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Performance Management (PM)

Class Notes

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Section B
Specialist cost and
management accounting
techniques

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What is the purpose of costing?

In paper F2 we learnt how to determine the cost per unit

for a product. We might need to know this cost in order
to:

• Value inventory • the cost per unit can be used to

value inventory in the statement of financial position
(balance sheet).
• Record costs • the costs associated with the
product need to be recorded in the income
statement.
• Price products • the business will use the cost per
unit to assist in pricing the product. For example, if
the cost per unit is $0.30, the business may decide to
price the product at $0.50 per unit in order to make
the required profit of $0.20 per unit.
• Make decisions • the business will use the cost
information to make important decisions regarding
which products should be made and in what
quantities.

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Overheads Review

Direct and indirect expenses

Direct expenses are expenses that can be directly traceable into the product cost.
There are few examples of direct expenses but royalties paid to a designer or fees
paid to a subcontractor for a specific job could be classed as direct expenses.
• Direct expenses are part of the prime cost of a product.

Indirect expenses cannot be directly traceable into the product cost.

• For example, the cost of renting a factory where shirts are manufactured is
classified as an indirect cost because it would be impossible to relate such costs to
shirts only, if other clothes, such as dresses and suits were also made in the same
factory.
• Indirect expenses are also known as overheads.

Absorption Costing:
• The main aim of absorption costing is to recover overheads in a way that fairly
reflects the amount of time and effort that has gone into making a product or service.

Step1: Allocation is the charging of overheads directly to specific departments

where they can be identified directly with a cost centre or cost unit.

Step 2: Apportionment is the sharing of overheads which relate to more than one
department on a fair basis. Service department costs need to be reapportioned to
the production departments, using a suitable basis linked to usage of the service.

Step 3: Costs within production cost centres are charged to a cost unit, using
Overhead absorption rates (OAR) based on:

• Labour or machine hours (traditional/volume based drivers)

• % of direct labour cost.

• OAR = Budgeted overheads / Budgeted level of activity

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Example 1

The Gadget Co produces three products, A, B and C, all made from the same
material. The company uses traditional absorption costing to allocate overheads to
its products. Information for the three products for the last year is as follows:
A B C
Production and sales volumes (units) 15,000 12,000 18,000
Selling price per unit $7.50 $12 $13
Raw material usage (kg) per unit 2 3 4
Direct labor hours per unit 0·1 0·15 0·2

The price for raw materials remained constant throughout the year at $1·20 per kg.
Similarly, the direct labor cost for the whole workforce was $14·80 per hour. The
annual overhead costs were $195,270.

Required: Calculate the product cost using Absorption costing?

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Activity Based Costing

The conventional approach to dealing with fixed overhead production costs is to
assume that the various cost types can be dumped together and a single overhead
absorption rate is derived. The absorption rate is usually presented in terms of
overhead cost per labour hour, or overhead rate per machine hour. This approach is
likely to be an over-simplification, but it has the merit of being relatively quick and
easy.

The conventional approach outlined above is satisfactory if the following conditions

apply:
1. Fixed costs are relatively immaterial compared to material and labour costs. This
is the case in manufacturing environments which do not rely on sophisticated
and expensive facilities and machinery.
2. Most fixed costs accrue with time.
3. There are long production runs of identical products with little customization.

The need of Activity Based Costing

Manufacturing has become more machine intensive and, as a result, the
proportion of production overheads, compared to direct costs, has
increased. Therefore, it is important that an accurate estimate is made of the
production overhead per unit.

Modern manufacturing relies on highly automated, expensive manufacturing

plants – so much so that some companies do not separately identify the cost of
labour because there is so little used. Instead, factory labour is simply regarded as a
fixed overhead and added in to the fixed costs of running the factory, its machinery,
and the sophisticated information technology system which coordinates production.
Additionally, many companies rely on customization of products to
differentiate themselves and to enable higher margins to be made. Dell, for
example, a PC manufacturer, has a website which lets customers specify their own PC
in terms of memory size, capacity, processor speed etc. That information is then fed
into their automated production system and the specified computer is built, more or
less automatically.
Instead of offering customers the ability to specify products, many companies
offer an extensive range of products, hoping that one member of the range will
match the requirements of a particular market segment. In Example 1, the company
offers two products: ordinary and deluxe. The company knows that demand for the
deluxe range will be low, but hopes that the price premium it can charge will still
allow it to make a good profit, even on a low volume item. However, the deluxe
product could consume resources which are not properly reflected by the time it
takes to make those units.
These developments in manufacturing and marketing mean that the conventional
way of treating fixed overheads might not be good enough. Companies need to know
the causes of overheads, and need to realise that many of their ‘fixed costs’ might not

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be fixed at all. They need to try to assign costs to products or services on the basis of
the resources they consume.
Comparing ABC with traditional methods

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 labor, energy, and machine related costs.

However, many organisational resources exist for activities that are

unrelated 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.

Steps involved in Activity Based Costing

1) Group production overheads into activities, according

to how they are driven.
2) Identify cost drivers for each activity, i.e. what causes
these activity costs to be incurred.
3) A cost driver is a factor that influences (or drives) the
level of cost.
4) 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.

5) Absorb the activity costs into the product.

The activity costs should be absorbed back into the individual products.

6) Calculate the full production cost.

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Advantages and Disadvantages of ABC

ABC has a number of advantages:

 It provides much better insight in to what drives overhead costs.

 ABC recognizes that overhead costs are not all related to production and sales
volume.
 Overheads cost is charged to the products in a more realistic way, hence the
pricing of the product can be done more accurately as product cost cross
subsidization is avoided.
 Individual product profitability is better understood because of ABC
implementation that aids in decision making process.
 It can be used as a tool for cost control as it focuses on cause and effect
relationship by identifying cost drivers.

Disadvantages of ABC:

 ABC benefits will be 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.
 The benefits obtained from ABC might not justify the costs.
 At times there are more than one cost driver for an activity.
 Organizations producing single product can’t yield benefits from ABC.
 Information processing can be an issue when it comes to implementing ABC.

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Example No. 2:
Duff Co manufactures three products, X, Y and Z. Demand for products X and Y is
relatively elastic whilst demand for product Z is relatively inelastic. Each product
uses the same materials and the same type of direct labour but in different quantities.
For many years, the company has been using full absorption costing and absorbing
overheads on the basis of direct labour hours. Selling prices are then determined
using cost plus pricing. This is common within this industry, with most competitors
applying a standard mark-up.
Budgeted production and sales volumes for X, Y and Z for the next year are 20,000
units, 16,000 units and 22,000 units respectively.
The budgeted direct costs of the three products are shown below:
Product X Y Z
$ per unit $ per unit $ per unit
Direct materials 25 28 22
Direct labour ($12 per hour) 30 36 24
In the next year, Duff Co also expects to incur indirect production costs of
$1,377,400, which are analyzed as follows:

Cost pools $ Cost drivers

Machine set up costs 280,000 Number of batches
Material ordering costs 316,000 Number of purchase orders
Machine running costs 420,000 Number of machine hours
General facility costs 361,400 Number of machine hours
––––––––––
1,377,400
––––––––––
The following additional data relate to each product:
Product X Y Z
Batch size (units) 500 800 400
No of purchase orders per batch 4 5 4
Machine hours per unit 1·5 1·25 1·4

Duff Co wants to boost sales revenue in order to increase profits but its capacity to do
this is limited because of its use of cost plus pricing and the application of the
standard mark-up. The finance director has suggested using activity based costing
(ABC) instead of full absorption costing, since this will alter the cost of the products
and may therefore enable a different price to be charged.

Required:
(a) Calculate the budgeted full production cost per unit of each product
using Duff Co.’s current method of absorption costing. All workings
should be to two decimal places.
(b) Calculate the budgeted full production cost per unit of each product
using activity based costing. All workings should be to two decimal
places.
(c) Discuss the impact on the selling prices and the sales volumes OF
EACH PRODUCT which a change to activity based costing would be
expected to bring about.

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Example 3:

A company manufactures two products, C and D, for which the following information
is available:

Product C Product D Total

Budgeted production (units) 1,000 4,000 5,000

Labour hours per unit/in total 8 10 48,000

Number of production runs required 13 15 28

Number of inspections during production 5 3 8

Total production set up costs $140,000

Total inspection costs $80,000

Other overhead costs $96,000

Other overhead costs are absorbed on the basis of labour hours per unit.

Using activity-based costing, what is the budgeted overhead cost per unit
of product D?

A) $43·84
B) $46·25
C) $131·00
D) $140·64

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Target Costing

Steps involved in Target Costing

Step 1: A product is developed that is perceived to be needed by customers and

therefore will attract adequate sales volumes. This will involve extensive customer
analysis, considering which features customer values and only these features are
included in the product design.
Step 2: A target price is then set based on the customers’ perceived value of the
product. This will take in to account the competitor products and the market
conditions expected at the time that the product will be launched. Hence a heavy
emphasis is placed on external analysis before any consideration is made of the
internal cost of the product. This will therefore be a market based price.
Step 3: The required target operating profit per unit is then calculated. This may be
based on either return on sales or return on investment.
Step 4: The target cost is derived by subtracting the target profit from the target
price.
Step 5: Costs for the product are then calculated and compared to the target cost
mentioned above.
Step 6: If there is a cost gap, attempts will be made to close the gap. Techniques
such as value engineering may be performed, which looks at every aspect of the value
chain business functions, with an objective of reducing costs while satisfying
customer needs.

Example 4:
A car manufacturer wants to calculate a target cost for a new car, the price of which
will be set at $17,950. The company requires an 8% profit margin on sales.
Required
What is the target cost?

Example 5:
A selling price of $44 has been set in order to compete with a similar radio on the
market that has comparable features to Edward Co.’s intended product. The board
has agreed that the acceptable margin (after allowing for all production costs) should
be 20%.

Cost information for the new radio is as follows:

Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are
bought in batches of 4,000 and additional delivery costs are $2,400 per batch.

Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each

completed radio. However, there is some waste involved in the process as wire is
occasionally cut to the wrong length or is damaged in the assembly process. Edward
Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs
$0·50 per meter to buy.

Other material– other materials cost $8·10 per radio.

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Assembly labour– these are skilled people who are difficult to recruit and retain.
Edward Co has more staff of this type than needed but is prepared to carry this extra
cost in return for the security it gives the business. It takes30 minutes to assemble a
radio and the assembly workers are paid $12·60 per hour. It is estimated that 10% of
hours paid to the assembly workers is for idle time.

Production Overheads– recent historic cost analysis has revealed the following
production overhead data:

Total production overhead Total assembly labour hours

$
Month 1 620,000 19,000
Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis based on

normal annual activity levels. In a typical year 240,000 assembly hours will be
worked by Edward Co.

Required:
(d) Calculate the expected cost per unit for the radio and identify any cost
gap that might exist.

Closing the Target Gap

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.

 Remove features from the product that add to cost but do not
significantly add value to the product when viewed by the customer. This
should reduce cost but not the achievable selling price. This can be referred to
as value engineering or value analysis.

 Team approach:
Cost reduction works best when a team approach is adopted. The company
should bring together members of the marketing, design, assembly and
distribution teams to allow discussion of methods to reduce costs. Open
discussion and brainstorming are useful approaches here.

 Review the whole supplier chain:

Each step in the supply chain should be reviewed, possibly with the aid of staff
questionnaires, to identify areas of likely cost savings. Areas which are
identified by staff as being likely cost saving areas can then be focused on by
the team. For example, the questionnaire might ask ‘are there more than five
potential suppliers for this component?’ Clearly a ‘yes’ response to this
question will mean that there is the potential for tendering or price
competition.

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 Labor Efficiency:
Productivity gains may be possible by changing working practices or by de-
skilling the process.

 Automation is increasingly common in assembly and manufacturing and the

company should investigate what is possible here to reduce the costs.

 The learning curve may ultimately help to close the cost gap by reducing
labor costs per unit.
 Clearly reducing the percentage of idle time will reduce product costs.
Better management, smoother work flow and staff incentives could all help
here. Focusing on continuous improvement in production processes may help.

 Acquiring new, more efficient technology.

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 labor 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?

Example:
The Swiss watch maker Swatch reportedly used target costing in
order to produce relatively low-cost, similar looking plastic
watches in a country with one of the world’s highest hourly labor
wage rates.

Suggest ways in which Swatch may have reduced their unit

costs for each watch?

Target costing in service industries

 Spontaneity: unlike goods, a service is consumed at the exact same time as it is

made available. No service exists until it is being experienced by the
consumer.
 Heterogeneity/variability: A service involves people and, because people are
all different, the service received may vary depending on which person
performs it. Standardization is expected by the customer but it is difficult to
maintain.
 Intangibility: unlike goods, services cannot be physically touched.
 Perishability: unused capacity cannot be stored for future use.
 No transfer of ownership takes place when a service is provided’
 Service industries rely heavily on their staff, which often has face-to-face
contact with the customer, and represent the organization’s brand’.

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Benefits of adopting target costing

 The organization will have an early external focus to its product development.
Businesses have to compete with others(competitors) and an early
consideration of this will tend to make them more successful. Traditional
approaches (by calculating the cost and then adding a margin to get a selling
price) are often far too internally driven.
 Only those features that are of value to customers will be included in the
product design. Target costing at an early stage considers carefully the product
that is intended. Features that are unlikely to be valued by the customer will
be excluded. This is often insufficiently considered in cost plus methodologies.
 Cost control will begin much earlier in the process. If it is clear at the design
stage that a cost gap exists, then more can be done to close it by the design
team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which
is often far too late to make a significant impact on a product that is too
expensive to make.
 Costs per unit are often lower under a target costing environment. This
enhances profitability. Target costing has been shown to reduce product cost
by between 20% and 40% depending on product and market conditions. In
traditional cost plus systems an organization may not be fully aware of the
constraints in the external environment until after the production has started.
Cost reduction at this point is much more difficult as many of the costs are
‘designed in’ to the product.
 It is often argued that target costing reduces the time taken to get a product to
market. Under traditional methodologies there are often lengthy delays whilst
a team goes ‘back to the drawing board’. Target costing, because it has an early
external focus, tends to help get things right first time and this reduces the
time to market.

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Life Cycle Costing

Lifecycle costing is a concept which traces all costs to a product over its complete
lifecycle, from design through to cessation. It recognizes that for many products
there are significant costs to be incurred in the early stages of its lifecycle. The design
and development of a product is a long and complicated process and it is likely that
the costs involved would be very significant.

The ‘classical’ life cycle of a product has five phases or stages:

1) Development. The product has a research or design and development stage.
Costs are incurred but the product is not yet on the market and there are no
sales revenues.

2) Introduction. The product is introduced to the market. Potential customers

are initially unaware of the product or service, and the organisation may have
to spend heavily on advertising to bring the product or service to the attention
of the market. In addition, capital expenditure costs may be incurred in order
to increase the production capacity as sales demand grows.

3) Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit.

4) Maturity. Eventually, the growth in demand for the product will slow down
and it will enter a period of relative maturity, when sales have reached a peak
and are fairly stable. This should be the most profitable phase of the
product’s life. The product may be modified or improved, as a means of
sustaining its demand and making this phase of the life cycle as long as
possible.

5) Decline. At some stage, the market will have bought enough of the product
and it will therefore reach 'saturation point'. Demand will start to fall.
Eventually it will become a loss-maker and this is the time when the
organization should decide to stop selling the product or service.
(withdrawal stage)

Examples of Products related to their life cycle:

Introduction 3D TVs
Growth Blue ray discs
Maturity DVD.
Decline Video cassette

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Calculation of Life Cycle Costs

Following costs are accumulated while calculating life cycle cost per unit:
1) Research & Development
2) Training cost
3) Cost of purchasing
4) Production cost
5) Marketing and advertisement cost
6) Inventory Cost (holding and warehouse etc.)
7) Retirement and disposal cost.

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Benefits of life cycle costing

1) The visibility of ALL costs is increased, rather than just costs relating to one
period. This facilitates better decision-making.
2) Individual profitability for products is more accurate because of this.
This facilitates performance appraisal and decision-making, and means that
prices can be determined with better knowledge of the true costs.
3) More accurate feedback can take place when assessing whether new
products are a success or a failure, since the costs of researching,
developing and designing those products are also taken into account.
4) It can be very useful for organizations that continually develop products with
a relatively short life, where it may be possible to estimate sales volumes
and prices can with reasonable accuracy.

How Life cycle costing is used to increase the product’s profitability?

There are a number of factors that need to be managed in order to maximize a

product’s return over its lifecycle:

Design costs out of the product:

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 across
functional team in order to minimize 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. Life
cycle costing aids here in the sense that majority of the decisions related to the
product are taken at the inception therefore reducing the time to market for a
particular product.

Minimize breakeven time (BET)

A short BET is very important in keeping an organisation liquid. The sooner the
product is launched the quicker the research and development costs will be
repaid, providing the organisation with funds to develop further products. In life
cycle costing, break even occurs when revenue from the product has covered all
the costs incurred to date, including design and development costs.

Maximize the length of the life cycle itself:

Generally, the longer the life cycle, the greater the profit that will be generated.
Another way of extending a product’s life is to find other uses, or markets, for the
product. This is especially true of materials, such as plastic, PVC, nylon and other
synthetic materials. The life cycle of these materials can be extended by finding

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new uses for them. The life cycle of the material is then a series of individual
product curves nesting on top of each other as shown below.

On the other hand, it may be possible to plan for a staggered entry in to different
markets at the planning stage.
Many organizations 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. A current example is the way in which new films are released in the
USA months are for the UK launch. This is done to build up the enthusiasm for
the film and to increase revenues overall. Other companies may not have the
funds to launch worldwide at the same moment and may be forced to stagger it.

Service and project life cycles

Services have life cycles. The only difference with the life cycle of a product is that
the R & D stages will not usually exist in the same way. The different processes
that go to form the complete service are important, however, and consideration
should be given in advance as to how to carry them out and arrange them so as to
minimize cost.

Customer Life cycle

Customers also have life cycles, and an organisation will wish to maximize the
return from a customer over their life cycle. The aim is to extend the life cycle of a
particular customer. This means encouraging customer loyalty. For example,
some supermarkets and other retail outlets issue loyalty cards that offer discounts
to loyal customers who return to the shop and spend a certain amount with the
organisation.

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Example 6:

Volt Co generates and sells electricity. It operates two types of power station: nuclear
and wind.

The costs and output of the two types of power station are detailed below:

Nuclear station

A nuclear station can generate 9,000 gigawatts of electricity in each of its 40 years of
useful life. Operating costs are $486m per year. Operating costs include a provision
for depreciation of $175m per year to recover the $7,000m cost of building the power
station.

Each nuclear station has an estimated decommissioning cost of $12,000m at the end
of its life. The decommissioning cost relates to the cost of safely disposing of spent
nuclear fuel.

Wind station

A wind station can generate 1,750 gigawatts of electricity per year. It has a life-cycle
cost of $55,000 per gigawatt and an average operating cost of $40,000 per gigawatt
over its 20-year life.

1) What is the life-cycle cost per gigawatt of the nuclear station (to the nearest
$’000)?
A) $54,000
B) $73,000
C) $87,000
D) $107,000

2) Which of the following will decrease the total life-cycle cost of a nuclear
station?

(1) Increasing the useful life of the station

(2) Reducing the decommissioning cost

A) 1 only

B) 2 only

C) Both 1 and 2

D) Neither 1 nor 2

3) Which of the following are benefits of life-cycle costing for Volt Co?

(1) It facilitates the designing out of costs at the product development stage

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(2) It can encourage better control of operating costs over the life cycle

(3) It gives a better understanding of the causes of overhead costs

(4) It provides useful data for short-term decision-making

A) 1, 2 and 3

B) 1 and 2 only

C) 1 and 4

D) 2, 3 and 4

Example 7:

A manufacturing company which produces a range of products has developed a

budget for the life-cycle of a new product, P. The information in the following table
relates exclusively to product P:

Lifetime total Per unit

Design costs $800,000

Direct manufacturing costs $20

Depreciation costs $500,000

Decommissioning costs $20,000

Machine hours 4

Production and sales units 300,000

The company’s total fixed production overheads are budgeted to be $72 million each
year and total machine hours are budgeted to be 96 million hours. The company
absorbs overheads on a machine hour basis.

What is the budgeted life-cycle cost per unit for product P?

A) $24·40
B) $25·73
C) $27·40
D) $22·73

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Throughput Accounting

The theory of constraints (TOC) is an approach to production management and

optimizing production performance. It states that producing maximum output or
operating at 100% capacity levels does not ensure that organization’s production is
efficient. Modern production efficiency concept says that production should be
linked with the available demand in the market. Thus, simply producing the output
without converting into sales is mirage for the organization.
An organization needs to find its real goal, which is actually the maximization of
profits in majority of organizations. Thus production is designed in such a way that it
meets the above stated objective then it is called efficient production.

Let’s first define few terms before summing up the concept of theory of constraints;

 ‘Throughput’ is the rate at which the system generates money through sales.
Thus, it’s the money received by the business from sales after deducting
material cost.
Throughput contribution= Sales – Material cost

 ‘Bottleneck Resource’ the factor that prevents the organization from

meeting its goals. Thus it’s an activity that limits the throughput contribution
of the organization.

 ‘Inventory’ is all the money that the system has invested in purchasing
things that it intends to sell. In throughput accounting inventory is
valued only at material cost.

 ‘Operational expense’ is all the money that the system spends in order to
turn raw material into sales. Thus it includes direct labor and factory
overheads. This operational cost is assumed to be fixed.

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TOC is applied where there is bottleneck resource in the production process. The
idea is that the production must be limited to the capacity of the bottleneck resource
but this capacity must be fully utilized.
There will be idle resources in non-bottleneck areas, but this does not matter. The
focus should be on maximizing throughput, given the limitation of the bottleneck.

JIT System in Throughput Costing

Throughput costing works with JIT system. Ina JIT environment, all inventory is a
'bad thing' and the ideal inventory level is zero. Products should not be made
unless a customer has ordered them. When goods are made, the factory effectively
operates at the rate of the slowest process, and there will be unavoidable idle capacity
in other operations.
However, output through the limiting factor should never be delayed or held up
otherwise sales will be lost. To avoid this being happened a small buffer inventory
should be built up immediately prior to the bottleneck constraint. This is the only
inventory that the business should hold, with the exception of possibly a very small
amount of finished goods inventory and raw materials, which is consistent with a
just-in-time (JIT) approach.

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Difference between Traditional and Throughput costing

In traditional cost accounting, improving efficiency and creating higher inventory

will increase profits. Higher inventories reduce the cost of sales and increase
reported profits.

In the theory of constraints using non-bottleneck resources above the amount

required for maximum throughput is wasteful. It does not increase throughput, it
only increases unused inventory levels.

Identifying the bottleneck resource

Example 8:
Often, in exam questions, you will be told what the bottleneck resource is. If not, it is
usually quite simple to work out. For example, let’s say that an organisation has
market demand of 50,000 units for a product that goes through three processes:
cutting, heating and assembly. The total time required in each process for each
product and the total hours available are:

Process Cutting Heating Assembly

Hours per Unit 2 3 4

Total Hours available 100,000 120,000 220,000

Identify the bottleneck resource?

Example 9:
The ‘goal unit’ of this organisation will be to progress a patient through all three
stages. The number of patients who complete all three 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 (stage 1) 0.50 80
Interpret the result (stage 2) 0.20 40
Recall patients (stage 3) 0.40 60

Identify the bottleneck stage?

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LIMITING FACTOR ANALYSIS AND THROUGHPUT ACCOUNTING

Once an organisation has identified its bottleneck resource, as demonstrated above,
it then has to decide how to get the most out of that resource. Given that most
businesses are producing more than one type of product (or supplying more than one
type of service), this means that part of the exploitation step involves working out
what the optimum production plan is, based on maximizing throughput per unit of
bottleneck resource.

Steps involved in the calculation of throughput accounting ratio:

1) Identify the bottleneck resource/activity.

2) Calculate the contribution per unit for each product.

Throughput contribution= Sales – Material cost

3) Calculate the contribution per limiting factor/ bottleneck resource

(Contribution per unit/Bottleneck hours needed per unit)
OR
(Contribution per unit*Units per bottleneck hour)

4) Calculate conversion cost per factory hour.

(Labour cost + Factory Overheads)/Number of bottleneck resource hours

Note: Here the cost in numerator should correspond to the hours in

denominator from time point of view.

5) Calculate throughput Accounting ratio

(Throughput contribution per bottleneck resource hour/ conversion cost per
factory hour)

6) Rank the products based upon throughput accounting ratio.

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 in a loss

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Example 10:
Beta Co produces 3 products, E, F and G, details of which are shown below:
E F G

$ $ $

Selling price per unit 120 110 130

Direct material cost per unit 60 70 85

Maximum demand (units) 30,000 25,000 40,000

Time required on the bottleneck

resource (hours per unit) 5 4 3
There are 320,000 bottleneck hours available each month.
Total fixed cost is $640,000
Required:
Calculate the optimum product mix each month.

Ways to improve throughput accounting ratio

Speed up the bottleneck process.

By increasing the speed of the bottleneck process the rate of throughput will also
increase, generating a greater rate of income for company if the extra production can
be sold. Automation might be used or a change in the detailed processes. Investment
in new machinery can also help here but the cost of that would need to be taken into
account.

Increase the selling prices.

It can be difficult to increase selling prices in what we are told is a competitive
market. Volume of sales could be lost leaving the company with unsold stock or idle
equipment. On the other hand, given the business appears to be selling all it can
produce, and then a price increase may be possible.

Reduce the material prices.

Reducing material prices will increase the net throughput rate. Considering the
industry maturity, suppliers of the raw material might be willing to negotiate on
price; this could have volume or quality based conditions attached. The company will
have to be careful to protect its quality levels. Bulk buying increases stock levels and
the cost of that would need to be considered.

Reduce the level of fixed costs.

The fixed costs should be listed and targets for cost reduction be selected. ABC
techniques can help to identify the cost drivers and with management these could be

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used to reduce activity levels and hence cost. Outsourcing, de-skilling or using
alternative suppliers (for stationery for example) are all possible cost reduction
methods.

Main assumptions:

 The only totally variable cost in the short-term is the purchase cost of raw
materials that are bought from external suppliers.
 Direct labor 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.

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

Example 11:
X Co uses a throughput accounting system. Details of product A, per unit, are as
follows:
Selling price $320
Material costs $80
Conversion costs $60
Time on bottleneck resource 6 minutes

What is the return per hour for product A?

A) $40
B) $2,400
C) $30
D) $1,800

Example 12:

The following statements have been made in relation to the concepts outlined in
throughput accounting:
(i) Inventory levels should be kept to a minimum
(ii) All machines within a factory should be 100% efficient, with no idle time

Which of the above statements is/are correct?

A) (i) only

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B) (ii) only
C) Both (i) and (ii)
D) Neither (i) nor (ii)

Example 13:

A manufacturing company uses three processes to make its two products, X and Y.
The time available on the three processes is reduced because of the need for
preventative maintenance and rest breaks.

The table below details the process times per product and daily time available:

Process Hours available Hours required Hours required

per day to make one unit to make one unit
of product X of product Y

1 22 1·00 0·75
2 22 0·75 1·00
3 18 1·00 0·50

Daily demand for product X and product Y is 10 units and 16 units respectively.

Which of the following will improve throughput?

A) Increasing the efficiency of the maintenance routine for Process 2
B) Increasing the demand for both products
C) Reducing the time taken for rest breaks on Process 3
D) Reducing the time product X requires for Process 1

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Types of Environmental Cost Accounting

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Section C
Decision-making techniques

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Limiting Factor Analysis

A limiting factor is any factor that is in scarce supply and that stops the organization
from expanding its activities further, so that there is a maximum level of activity at
which the organization can operate.
For example;
 Limited demand
 Skilled labor
 Material
 Machine capacity
 Limited finance (‘capital rationing’) etc.

In limiting factor analysis management will decide to use its scarce resources in such
a way as to maximize total contribution (and so profit). In other words, marginal
costing ideas are applied.
If there is just one limiting factor, total contribution will be maximized by
earning the highest possible contribution per unit of limiting factor.

Limiting factor Analysis Calculation (one factor only)

Step 1: identify the scarce resource.

Step 2: calculate the contribution per unit for each product.
Step 3: calculate the contribution per unit of the scarce resource for each product.
Step 4: rank the products in order of the contribution per unit of the scarce
resource.
Step 5: allocate resources using this ranking

Example 14:

X Ltd makes three products, A, B and C, of which unit costs, machine hours and
selling prices are as follows:

Product A Product B Product C

Machine hours 10 12 14
$ $ $
Direct materials
@ 50cperkg 7(14kg) 6(12kg) 5(10kg)
Direct wages
@$7.50perhour 9(1.2hours) 6(0.8hours) 3(0.4hours)
Variable overheads 3 3 3
––– ––– –––
Marginal cost 19 15 11
Selling price 25 20 15
––– ––– –––
Contribution 6 5 4
––– ––– –––

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Sales demand for the period is limited as follows.

Product A 4,000
Product B 6,000
Product C 6,000
Company policy is to produce a minimum of 1,000 units of Product A.
The supply of materials in the period is unlimited, but machine hours are limited to
200,000 and direct labor hours to 5,000.

Required:

Indicate the production levels that should be adopted for the three
products in order to maximize profitability, and state the maximum
contribution.

Limiting Factor Analysis

However, where there are two or more resources in short supply which limit the
organization’s activities then linear programming is required to find the solution.
In examination questions linear programming is used to:

 Maximize contribution and/or

 Minimize costs.
The graphical method of linear programming can be used when there are just two
products (or services). The steps involved are as follows.
 Define variables
 Establish constraints
 Construct objective function
 Draw the constraints on a graph
 Establish the feasible region for the optimal solution
 Determine the optimal solution

Finding the optimal solution using the graph

Once feasible region the problem now is to find the optimal solution within this
feasible region.
There are two approaches to this final stage.

 By inspection it is clear that the maximum contribution will lie on one of the
corners of the feasible region. The optimal solution can be reached simply by
calculating the contributions at each corner. This approach is not
recommended in the exam since it tends to be quite time consuming.
 By drawing an iso-contribution line (an objective function for a particular
value of C), which is a line where all points represent an equal contribution.
This is the recommended approach, particularly for more complex problems.

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Slack and Surplus:

When discussing constraints, slack is the amount by which a resource is

underutilized, i.e. slack occurs when the maximum availability of a resource is not
used. Graphically speaking, it will occur when the optimum point does not fall on a
given resource line.

 The optimal solution will typically occur where two constraint lines cross.
There will be no slack for these constraints / resources as they will be fully
utilised
 For other constraint lines, the fact that the optimal solution is not on these
lines means that the resources are not fully utilized, so there will be slack

Slack is important for two reasons

 For critical constraints (zero slack), then gaining additional units of these
scarce resources will allow the optimal solution to be improved (e.g. higher
contribution earned). Similarly, if another department wants these resources
then it will result in lower contribution.
 For noncritical constraints, gaining or losing a small number of units of the
scarce resource will have no impact on the total contribution earned.

Shadow Price

The shadow price or dual price of a limiting factor is the increase in

contribution created by the availability of one additional unit of the
limiting factor at the original cost.

 The shadow price of a resource can be found by calculating the increase in

value (usually extra contribution) which would be created by having available
one additional unit of a limiting resource at its original cost.
 It therefore represents the maximum premium that the firm should be
willing to pay for one extra unit of each constraint. This aspect is
discussed in more detail below.
 Noncritical constraints will have zero shadow prices as slack exists already.

Calculating shadow prices

The simplest way to calculate shadow prices for a critical constraint is as follows:

Step 1: Take the equations of the straight lines that intersect at the optimal point.
Add one unit to the constraint concerned, while leaving the other critical constraint
unchanged.
Step 2: Use simultaneous equations to derive a new optimal solution.
Step 3: Calculate the revised optimal contribution. The increase is the shadow price
for the constraint under consideration.

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Example 15:
Higgins Co (HC) manufactures and sells pool cues and snooker cues. The cues both
use the same type of good quality wood (ash) which can be difficult to source in
sufficient quantity. The supply of ash is restricted to 5,400 kg per period. Ash costs
$40 per kg.
The cues are made by skilled craftsmen (highly skilled labour) who are well known
for their workmanship. The skilled craftsmen take years to train and are difficult to
recruit. HC’s craftsmen are generally only able to work for 12,000 hours in a period.
The craftsmen are paid $18 per hour.
HC sells the cues to a large market. Demand for the cues is strong, and in any period,
up to 15,000 pool cues and 12,000 snooker cues could be sold. The selling price for
pool cues is $41 and the selling price for snooker cues is $69.
Manufacturing details for the two products are as follows:
Pool cues Snooker cues
Craftsmen time per cue 0·5 hours 0·75 hours
Ash per cue 270 g 270 g
Other variable costs per cue $1·20 $4·70
HC does not keep inventory.

Required:
(a) Calculate the contribution earned from each cue.

(b) Determine the optimal production plan for a typical period

assuming that HC is seeking to maximize the contribution earned.
You should use a linear programming graph (using the graph
paper provided), identify the feasible region and the optimal point
and accurately calculate the maximum contribution that could be
earned using whichever equations you need.

Some of the craftsmen have offered to work overtime, provided that they are paid
double time for the extra hours over the contracted 12,000 hours. HC has estimated
that up to 1,200 hours per period could be gained in this way.

Required:
(c) Explain the meaning of a shadow price (dual price) and calculate the
shadow price of both the labour (craftsmen) and the materials (ash).
(d) Advise HC whether to accept the craftsmen’s’ initial offer of working
overtime, discussing the rate of pay requested, the quantity of hours and
one other factor that HC should consider.

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Example 16:
The Cosmetic Co is a company producing a variety of cosmetic creams and lotions.
The creams and lotions are sold to a variety of retailers at a price of $23·20 for each
jar of face cream and $16·80 for each bottle of body lotion. Each of the products has a
variety of ingredients, with the key ones being silk powder, silk amino acids and aloe
vera. Six months ago, silk worms were attacked by disease causing a huge reduction
in the availability of silk powder and silk amino acids. The Cosmetic Co had to
dramatically reduce production and make part of its workforce, which it had trained
over a number of years, redundant.
The company now wants to increase production again by ensuring that it uses the
limited ingredients available to maximize profits by selling the optimum mix of
creams and lotions. Due to the redundancies made earlier in the year, supply of
skilled labour is now limited in the short-term to 160 hours (9,600 minutes) per
week, although unskilled labour is unlimited. The purchasing manager is confident
that they can obtain 5,000 grams of silk powder and 1,600 grams of silk amino acids
per week. All other ingredients are unlimited. The following information is available
for the two products:
Cream
Lotion
Materials required: silk powder (at $2·20 per gram) 3 grams 2 grams
– silk amino acids (at $0·80 per gram) 1 gram 0·5 grams
– aloe vera (at $1·40 per gram) 4 grams 2 grams
Labour required: skilled ($12 per hour) 4 minutes 5 minutes
– unskilled (at $8 per hour) 3 minutes 1·5
minutes

Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of
lotion generates a contribution of $8 per unit. The maximum demand for lotions is
2,000 bottles per week, although demand for creams is unlimited. Total Fixed costs
$1,800 per week. The company does not keep inventory although if a product is
partially complete at the end of one week, its production will be completed in the
following week.

Required:
(a) On the graph paper provided, use linear programming to calculate
the optimum number of each product that the Cosmetic Co should make
per week, assuming that it wishes to maximize contribution. Calculate
the total contribution per week for the new production plan. All
workings MUST be rounded to 2 decimal places.
(b) Calculate the shadow price for silk powder and the slack for silk
amino acids. All workings MUST be rounded to 2 decimal places.

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Example 17:
Tablet Co makes two types of tablet computer, the Xeno (X) and the Yong (Y). X
currently generates a contribution of$30 per unit and Y generates a contribution of
$40 per unit. There are three main stages of production: the build stage, the program
stage and the test stage. Each of these stages requires the use of skilled labour which,
due to a huge increase in demand for tablet computers over recent months, is now in
short supply. The following information is available for the two products:
Stage Xeno (X) Yong (Y)
Minutes per unit Minutes per unit
Build ($10 per hour) 24 20
Program ($16 per hour) 16 14
Test ($12 per hour) 10 4

Tablet Co is now preparing its detailed production plans for the next quarter. During
this period it expects that the skilled labour available will be 30,000 hours
(1,800,000 minutes) for the build stage, 28,000 hours (1,680,000 minutes) for the
program stage and 12,000 hours (720,000 minutes) for the test stage. The maximum
demand for X and Y over the three-month period is expected to be 85,000 units and
66,000 units respectively. Fixed costs are $650,000 per month.
Due to rapid technological change, the company holds no inventory of finished
goods.

Required:
(a) On the graph paper provided, use linear programming to calculate
the optimum number of each product which Tablet Co should make in
the next quarter assuming it wishes to maximize contribution. Calculate
the total profit for the quarter.
(b) Calculate the amount of any slack resources arising as a result of the
optimum production plan and explain the implications of these amounts
for decision-making within Tablet Co.

(c) Suggest and discuss THREE ways in which S Co could try to increase
its production capacity and hence increase throughput in the next year
without making any additional investment in machinery.

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Example 18:

A jewellery company makes rings (R) and necklaces (N).

The resources available to the company have been analysed and two constraints have
been identified:

Labour time 3R + 2N ≤ 2,400 hours

Machine time 0·5R + 0·4N ≤ 410 hours

The management accountant has used linear programming to determine that R =

500 and N = 400.

Which of the following is/are slack resources?

(1) Labour time available

(2) Machine time available

A) 1 only

B) 2 only

C) Both 1 and 2

D) Neither 1 nor 2

Example 19:
A company has the following production planned for the next four weeks. The figures
reflect the full capacity level of operations. Planned output is equal to the maximum
demand per product.
Product A B C D
$ per unit $ per unit $ per unit $ per unit
Selling price 160 214 100 140
Raw material cost 24 56 22 40
Direct labour cost 66 88 33 22
Variable overhead cost 24 18 24 18
Fixed overhead cost 16 10 8 12
–––– –––– –––– ––––
Profit 30 42 13 48
–––– –––– –––– ––––
Planned output 300 125 240 400
Direct labour hours per unit 6 8 3 2

The direct labour force is threatening to go on strike for two weeks out of the coming
four. This means that only 2,160 hours will be available for production rather than
the usual 4,320 hours.

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If the strike goes ahead, which product or products should be produced if

profits are to be maximized?

A) D and A
B) B and D
C) D only
D) B and C

Example 20:

A linear programming model has been formulated for two products, X and Y. The
objective function is depicted by the formula C = 5X + 6Y, where C = contribution,
X = the number of product X to be produced and Y = the number of product Y to be
produced.

Each unit of X uses 2 kg of material Z and each unit of Y uses 3 kg of material Z. The
standard cost of material Z is $2 per kg.

The shadow price for material Z has been worked out and found to be $2·80 per kg.
If an extra 20 kg of material Z becomes available at $2 per kg, what will
the maximum increase in contribution be?

A) Increase of $96
B) Increase of $56
C) Increase of $16
D) No Change

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Pricing Decisions

When demand is linear the equation for the demand curve is:
P = a – bQ
where
P = the price
Q = the quantity demanded
a = the price at which demand would be nil
b =(change in price /change in quantity)

Example 21: Deriving the demand equation

The current price of a product is $12. At this price the company sells 60 items a
month. One month the company decides to raise the price to $15, but only 45 items
are sold at this price. Determine the demand equation, which is assumed to be a
straight line equation

Example 22:
The current price of a product is $30 and it’s the producers sell 100 items a week at
this price. One week the price is dropped by $3 as a special offer and the producers
sell 150 items. Find an expression for the demand curve, assuming that this is a
linear equation.

The profit-maximizing price/output level

If we have a demand curve P = a – bQ and a total cost curve that states costs as fixed
costs plus variable costs (C = F + vQ), we can calculate the selling price that will
maximise profit. This is the price at which marginal cost equals marginal
revenue (MC = MR).

When
Demand equation is P = a - bQ
MR = a – 2bQ
where
P = the price
Q = the quantity demanded
a = the price at which demand would be nil
b =(change in quantity/ change in price)

Marginal cost is the cost of producing one extra unit of the product.
Therefore, MC=Variable cost

Example: 23 (MC = MR)

AB has used market research to determine that if a price of $250 is charged for
product G, demand will be 12,000 units. It has also been established that demand
will rise or fall by 5 units for every $1 fall/rise in the selling price. The marginal cost
of product G is $80.

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Required
If marginal revenue = a –2bQ when the selling price (P) = a – bQ,
calculate the profit-maximising sellingprice for product G.

Example 24:
Heat Co is now trying to ascertain the best pricing policy that they should adopt for
the Energy Buster’s launch onto the market. Demand is very responsive to price
changes and research has established that, for every $15 increase in price, demand
would be expected to fall by 1,000 units. If the company set the price at $735, only
1,000 units would be demanded.
The costs of producing each air conditioning unit are as follows:
$
Direct materials 42
Labour 12 (1·5 hours at $8 per hour
Fixed overheads 6 (based on producing 50,000 units per annum)
–––
Total cost 60
–––
(i) Establish the demand function (equation) for air conditioning units;
(ii) Calculate the marginal cost for each air conditioning unit?
(iii) Equate marginal cost and marginal revenue in order to calculate the
optimum price and quantity.

Increasing sales and production levels

When an opportunity to increase sales and production levels arises in a business the
key question to answer is:
Whether incremental revenue exceeds the incremental costs or not? If yes accept the
offer otherwise reject it.

Example 25:
An opportunity arises to increase sales by 10,000 units:

•Selling price of additional units = $10

•Variable cost of additional units = $6
•Fixed costs will increase by = $50,000

Required:
Should the opportunity be accepted?

Price Strategies
1) Cost-Plus Pricing
In practice cost is one of the most important influences on price. Many firms
base price on simple cost plus rules (costs are estimated and then a profit
margin is added in order to set the price). The 'full cost' may be a fully
absorbed production cost only, or it may include some absorbed
administration, selling and distribution overhead.

Businesses that carry out a large amount of contract work or jobbing

work, for which individual job or contract prices must be quoted regularly

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would find this a useful method to adopt. Since every job or contract is
different, there are no market prices; and in the absence of a market price,
adding a profit mark-up to cost provides a logical way to decide the selling
price. The percentage profit mark-up, however, does not have to be rigid and
fixed, but can be varied to suit different circumstances

Advantages of Full Cost Plus Pricing:

1) It is a quick and simple of method of calculating price.
2) Using the full cost plus pricing the company ensures to recover all cost
through selling price.
3) When there is no market price usually this method is preferred.

Disadvantages of Full Cost Plus Pricing:

1) It fails to recognize that price does have impact on demand.
2) Price of the product may be adjusted with conditions of the market like
competitor price.
3) Needs to estimate budgeted output and overhead cost, thus there comes
the issue of over/under absorbed overheads.

2) Marginal/ Variable Cost plus pricing:

The use of marginal cost is simpler as there is no need for the absorption of fixed
overheads and could be argued to be more consistent with the use of contribution in
decision making. The main difficulty lies in setting an appropriate margin or markup
as this will need to ensure that fixed costs are covered. In practice the danger is often
that prices are set too low. Marginal costing is particularly useful in short term
decisions concerning the use of excess capacity or one off contract.

Advantages of Marginal Cost Plus Pricing:

1) It is a simple and easy method to use.
2) The mark-up percentage can be varied, and so mark-up pricing can be
adjusted to reflect demand conditions.
3) It draws management attention to contribution, and the effects of higher or
lower sales volumes on profit.

Disadvantages of Marginal Cost Plus Pricing:

1) Although markup can be adjusted to reflect demand conditions yet it doesn’t
fully focus on competitive or market pricing.
2) It ignores fixed overheads and in the pricing decision, but the sales price must
be sufficiently high to ensure that a profit is made after covering fixed costs.

3) Market skimming:
Market skimming is a strategy that attempts to exploit those areas of the market
which are relatively insensitive to price changes. Initially, high prices for the product
would be charged in order to take advantage of those buyers who want to buy it as
soon as possible, and are prepared to pay high prices in order to do so.
The existence of certain conditions is likely to make the strategy a suitable one for
Company. These are as follows:
a) Where a product is new and different, so that customers are prepared to pay
high prices in order to gain the perceived status of owning the product early.

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b) Where products have a short life cycle this strategy is more likely to be used,
because of the need to recover development costs and make a profit quickly.
c) Where high prices in the early stages of a product’s life cycle are expected to
generate high initial cash inflows. If this were to be the case, it would be
particularly useful for Company if they are having liquidity problems.
d) Where barriers to entry exist, which deter other competitors from entering the
market; as otherwise, they will be enticed by the high prices being charged.
These might include prohibitively high investment costs, patent protection or
unusually strong brand loyalty.

4) Market Penetration:
With penetration pricing, a low price would initially be charged for the product. The
idea behind this is that theprice will make the product accessible to a larger number
of buyers and therefore the high sales volumes will compensate for the lower prices
being charged. A large market share would be gained by using this policy.
The circumstances that would favor a penetration pricing policy are:
a) Highly elastic demand for the product i.e. the lower the price, the higher the
demand.
b) If significant economies of scale could be achieved by company, then higher
sales volumes would result in sizeable reductions in costs.
c) The life cycle of the product is relatively long and hence the company does not
need to recover the initial development cost so quickly.
d) The company is producing a product that is similar or identical to the
competitor’s product therefore to attract the customers the company might
implement penetration policy.

5) Complementary products:
Complementary products are sold separately but are connected and dependent on
each other for sales, for example, an electric toothbrush and replacement toothbrush
heads. The electric toothbrush may be priced competitively to attract demand but the
replacement heads can be relatively expensive.
A loss leader is when a company sets a very low price for one product intending to
make consumers buy other products in the range which carry higher profit margins.
Another example is selling razors at very low prices whilst selling the blades for them
at a higher profit margin.

6) Price discrimination:
Price discrimination is the practice of charging different prices for the same product
to different groups of buyers.
There are a number of bases on which such discriminating prices can be set:
a) By age:
For example, some products are sold at a lower price to students or old
individuals.
b) By market segment:
Different products are sold in different markets at different prices, e.g.
McDonald products etc.
c) By place:
Theatre seats are usually sold according to their location so that patrons pay
different prices for the same performance according to the type of seat and its
location in the theatre auditorium.

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d) By time:
This is perhaps the most popular type of price discrimination. Off-peak travel
bargains, hotel prices and telephone charges are all attempts to increase sales
revenue by covering variable but not necessarily average cost of provision.
Airline companies are successful price discriminators, charging more to rush
hours whose demand is inelastic at certain times of the day.

7) Relevant cost plus pricing:

Relevant cost is the cost that is incurred by taking a particular decision. Hence
first calculate relevant cost and then add markup on it to get the selling price.
It is also known as minimum price or bid price charged. When company has
spare capacity or the company wants to quote minimum price it calculates
price using relevant costing techniques.

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Risk &Uncertainty

Risk& uncertainty:
Risk involves events that have several outcomes and the probability of each outcome
can be estimated whereas if probabilities are not attached with the outcomes then it
is called uncertainty.

For example; Occurrence of rain is an event if we say that 20% chance is there it
will rain based upon past experience then it is an example of risk and if we are unable
to attach the likelihood of occurrence of rain then it is called uncertainty.

Risk attitudes of investors:

A risk seeker (Optimistic) is a decision maker who is interested in the best

outcomes no matter how small the chance that they may occur.
A decision maker is risk neutral if he is prepared to make a decision that balances
risk and return. He is willing take on more risk, but only if the expected profit or
return is higher. He will also accept a lower return for lower risk.
A risk averse (Pessimistic) decision maker acts on the assumption that the worst
outcome might occur and will make a decision that limits or minimizes the risk.

Payoff tables

A profit table (payoff table) can be a useful way to represent and analyses a scenario
where there is a range of possible outcomes and a variety of possible responses. A pay-
off tables imply illustrates all possible profits/losses.

Example 26:
Omelette Co is trying to set the sales price for one of its products. Three prices are
under consideration, and expected sales volumes and costs are as follows.
Probabilities of outcomes are 20%,50% and 30% for best possible, most likely and
worst possible respectively.
Pricing choices Sales demand (units)

$4 Best possible 16,000

Most likely 14,000
Worst possible 10,000

$4.30 Best possible 14,000

Most likely 12,500
Worst possible 8,000

$4.40 Best possible 12,500

Most likely 12,000
Worst possible 6,000

Fixed costs are $20,000 and variable costs of sales are $2 per unit.

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Prepare a pay-off table for the different possible outcomes for each
decision option?
Maximax, maximin and minimax regret
When probabilities are not available, there are still tools available for incorporating
uncertainty in to decision making.

Maximax
The maximax rule involves selecting the alternative that maximizes the maximum
payoff achievable.

This approach would be suitable for an optimist, or 'risk seeking' investor, who seeks
to achieve the best results if the best happens.

Maximin
The investor would look at the worst possible outcome at each level and then selects
the highest one of these. The decision maker therefore chooses the outcome which is
guaranteed to minimize his losses. In the process, he loses out on the opportunity of
making big profits.

This approach would be appropriate for a risk averse pessimist who seeks to achieve
the best results if the worst happens.

Minimax Regret rule

The minimax regret strategy is the one that minimizes the maximum regret. It is
useful for a risk averse decision maker. Essentially, this is the technique for a ‘sore
loser’ who does not wish to make the wrong decision.

‘Regret’ in this context is defined as the opportunity loss through having made the
wrong decision.

Expected value:

Where probabilities are assigned to different outcomes we can measure the weighted
average value of the different possible outcomes. Each possible outcome is given a
weighting equal to the probability that it will occur.
The expected value (EV) decision rule is that the decision option with the highest EV
of benefit.

Example 27:
Cement Co is a company specializing in the manufacture of cement, a product used
in the building industry. The company has found that when weather conditions are
good, the demand for cement increases since more building work is able to take
place.
Last year, the weather was so good, and the demand for cement was so great, that
Cement Co was unable to meet demand. Cement Co is now trying to work out the
level of cement production for the coming year in order to maximise profits. The
company doesn’t want to miss out on the opportunity to earn large profits by running
out of cement again. However, it doesn’t want to be left with large quantities of the
product unsold at the end of the year, since it deteriorates quickly and then has to be

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disposed of. The company has received the following estimates about the probable
weather conditions and corresponding demand levels for the coming year:

Weather Probability Demand

Good 25% 350,000 bags
Average 45% 280,000 bags
Poor 30% 200,000 bags

Each bag of cement sells for $9 and costs $4 to make. If cement is unsold at the end
of the year, it has to be disposed of at a cost of $0·50 per bag.
Cement Co has decided to produce at one of the three levels of production to match
forecast demand. It now has to decide which level of cement production to select.

Required:
(a) Construct a payoff table to show all the possible profit outcomes.
(b) Decide the level of cement production the company should choose,
based on the following decision rules:
(i) Maximin
(ii) Maximax
(iii) Expected value
(iv) Minimax Regret Rule

You must justify your decision under each rule, showing all necessary
calculations.

(c) Describe the ‘maximin’ and ‘expected value’ decision rules, explaining
when they might be used and the attitudes of the decision makers who
might use them.

Example 28:
Shifters Haulage (SH) is considering changing some of the vans it uses to transport
crates for customers. The new vans come in three sizes; small, medium and large. SH
is unsure about which type to buy. The capacity is 100 crates for the small van, 150
for the medium van and 200 for the large van.
Demand for crates varies and can be either 120 or 190 crates per period, with the
probability of the higher demand figure being 0·6.
The sale price per crate is $10 and the variable cost $4 per crate for all van sizes
subject to the fact that if the capacity of the van is greater than the demand for crates
in a period then the variable cost will be lower by 10% to allow for the fact that the
vans will be partly empty when transporting crates.
SH is concerned that if the demand for crates exceeds the capacity of the vans then
customers will have to be turned away. SH estimates that in this case goodwill of
$100 would be charged against profits per period to allow for lost future sales
regardless of the number of customers that are turned away.
Depreciation charged would be $200 per period for the small, $300 for the medium
and $400 for the large van.
SH has in the past been very aggressive in its decision-making, pressing ahead with
rapid growth strategies. However, its managers have recently grown more cautious
as the business has become more competitive.

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Required:
(a) Explain the principles behind the maximax, maximin and expected
value criteria that are sometimes used to make decisions in uncertain
situations.
(b) Prepare a profits table showing the SIX possible profit figures per
period.
(c) Using your profit table from (b) above discuss which type of van SH
should buy taking into consideration the possible risk attitudes of the
managers.

Problems of using expected values for decisions

Expected values give us a long run average of the outcome that would be expected if a
decision was to be repeated many times. The actual outcome may not be very close to
the expected value calculated and the technique is therefore not really very useful.
Also, estimating accurate probabilities is difficult because it depends upon the past
information.
The expected value criterion for decision-making is useful where the attitude of the
investor is risk neutral.
Decision Tree

Decision trees are diagrams which illustrate the choices and possible outcomes of a
decision. The possible outcomes are usually given associated probabilities of
occurrence.

How to draw a decision tree

 Decision tree starts from a decision point that is represented by a square

 Next step is to draw options and these are represented as the branches of tree.
 If the outcome from any choice is certain, the branch of the decision tree for
that decision option is complete.
 If the outcome is not certain then we will have decision options, these are
represented as circle
 First draw the full tree with outcomes and their respective probabilities and
then solve it backwards to conclude the decision point.
 The decision taken by this method is based upon expected value.

Example 29:
Beethoven Co has a new wonder product, the vylin, of which it expects great things.
At the moment the company has two courses of action open to it, to test market the
product or abandon it.
If the company test markets it, the cost will be $100,000 and the market response
could be positive or negative with probabilities of 0.60 and 0.40.
If the response is positive the company could either abandon the product or market it
full scale. If it markets the vylin full scale, the outcome might be low, medium or high
demand, and the respective net gains/(losses) would be (200), 200 or 1,000 in units
of $1,000 (the result could range from a net loss of $200,000 to a gain of
$1,000,000). These outcomes have probabilities of 0.20, 0.50 and 0.30 respectively
If the result of the test marketing is negative and the company goes ahead and
markets the product, estimated losses would be $600,000.

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

Required
(a) Draw a decision tree.
(b) Include figures for cost, loss or profit on the appropriate branches of
the tree.
The value of perfect information

In many questions the decision makers receive a forecast of a future outcome (for
example a market research group may predict the forthcoming demand for a
product). This forecast may turn out to be correct or incorrect. The question often
requires the candidate to calculate the value of the forecast.

Perfect information
The forecast of the future outcome is always a correct prediction. If a firm can obtain
a 100% accurate prediction they will always be able to undertake the most beneficial
course of action for that prediction.

The value of perfect information can be calculated as follows:

Expected Profit (Outcome) WITH the information
LESS
Expected Profit (Outcome) WITHOUT the information
Example 30:
The management of Ivor Ore must choose whether to go ahead with either of two
mutually exclusive projects, A and B. The expected profits are as follows.

Profit/(loss) if there is Profit if there is Profit(Loss) if there is

strong demand moderate demand weak demand

Option A $4,000 $1,200 $(1,000)

Option B $1,500 $1,000 $500
Probability
of demand 0.2 0.3 0.5

Required
(a) Ascertain what the decision would be, based on expected values, if no
information about demand were available.
(b) Calculate the value of perfect information about demand.

Methods of uncertainty reduction:

– Market research.
This can be desk-based (secondary) or field-based (primary). Desk-based is cheap
but can lack focus.
Field-based research is better in that you can target your customers and your product
area, but can be time consuming and expensive. The internet is bringing down the

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cost and speeding up this type of research, email is being used to gather information
quickly on the promise of free gifts etc.

– Simulation.
Computer models can be built to simulate real life scenarios. The model will predict
what range of returns an investor could expect from a given decision without having
risked any actual cash. The models use random number tables to generate possible
values for the uncertainty the business is subject to. Again, computer technology is
assisting in bringing down the cost of such risk analysis.

– Sensitivity analysis.
This can be used to assess the range of values that would still give the investor a
positive return.
The uncertainty may still be there, but the affect that it has on the investor’s returns
will be better understood. Sensitivity calculates the % change required in individual
values before a change of decision results. If only a (say) 2% change is required in
selling price before losses result an investor may think twice before proceeding. Risk
is therefore better understood.

Example 31:
Sensivite Co has estimated the following sales and profits for a new product which it
may launch on to the market.
$ $
Sales (2,000 units) 4,000
Variable costs: materials 2,000
Labour 1,000
3,000
Contribution 1,000
Less incremental fixed costs 800
Profit 200

Required
Analyze the sensitivity of the project to changes in key variables.

– Calculation of worst and best case figures.

An investor will often be interested in range. It enables a better understanding of
risk. An accountant could calculate the worst case scenario, including poor demand
and high costs whilst being sensible about it. He could also calculate best case
scenarios including good sales and minimum running costs. This analysis can often
reassure an investor. The production of a probability distribution to show an investor
the range of possible results is also useful to explain risks involved. A calculation of
standard deviation is also possible.

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CVP Analysis

Cost-volume-profit analysis looks primarily at the effects of differing

levels of activity on the financial results of a business

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we
could look into a crystal ball and find out exactly how many customers were going to
buy our product, we would be able to make perfect business decisions and maximize
profits.
Take a restaurant, for example. If the owners knew exactly how many customers
would come in each evening and the number and type of meals that they would
order, they could ensure that staffing levels were exactly accurate and no waste
occurred in the kitchen. The reality is, of course, that decisions such as staffing and
food purchases have to be made on the basis of estimates, with these estimates being
based on past experience.
While management accounting information can’t really help much with the crystal
ball, it can be of use in providing the answers to questions about the consequences of
different courses of action.
One of the most important decisions that need to be made before any business even
starts is ‘how much do we need to sell in order to break-even?’
By ‘break-even’ we mean simply covering all our operating costs without
making a profit.
Prior Knowledge Formulas

Contribution per unit = unit selling price – unit variable costs

Profit = (sales volume × contribution per unit) – fixed costs

Breakeven point
(Activity level at which there is neither profit nor loss) = total fixed costs/
contribution per unit

Contribution/sales (C/S) ratio = (contribution/sales) × 100

Sales revenue at breakeven point = (fixed costs) / (C/S ratio)

Margin of safety (in units) = budgeted sales units – breakeven sales units

Margin of safety (as %) = ((budgeted sales – breakeven sales)/ budgeted sales) ×

100%

Sales volume to achieve a target profit = (fixed cost + target profit)/

contribution per unit

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Example 32:
The following data relate to Product PQ:
Selling price £25perunit
Variable cost £20perunit
Fixed costs are £50,000.
Required:
a) Calculate the number of units that must be made and sold in order
to break even.
b) Calculate the level of activity that is required to generate a profit of
£40,000.
c) The company budgets to sell 13,000 units of Product PQ. Calculate
the margin of safety.
d) Calculate the Contribution/Sales ratio for Product PQ.
e) Calculate the breakeven point again, this time expressed in terms
of sales revenue.
f) Calculate the sales revenue that is required to generate a profit of
£40,000.

Single Product Breakeven Charts

For Breakeven Chart draw the following lines;

 Fixed cost
 Total cost
 Total Revenue

For Contribution Chart draw the following lines;

 Total Variable Cost
 Total Revenue
 Total Cost

For Profit and Volume Chart draw the following lines;

 Profit/Loss

For all of these Graphs, take costs, revenues, profit/ loss on y-axis whereas output on
x-axis.

Example 34:
A new product has the following sales and cost data.
Selling price $60 per unit
Variable cost $40 per unit
Fixed costs $25,000 per month
Forecast sales 1,800 units per month
Required
Prepare breakeven, contribution and Profit/ Volume charts using the
above data.

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Example 35:
A company manufactures Product RS. The following data are available:
Selling price: $100 per unit
Variable cost: $60 per unit.
Fixed costs are $250,000. The company budgets to produce 12,000 units in the next
period.

Required:

(a) Scenario I – Calculate:

(i) The breakeven point (expressed in units and $ of revenue).
(ii) The level of activity required to generate a profit of $90,000
(expressed in units).
(iii) The margin of safety as a percentage.
(b) Using graph paper, draw a profit volume chart for scenario I.

(c) Scenario II – Using the graph drawn in (b), illustrates and explain
the impact of a change in Selling Price to $120 per unit, on:
(i) The breakeven point (expressed in units and $ of revenue) ;
(ii) The level of activity required to generate a profit of $90,000
(expressed in units) ;
(iii) The margin of safety.

Breakeven analysis in a multi-product environment

The basic breakeven model can be used satisfactorily for a business operation with
only one product. However, most companies sell a range of different products, and
the model has to be adapted when one is considering a business operation with
several products.
CVP Analysis assumes that, if a range of products is sold, sales will be in accordance
with a predetermined sales mix.

The calculation of breakeven point in a multiproduct firm follows the same pattern as
in a single product firm. While the numerator will be the same fixed costs, the
denominator now will be the weighted average contribution margin.

In multiproduct situations, a weighted average C/S ratio is calculated by using the

formula:

Total Contribution
Weighted Average C/S ratio = —————————
Total Revenue

The Weighted Average C/S ratio is useful in its own right, as it tells us what
percentage each $ of sales revenue contributes towards fixed costs; It is also
invaluable in helping us to quickly calculate the breakeven point in sales revenue:

Fixed costs
Breakeven revenue = —————————————
Weighted Average C/S ratio

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Fixed costs
Breakeven units = —————————————
Weighted Average Contribution per unit

Example 36:
Company A Produces Product X and Product Y. Fixed overhead costs amount to
$200,000 every year. The following budgeted information is available for both
products for next year:
Product X Product Y
Sales Price $50 $60
Variable Cost $30 $45
Contribution per unit $20 $15
Budgeted Sales (in units) 20,000 10,000
Calculate the breakeven revenue?

Example 37:
Breakeven point for multiple products
PL produces and sells two products, M and N. Product M sells for $7 per unit and has
a total variable cost of $2.94 per unit, while Product N sells for $15 per unit and has a
total variable cost of $4.40 per unit. The marketing department has estimated that
for every five units of M sold, one unit of N will be sold. The organization’s fixed costs
per period total $123,600.
Required
Calculate the breakeven point for PL.

Example 38:
H Limited manufactures and sells two products – J and K. Annual sales are expected
to be in the ratio ofJ:1 K:3. Total annual sales are planned to be £420,000. Product J
has a contribution to sales ratio of 40% whereas that of product K is 50%. Annual
fixed costs are estimated to be £120,000.

Required:
What is the budgeted breakeven sales value?

Example 39:
PER plc sells three products. The budgeted fixed cost for the period is£648,000. The
budgeted contribution to sales ratio (C/S ratio) and sales mix are as follows:

Product C/S ratio Mix

P 27% 30%
E 56% 20%
R 38% 50%
Required:
What is the breakeven sales revenue?

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Establishing a Target Profit for Multiple Products

The approach is the same as in single product situations, but the weighted average
contribution to Sales Ratio is now used so that:

Fixed costs + required profit

Target Profit =
Weighted Average C/S ratio

Example 40:
For the above example, calculate the breakeven point if A company requires a
minimum of $300,000 profit.
Margin of Safety Calculations

The basic breakeven model for calculating the margin of safety can be adapted to
multiproduct environments. Calculating the margin of safety for multiple products is
exactly the same as for single products, but we use the standard mix. The easiest way
to see how it's done is to look at an example below:

Example 41:
Murray Ltd produces and sells two types of sports equipment items for children,
balls (in batches) and miniature racquets.
A batch of balls sells for $8 and has a variable cost of $5. Racquets sell for $4 per unit
and have a unit variable cost of $2.60.
For every 2 batches of balls sold, one racquet is sold. Murray budgeted fixed costs are
$407,000 per period. Budgeted sales revenue for next period is $1,250,000 in the
standard mix.
Calculate the margin of safety of Murray ltd.

Example 42:
Hair Co manufactures three types of electrical goods for hair: curlers (C),
straightening irons (S) and dryers (D.) The budgeted sales prices and volumes for the
next year are as follows:
C S D
Selling price $110 $160 $120
Units 20,000 22,000 26,000
Each product is made using a different mix of the same materials and labour.
Product S also uses new revolutionary technology for which the company obtained a
ten-year patent two years ago. The budgeted sales volumes for all the products have
been calculated by adding 10% to last year’s sales.
The standard cost card for each product is shown below.
C S D
$ $ $
Material 1 12 28 16
Material 2 8 22 26
Skilled labor 16 34 22
Unskilled labor 14 20 28
Both skilled and unskilled labor costs are variable.
The general fixed overheads are expected to be $640,000 for the next year.

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Required:
(a) Calculate the weighted average contribution to sales ratio for Hair Co.
(b) Calculate the total break-even sales revenue for the next year for Hair
Co.
(c) Using the graph paper, draw a multi-product profit-volume (PV)
chart showing clearly the profit/loss lines assuming:
(i) You are able to sell the products in order of the ones with the highest
ranking contribution to sales ratios first; and
(ii) You sell the products in a constant mix.
(d) Briefly comment on your findings in (c)

LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS

 Cost-volume-profit analysis is invaluable in demonstrating the effect on an

organisation that changes in volume (in particular), costs and selling prices,
have on profit. However, its use is limited because it is based on the following
assumptions: Either a single product is being sold or, if there are multiple
products, these are sold in a constant mix. But if the constant mix assumption
changes, break-even point also gets changed.
 All other variables, apart from volume, remain constant, i.e. volume is the only
factor that causes revenues and costs to change. In reality, this assumption
may not hold true as, for example, economies of scale may be achieved as
volumes increase. Similarly, if there is a change in sales mix, revenues will
change. Furthermore, it is often found that if sales volumes are to increase,
sales price must fall.
 The total cost and total revenue functions are linear. This is only likely to hold
a short-run, restricted level of activity.
 Costs can be divided into a component that is fixed and a component that is
variable. In reality, some costs may be semi-fixed, such as telephone charges,
whereby there may be a fixed monthly rental charge and a variable charge for
calls made.
 It assumes that production volumes are equal to sales volumes.

Advantages of CVP Analysis

 Graphical representation of cost and revenue data can be more easily

understood by non-financial managers.
 A breakeven model enables profit or loss at any level of activity within the
range for which the model is valid to be determined, and
 The C/S ratio can indicate the relative profitability of different products.
 Highlighting the breakeven point and the margin of safety gives managers
some indication of the level of risk involved.

Example: 42

A company makes and sells product X and product Y. Twice as many units of
product Y are made and sold as that of product X. Each unit of product X makes a
contribution of $10 and each unit of product Y makes a contribution of $4. Fixed
costs are $90,000.

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What is the total number of units which must be made and sold to
make a profit of $45,000?

A) 7,500
B) 22,500
C) 15,000
D) 16,875

Example 43:

P Co makes two products – P1 and P2 – budgeted details of which are as follows:

P1 P2
$ $
Selling price 10·00 8·00
Cost per unit:
Direct materials 3·50 4·00
Direct labour 1·50 1·00
Variable overhead 0·60 0·40
Fixed overhead 1·20 1·00
––––– –––––
Profit per unit 3·20 1·60
––––– –––––

Budgeted production and sales for the year ended 30 November 2015 are:
Product P1 10,000 units
Product P2 12,500 units

The fixed overhead costs included in P1 relate to apportionment of general overhead

costs only. However, P2 also includes specific fixed overheads totaling $2,500.
If only product P1 were to be made, how many units (to the nearest unit)
would need to be sold in order to achieve a profit of $60,000 each year?

A) 25,625 units
B) 19,205 units
C) 18,636 units
D) 26,406 units

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Short Term Decisions

Following short term decisions are taken by the organization:

 Relevant cost
 Make or buy decision
 Outsourcing
 Further processing decision
 Shut down decisions

Relevant Cost

A relevant cash flow is a 'future incremental cash flow'.

 Future
Only future cash flows that occur as a result of the decision should be considered, e.g.
any future costs or revenue.
Sunk costs (i.e. costs that have already been incurred in the past) are not relevant to
the decision and should therefore be ignored we cannot change the past.

 Incremental
Only extra cash flows that occur as a result of the decision should be considered, e.g.
extra costs or revenues.
Fixed costs should be ignored unless there is an incremental fixed cost as a result of
the decision.
Committed costs (i.e. costs that are unavoidable in the future) are not affected by the
decision and should therefore be ignored.
Opportunity costs should be included look at the next best alternative use of a
resource

 Cash flows
Only cash items are relevant to the decision.
For example, depreciation is not relevant since it is not a cash flow.

Example 44:
Identify which of the following costs are relevant to the decisions specified:
(a) The salary to be paid to a market researcher who will oversee the development of
a new product. This is a new post to be created especially for the new product but the
£12,000 salary will be a fixed cost.
Is this cost relevant to the decision to proceed with the development of
the product?

(b) The £2,500 additional monthly running costs of a new machine to be purchased
to manufacture an established product. Since the new machine will save on labour
time, the fixed overhead to be absorbed by the product will reduce by £100 per
month.
Are these costs relevant to the decision to purchase the new machine?
(c) Office cleaning expenses of £125 for next month. The office is cleaned by
contractors and the contract can be cancelled by giving one month’s notice.

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Is this cost relevant to a decision to close the office?

(d) Expenses of £75 paid to the marketing manager. This was to reimburse the
manager for the cost of travelling to meet a client with whom the company is
currently negotiating a major contract.
Is this cost relevant to the decision to continue negotiations?

Opportunity Cost
Opportunity cost is an important concept for decision-making purposes. It is the
value of the best alternative that is foregone when a particular course of action is
undertaken. It emphasizes that decisions are concerned with choices and that by
choosing one plan; there may well be sacrifices elsewhere in the business.

Relevant cost of Material

Any historic cost given for materials is always a sunk cost and never relevant unless it
happens to be the same as the current purchase price.
Note: The above diagram assumes that it is possible to buy more
materials if required. This may not always be the case.

 If a material is in short supply, then the only way a proposal can be

undertaken would be by denying another part of the organization that
resource.
 In this case the relevant cost = normal materials cost + lost contribution in the
other department

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Example 45:
O'Reilly Co has been approached by a customer who would like a special job to be
done for him, and who is willing to pay $22,000 for it. The job would require the
following materials:

Material Required Units Book value Scrap value Market value

$/unit $/unit $/unit
A 1,000 0 – – 6
B 1,000 600 2 2.5 5
C 1,000 700 3 2.5 4
D 200 200 4 6.0 9

a) Material B is used regularly by O'Reilly Ltd, and if units of B are required for this
job, he would need to be replaced to meet other production demand.
b) Materials C and D are in inventory as the result of previous over-buying, and they
have a restricted use. No other use could be found for material C, but the units of
material D could be used in another job as substitute for 300 units of material E,
which currently costs $5 per unit (of which the company has no units in inventory at
the moment).

What are the relevant costs of material, in deciding whether or not to

accept the contract?

Relevant cost of Labor

Items that are not relevant

 Depreciation is not a cash flow so is never relevant

 Profit or loss on disposal incorporates accumulated depreciation so is not
relevant instead look at the cash element only i.e. the scrap proceeds
 The original purchase price of existing machinery is a sunk cost

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 The NBV of existing machinery is a combination of the original price(sunk)

and accumulated depreciation (not a cash flow).

Example 46:
The Telephone Co (T Co) is a company specializing in the provision of telephone
systems for commercial clients. There are two parts to the business:

– installing telephone systems in businesses, either first time installations or

replacement installations;
– supporting the telephone systems with annually renewable maintenance contracts.

T Co has been approached by a potential customer, Push Co, who wants to install a
telephone system in new offices it is opening. Whilst the job is not a particularly large
one, T Co is hopeful of future business in the form of replacement systems and
support contracts for Push Co. T Co is therefore keen to quote a competitive price for
the job. The following information should be considered:

1. One of the company’s salesmen has already been to visit Push Co, to give them
a demonstration of the new system, together with a complimentary lunch, the
costs of which totaled $400.

2. The installation is expected to take one week to complete and would require
three engineers, each of whom is paid a monthly salary of $4,000. The
engineers have just had their annually renewable contract renewed with T Co.
One of the three engineers has spare capacity to complete the work, but the
other two would have to be moved from contract X in order to complete this
one. Contract X generates a contribution of $5 per engineer hour.
There are no other engineers available to continue with Contract X if these two
engineers are taken off the job. It would mean that T Co would miss its
contractual completion deadline on Contract X by one week. As a result, T Co
would have to pay a one-off penalty of $500. Since there is no other work
scheduled for their engineers in one week’s time, it will not be a problem for
them to complete Contract X at this point.

3. T Co’s technical advisor would also need to dedicate eight hours of his time to
the job. He is working at full capacity, so he would have to work overtime in
order to do this. He is paid an hourly rate of $40 and is paid for all overtime at
a premium of 50% above his usual hourly rate.

4. Two visits would need to be made by the site inspector to approve the
completed work. He is an independent contractor who is not employed by T
Co, and charges Push Co directly for the work. His cost is $200 for each visit
made.

5. T Co’s system trainer would need to spend one day at Push Co delivering
training. He is paid a monthly salary of $1,500 but also receives commission
of $125 for each day spent delivering training at a client’s site.

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6. 120 telephone handsets would need to be supplied to Push Co. The current
cost of these is $18·20 each, although T Co already has 80 handsets in
inventory. These were bought at a price of $16·80 each. The handsets are the
most popular model on the market and frequently requested by T Co’s
customers.

7. Push Co would also need a computerized control system called ‘Swipe 2’. The
current market price of Swipe 2 is $10,800, although T Co has an older
version of the system, ‘Swipe 1’, in inventory, which could be modified at a
cost of $4,600. T Co paid $5,400 for Swipe 1 when it ordered it in error two
months ago and has no other use for it. The current market price of Swipe 1 is
$5,450, although if T Co tried to sell the one they have, it would be deemed to
be ‘used’ and therefore only worth $3,000.

8. 1,000 metres of cable would be required to wire up the system. The cable is
used frequently by T Co and it has 200 metres in inventory, which cost $1·20
per metre. The current market price for the cable is $1·30 per metre.

9. You should assume that there are four weeks in each month and that the
standard working week is 40 hours long.

Required:
(a) Prepare a cost statement, using relevant costing principles, showing
the minimum cost that T Co should charge for the contract. Make
DETAILED notes showing how each cost has been arrived at and
EXPLAINING why each of the costs above has been included or excluded
from your cost statement.
(b) Explain the relevant costing principles used in part (a) and explain
the implications of the minimum price that has been calculated in
relation to the final price agreed with Push Co.

Example 47:
The Hi Life Co (HL Co) makes sofas. It has recently received a request from a
customer to provide a one-off order of sofas, in excess of normal budgeted
production. The order would need to be completed within two weeks. The following
cost estimate has already been prepared:

Direct materials: Note $

Fabric 200 m2 at $17 per m2 1 3,400
Wood 50 m at $8·20 per m2 2 410
Direct labour:
Skilled 200 hours at $16 per hour 3 3,200
Semi-skilled 300 hours at $12 per hour 4 3,600

Factory overheads 500 hours at $3 per hour 5 1,500

–––––––
Total production cost 12,110

Administration overheads at 10% of total production cost 6 1,211

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–––––––
Total cost 13,321
–––––––

Notes
1) The fabric is regularly used by HL Co. There are currently 300 m2 in
inventory, which cost $17 per m2. The current purchase price of the fabric is
$17·50 per m2.
2) This type of wood is regularly used by HL Co and usually costs $8·20 per m2.
However, the company’s current supplier’s earliest delivery time for the wood
is in three weeks’ time. An alternative supplier could deliver immediately but
they would charge $8·50 per m2. HL Co already has 500 m2 in inventory but
480 m2 of this is needed to complete other existing orders in the next two
weeks. The remaining 20 m2 is not going to be needed until four weeks’ time.
3) The skilled labour force is employed under permanent contracts of
employment under which they must be paid for 40 hours’ per week’s labour,
even if their time is idle due to absence of orders. Their rate of pay is $16 per
hour, although any overtime is paid at time and a half. In the next two weeks,
there is spare capacity of 150 labour hours.
4) There is no spare capacity for semi-skilled workers. They are currently paid
$12 per hour or time and a half for overtime. However, a local agency can
provide additional semi-skilled workers for $14 per hour.
5) The $3 absorption rate is HL Co’s standard factory overhead absorption rate;
$1·50 per hour reflects the cost of the factory supervisor’s salary and the other
$1·50 per hour reflects general factory costs. The supervisor is paid an annual
salary and is also paid $15 per hour for any overtime he works. He will need to
work 20 hours’ overtime if this order is accepted.
6) This is an apportionment of the general administration overheads incurred by
HL Co.

Required:
Prepare, on a relevant cost basis, the lowest cost estimate which could
be used as the basis for the quotation.
Explain briefly your reasons for including or excluding each of the
costs in your estimate.

Make or Buy Decision

Businesses may be faced with the decision whether to make components for their
own products themselves, or to concentrate their resources on assembling the
products, obtaining the components from outside suppliers instead of making them
'in house'.

If the resources are bought in, their purchase cost is relevant. However, if it is
decided to manufacture the components internally, the comparative costs of doing so
will be the direct materials and wages costs, plus the variable factory overhead i.e.
the variable cost (marginal cost).

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If the total variable costs of internally manufactured components are

seen to be greater than the cost of obtaining similar components
elsewhere, it is obviously uneconomic to produce these items internally.

Example 48:
Shellfish Co makes four components, W, X, Y and Z, for which costs in the
forthcoming year are expected to be as follows.
W X Y Z
Production (units) 1,000 2,000 4,000 3,000
Unit marginal costs $ $ $ $
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12
Directly attributable fixed costs per annum and committed fixed costs:
$
Incurred as a direct consequence of making W 1,000
Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other fixed costs (committed) 30,000
50,000

Directly attributable fixed costs are all items of cash expenditure that are incurred as
a direct consequence of making the product in-house.
A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and
$14 respectively.
Should Shellfish make or buy the components?

Outsourcing
Outsourcing is the use of external suppliers for finished products, components or
services. This is also known as contract manufacturing or sub-contracting.
Basically, a decision about outsourcing activities or using internal staff
to do the work is a form of ‘make or buy’ decision, and the basic
principles are the same.

Reasons for the trend towards outsourcing activities include the following:
 the decision is made on the grounds that specialist contractors can offer
superior quality and efficiency
 Contracting out manufacturing frees capital that can then be invested in core
activities elsewhere.
 Contractors have the capacity and flexibility to start production very quickly to
meet sudden variations in demand.
 The cost of outsourcing is less as compared to producing that output
internally.

Other Factors to consider for outsourcing/buying decision

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In addition to the relative cost of buying externally compared to making in house,

management must consider a number of other issues before a final decision is made.
Reliability of external supplier: can the outside company be relied upon to meet the
requirements in terms of:
 quantity required
 quality required
 delivering on time
 price stability
•Specialist skills: the external supplier may possess some specialist skills that are not
available in-house.
•Alternative use of resource: outsourcing will free up resources which may be used in
another part of the business.
•Social: will outsourcing result in a reduction of the workforce?
Redundancy costs should be considered.
•Confidentiality: is there a risk of loss of confidentiality, especially if the external
supplier performs similar work for rival companies.

Further Processing

•Joint products arise where the manufacture of one product inevitably results in the
manufacture of other products.
•The specific point at which individual products become identifiable is known as the
split off point.
•Costs incurred before the split off point are called joint costs and must be shared
between joint products produced.
•After separation products may be sold immediately or may be processed further.
Any further processing costs are allocated directly to the product on which they are
incurred.

Further processing decision

When deciding whether to process a particular product further or to sell after split off
only future incremental cash flows should be considered:

 Any difference in revenue and any extra costs.

 Joint costs are sunk at this stage and thus not relevant to the decision.
(Note: if we are considering the viability of the whole process, then the joint
costs would be relevant)

Example 49:
The Poison Chemical Company produces two joint products, Alash and Pottum from
the same process.
Joint processing costs of $150,000 are incurred up to split-off point, when 100,000
units of Alash and 50,000 units of Pottum are produced. The selling prices at split-
off point are $1.25 per unit for Alash and $2.00 per unit for Pottum.

The units of Alash could be processed further to produce 60,000 units of a new
chemical, Alashplus, but at an extra fixed cost of $20,000 and variable cost of 30c
per unit of input. The selling price of Alashplus would be $3.25 per unit.
Should the company sell Alash or Alashplus.

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Example 50:
Process Co has two divisions, A and B. Division A produces three types of chemicals:
products L, M and S, using a common process. Each of the products can either be
sold by Division A to the external market at split-off point (after the common process
is complete) or can be transferred to Division B for individual further processing into
products LX, MX and SX.
In November 2013, which is a typical month, Division A’s output was as follows:
Product Kg
L 1,200
M 1,400
S 1,800

The market selling prices per kg for the products, both at split-off point and after
further processing, are as follows:
$ $
L 5·60 LX 6·70
M 6·50 MX 7·90
S 6·10 SX 6·80

The specific costs for each of the individual further processes are:
$
Variable cost of $0·50 per kg of LX
Variable cost of $0·70 per kg of MX
Variable cost of $0·80 per kg of SX

Further processing leads to a normal loss of 5% at the beginning of the process for
each of the products being processed.

Required:
(a) Calculate and conclude whether any of the products should be further
processed in Division B in order to optimize the profit for the company
as a whole.

Shut Down Decisions

Part of a business, for example a department or a product, may appear to be
unprofitable. The business may have to make a decision as to whether or not this
area should be shutdown.

The decision should be based upon avoidable and unavoidable cost. The
costs that can be avoided as a result of closure of operation should be
considered as cost savings and the contribution lost should be shown as
outflow.

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Section D
Budgeting and control

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Budgeting

A budget is a plan for the future expressed in quantitative terms. As the future is
uncertain therefore planning is done to avoid this uncertainty to some extent.

Objectives of Budgetary Control System

1) Planning:
Budgeting makes sure that managers plan for the future, producing detailed plans in
order to ensure the implementation of the company’s long term plan. Budgeting
makes managers look at the year ahead and consider the changes in conditions that
might take place and how to respond to those changes in conditions.

2) Co-ordination:
Budgeting is a method of bringing together the activities of all the different
departments into a common plan. If an advertising campaign is due to take place in a
company in three months’ time, for example, it is important that the production
department know about the expected increase in sales so that they can scale up
production accordingly. Each different department may have its own ideas about
what is good for the organization. For example, the purchasing department may want
to order in bulk in order to obtain bulk quantity discounts, but the accounts
department may want to order in smaller quantities so as to preserve cash flow.

3) Communication:
Through the budget, top management communicates its expectations to lower level
management. Each department has a part to play in achieving the desired results of
the company, and the annual budget is the means of formalizing these expectations.
The whole process of budget setting, whereby information is shared between
departments, facilitates this communication process.

4) Motivation:
The budget provides a basis for assessing how well managers and employees are
performing. In this sense, it can be motivational. However, if the budget is imposed
from the top, with little or no participation from lower level management and
employees, it can have a seriously de-motivational effect.

5) Control:
Expenditure within any organization needs to be controlled and the budget facilitates
this. Actual results are compared to expected results, and the reasons for any
significant, unexpected differences are investigated. Sometimes the reasons are
within the control of the departmental manager and he/she must be held
accountable; at other times, they are not.

6) To evaluate performance
Often, managers and employees will be awarded bonuses based on achieving
budgeted results. This makes more sense than evaluating performance by simply
comparing the current year to the previous year. The future may be expected tobe
very different than the past as economic conditions change. Also, events happen that
may not be expected to reoccur.

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For example, if weather conditions are particularly wet one year, a company making
and selling umbrellas would be expected to make higher than usual sales. It would
not be fair to assess managers against these historical sales levels in future years,
where weather conditions are more normal.

7) To ensure achievement of the management’s objectives:

Objectives are set not only for the organisation as a whole but also for individual
targets. The budget helps to work out how these objectives can be achieved.

Planning and Control Cycle

The seven steps of planning and control cycle are:

1) Identify objectives
2) Identify potential strategies
3) Evaluate strategies
4) Choose alternative courses of action
5) Implement the long-term plan
6) Measure actual results and compare with the plan
7) Respond to divergences from the plan

Feedback occurs when the results of a system are used to control it, by adjusting the
input or behaviour of the system. Feedback is information produced as output from
operations; it is used to compare actual results with planned results for control
purposes.

Types of Feedback:
A business organization uses feedback for control.

(a) Negative feedback indicates that results or activities must be brought back on
course, as they are deviating from the plan.

(b) Positive feedback results in control action continuing the current course. You
would normally assume that positive feedback means that results are going according
to plan and that no corrective action is necessary.

(c) Feed forward control is control based on forecast results: in other words if
the forecast is bad, control action is taken well in advance of actual results.

There are two types of feedback.

(a) Single loop feedback is control, like a thermostat, which regulates the output
of a system. For example, if sales targets are not reached, control action will be taken
to ensure that targets will be reached soon. The plan or target itself is not changed,
even though the resources needed to achieve it might have to be reviewed.

(b) Double loop feedback is of a different order. It is information used to change

the plan itself. For example, if sales targets are not reached, the company may need
to change the plan.

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Mnemonic for advantages and disadvantages of Budgeting

M (Motivation)
R (Responsibility Accounting)
R (Realistic Budget)
E (Expenditure of making the budget)
S (Slack in the budget)
T (Time needed to prepare the budget)

Use this mnemonic to discuss the advantages and disadvantages of each budgeting
style.

Top down Budgeting Approach

According to top-down budgeting, budget targets are set at senior management level
for the organization as a whole and for each major department or activity within the
organization. The departmental budget targets are then given to the departmental
managers, who are required to prepare a budget that conforms to the targets that
have been imposed on them from above.

Suitability:
The culture of the organization may dictate whether imposed budgeting style is more
effective or not. If there are managers who are NOT trained in budgeting and costs
are mainly uncontrollable then it may be preferable to use a centrally controlled,
imposed budget.

Advantages of imposed style

There are a number of reasons why it might be preferable for managers not to be
involved in setting their own budgets:

(1) Involving junior managers in the setting of budgets is more time

consuming than if senior managers simply imposed the budgets.

(2) Managers may not have the skills or motivation to participate usefully
in the budgeting process.

(3) Senior managers have the better overall view of the company and its
resources and may be better placed to create a budget which utilizes those
scarce resources to best effect.

(4) Senior managers also are aware of the longer term strategic objectives
of the organization and can prepare a budget which is in line with that
strategy.

(5)By having the budgets imposed by senior managers, i.e. someone outside
the department, a more objective, fresher perspective may be gained.

Participative Budgets

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With bottom-up budgeting, the budgeting process starts at a relatively low level of
management.
Managers are required to draft a budget for their area of operations. These are
submitted to their superior, who combines the lower-level budgets into a combined
budget for the department as a whole. Departmental budgets are then submitted to
senior management, where they are combined into a coordinated budget for the
organization as a whole.

Suitability:
The culture of the organisation may dictate whether a participative or imposed
budgeting style is more effective. If there are managers who are trained in
budgeting and costs are mainly controllable then it may be preferable to
adopt a participative approach to empower and motivate staff.

Advantages of participative budgets

(1) The morale of the management is improved. Managers feel like their opinion
is listened to, that their opinion is valuable.

(2) Managers are more likely to accept the plans contained within the
budget and strive to achieve the targets if they had some say in setting the
budget, rather than if the budget was imposed upon them. Failure to achieve
the target that they themselves set is seen as a personal failure as well as an
organizational failure.

(3) The lower level managers will have a more detailed knowledge of their
particular part of thebusiness than senior managers and thus will be able to
produce more realistic budgets.

Incremental budgeting
‘Incremental budgeting’ is the term used to describe the process whereby a
budget is prepared using a previous period’s budget or actual performance as a base,
with incremental amounts then being added for the new budget period. The budget is
prepared after an adjustment for inflation and other incremental factors.

Suitability:
It is appropriate in some circumstances. For example, in a stable business, the
amount of stationery spent in one year is unlikely to be significantly different in the
next year, so taking the actual spend in year one and adding a little for inflation
should be a reasonable target for the spend in the next year.
Its significance becomes more prominent for routine activities where
justification is as such not needed.

Advantages of Incremental Budgeting

1) Incremental budgeting is very easy to perform. This makes it possible for a
person without any accounting training to build a budget.
2) Incremental budgeting is also very quick compared to other budgeting
methods.
3) The information required to complete it is also usually readily available.

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Disadvantages of Incremental Budgeting

1) On the other hand, incremental budgeting encourages inefficiency because it
does not question the preceding year’s figures on which it is based. No-one
asks how those figures could be reduced.
2) Similarly, in some organizations, it encourages slack because departmental
managers may attempt to use their entire budget up for one year, even if they
do not need to, just to ensure that that cash is available again the next year.
3) Errors from one year are carried to the next, since the previous year’s figures
are not questioned.

Zero based Budgeting

‘Zero-based budgeting’, on the other hand, refers to a budgeting process which starts
from a base of zero, with no reference being made to the prior period’s budget or
performance. Every department function is reviewed comprehensively, with all
expenditure requiring approval, rather than just the incremental expenditure
requiring approval.

Steps involved in Zero based Budgeting

Zero-based budgeting involves three main stages:
1) Activities are identified by managers. These activities are then described in
what is called a ‘decision package’. This decision package is prepared at the
base level, representing the minimum level of service or support needed to
achieve the organization’s objectives. Further incremental packages may then
be prepared to reflect a higher level of service or support.

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

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

Advantages of zero based budgeting

(1) Inefficient or obsolete operations can be identified and discontinued
(2) ZBB leads to increased staff involvement at all levels since a lot more information
and work is required to complete the budget
(3) ZBB will respond to changes in the economic environment since the budget starts
from scratch each year and takes into account the environment at that time.
(4) ZBB focuses attention on outputs in relation to value for money. This is
particularly important in the public sector where the 3 Es (economy, efficiency and
effectiveness) are often used to measure performance.
(5) Resources should be allocated efficiently and economically as slack can be
minimized.

Disadvantages of zero based budgeting

1) Departmental managers will not have the skills necessary to construct
decision packages. They will need training for this and training takes time and
money.

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2) In a large organization, the number of activities will be so large that the

amount of paperwork generated from ZBB will be unmanageable.
3) Ranking the packages can be difficult, since many activities cannot be
compared on the basis of purely quantitative measures. Qualitative factors
need to be incorporated but this is difficult.
4) The process of identifying decision packages, determining their purpose, costs
and benefits is massively time consuming and therefore costly.

Suitability:
It could be argued that ZBB is more suitable for public sector than for
private sector organizations. This is because, firstly, it is far easier to put
activities into decision packages in organizations which undertake set definable
activities. Local government, for example, has set activities including the provision of
housing, schools and local transport. Secondly, it is far more suited to costs
that are discretionary in nature or for support activities. Such costs can be
found mostly in not for profit organizations or the public sector, or in the service
department of commercial operations.

Since ZBB requires all costs to be justified, it would seem inappropriate to

use it for the entire budgeting process in a commercial organization. Why
take so much time and resources justifying costs that must be incurred in order to
meet basic production needs? It makes no sense to use such a long-winded process
for costs where no discretion can be exercised anyway. Incremental budgeting is, by
its nature, quick and easy to do and easily understood. These factors should not be
ignored.
In conclusion, whilst ZBB is more suited to public sector organizations, and is more
likely to make cost savings in hard times such as these, its drawbacks should not be
overlooked.

Activity Based Budgeting

ABB is defined as: ‘a method of budgeting based on an activity framework and
utilizing cost driver for the budget setting and variance feedback processes’.
Or, put more simply, preparing budgets using overhead costs from activity based
costing methodology.

Suitability:
The fixed costs may need close control and therefore some form of ABB may be
appropriate.

Advantages of Activity based budgeting

The advantages of ABB are similar to those provided by activity based costing (ABC).
1) It draws attention to the costs of ‘overhead activities’ which can be a large
proportion of total operating costs.
2) It recognizes those activities which drive costs. If we can control the causes
(drivers) of costs, then costs should be better managed and understood.
3) ABB can provide useful information in a total quality management (TQM)
environment, by relating the cost of an activity to the level of service provided.

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Disadvantages of ABB
1) A considerable amount of time and effort might be needed to establish the key
activities and their cost drivers.
2) It may be difficult to identify clear individual responsibilities for activities.
3) It could be argued that in the short-term many overhead costs are not
controllable and do not vary directly with changes in the volume of activity for
the cost driver.

Rolling Budget
A budget (usually annual) kept continuously up to date by adding another accounting
period (e.g. month or quarter) when the earliest accounting period has expired.

Suitable if:
1) Accurate forecasts cannot be made. For example, in a fast moving
environment. Environment is too much dynamic.
2) For any area of business that needs tight control.

Preparation of Rolling Budget

The rolling budget would be a budget covering a 12-month period and would be
updated monthly or quarterly.
However, instead of the 12-month period remaining static, it would always roll
forward by one month or quarter. This means that, as soon as one month or a quarter
has elapsed, a budget is prepared for the corresponding month or quarter.
When the budget is initially prepared for the year, the first month or quarter is
prepared in detail, with much less detail being given to later months or quarters,
where there is a greater uncertainty about the future.
Advantages of Rolling Budget
1) Planning and control will be based on a more accurate budget.
2) Rolling budgets reduce the element of uncertainty in budgeting since they
concentrate on the short-term when the degree of uncertainty is much
smaller.
3) There is always a budget that extends into the future (normally 12 months)

Disadvantages of Rolling Budget

1) It forces management to reassess the budget regularly and to produce budgets
which are more up to date.
2) Rolling budgets are costlier and time consuming than incremental budgets
3) May demotivate employees if they feel that they spend a large proportion of
their time budgeting or if they feel that the budgetary targets are constantly
changing.

Beyond Budgeting
Beyond Budgeting is a budgeting model which proposes that traditional budgeting
should be abandoned. Adaptive management processes should be used rather
than fixed annual budgets.

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Criticisms of budgeting
1) Budgets are time-consuming and expensive.
2) Budgets fail to focus on shareholder value.
3) Budgets are too rigid and prevent fast response.
4) Budgets protect rather than reduce costs.
5) Budgets lead to unethical behavior.

Changing Budgetary System

1) Resistance by employees. Employees will be familiar with the current
system and may have built in slack so will not easily accept new targets. New
control systems that threaten to alter existing power relationships may be
thwarted by those affected.
2) Loss of control. Senior management may take time to adapt to the new
system and understand the implications of results.
3) Fast forward costs of implementation. Any new system or process
requires careful implementation which will have cost implications. For
example, the procedures for preparing budgets will have to be re written in a
new budget manual. Establishing a system of zero based budgeting, for
example, will require the design and documentation of a large number of
decision packages.
4) Training. In order to prepare and implement budgets under the new system,
managers will need to be fully trained. This is time-consuming and expensive.
5) Lack of accounting information. The organization may not have the
systems in place to obtain and analyze the necessary information for
preparing the new style budget. For example, an organization needs a system
of activity-based costing if it is to implement activity-based budgeting.

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Example 51:
Northland’s major towns and cities are maintained by local government
organizations (LGO), which are funded by central government. The LGOs submit a
budget each year which forms the basis of the funds received.
You are provided with the following information as part of the 2010 budget
preparation.

Overheads
Overhead costs are budgeted on an incremental basis, taking the previous year’s
actual expenditure and adding a set % to allow for inflation. Adjustments are also
made for known changes. The details for these are:

Overhead 2009 cost ($) Known changes Inflation

cost category adjustment
Property cost 120,000 None +5%
Central wages 150,000 Note 1 below +3%
Stationery 25,000 Note 2 below 0%

Note 1: One new staff member will be added to the overhead team; this will cost
$12,000 in 2010
Note 2: A move towards the paperless office is expected to reduce stationery costs by
40% on the 2009 spend

Road repairs
In 2010 it is expected that 2,000 meters of road will need repairing but a contingency
of an extra 10% has been agreed.
In 2009 the average cost of a road repair was $15,000 per meter repaired, but this
excluded any cost effects of extreme weather conditions. The following probability
estimates have been made in respect of 2010:

Weather type predicted Probability Increase in repair cost

Good 0·7 0
Poor 0·1 +10%
Bad 0·2 +25%

Inflation on road repairing costs is expected to be 5% between 2009 and 2010.

Required:
(a) Calculate the overheads budget for 2010.
(b) Calculate the budgets for road repairs for 2010.

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Quantitative Analysis in Budgeting

 High Low Method

 Learning Curve Analysis

High Low Method Example

A department in a large organization wishes to develop a method of predicting its
total costs in a period.

Example: 52

The following data have been recorded.

Month Activity level (X) Cost
units $
January 1,600 28,200
February 2,300 29,600
March 1, 900 28,800
April 1,800 28,600
May 1,500 28,000
June 1,700 28,400

Required:
The total cost model for a period could be represented by what equation
and what is the total cost at 2000 level activity?

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Merits

The following are the main points of merit that go in favor of correlation:

 This method not only indicates the presence, or absence of correlation between any two
variables but also, determines the exact extent, or degree to which they are correlated.

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 Correlation can also ascertain the direction of the correlation i.e. whether the correlation
between the two variables is positive, or negative.
 It enables us in estimating the value of a dependent variable with reference to a particular
value of an independent variable through regression equations.

Demerits
Despite the above points of merits, this method also suffers from the following demerits:

 It is comparatively difficult to calculate as its computation involves intricate algebraic

methods of calculations.
 It is very much affected by the values of the extreme items.
 It is based on a large number of assumptions viz. linear relationship, cause and effect
relationship etc. which may not always hold good.

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Example:

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Example:

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Learning Curve Analysis:

In practice, it is often found that the resources required to make a product decrease
as production volumes increase. It costs more to produce the first unit of a product
than it does to produce the one hundredth unit.
In part, this is due to economies of scale since costs usually fall when
products are made on a larger scale. This may be due to bulk quantity
discounts received from suppliers, for example. The learning curve, effect,
however, is not about this; it is not about cost reduction.
It is a human phenomenon that occurs because of the fact that people get quicker
at performing repetitive tasks once they have been doing them for a
while. The first time a new process is performed, the workers are unfamiliar with
it since the process is untried. As the process is repeated, however, the workers
become more familiar with it and better at performing it. This means that it takes
them less time to complete it.
A BRIEF HISTORY OF THE LEARNING CURVE

The first reported observation of the learning curve goes as far back as 1925 when
aircraft manufacturers observed that the number of man hours taken to assemble
planes decreased as more planes were produced. TP Wright subsequently established
from his research of the aircraft industry in the 1920s and 1930s that the rate at
which learning took place was not random at all and that it was actually possible to
accurately predict how much labour time would be required to build planes in the
future.
During World War II, US government contractors then used the learning curve to
predict cost and time for ship and plane construction. Gradually, private sector
companies also adopted it after the war.
How Learning curve factor works

The specific learning curve effect identified by Wright was that the cumulative
average time per unit decreased by a fixed percentage each time cumulative output
doubled. While in the aircraft industry this rate of learning was generally seen to be
around 80%, in different industries other rates occur. Similarly, depending on the
industry in question, it is often more appropriate for the unit of measurement to be a
batch rather than an individual unit.
The learning process starts as soon as the first unit or batch comes off the
production line. Since a doubling of cumulative production is required in order for
the cumulative average time per unit to decrease, it is clearly the case that the effect
of the learning rate on labour time will become much less significant as
production increases. Eventually, the learning effect will come to an end
altogether. You can see this in Figure 1 below. When output is low, the learning
curve is really steep but the curve becomes flatter as cumulative output increases,
with the curve eventually becoming a straight line when the learning effect ends.

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Figure 1

Where does learning curve theory apply?/Limitations of Learning curve

 Learning curve effect applies on labor rather than machines.

 When the task is new for the labor.
 When the nature of work is repetitive.
 Where the tasks are complex.
 There are no breaks in production.

Significance of Learning Curve Impact

Learning curve models enable users to predict how long it will take to complete a
future task. Management accountants must therefore be sure to take into account
any learning rate when they are carrying out planning, control and decision-making.
If they fail to do this, serious consequences will result. As regards its importance in
decision-making,
Let us look at the example of a company that is introducing a new product onto the
market. The company wants to make its price as attractive as possible to customers
but still wants to make a profit, so it prices it based on the full absorption cost plus a
small 5% mark-up for profit. The first unit of that product may take one hour to
make. If the labour cost is $15 per hour, then the price of the product will be based
on the inclusion of that cost of $15 per hour. Other costs may total $45. The product
is therefore released onto the market at a price of $63. Subsequently, it becomes
apparent that the learning effect has been ignored and the correct labour time per
unit should is actually 0.5 hours. Without crunching through the numbers again, it is
obvious that the product will have been launched onto the market at a price which is
far too high. This may mean that initial sales are much lower than they otherwise
would have been and the product launch may fail. Worse still, the company may have
decided not to launch it in the first place as it believed it could not offer a competitive
price.
Importance in Planning and Control Cycle:
Let us now consider its importance in planning and control. If standard costing is to
be used, it is important that standard costs provide an accurate basis for the
calculation of variances. If standard costs have been calculated without taking into
account the learning effect, then all the labour usage variances will be

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favorable because the standard labour hours that they are based on will
be too high. This will make their use for control purposes pointless.
Finally, it is worth noting that the use of learning curve is not restricted to the
assembly industries it is traditionally associated with. It is also used in
other less traditional sectors such as professional practice, financial
services, publishing and travel. In fact, research has shown that just
under half of users are in the service sector.
The learning rate and learning effect
Where a learning curve applies, there is a learning rate and a learning effect.
The learning rate is expressed as a percentage value, such as an 80% learning curve
or a 70% learning curve. The learning effect is that as the work force learns from
experience how to make the new product, there is a big reduction in the time to make
additional units.
Specifically, every time that the cumulative output of the product doubles,
the average time to make all the units produced to date is a proportion of
what it was before. This proportion is the learning rate.

So if a 90% learning curve applies, and the labour time to make the first unit is 100
hours:
(a) The average time to make the first two units will be 90% × 100 hours = 90
hours, and the total time for the first two units will be 180 hours. Since the
first unit takes 100 hours, the second unit will take 80 hours.
(b) The average time to make the first four units will be 90% × 90 hours = 81
hours and the total time for the first four units will be 324 hours. Since the
first two units take 180 hours, the third and fourth units together will take 144
hours.
This learning process continues until the learning effect comes to an end and a
‘steady state’ of production is achieved.

Approaches to Learning Curve

The two approaches to learning curve problems
There are two methods that can be used to deal with a learning curve scenario. Be
prepared to use either or both in the exam.
Method 1. The tabular approach
Method 2. The algebraic approach

Tabular approach:
The tabular approach is quicker and easier when it can be used, but it can be used
only for a limited type of problem. The algebraic approach is more likely to be
examined and requires the application of a formula to calculate the cumulative
average time per unit produced.

Example 53:
Bortamord anticipates that a 90% learning curve will apply to the production of a
new item. The first item will take 500 labour hours. The cost per hour for labour and
variable overhead is $5.

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You are required to calculate the total labor cost for the first unit and for
the first 8 units.

Algebraic approach:
The problem with total doubling 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=a*xb
Where
 x = cumulative number of units.
 Y = cumulative average time per unit to produce X units.
 a = time required to produce the first unit of output.
 b = index of learning = log r / log 2, where r = the learning rate expressed as a
decimal.

Calculating the time for a specific unit

The formula approach is used to calculate the incremental time for any unit where a
learning curve applies.
Suppose that we want to know the time that it will take to make the third and the
fifth units, where a learning curve applies.
To calculate the time to make the third unit:

 Calculate the cumulative average time for the first three units and the total
time for the first three units.
 Calculate the cumulative average time for the first two units and the total
time for the firsttwo units.
 The time for the third unit is the difference in these two totals.

Example 54:
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.

Example 55:
The first batch of a new product took 20 hours to produce. The learning rate is 90%.
Required:
If the learning effect ceases after 72 batches (i.e. all subsequent batches
take the same time as the 72nd), how long will it take to make a grand
total of 100 batches?

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Example 56:
Suppose that an 80% learning curve applies to production of a new product item
ABC. To date (the end ofJune) 30 units of ABC have been produced. Budgeted
production in July is 5 units. The time to make the very first unit of ABC in January
was 120 hours. The labour cost is $10 per hour.
Required
(a) Calculate the time required to make the 31st unit.
(b) Calculate the budgeted total labour cost for July.

Example 57:
Mic Co produces microphones for mobile phones and operates a standard costing
system. Before production commenced, the standard labour time per batch for its
latest microphone was estimated to be 200 hours. The standard labour cost per hour
is $12 and resource allocation and cost data were therefore initially prepared on this
basis.
Production of the microphone started in July and the number of batches assembled
and sold each month was as follows:
Month No of batches assembled and sold
July 1
August 1
September 2
October 4
November 8
The first batch took 200 hours to make, as anticipated, but, during the first four
months of production, a learning effect of 88% was observed, although this finished
at the end of October. The learning formula is shown on the formula sheet and at the
88% learning rate the value of b is –0·1844245.

(a) Calculate the actual total monthly labour costs for producing the
microphones for each of the five months from July to November.

Calculating the Learning Curve rate:

Example 58:
P Co. operates a standard costing system. The standard labour time per batch for its
newest product was estimated to be 200 hours, and resource allocation and cost data
were prepared on this basis.
The actual number of batches produced during the first six months and the actual
time taken to produce them is shown below:
Incremental Incremental
number of labour hours
batches taken to
produced produce the
Month each month batches

June 1 200

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Incremental Incremental
number of labour hours
batches taken to
produced produce the
Month each month batches

July 1 152

August 2 267.52

September 4 470.8

October 8 1,090.32

November 16 2,180.64

Required:
(a) Calculate the monthly learning rate that arose during the period.
(b) Identify when the learning period ended and briefly discuss the
implications of this for P Co.

Example 59:
The first batch of a new product took six hours to make and the total time for the first
16 units was 42.8 hours, at which point the learning effect came to an end.
Calculate the rate of learning.

Example 60:
Chair Co has developed a new type of luxury car seat. The estimated labour time for
the first unit is 12 hours but alearning curve of 75% is expected to apply for the first
eight units produced. The cost of labour is $15 per hour. The cost of materials and
other variable overheads is expected to total $230 per unit.
Chair Co plans on pricing the seat by adding a 50% mark-up to the total variable cost
per seat, with the labour cost being based on the incremental time taken to produce
the 8th unit.

Required:
(a) Calculate the price which Chair Co expects to charge for the new seat.
Note: The learning index for a 75% learning curve is –0·415.

(b) The first phase of production has now been completed for the new car seat. The
first unit actually took 12·5 hours to make and the total time for the first eight units
was 34·3 hours, at which point the learning effect came to an end. Chair Co is
planning on adjusting the price to reflect the actual time it took to complete the 8th
unit.
Required:

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(i) Calculate the actual rate of learning and state whether this
means that the labour force actually learnt more quickly or less
quickly than expected.

Use of Spreadsheets in Budgeting

Advantages:
1) The budgeting model can be built in the laptop of the manager so he can do
work even if he is away from the office.
2) Different inputs can be linked with each other by applying formulas thus it’s
easy to design the new version of the model simply by changing the inputs
figures.
3) Sensitivity analysis can also be performed on the spreadsheet.
4) It takes less time and cost to do budgeting on spreadsheet.

Disadvantages:
1) If there is any error in any of the formulae, all the numbers in the budget will
be wrong.
2) A model can become easily corrupted simply by putting a number in the
wrong cell.
3) When spreadsheets are used, there is no audit trail that can be followed in
order to check the numbers.
4) Spreadsheets cannot take account of qualitative factors since they are
invariably difficult to quantify. Decisions should not be made on the basis of
quantitative information alone.

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Standard Costing
Standard cost:
A standard cost is an estimated unit cost.

Standard costing has three main uses.

 To value inventories. It is an alternative to FIFO and average cost as a
method of inventory valuation.
 To budget production costs. When a standard per unit of product as been
established, budgeting production costs becomes a fairly straightforward
process.
 To act as a control device by establishing standards (expected costs) and
comparing actual costs with the expected costs. Variances between actual and
standard cost indicate aspects of operations which may be out of control.
For what kind of cost standard costing is used?
 Mass production
 Repetitive tasks
 Process costing
Not suitable for those industries where work is carried down upon the
request of customer.

The Type of Standard set

Individuals might respond to standards in different ways, according to the difficulty
of achieving the standard level of performance.

 Ideal standard:
When a standard level of performance is high, e.g. an ideal standard,
employees and their managers will recognise that they cannot achieve it. Since
the target is not achievable, they might not even try to get near it.
 Current standard:
When the standard of performance is not challenging (e.g. a current
standard), employees and their managers might be content simply to achieve
the standard without trying to improve their performance.
 Attainable standard:
An attainable standard might be set which challenges employees and their
managers to improve their performance. If this attainable standard is realistic,
it might provide a target that they try to achieve. Some employees will be
motivated by this challenge and will work harder to achieve it. However, some
employees may prefer standards to be set at a low level of performance, in
order to avoid the need to work harder.
 Basic standard:
This type of standard may motivate employees since it gives them a longterm
target to aim for. However, the standard may become out of date quickly and,
as result, may actually demotivate employees.

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Budgets and standards are similar in the following ways:

 They both involve looking to the future and forecasting what is likely to
happen given a certain set of circumstances.
 They are both used for control purposes. A budget aids control by setting
financial targets or limits for a forthcoming period. Actual achievements or
expenditures are then compared with the budgets and action is taken to
correct any variances where necessary. A standard also achieves control by
comparison of actual results against a predetermined target.

There are, however, important differences between budgets and

standards.

BUDGETS STANDARD
1) Budgets give the total estimate of 1) Standards give the idea about the
the activity or the cost center. per unit cost of resource or
2) Prepared for all the functions of activity.
the organisation. 2) Prepared for specific areas where
the nature of tasks are repetitive
and it is in mass production.
3) Expressed in money terms.
3) Not necessary to be expressed in
money terms just like kg’s
required to produce one unit.

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Example: 61

Corfe Co is a business which manufactures computer laptop batteries and it has

developed a new battery which has a longer usage time than batteries currently
available in laptops. The selling price of the battery is forecast to be $45.

The maximum production capacity of Corfe Co is 262,500 units. The company’s

management accountant is currently preparing an annual flexible budget and has
collected the following information so far:

Production (units) 185,000 200,000 225,000

$ $ $

Material costs 740,000 800,000 900,000

Labour costs 1,017,500 1,100,000 1,237,500

Fixed costs 750,000 750,000 750,000

In addition to the above costs, the management accountant estimates that for each
increment of 50,000 units produced, one supervisor will need to be employed. A
supervisor’s annual salary is $35,000.

The production manager does not understand why the flexible budgets have been
produced as he has always used a fixed budget previously.

1) Assuming the budgeted figures are correct, what would the flexed
total production cost be if production is 80% of maximum
capacity?
A) $2,735,000
B) $2,770,000
C) $2,885,000
D) $2,920,000

2) The management accountant has said that a machine maintenance cost was
not included in the flexible budget but needs to be taken into account.

The new battery will be manufactured on a machine currently owned by Corfe Co

which was previously used for a product which has now been discontinued. The
management accountant estimates that every 1,000 units will take 14 hours to
produce. The annual machine hours and maintenance costs for the machine for the
last four years have been as follows:

Machine time Maintenance costs

(hours) ($’000)
Year 1 5,000 850

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Year 2 4,400 735

Year 3 4,850 815
Year 4 800 450

What is the estimated maintenance cost if production of the battery is

80% of maximum capacity (to the nearest$’000)?

A) $575,000
B) $593,000
C) $500,000
D) $735,000

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Standard costing & Variance Analysis

The purposes of standard costing

A standard cost is the planned unit cost of a product or service. It is an indication of

what a unit of product or service should cost.

Types of cost standards

There are four main types of cost standards.

• Basic standards.

• Ideal standards.

• Attainable standards.

• Current standards.

Variance analysis

The following variance analysis produces more detailed results as to the causes of the
differences between what the costs and revenues should have been and what they
actually were.

As well as being the basis for preparing budgets, standard costs are also used for
calculating and analyzing variances.

The variances that will be looked at are:

• Sales variances

• Raw material variances

• Labour variances

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Sales variances

Introduction

There are two causes of sales variances

• a difference in selling price

• a difference in sales volume

Sales volume variance

The sales volume variance calculates the effect on profit of the actual sales volume
being different from that budgeted. The effect on profit will differ depending upon
whether a marginal or absorption costing system is being used.

• Under absorption costing any difference in units is valued at the standard profit per
unit.

• Under marginal costing any difference in units is valued at the standard

contribution per unit.

Sales volume variance

(Actual quantity sold – Budget quantity sold) × Standard margin

The Standard margin is the standard contribution per unit (marginal costing), or the
standard profit per unit (absorption costing).

If the actual quantity sold is greater than the budget this will produce a favourable
variance as it increases profit.

Sales price variance

The sales price variance shows the effect on profit of selling at a different price from
that expected.

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Sales price variance

(Actual price – Budget price) × Actual quantity sold

If the actual price is greater than the budget this will produce a favourable variance
as it increases profit.

Example 62:

The following data relates to 20X8.

Actual sales: 1,000 units @ $650 each

Budgeted output and sales for the year: 900 units

Standard selling price: $700 per unit

Budgeted contribution per unit: $245

Budgeted profit per unit: $205

Required:

Calculate the sales volume variance (under absorption and marginal

costing) and the sales price variance.

Example 63:

The following data relates to 20X8.

Actual sales: 500 units @ $2 each

Budgeted output and sales for the year: 400 units

Budgeted selling price: $2.5

Variable cost Standard & expected: $1.80

Required:

Calculate the sales volume variance and the sales price variance.

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Materials cost variances

Introduction

There are two causes of material cost variances

• a difference in purchase price

• a difference in quantity used.

The total variance can be analysed into two sub-variances:

• A materials price variance analyses whether the company paid more or less than
expected for the materials purchased.

• The purpose of the materials usage variance is to quantify the effect on profit of
using a different quantity of raw material from that expected for the actual
production achieved.

Material variances

Material price variance = (standard price - actual price) × Actual quantity

purchased

Material usage variance = (standard quantity used for actual production - actual
quantity used) × standard price

Example 64:

The following information relates to the production of Product X.

Extract from the standard cost card of Product X.

Direct materials (40 square metres × $5.30 per square metre) $212.

Actual results for direct materials in the period: 1,000 units were produced and
39,000 square metres of material costing $210,600 in total were purchased and
used.

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Required:

Calculate the materials total, price and usage variances for Product X in
the period.

Example 65:

James Marshall Ltd makes a single product with the following budgeted material
costs per unit:

2 kg of material A at $10/kg

Actual details:

Output 1,000 units

Material purchased and used 2,200 kg

Material cost $20,900

Calculate materials price and usage variances.

Labour cost variances

Introduction

There are two causes of labour cost variances

• a difference in rate paid

• a difference in hours worked.

The total variance can be analysed into two sub-variances:

• A labour rate variance analyses whether the company paid more or less than
expected for labour.

• A labour efficiency variance analyses whether the company used more or less
labour hours than expected.

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Labour variances

Labour rate variance = (standard rate per hour - actual rate per hour) × Actual
hours paid

Labour Efficiency variance = (standard hours used for actual production - actual
hours worked) × standard rate of labour per hour

Example 66:

Roseberry Ltd makes a single product and has the following budgeted information:

Budgeted production 1,000 units

Budgeted labour hours 3,000 hours

Budgeted labour cost $15,000

Actual results:

Output 1,100 units

Hours paid for 3,400 hours

Labour cost $17,680

Required:

Calculate the labour total, rate and efficiency variances for Roseberry
Ltd

Example 67:

The following information relates to the production of Product X. Extract from the
standard cost card of Product X

Direct labour:

Bonding (24 hrs @ $5 per hour) 120

Actual results for wages:

Production 1,000 units produced

Bonding 23,900 hours costing $131,450 in total

Required:

Calculate the labour total, rate and efficiency variances in the Bonding
department for Product X in the period.

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Planning and operational variances

The standard is set as part of the budgeting process which occurs before the period to
which it relates.

This means that the difference between standard and actual may arise partly due to
an unrealistic budget and not solely due to operational factors. The budget may need
to be revised to enable actual performance to be compared with a standard that
reflects these changed conditions.

Calculating the planning & operational variances for Material

Material Price Planning Variance

(Original Standard price –Revised Standard Price) x Actual Quantity Purchased

Material Price Operational Variance

(Revised Standard price – Actual Price) x Actual Quantity Purchased

Material Usage Planning Variance

(Original Std. Quantity for Actual Production – Revised Std. Quantity for Actual
Production) x Standard rate

Material Usage Operational Variance

(Revised standard Quantity for Actual Production –Actual quantity used) x

Standard rate

Some possible causes of these variances include:

Planning

Material price – error in original standard, market price change due to worldwide
shortage or surplus of the material, closure of a material supplier, unforeseen
inflation

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Material usage – error in original standard, changes in technology leading to more /

less material being required, changes in legal / regulatory requirements for the
material, flood/fire destroying material

Operational

Material price – buy lower / higher quality material, deliberate change of supplier,
bulk buying discounts

Material usage – training or supervision of staff being better or worse than expected,
quality of material being different to what was expected.

Calculating the planning & operational variances for Labour

Labour Rate Planning Variance

(Original Standard rate –Revised Standard rate) x Actual hours paid

Labour Rate Operational Variance

(Revised Standard rate – Actual rate) x Actual hours paid

Labour Efficiency Planning Variance

(Original Std. hours for Actual Production – Revised Std. hours for Actual
Production) x Standard rate

Labor Efficiency Operational Variance

(Revised standard hours for Actual Production –Actual hours worked) x Standard
rate

Some possible causes of these variances include:

Planning

Labour rate – error in original standard, labour shortage or surplus in the market in
general leading to market wage rates changing, change in product specification due
to change in law causing a different grade of labour to be needed

Labour efficiency – error in original standard, change in work practices due to

regulatory requirements such as increased rest periods for staff, increased quality
requirements set externally.

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If there is a learning effect with labour, then there may be an impact on the planning
and operational variances for labour efficiency. If, for example, in the original budget
there was expected to be a 90% learning effect but due to an error this was incorrect
and should have been 80% then there would be a planning and operational impact.

Operational

Labour rate – overtime working required, employing different quality staff, staff
bonuses paid for increased productivity

Labour efficiency – different quality staff used, poor work scheduling leading to
increased idle time, training or supervision of staff being better or worse than
expected.

Calculating the planning & operational variances for Sales

Sales Price Planning Variance

(Original Standard Selling Price–Revised Standard Selling Price) x Actual unit sold

Sales Price Operational Variance

(Actual Selling Price – Revised Standard Selling Price) x Actual units sold

Sales Volume Planning Variance (Market Size Variance)

(Revised Budgeted Sales units – Budgeted sales units) x Std. profit or contribution
per unit

Sales Volume Operational Variance (Market Share Variance)

(Actual Sales units – Revised Budgeted sales units) x Std. profit or contribution per
unit

Reasons

These variances may be caused by an upturn or downturn in general economic

conditions, changes in technology meaning a product is much more relevant now.

Operational sales variances look into the differences between actual results and the
revised budget. The operational sales volume variance is also referred to as the
market share variance. These variances could be due to new competitors,

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competitors leaving the industry, the performance of the sales team, the quality of
the product etc.

Revision of original budget

The original budget should therefore only be revised for one of the following reasons:

1) Poor planning – if the mistake is a planning error e.g. someone putting down
the wrong figures
2) Uncontrollable factors – if the change is due to something which is outside of
the control of the organization e.g. supplier liquidation, government
legislation or market downturn.

If there has been an operational issue, this should not be reflected in a revised budget
as the whole purpose of variance analysis is to identify such issues.

Example 68:

Glove Co makes high quality, hand-made gloves which it sells for an average of $180
per pair. The standard cost of labour for each pair is $42 and the standard labour
time for each pair is three hours. In the last quarter, Glove Co had budgeted
production of 12,000 pairs, although actual production was 12,600 pairs in order to
meet demand. 37,000 hours were used to complete the work and there was no idle
time. The total labour cost for the quarter was $531,930.

At the beginning of the last quarter, the design of the gloves was changed slightly.
The new design required workers to sew the company’s logo on to the back of every
glove made and the estimated time to do this was 15 minutes for each pair. However,
no-one told the accountant responsible for updating standard costs that the standard
time per pair of gloves needed to be changed. Similarly, although all workers were
given a 2% pay rise at the beginning of the last quarter, the accountant was not told
about this either. Consequently, the standard was not updated to reflect these
changes.

a) Analyse the above total variances into component parts for

planning and operational variances in as much detail as the
information allows.
b) Assess the performance of the production manager for the last
quarter.

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Example 69:

Truffle Co makes high quality, hand-made chocolate truffles which it sells to a local
retailer. All chocolates are made in batches of 16, to fit the standard boxes supplied
by the retailer. The standard cost of labor for each batch is $6·00 and the standard
labour time for each batch is half an hour. In November, Truffle Co had budgeted
production of 24,000 batches; actual production was only 20,500 batches. 12,000
labour hours were used to complete the work and there was no idle time. All workers
were paid for their actual hours worked. The actual total labour cost for November
was $136,800. The production manager at Truffle Co has no input into the budgeting
process.

At the end of October, the managing director decided to hold a meeting and offer
staff the choice of either accepting a 5% pay cut or facing a certain number of
redundancies. All staff subsequently agreed to accept the 5% pay cut with immediate
effect.

At the same time, the retailer requested that the truffles be made slightly softer. This
change was implemented immediately and made the chocolates more difficult to
shape. When recipe changes such as these are made, it takes time before the workers
become used to working with the new ingredient mix, making the process 20%
slower for at least the first month of the new operation.

The standard costing system is only updated once a year in June and no changes are
ever made to the system outside of this.

a) Analyze the total labor rate and total labor efficiency variances into
component parts for planning and operational variances in as
much detail as the information allows.
b) Assess the performance of the production manager for the month
of November.

Example 70:

Secure Net (SN) manufacture security cards that restrict access to government
owned buildings around the world. The standard cost for the plastic that goes into
making a card is $4 per kg and each card uses 40g of plastic after an allowance for
waste. In November 100,000 cards were produced and sold by SN and this was well
above the budgeted sales of 60,000 cards.

The actual cost of the plastic was $5·25 per kg and the production manager (who is
responsible for all buying and production issues) was asked to explain the increase.
He said ‘World oil price increases pushed up plastic prices by 20% compared to our

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budget and I also decided to use a different supplier who promised better quality and
increased reliability for a slightly higher price. I know we have overspent but not all
the increase in plastic prices is my fault’

The actual usage of plastic per card was 35g per card and again the production
manager had an explanation. He said ‘The world-wide standard size for security
cards increased by 5% due to a change in the card reader technology, however, our
new supplier provided much better quality of plastic and this helped to cut down on
the waste.’

SN operates a just in time (JIT) system and hence carries very little inventory.

a) Analyze the above total variances into component parts for

planning and operational variances in as much detail as the
information allows.
b) Assess the performance of the production manager.

Example 71:

Bedco manufactures pillowcases which it supplies to a major hotel chain. It uses a

just-in-time system and holds no inventories.

The standard cost for the cotton which is used to make the pillowcases is $5 per m2.
Each pillowcase uses 2 m2 of cotton. Production levels for pillowcases for November

were as follows:

Budgeted production Actual production

levels (units) levels (units)

Pillowcases 190,000 180,000

The actual cost of the cotton in November was $5·80 per m2. 95,000 m2 of cotton
was used to make the pillowcases.

The world commodity prices for cotton increased by 20% in the month of November.
At the beginning of the month, the hotel chain made an unexpected request for an
immediate design change to the pillowcases. The new design required 10% more
cotton than previously. It also resulted in production delays and therefore a shortfall
in production of 10,000 pillowcases in total that month.

The production manager at Bedco is responsible for all buying and any production
issues which occur, although he is not responsible for the setting of standard costs.

Required:

a) Calculate the following variances for the month of November:

(i) Material price planning variance;

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(ii) Material price operational variance;

(iii) Material usage planning variance;

(iv) Material usage operational variance.

b) Assess the performance of the production manager for the month

of November.

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Materials mix variance

Materials mix variance = difference between the standard mix of materials and the
actual mix of materials, valued at the standard material cost.

In other words, looking at the quantity of material actually input, how does the actual
mix of that material compare to what we would have expected to have used of each
material.

Formula:

Materials AQSM AQAM Diff Std. rate Variance

Materials yield variance

Materials yield variance = difference between the actual output from the materials
used and the standard output, valued at the standard material cost

Did we get more or less finished output than we’d have expected from the amount of
material being input into the process?

Formula:

Materials SQSM AQSM Diff Std. rate Variance

Sales mix and quantity variances

Sales volume variance

For the sales volume variance, it may be worth analysing the sales volume variance
into a mix and quantity element.

This is worth doing if the company sells more than one product and the products are
to some extent linked, for example: Complementary products (e.g. knives and forks)

Remember, the sales volume variance overall considers the difference between
volumes actually sold and budget volumes but does not concern itself with the
breakdown of those sales.

Sales mix variance

Sales mix variance = difference between the standard mix of actual sales volume and
the actual mix of actual sales volume (i.e. the actual sales volumes), valued at the
standard profit/contribution

Formula:

Products AQAM AQSM Diff Std. profit/cont. Variance

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Looking at the volume of actual sales, how does the actual mix of sales compare to
what we would have expected to have sold of each product to make up actual volume.

Causes of sales mix variance

An adverse sales mix variance arises if you proportionately sell fewer of your more
profitable products and more of your less profitable products. This could be caused
by:

1) A downturn in the economy, leading to customers becoming more cost

conscious and preferring to purchase cheaper goods.
2) Failure of a marketing campaign to try and boost sales of the more profitable
item.
3) Increased competition in the marketplace for the more profitable item.

Sales quantity variance

Sales quantity variance = difference between the actual sales volume (at standard
mix) and the budgeted volume valued at the standard profit/contribution.

This measures the impact on profit resulting purely from selling more or less units
than budgeted and is unaffected by the actual mix of sales.

Formula:

Products AQSM SQSM Diff Std. profit/cont. Variance

Causes of sales quantity variance

A favorable quantity variance could be due to:
1) An increase in the overall market size for the company’s products
2) Good performance by the sales team in exceeding targets (possibly due to a
new reward scheme being introduced)

Staff motivation

Variances are calculated once the period has ended i.e. they are historic and thus it is
too late for the staff to do anything about them. This can be de-motivating. As staff
know that their performance will be judged by the variances, they may be motivated
to try to set an easy standard or to falsify the actual results so that their variances are
favorable.

There is a tendency to focus on adverse variances and so staff may be motivated to

avoid adverse variances rather than achieve favorable variances.

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Section E
Performance measurement
and control

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Measuring profitability

The primary objective of a company is to maximize profitability. Profitability ratios

can be used to monitor the achievement of this objective.

Gross profit margin

This is the gross profit as a percentage of turnover.

Gross profit margin = Gross profit ×100

Turnover

A high gross profit margin is desirable. It indicates that either sales prices are
high or that production costs are being kept well under control.

Operating profit margin

This is the operating profit (turnover less all expenses) as a percentage of turnover.

Operating profit margin = Operating profit ×100

Turnover

A high operating profit margin is desirable. It indicates that either sales prices are
high or that all costs are being kept well under control.

Return on capital employed (ROCE)

This is a key measure of profitability. It is the operating profit as a percentage of the

capital employed. The ROCE shows the operating profit that is generated from each
$1 of assets employed.

ROCE = Operating profit ×100

Capital employed

Where capital employed = total assets less current liabilities or total equity plus
long-term debt.

If operating profit (profit before finance charges and tax) is not given in the
question, use net profit instead.

A high ROCE is desirable. An increase in ROCE could be achieved by:

 Increasing operating 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.

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The ROCE can be understood further by calculating the operating profit margin
(operating profit/sales × 100) and the asset turnover (Sales / Capital Employed)

ROCE = operating profit margin × asset turnover

Asset turnover
This is the turnover divided by the capital employed. The asset turnover shows the
turnover that is generated from each $1 of assets employed.

Asset turnover = Turnover

Capital employed

A high asset turnover is desirable. An increase in the asset turnover could be

achieved by:
 Increasing turnover, e.g. through the launch of new products or a successful
advertising campaign.
 Reducing capital employed, e.g. through the repayment of long term debt.

Measuring liquidity

A company can be profitable but at the same time encounter cash flow problems.
Liquidity and working capital ratios give some indication of the company's liquidity.

Current ratio
This is the current assets divided by the current liabilities.
Current ratio = Current assets
Current liabilities

The ratio measures the company's ability to meet its short term liabilities as they
fall due. A ratio in excess of 1 is desirable but the expected ratio varies between the
type
of industry.

A decrease in the ratio year on year or a figure that is below the industry average
could indicate that the company has liquidity problems. The company should take
steps to improve liquidity, e.g. by paying creditors as they fall due or by better
management of receivables in order to reduce the level of bad debts.

Quick ratio (acid test)

This is a similar to the current ratio but inventory is removed from the current assets
due to its poor liquidity in the short term.

Quick ratio = Current assets – Inventory

Current liabilities

The comments are the same as for the current ratio.

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Inventory holding period

Inventory holding period = Inventory × 365

Cost of sales

This indicates the average number of days that inventory items are held for. An
increase in the inventory holding period could indicate that the company is having
problems selling its products and could also indicate that there is an increased level
of obsolete inventory. The company should take steps to increase inventory turnover,
e.g. by removing any slow moving or unpopular items of inventory and by getting rid
of any obsolete inventory.

A decrease in the inventory holding period could be desirable as the company's

ability to turn over inventory has improved and the company does not have excess
cash tied up in inventory.
However, any reductions should be reviewed further as the company may be
struggling to manage its liquidity and may not have the cash available to hold the
optimum level of inventory.

Receivables (debtor) collection period

Receivables collection period = Receivables × 365

Credit sales
This is the average period it takes for a company's debtors to pay what they owe.

An increase in the receivables collection period could indicate that the company is
struggling to manage its debts. Possible steps to reduce the ratio include:

 Credit checks on customers to ensure that they will pay on time

 Improved credit control, e.g. invoicing on time, chasing up bad debts.

A decrease in the receivables collection period may indicate that the companies has
improved its management of receivables. However, a receivables collection period
well below the industry average may make the company uncompetitive and
profitability could be impacted as a result.

Payables (creditor) period

Payables period = Payables × 365
Credit Purchases

This is the average period it takes for a company to pay for its purchases. If credit
purchases are not available, ‘purchases’ or ‘cost of sales’ should be used.

An increase in the company's payables period could indicate that the company is
struggling to pay its debts as they fall due. However, it could simply indicate that the
company is taking better advantage of any credit period offered to them.

A decrease in the company's payables period could indicate that the company's
ability to pay for its purchases on time is improving. However, the company should
not pay for its purchases too early since supplier credit is a useful source of finance.

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Measuring risk
In addition to managing profitability and liquidity it is also important to manage
risk. The following ratios may be calculated:

Financial gearing
This is the long term debt as a percentage of equity.

Gearing = Debt × 100

Equity

or = Debt × 100
Debt + Equity

A high level of gearing indicates that the company relies heavily on debt to finance its
long term needs. This increases the level of risk for the business since interest and
capital repayments must be made on debt, where as there is no obligation to make
payments to equity.

The ratio could be improved by reducing the level of long term debt and raising long
term finance using equity.

Interest cover
This is the operating profit (profit before finance charges and tax) divided by the
finance cost.

Interest cover = Operating profit

Finance cost

A decrease in the interest cover indicates that the company is facing an increased risk
of not being able to meet its finance payments as they fall due.

The ratio could be improved by taking steps to increase the operating profit, e.g.
through better management of costs, or by reducing finance costs through reducing
the level of debt.

Issues surrounding the use of financial performance indicators to

monitor performance

All of the ratios reviewed so far have concentrated on the financial performance of
the business.
However, there are a number of problems associated with the use of financial
performance indicators to monitor performance:

 Short-termism
 Manipulation of results
 Do not convey the full picture

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A firm’s success usually involves focusing on a small number of critical areas that
they must excel at.

Most of these are best assessed using non-financial performance indicators.

Financial performance appraisal often reveals the ultimate effect of operational
factors and decisions but non-financial indicators are needed to monitor causes.

 Competitiveness
 Flexibility
 Resource utilization
 Quality
 Innovation
 Customer Satisfaction

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Balanced Scorecard

Performance assessment tool that creates a balance between financial and non-
financial aspects.

Financial perspective

This perspective is concerned with how a company looks to its shareholders.

How can it create value for them?
Three core financial themes which will drive the business strategy:
 revenue growth and mix,
 cost reduction and
 asset utilization.

Customer perspective
This considers how the organization appears to customers. The organisation should
ask itself: ‘to achieve our vision, how should we appear to our customers?’
The customer perspective should identify the customer and market segments in
which the business will compete. There is a strong link between the customer
perspective and the revenue objectives in the financial perspective.
If customer objectives are achieved, revenue objectives should be too.
These will include:
 On time delivery
 Percentage of sales from new products
 Customer retention rate (Customer satisfaction)
 Number of rejections

Internal perspective
This requires the organisation to ask itself: ‘what must we excel at to achieve our
financial and customer objectives?
’It must identify the internal business processes which are critical to the
implementation of the organization’s strategy.
These will include:
 innovation process (Development of new products)
 operations process
 the post-sales process

Learning and growth perspective

This requires the organisation to ask itself whether it can continue to improve and
create value. The organisation must continue to invest in its infrastructure that is
people, systems and organisational procedures in order to improve the capabilities
which will help the other three perspectives to be achieved.

 Staff Training
 Staff abseentism
 Employee satisfaction

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Building Block Model

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Divisional performance measurement

Responsibility Centers

 Cost Center
 Revenue Center
 Profit Center
 Investment Center

Return on investment (ROI)

This is a similar measure to ROCE but is used to appraise the investment decisions of
an individual department.

ROI = Controllable profit/Capital employed × 100

 Controllable profit is usually taken after depreciation but before tax. However,
in the exam you may not be given this profit figure and so you should use the
profit figure that is closest to this. Assume the profit is controllable, unless
told otherwise.
 Capital employed is total assets less current liabilities or total equity plus long
term debt. Use net assets if capital employed is not given in the question.
 Non-current assets might be valued at cost, net replacement cost or net book
value (NBV). The value of assets employed could be either an average value for
the period as a whole or a value as at the end of the period. An average value
for the period is preferable. However, in the exam you should use whatever
figure is given to you.

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.

Advantages
 It is widely used and accepted since it is line with ROCE which is frequently
used to assess overall business performance.
 As a relative measure it enables comparisons to be made with divisions or
companies of different sizes.
 It can be broken down into secondary ratios for more detailed analysis, i.e.
profit margin and asset turnover.

Disadvantages
 It may lead to dysfunctional decision making, e.g. a division with a current
ROI of 30% would not wish to accept a project offering a ROI of 25%, as this
would dilute its current figure. However, the 25% ROI may meet or exceed the
company's target.
 ROI increases with the age of the asset if NBVs are used, thus giving managers
an incentive to hang on to possibly inefficient, obsolescent machines.

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 It may encourage the manipulation of profit and capital employed figures to

improve results, e.g. in order to obtain a bonus payment.
 Different accounting policies can confuse comparisons (e.g. depreciation
policy).

Residual income (RI)

RI = Controllable profit – Notional interest on capital

Controllable profit is calculated in the same way as for ROI.

Notional interest on capital = the capital employed in the division multiplied

by a notional cost of capital or interest rate.

Capital employed is calculated in the same way as for ROI.

The selected cost of capital could be the company’s average cost of funds (cost of
capital). However, other interest rates might be selected, such as the current cost of
borrowing, or a target ROI. (You should use whatever rate is given in the exam).

Evaluation of RI as a performance measure

Compared to using ROI as a measure of performance, RI has several advantages and
disadvantages:

Advantages

 It encourages investment center managers to make new investments if they

add to RI. A new investment might add to RI but reduce ROI. In such a
situation, measuring performance by RI would not result in dysfunctional
behavior, i.e. the best decision will be made for the business as a whole.
 Making a specific charge for interest helps to make investment center
managers more aware of the cost of the assets under their control.
 Risk can be incorporated by the choice of interest rate used: different interest
rates for the notional cost of capital can be applied to investments with
different risk characteristics.

Disadvantages

 It does not facilitate comparisons between divisions since the RI is driven by

the size of divisions and of their investments.
 It is based on accounting measures of profit and capital employed which may
be subject to manipulation, e.g. in order to obtain a bonus payment.

Transfer pricing

Objectives of a transfer pricing system

 Goal congruence
 Performance measurement

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 Autonomy
 Maximization of Group objectives

Types of Transfer Pricing

 Marginal cost Approach

 Full Cost approach
 Market Based Approach
 Opportunity cost Approach

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Performance measurement in not-for profit organizations

The problem of non-quantifiable objectives

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.

The problem of multiple objectives

The primary objective in not-for-profit organizations is not to make money, but to benefit
prescribed groups of people. As with any organizations, NFPs will use a mixture of financial
and non-financial objectives.

Value for money (VFM)

A common method of assessing public sector performance is to assess value
for money (VFM). This comprises three elements:

Economy – an input measure. Are the resources used the cheapest possible for the quality
required?

Efficiency – here we link inputs with outputs. Is the maximum output being achieved from the
resources used?

Effectiveness – an output measure looking at whether objectives are being met.

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Section A
Information, technologies
and systems for
organizational performance

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