
Cash flow/liquidity

External considerations in performance measurement

Performance measures provide useful information to management which aid in the control of the business.
However, they need to be considered in the context of the environment external to the business to gain a full
understanding of how the business has performed and to develop actions which should be taken to improve
performance. External considerations which are particularly important are;
● Stakeholders – a stakeholder is any individual or group that has an interest in the business and may
include: shareholder, employees’ loan providers, government, community, customers, environmental
groups. Stakeholders will have different objectives and companies may deal with this by having a range of
performance measures to assess the achievement of these objectives.
● Market conditions – these will impact business performance. For example, a downturn in the industry or in
the economy as a whole could have a negative impact on performance.
● Competitors – the actions of competitors must also be considered. For example, company demand may
decrease if a competitor reduces its prices or launches a successful advertising campaign.

Divisional performance measurement

Introduction
In this sub topic we will consider the situation where an organization is divisionalized (or decentralized) and
the importance of proper performance measurement in this situation.
We will also consider the possible problems that can result from the use of certain standard performance
measures.

The meaning of divisionalization

Divisionalisation is the situation where managers of business areas are given a degree of autonomy over
decision making i.e. they are given the authority to make decisions without reference to senior management
of the entire company. In effect they are allowed to run their part of the business almost as though it were
their own company.
Type of division Description Typical performance measures
Cost center Division incurs costs Total cost and cost per unit
But has no revenue • Cost variances.
Stream, e.g. The IT support• NFPIS related to quality,
department of an organization. Productivity & efficiency
Profit center Division has both costs andAll of the above plus:
revenue. • total sales and market share.
• manager does not have the • Profit.
 authority to alter the level of • Sales variances.
Investment in the division • working capital ratios
(depending on the division
Concerned).
• NFPIS e.g. Related to
Productivity, quality and
Customer satisfaction
Investment center Division has both costs andAll of the above plus:
revenue. ROI AND RI.
• manager does have the authorityThese measures are used to assess
to invest in new assets or dispose ofthe investment decisions made by
existing ones Managers and are discussed in
More detail below.

NB; for each of these care must be taken to assess managers on controllable factors only. So for example,
the manager of a cost center should only be assessed on controllable costs.
Associated advantages of divisionalisation include the following;
● Specialism in product/country/customer
● Greater motivation for managers
● Allows divisions to be profit centres (motivating and promotes efficiency)
● Allows performances between divisions to be compared
● Clearer objectives for managers (concentrate on one area of the business only)u sually accompanied
by decentralization, so potentially better decisions.

Associated problems of divisionalisation may also include;

● Co-ordination difficulties.
● Requires transfer prices to be established
● Lack of goal congruence/dysfunctional decision-making
● Difficulties in ‘fair’ comparison of divisions.
● Potential duplication of some services.

THE USE OF ROI AND RI AS PERFORMANCE MEASURES

Return on investment (ROI)

ROI is defined as: controllable division profit expressed as a percentage of divisional investment/ capital
employed. It is equivalent to return on capital employed and this is one of the reasons that it is very popular in
practice as a divisional performance measure as it can be easily identified from the SOCIS and SOFP.
Evaluation of ROI as a performance measure
ROI is a popular measure for divisional performance but has some serious failings which must be considered
when interpreting results.
The benefits include;
● Its relative measure and thus enables comparisons to be made with divisions or companies of different
sizes.
● It’s used externally and is well understood by users of accounts
● ROI forces managers to make use of existing capital resources and focuses attention on them particularly
when funds for further investment are linked.
● It encourages reduction in the level of assets such as obsolete equipment and excessive working capital.
● It can be broken down into secondary ratios for more detailed analysis, i.e. Profit margin and asset
turnover
The setbacks of ROI may include;
● Disincentive to investment. The division manager will not wish to make an adequate return as far as the
overall company is concerned if it reduces the division current return on investment.
● By the same logic, existing assets may be sold by doing so ROI is improved.
● ROCE improves with aging of fixed assets.
● Corporate objectives of maximum total shareholder’s wealth are not achieved by making decisions on the
basis of ROCE.

Illustration four
An investment center has reported a profit of $28,000. It has the following assets and liabilities.

Non-current assets (at NBV) 100,000

Inventory 20,000
Trade receivables 30,000
Trade payables 80,000

Required: calculate the ROI for the division. State any additional information that would be useful when
calculating the ROI.
Illustration .five
Xyz plc has divisions throughout the Baltic States. The vents division is currently making a profit of $82,000
p.a. On investment of $500,000. Xyz has a target return of 15%. The manager of vents is considering a new
investment which will require additional investment of $100,000 and will generate additional profit of $17,000
p.a.
Required;
(a) Calculate whether or not the new investment is attractive to the company as a whole.
(b) Calculate the ROI of the division, with and without the new investment and hence determine
Whether or not the manager would decide to accept the new investment.
Illustration .six
Nielsen ltd has two divisions with the following information;
Division p Q
Profit 90,000 10,000
Capital employed 300,000 100,000
ROI 30% 10%
Division p has been offered a project costing $100,000 and giving annual returns of $20,000. Division q has
been offered a project costing $100,000 and giving annual returns of $12,000. The company’s cost of capital
is 15%. Divisional performance is judged on roi and ri and the roi related bonus is sufficiently high to influence
the managers’ behavior.

Required:
• What decisions will be made by management if they act in the best interests of their division (and in the
best interests of their bonus)
• What should the managers do if they act in the best interests of the company as a whole?

RESIDUAL INCOME (RI)

Instead of using a percentage measure, as with ROI, the residual income approach assesses the
Manager on absolute profit/loss which leads to more goal congruent decisions. However, in order to take
account of the capital investment, notional (or imputed, or ‘assumed’) interest is deducted from the P&L figure.
The balance remaining is known as the residual income. (note that the interest charge is only notional, and is
only made for performance measurement purposes).
NB: notional interest can be the cost of capital employed, current cost of borrowing, or a target ROI.
It is a measure of the center’s profits after deducting a notional or imputed interest.

Illustration seven
Mponya ltd operates two divisions A and B. Given that the controllable profits for division a and b are
ugx.1,000,000 and ugx 3,500,000 respectively. The availed investment for A and B is ugx 5,000,000 and ugx
20, 000,000 for A and B respectively. The company’s target ROI is 10%.
Required: compute each division’s residual income and comment on their respective performance.

Illustration eight.
Braaks co is split into two divisions, A and B, each with their own cost and revenue streams. Each of the
divisions is managed by a divisional manager who has the power to make all investment decisions within the
division. The cost of capital for both divisions is 12%. Historically, investment decisions have been made by
calculating the return on investment (ROI) of any opportunities and at present, the return on investment of
each division is 16%. A new manager who has recently been appointed in division A has argued that using
residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the
company.
Each division is currently considering the following separate investments:
Project for division .A project for division .B
Capital required for investment $82·8 million $40·6 million
Sales generated by investment $44·6 million $21·8 million
Net profit margin 28% 33%
Required: calculate both the ROI and RI of the new investment for each of the two divisions and comment on
these results, taking into consideration the manager’s views about residual income.
Illustration nine; two divisions of a company are considering new investments.

Division X Y
Net assets Shs.10,000,000 Shs.10,000,000
Current divisional profit Shs. 2,500,000 Shs. 1,200,000
Investment in the project Shs. 1,000,000 Shs. 1,000,000
Projected project profit Shs. 200,000 Shs. 150,000
The required company’s ROI is 18%
Task; assess the above projects using both ROI and RI

Advantages of RI
1. It reduces the problem of under investing or failing to accept projects with ROI’s greater than the group
target but less than the division current ROI.
2. It is more consistent with the objective of maximizing the total profitability of the group.
3. It is possible to use different rates of interest for different types of assets.
4. The cost of financing a division is brought home to divisional managers.
Disadvantages of RI
● It suffers from conflict with NPV
● It suffers from profit and asset measurement problems
● Difficulty in comparison of companies with different sizes.
● It’s not widely used.

Other methods of comparing divisional performance

Divisional performance can be compared in many ways. ROI and RI are common methods but other methods
could be used.
● Variance analysis – is a standard means of monitoring and controlling performance. Care must be taken
in identifying the controllability of, and responsibility for, each variance.
● Ratio analysis – there are several profitability and liquidity measures that can be applied to divisional
performance reports.
● Other management ratios – this could include measures such as sales per employee or square foot as
well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per
chargeable hour.
● Other information – such as staff turnover, market share, new customers gained, innovative products or
services developed.

TRANSFER PRICING
Introduction
In a previous chapter we looked at divisionalisation. When a company is divisionalised it is very common to
have the situation where one division supplies goods or services to another division.
If we are measuring the performance of each division separately then it becomes important that divisions are
able to charge each other for goods or services supplied.
In this chapter we will explain the importance of this, and also the importance of divisions charging each other
‘sensible’ transfer prices.

What is a transfer price?

The transfer price is the price that one division charges another division of the same company for goods or
services supplied from one to the other. It is an internal charge – the ‘sale’ of one division is the ‘purchase’ of
the other. Although it will be reflected in the results for each division individually, there is no effect in the
accounts of the company as a whole.
The transfer price merely apportions the company profits between divisions to reflect their individual
contribution to company profit/loss.
It can be from one member to another of the same group of companies.
For example subsidiary a might make a component that is used as part of a product made by subsidiary b of
the same company but can also be sold to the external market including makers of rival products to subsidiary
b’s products. This creates two sources of revenue;

a. External sales revenue from sales made to other organizations.

b. Internal sales revenue from sales made to other responsibility centers within the same organization
valued at the transfer price.

Transfer price is the price charged by one division for goods and services supplied to another division.
Objectives of a transfer pricing system
 Goal congruence
The decisions made by each profit centre manager should be consistent with the objectives of the
organization as a whole, i.e. the transfer price should assist in maximizing overall company profits. A
common feature of exam questions is that a transfer price is set that results in sub-optimal behavior.
 Performance measurement
The buying and selling divisions will be treated as profit centres. The transfer price should allow the
performance of each division to be assessed fairly. Divisional managers will be demotivated if this is not
achieved.
 Autonomy
The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If
autonomy is maintained, managers tend to be more highly motivated but sub-optimal decisions may be
made.
 Recording the movement of goods and services
In practice, an extremely important function of the transfer pricing system is simply to assist in recording
the movement of goods and services.

Ideally transfer prices should

● Be perceived as fair to both divisions and therefore good for performance measurement and
management.
● Provide profits for both divisions because profits are motivating
● Promote goal congruence so that divisions volunteer to do what is good for the group
● Promote autonomy i.e. Minimize head office interference.

Setting the transfer price

There are two main methods available;
Method 1: market based approach
If an external market exists for the transferred goods then the transfer price could be set at the prevailing
external market price.
Advantages of this method
The transfer price should be deemed to be fair by the managers of the buying and selling divisions. The
selling division will receive the same amount for any internal or external sales. The buying division will pay the
same for goods if they buy them internally or externally.
The company's performance will not be impacted negatively by the transfer price because the transfer price is
the same as the external

Disadvantages of this method;

There may not be an external market price.
• The external market price may not be stable. For example, discounts may be offered to certain customers
or for bulk orders.
• Savings may be made from transferring the goods internally. For example, delivery costs will be saved.
These savings should ideally be deducted from the external market price before a transfer price is set,
giving an "adjusted market price".
Method 2: Cost based approach
The transferring division would supply the goods at cost plus a % profit. A standard cost should be used
rather than the actual cost since:
● Actual costs do not encourage the selling division to control costs.
● If a standard cost is used, the buying division will know the cost in advance and can therefore put plans in
place.
There are a number of different standard costs that could be used;
● Full cost
● Marginal (variable) cost
● Opportunity cost.

Illustration;
Division a produces goods and transfers them to division b which packs and sells them to outside customers.
Division a has costs of $10 per unit, and division b has additional costs of $4 p.u.. Division b sells the goods to
external customers at a price of $20 p.u. Assuming a transfer price between the divisions of $12 p.u.
Calculate:
(a) The total profit p.u. Made by the company overall
(b) The profit p.u. Made by each division
Why have a transfer price?
The reason for having a transfer price is to be able to make each division profit accountable. If, in the previous
example, there was no transfer price and goods were transferred ‘free of charge’ between the division, then
the overall profit for the company would be unchanged. However, division A would only be reporting costs,
and division B would be reporting an enormous profit. The problem would be compounded if division A was
selling the same product externally as well as transferring to division B.

Cost-plus transfer pricing

A very common way in practice of determining a transfer price is for the company to have a policy that all
goods are transferred at the cost to the supplying division plus a fixed percentage.

Illustration .1.
Division A has costs of $15 p.u., and transfer goods to division b which has additional costs of $5 p.u. Division
b sells externally at $30 p.u. The company has a policy of setting transfer prices at cost + 20% .calculate:
(a) The transfer price
(b) The profit made by the company overall
(c) The profit reported by each division separately
Goal congruence
If we are properly divisionalised, then each divisional manager will have autonomy over decision making. It
will be therefore the decision of each manager which products are worth producing in their division (for these
purposes we assume that each division has many products and therefore stopping production of one product
will not be a problem). A cost-plus approach, which easy to apply can lead to problems with goal congruence
in that in some situations a manager may be motivated not to produce a product which is in fact to the benefit
of the company as a whole.

Illustration.1.
Division A has costs of $20 p.u., and transfer goods to division B which has additional costs of $8 p.u. Division
B sells externally at $30 p.u. The company has a policy of setting transfer prices at cost + 20%.
Calculate:
(a) The transfer price
(b) The profit made by the company overall
(c) The profit reported by each division separately
(d) Determine the decisions that will be made by the managers and comment on whether or not goal
congruent decisions will be made.

Illustration .2;
Division A has costs of $15 p.u., and transfers goods to division B which has additional costs of $10 p.u..
Division b sells externally at $35 p.u.
A can sell part-finished units externally for $20 p.u.. There is unlimited external demand from A, and A has
limited production capacity.
Determine a sensible range for the transfer price in order to achieve goal congruence.
Illustration .3;
A manufacturing and distribution company movers ltd has two divisions packing (P) and loading (L). The
company deals in a single standard product. Division p packages a certain commodity that can be forwarded
to both division l and external customers. You are further given the information below in the table;
Particulars division P (ushs) division L (ushs)
Selling price/per unit 68,000 70,400
Direct materials/per unit (18,800) (20,000)
Direct labour/per unit (23,900) (21,850)
Variable overheads/per unit (8,200) (10,600)
Selling & distribution/per unit (4,800) (7,680)
Head office apportioned fixed costs 32,000,000 26,000,000
Production capacity (units) 3,000 2,000
Additional information;
● Division p charges the same price for the commodity to both division l and external customers. However it
does not incur the selling and distribution costs when transferring internally.
● Divisions must cover up for head office apportioned fixed costs before deriving their divisional net profit.
● Division l has just been approached by a new external supplier who has offered to supply it with a similar
commodity at a price ushs 52,600 per unit.
● It is the head office policy to let the divisions operate autonomously with minimum interference from head
office.
Required;
a) Calculate the net benefit or loss for the company if division l accepts the external supplier’s price
b) From the information above about the divisions, calculate the total annual net profits or losses attributable
to each division and the company as a whole.
c) Highlight on the likely managers’ reactions (divisional and company levels) towards the transfer price
used in (b) above.
d) Enlighten the CEO of movers ltd on the three types of divisions that can be operated clearly bringing out
the typical performance measures used under each type.
e) Discuss any 3 three advantages that may accrue to movers ltd for operating these divisions.
PERFORMANCE IN THE NOT FOR-PROFIT SECTOR (NPOS’)
Introduction
Non-profit seeking organizations are those whose prime goal cannot be assessed by economic means.
Examples would include charities and state bodies such as the police and the health service. For this sort of
organization, it is not possible or desirable to use standard profit measures. Instead (in for example the case
of the health service) the objective is to ensure that the best service is provided at the best cost.
In this chapter we will consider the problems of performance measures and suggestions as to how to
approach it.
The not-for-profit sector incorporates a diverse range of operations including national government, local
government, charities, executive agencies, trusts and so on. The critical thing about such operations is that
they are not motivated by a desire to maximize profit. Many, if not all, of the benefits arising from expenditure
by these bodies are non-quantifiable (certainly not in monetary terms, e.g. Social welfare). The same can be
true of costs. So any cost/benefit analysis is necessarily quite judgmental, i.e. social benefits versus social
costs as well as financial benefits versus financial costs. The danger is that if benefits cannot be quantified,
then they might be ignored. Another problem is that these organizations often do not generate revenue but
simply have a fixed budget for spending within which they have to keep (i.e. a capital rationing problem).
Value for money (‘VFM’) is often quoted as an objective here but it does not get round the problem of
measuring ‘value.

Problems with performance measurement in NPOS.

• Multiple objectives
Even if all objectives can be clearly identified, it may be impossible to identify an over-riding objective or
to choose between competing objectives.

• The difficulty of measuring outputs

An objective of the health service is obviously to make ill people better. However, how can we in practice
measure how much better they are?

• Financial constraints
Public sector organizations have limited control over the level of funding that they receive and the
objectives that they can achieve.

• Political, social and legal considerations

The public have higher expectations from public sector organizations than from commercial ones, and
such organizations are subject to greater scrutiny and more onerous legal requirements.

• Little market competition and no profit motive.

Value for money

Non-profit organizations, such as the health service, are expected to provide value for money. This can be
defined as providing a service in a way which is economical, efficient and effective.

Performance should be assessed under each of these ‘3 e’s ‘

 Economy
Attaining the appropriate quantity and quality of inputs at the lowest cost. This is about balancing the cost
with the quality of the resources. Therefore, it will review areas such as the cost of books, computers and
teaching compared with the quality of these resources. It recognises that the organisation must consider
 its expenditure but should not simply aim to minimise costs. E.g. Low cost but poor quality teaching or
books will hinder student performance and will damage the reputation of the university.
 Efficiency
Maximizing the output for a given input (or, for a given output achieving the minimum input). How often
are the library books that are bought by the university taken out on loan by students? What is the
utilization of it resources? What % of their working time do lecturers spend teaching or researching?
 Effectiveness
Determining how well the organization has achieved its desired objectives. The % of students achieving a
target grade. The % of graduates who find full time employment within 6 months of graduating.

Example; T john’s hospital is a charity which collects funds and donations and utilizes these in the care of
terminally ill patients. The governing body has set the manager three performance objectives for the three
months to 30june 2018;
● To achieve a level of donations of ugx 150,000,000 over the three months period.
● To keep administration costs to not more than 8% of donations.
● To achieve 80% of respite care requested from the community.

Actual results were as follows;

April May June
Donations (ugx) 35,000,000 65,000,000 55,000,000
Administration costs (ugx) 2,450,000 5,850,000 4,400,000
Care requests (days) 560 570 600
Care provided (days) 392 430 510
Required; prepare a statement to assist the manager in evaluating performance against objectives and
comment on performance.

MEASURING CORPORATE FAILURE

When any company fails, its ‘stakeholders’ i.e. Investors, employees, suppliers and customers stand to lose
out financially. Investors will usually lose the money they put into the business and unpaid creditors will often
have to write off their debts.
This chapter therefore covers the reasons for companies failing, and various suggestions as to how
corporate failure might be predicted and hence avoided or prevented.

Causes of business failure

The causes of business failure are many and varied and may stem both from the external environment and
from factors internal to the business. Internal causes of business failure may in many cases be capable of
being foreseen in advance, while on the other hand some external causes are not so predictable. In most
cases, a complex mixture of causes contributes to business failure; it is very rare for one single factor to be
involved.

Internal causes
By definition, problems that are ‘internal’ to a business are more likely to be predictable than matters which
are external to the business and over which the latter may have no control. Accordingly, ‘internal’ threats to
the viability of a business are more capable of being anticipated and planned for. They include some of the
following;
Poor management
The most commonly occurring ‘internal’ factor in business failure among businesses is poor management.
Even other internal causes of business failure are often inevitably linked to poor management. This term is
used here in a broad sense to refer to the failure of the management to be able to ensure that problems are
identified promptly and the correct solutions applied, so as to give the company the best possible chance of
survival and growth.

Personal extravagance
This can be especially with shareholders who may withdraw profits for their personal interests that stagnates
repeated re-investments into the business hence insolvency in the long-run.

Deficit in accounting
Business decisions need to be supported by good quality financial information, which needs to be relevant,
user-friendly and available in a timely manner. Poor accounting and reporting and decisions based upon
inaccurate or incorrect financial information can actually cause problems which may threaten the solvency of
the business. Where a business operates poor bookkeeping practices which do not comply with recognized
accounting principles, it risks incurring penalties from the regulatory authorities. This can apply in many areas,
going from general ledger, receivables and payables, to indirect and direct tax (vat books, vat returns, other
indirect taxes, and income return). In addition, poor accounting increases the risk of the business of not being
aware of significant problems or of it recognizing them too late. Elements such as excessive fixed and
variable costs, incorrect revenue recognition, decrease in sales, etc., if not promptly recognized, can lead in
the long run to damage to the solvency of the business.

Poor cash flow management

Poor cash flow management, amongst the most common internal causes of business failure, implies an
imbalance between the payment terms taken by debtors and those given to creditors. The most obvious
outcome of defective cash flow management is a significant decline in cash, with the business
being unable to cover its repayment obligations, either to banks for loans, or towards suppliers for purchased
goods and services. The ultimate result of poor cash flow management is lack of working capital to run day-
to-day activities.

Inappropriate sources of finance

This is normally as a result of an unbalanced mix of equity capital and loan capital that represents a threat to
the solvency of the business.
An extreme reliance on loan finance can test the company’s cash flow position, leading to excessive
obligations for the company to repay capital and associated interest, especially when loan conditions allow
the lender to vary interest rates. If the company starts to experience financial difficulties, insufficient equity
capital will only worsen the situation, as the existing loan capital may prevent raising further debt finance. In
addition, unsuitable financing options result in an inconsistency between the liquidity of assets and the
sources of financing, i.e. financing short-term assets with long term loans, instead of short-term debt, or
borrowing short to invest long.

Dependency on particular customers or suppliers

Excessive reliance on one or a few customers, or alternatively only one supplier, poses very high risks to a
business. In the event of the only customer’s insolvency or withdrawal of orders, the gross margin will drop
significantly owing to the sudden reduction in sales. The whole future of the business is put at risk, as there
may be no market for its products or services.

Looming bad debt

This is also a possible cause of business failure that is capable of being predicted in advance. Bad debts may
increase significantly, due to the insolvency or disappearance of loyal and potential customer. This often
leads to long run insolvency.
Overtrading
When the company expands excessively and grows rapidly by taking on more commitments than it is able
to cope with, the survival of the business is put at risk.

Poor marketing and research

Amongst start-up businesses a frequent cause of businesses failure is a lack of adequate and
appropriate market research. Market research is required to help businesses to identify their customers and
inform them of the size of the potential customer base, to determine what price customers might be prepared
to pay and to suggest how demand for the product or service will change according to the price charged.
Research will also inform them about their competitors and their likely reaction to a
new entrant to the marketplace. In a new business this information is vital to enable the company to calculate
whether it will make sufficient gross margins to cover its overheads and financing costs and make an
adequate profit.

Fraud and collusion

These were not detected in good time, and can also cause significant financial loss and reduction of business
performance. The most typical case of fraud is the one committed by employees, namely by falsifying
expense reports or by stealing small unit-value items, such as stationery or cleaning products. When such
thefts happen regularly, and are left uncontrolled, they can lead to significant losses leading to corporate
failure. Additionally fraud can be also perpetrated by the entrepreneur or their spouse, or by a trusted advisor

External causes
External factors which in the long run may cause businesses to fail cannot always easily be predicted, since
they may involve extraordinary or unusual events happening in the region or country where the company
operates, events over which the business has no influence. The most frequent unpredictable external causes
may include;
● Economy such as a general economic recession,
● Natural disasters such as fire, floods, earthquakes and terrorism cannot normally be foreseen
● Governmental measures and international developments that may not always be predicted
● Environmental protection and other regulatory requirements
● Bankruptcy of major customers or suppliers.

Effects of business failure

Business failure can produce effects not only for the company itself, but also for its stakeholders; the result
can be serious damage to businesses in the short term and the mid-long term as well.

Effects at company level.

Where a business becomes insolvent and cannot be rescued, the most common effect for the company itself
is bankruptcy, with legal consequences which vary from country to country. The ultimate consequence of
business failure is usually the closure of the business.

Effects at stakeholder level.

These would include the following;
● Economic loss i.e. where there is no compensation.
● Unemployment
● Declined sales performance by suppliers
● Lost market by potential /loyal customers
● Lost investments by potential shareholders
Avoiding corporate failure
Pre-emptive procedures;
These are the measures before the company fails totally i.e. when financial problems begin to signal. They
include the following.

 External advice
May be obtained from professionally qualified financial accountants who should be sought regularly,
beginning at the start-up phase, and continuing through all the stages of business life.

 Adequate planning, budgeting and forecasting

A well-run business will have controls in place to monitor the business plans and an information system
which regularly updates the management on progress towards its objectives. Controls should also give an
early warning that the trading performance is deteriorating and provide pointers to steps which should be
taken to correct the situation.

 Audit
Where the financial statements of the company are audited, the entrepreneur will have a higher level of
assurance that the company’s financial information provides a sound basis for economic decisions.
Independent audit is also a deterrent against fraud and increases the likelihood that any frauds committed
will be detected. For this reason, it is advisable also for those companies for which audits are not
compulsory by national law to commission a voluntary audit of their financial statements

 Cash flow statements preparation and review;

A cash flow statement is one of the most useful financial management tools to assess the timing, amount
and predictability of future cash flows and can be the basis for budgeting.

 Management of risk
 Basically, both internal control and risk management systems allow the business to have a proactive
approach, identifying in due time any threats to the survival of the business itself.

Rescue procedures
Businesses can be rescued from failure either by taking appropriate measures for the recovery of the
business or by the transfer of the business to another entrepreneur. These can be;
● Sale-offs to pay off creditors
● Mergers/ acquisitions
● Re-structuring.

Ross and kami further suggested a list of Ten Commandments’ that should be followed by a company to
avoid business failure;
• You must have a strategy
● You must have controls
● The board must participate
● You must avoid one-man rule approach
● There must be management in depth
● Keep informed of, and react to, change
● Accept the fact that the customer is king
● Do not misuse computers
● Do not manipulate your accounts
● Endeavor to meet employees’ needs.
Prediction/determination of corporate failure
Investors and creditors and their analysts employ accounting numbers in a variety of ways, and one of the
enduring practices is the prediction of corporate failure. Bankruptcy is an important event to predict because
of the dire consequences when it occurs. Investors and creditors stand a chance to lose some or all of their
investment as well as forfeit chances for profits if a business enterprise collapses.

Corporate failure models/measures

There are two types of corporate failure models; quantitative models, which are based largely on published
financial information; and qualitative models, which are based on an internal assessment of the company
concerned.

Altman’s bankruptcy prediction model (quantitative-approach)

A number of statistical models have been around for decades, and one of the most popular prediction
schemes is the Altman z-model. Altman described a statistical method of discriminant analysis to a set of
bankrupt firms that were paired to similar non bankrupt firms. The dependent variable z denotes the firm’s
bankruptcy status. A value of z = 1 indicated healthy firms, but a value of z = 0 denoted unhealthy companies.
Altman examined several possible independent variables and derived the following model as his best
prediction model. Altman started with a list of 22 financial ratios for the independent variables. From this list
he chose five that embrace the best possible model;

★ Working capital / total assets

★ Retained earnings/ total assets
★ Earnings before interest and taxes /total assets
★ Market value of equity/ book value of total debt.
★ Sales/ total assets.

The following coefficients for the model are shown below;

Z = 1.2 X1+1.4 X2 + 3.3 X3 + 0.66 X4 + 1.0 X5 where:

X1 = working capital / total assets; measures the liquid assets in relation to the size of the company.

X2 = retained earnings / total assets; measures profitability that reflects the company’s age and earning
power.

X3 = earnings before interest and taxes / total assets; measures operating efficiency before tax and interest
as they are important for long term viability.

X4 = market value of equity / book value of total debt; it’s a market dimension that shows security price
fluctuations.

X5 = sales / total assets; measures total asset turn-over.

To use the model, determine the values of the five independent variables and substitute them into the model
and determine the resulting z-score. Then evaluate this z-score as follows.
● If z = 2.99: predict healthy/ continuing /safe zone.

● If 1.81 < z < 2.99: grey/fair/average

operations.
 ● If z = 1.81: predict failing/ distress zone.

Illustration
(Check in topic 5 handout)

TOPIC 6:
PERFORMANCE MANAGEMENT INFORMATION SYSTEMS
AND OTHER EMERGING ISSUES
PERFORMANCE MANAGEMENT INFORMATION SYSTEMS (PMIS)

Introduction
The purpose of an information system in a business is to provide management with the information that they
need in order to make good decisions and in order to monitor the progress of a given entity.

This chapter emphasizes the different information needs of management for different levels of decision
making.

Levels of management and the information requirements

• Strategic planning
Strategic planning is deciding on the long-term (usually at least five years) direction of the business
and making decisions on how to follow this strategy. The sorts of decisions that may be considered
are, for example, what new products to launch, or which new markets to enter. Information is
required mainly from external sources (for example, information about competitors, and
information about government policies insofar as they may affect the business), and also from internal
sources (for example, overall profitability forecasts, and capital spending
requirements).

• Management control
Management (or tactical) control is managing the implementation of the strategic plan in the short-
term - generally around twelve months. Short-term budgets will be prepared and operations
measured against the budgets. Information will be required from both external and internal sources,
and will include such things as variance analysis reports and productivity measurements.

• Operational control
Operational control is concerned with monitoring and controlling the day-by-day performance of the
business. The information required will be primarily internal to the business and will include such
things as hours worked by employees, raw material usage and wastage reports, and quality control
reports.

Information systems used by management.

In order to make decisions at the various levels outlined in the previous paragraph, management needs
information systems to supply the information they require and to present it in a way that is useful for them.
You should be aware of the following types of information processing system, and the level of management
that benefits from them.
1. Transaction processing systems (TPS)
TPS collect, store, modify and retrieve the transactions of an organization. Transaction processing
is the recording of the daily routine transactions of the business. This includes recording all the financial
transactions, keeping records of inventory, the processing of orders, etc. The information provided is used
mainly for operational control.

Characteristics of TPS

Controlled processing. Processing must support an organization’s operations.

Inflexibility. A TPS wants every transaction processed in the same way regardless of user time.

Rapid response. Fast performance is critical. Input must become output in seconds so customers don’t wait.

Reliability. Organizations rely heavily on transaction processing systems with failure potentially stopping
business. Back-up and recovery procedures must be quick & accurate.

The components of a TPS include hardware, software, and people. People in a TPS can be divided into three
categories - users (employees of the company who own the TPS), participants (direct users of the system i.e.
People who enter the data), and people from environment (people who sometimes require the services of a
TPS as they enter transactions and validate data, such as customers withdrawing money from an ATM).

2. Management information systems (MIS)

MIS extract, process and summarize data from the TPS and provide periodic reports to managers e.g.
weekly, monthly or quarterly. The purpose of the management information system is to convert data into
information that is useful for performance managers at all levels, but is particularly useful at the level of
management control. For example, the transaction processing system will provide a list of all receivables on a
given day, but the management information system can process the transactions and provide information as
to sales per customer and as to the trends in sales. Similarly, it is the management information system that
can process the transaction information and produce reports of variances.

Characteristics of MIS
★ Support structured decisions at operational and management control levels.
★ Designed to report on existing operations.
★ Have little analytical capability.
★ Relatively inflexible.
★ Have internal focus.

3. Executive information systems (EIS)

Whereas the traditional management information system can produce reports as outlined above, these
reports tend to be standard reports and need planning in advance (for example, it may be programmed to
produce a standard variance report each month). EIS draws data from the MIS and allows communication
with external sources of information. EIS are designed to facilitate senior managers’ access to information
quickly and effectively.
An executive information system enables the user to access the data and produce flexible
‘nonstandard’ reports. They are designed to be easy to use - the user can request a report without any
programming knowledge, there is an emphasis on presenting the information graphically, and there is the
ability to ‘drill-down’ (the information is initially presented very much in summary, but by clicking on the graphs
it is possible to get more and more detail as required). These systems are mainly for the use of top
management and are more for the strategic level of decision making.

4. Enterprise resource planning systems (ERP)

The word ‘planning’ here gives the wrong impression in that these systems are not really anything directly to
do with planning!
An enterprise resource planning system is software that integrates all the applications within the business and
uses a common database. The same system is used for processing transactions and providing management
information. These systems integrate all departments and functions into a single computer system. Instead of
the accounting department having their own system, separate from (for example) the system used by the
warehouse, there is a single system serving all the departments.

The system runs off a single database so that the various departments can more easily share
information.
As an example of its usefulness, an order received from a customer will be entered into the system and its
status will be updated by the relevant department as it progresses (the warehouse will update when it is
dispatched, the accounts department will update when it is invoiced for, and soon). If implemented well, it
means greater efficiency, less duplication, greater accuracy, and the ability of any department to access
information related to other departments.

Open and closed systems

Open systems are systems that can respond to changes external to the company, whereas closed systems
follow a fixed set of ‘rules’ and do not change.

For example, basic accounting system is a closed system in that it follows fixed rules. However, businesses
do need to change in response to changes in external factors such as the actions of competitors and
changes in the economic environment. As a result, although there may be sub-systems that are closed, the
overall information system needs to be an open system in that information requirements will change as the
business itself changes.

Closed systems are easier to control and maintain because they do not change. Open systems provide
flexibility and can provide better information, but are harder to control and maintain because of the
changes made.
If an organization’s performance is influenced by environmental factors, it should operate an open system
that accepts inputs from the external factors and examines their impact on performance output.

Sources of management information and management reports.

Possible external sources of information include:
• Government statistics
• Industry publications
• Competitors financial statements
• The internet

Possible internal sources of information include:

• Receivables ledger
• Payables ledger
• Payroll system

Monetary vs non-monetary sources: monetary sources have to do with quantitative sources like financial
statements while non-monetary sources include qualitative sources like quality, customer satisfaction,
innovation, etc.

Information system controls

It is important that controls exist on three aspects.
● Input - to prevent so far as possible input errors, and to prevent the wrong people inputting data.
● Processing and storage - to prevent data being changed without authorization, and to comply with
legislation (in particular the data protection laws that exist in most countries).
● Output - to ensure that only authorized people are allowed to access information

The types of controls that should be considered include:

Input stage;
● Pass words - to only allow authorized users to input and also to keep a record of who has entered data
● Range tests - to help ensure input is accurate. For example, only allow hours worked per week to be
within the range 0 to 50.
● Format checks - to help ensure input is accurate. For example, employees' names should be all
characters (not numbers).

Processing and storage stage;

● passwords - only authorized users are able to change data
● Audit trails - a record is kept within the software of all changes made to data (and by whom)
● Data protection officer - an employee with the responsibility of making sure that data protection laws
are complied with.
Output
● Passwords - only authorized users are allowed to access data

Other emerging issues in performance management

Business process reengineering

Business process reengineering is the practice of rethinking and redesigning the way work is
done to better support an organization’s mission, reduce costs, and improve customer service. It seeks to
help companies radically restructure their organizations by focusing on the ground-up design of their business
processes. Reengineering starts with a high level assessment of the organization’s mission, strategic goals,
and customer needs. Basic questions are asked, such as “does our mission need to be redefined? Are our
strategic goals aligned with our mission? Who are our customers?

The five major steps of business process re - engineering

Managers should;
● Re-focus company values on customer needs.
● Re-design core processes, often using information technology to enable improvements.
● Re organize a business into cross-functional teams with end-to-end responsibility for a process.
● Rethink basic organizational and people issues.
● Improve business processes across the organization.
Bench marking
Benchmarking is a measurement of the quality of an organization’s policies, products, programs, strategies,
etc. and their comparison with standard measurements, or similar measurements of its peers. It is a way of
discovering what is the best performance being achieved - whether in a particular company, by a competitor
or by an entirely different industry.

Objectives of bench marking

● To analyze how other organizations achieve their high performance levels and to use this information to
improve performance.
● To determine what and where improvements are called for.

SIX SIGMA SCORE CARD

Six-sigma score card is a business management methodology that guides organization through
the process of defining, measuring, analyzing, improving and controlling all processes within the organization.

It’s an approach to quality control that was originally devised by Motorola, a high tech
electronics company that manufactures, amongst other products, microprocessor chips.

The aim of the company was to achieve very low rejection rates, < 3.4 defects/million, though that specific
objective is not as important as their methodology, known as DMAIC: define measure, analyse, improve,
control.

● Define: what is meant by quality. For example, reliability, style, fast response, helpful service.
● Measure: looks at the means of measuring the quality factors. For example, failure rate for reliability,
customer surveys for style. Measure both current performance and use the
measurement methods to better define what is meant by quality i.e. Set targets.
● Analyze: investigate why current performance falls short of required performance.
● Improve: attempt to improve current performance.
● Control: control is continuously applied to ensure, for example, that definitions are still relevant, that
costs are within budget and that progress is being made.

NB: Repeat the D, M, A, I cycle until the required standards have been achieved.

Advantages of six sigma scorecard

● It helps the organization discover customer traceable defects & works to quantify & eliminate them.
● Six sigma allows you to add value and ensure quality within your overall operation.

Disadvantages of six sigma

● Six sigma is able to inspect the business minute-by-minute and generate large quantities of empirical data
leading to time-consuming and complicated procedures.
● Since six sigma pertains to quality improvement and is a quality improvement process at its root, adoption
of its protocols often leads to an increase in the overall costs.
● There are times when a company implements six sigma and there will be problems that arise as the
company focuses on six sigma endorsed policies only and forgets about its specific mission statement or
policies.
● For small business, it may also constrain new ideas favoring creativity and innovation, which requires
some risk to implement.