Icaew Mi Work Book 2023
Icaew Mi Work Book 2023
Icaew Mi Work Book 2023
Icaew-MI-Work-Book-2023
Management
Information
Workbook
For exams in 2023
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Management Information
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-0355-0153-3
Previous ISBN: 978-1-5097-4203-5
e-ISBN: 978-1-0355-0212-7
First edition 2007
Sixteenth edition 2022
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mechanical including photocopying, recording, scanning or otherwise, without the
prior written permission of the publisher.
The content of this publication is intended to prepare students for the ICAEW
examinations, and should not be used as professional advice.
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A catalogue record for this book is available from the British Library.
Contains public sector information licensed under the Open Government Licence
v3.0.
The publisher is grateful to the IASB for permission to reproduce extracts from
IFRS® Standards, IAS® Standards, SIC and IFRIC. This publication contains
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Contents
Welcome to ICAEW iv
Management Information v
Key resources vi
Professional skills required by the ACA qualification vii
Questions within the Workbook should be treated as preparation questions, providing you with a
firm foundation before you attempt the exam-standard questions. The exam-standard questions are
found in the Question Bank.
Welcome to ICAEW
I’d like to personally welcome you to ICAEW.
As we continue the global recovery from COVID-19, the role of the accountancy profession has never
been more important.
As an ICAEW Chartered Accountant, you will make decisions that will define the future of global
business in a fast-changing and volatile world.
Whether studying for our internationally recognised Certificate in Finance, Accounting and Business
(ICAEW CFAB) or our world-leading chartered accountancy qualification, the ACA, you will acquire
exceptional knowledge and skills – with technology, sustainability and ethics at the heart of your
learning. A focus on capabilities such as judgement and scepticism will enable you to make the right
decisions in diverse and often complex environments.
You will be equipped to flourish and to lead in areas that are transforming the business landscape.
This includes embracing technological change and harnessing digital disruption, to help our
profession deliver greater value. It also includes putting climate change and sustainability at the heart
of business strategy. We will equip you to be adaptable and agile in your work and all within a set of
values fundamental to trust and transparency, which will set you apart from others.
Joining over 195,000 ICAEW Chartered Accountants and students worldwide, you are now part of a
global community. This unique network of talented and diverse professionals work in the public
interest to build economies that are sustainable, accountable and fair.
You are also joining a community of 1.8m chartered accountants and students as part of Chartered
Accountants Worldwide – a family of leading institutes, of which we are a founder member.
We will support you through your studies and throughout your career: this is the start of a lifetime
relationship, and we will be with you every step of the way to ensure you are ready to face the
challenges of the global economy. Visit the Key resources section to review the resources available as
you study.
With our training, guidance and support, you will join our members in realising your career
ambitions, developing world-leading insights and maintaining a competitive edge.
We will enable a world of sustainable economies, together.
I wish you the best of luck with your studies.
Michael Izza
Chief Executive
ICAEW
Management Information
You can access this guide and more exam resources on our website. If you are studying this exam as
part of the ACA qualification go to icaew.com/examresources or if you are studying the ICAEW CFAB
qualification go to icaew.com/cfabstudents.
Module aim
To enable you to prepare essential financial information for the management of a business.
On completion of this module, you will be able to:
• calculate the costs of products and services and use them to determine sales and transfer prices;
• identify appropriate budgeting and forecasting approaches and methods and prepare budgets;
• identify key features of effective performance management systems, select and calculate
appropriate performance measures, calculate differences between actual performance and
standards or budgets, and identify the key features, risks and benefits of a range of approaches to
management information operations; and
• identify and calculate relevant data for use in management decision-making.
Method of assessment
The Management Information exam is 1.5 hours long. 20% of the marks are allocated in one
scenario-based question. This will cover a single syllabus area, either: costing and pricing; budgeting
and forecasting; performance management; or management decision-making. The remaining 80%
of the marks are from 32 multiple choice, multi-part multiple choice or multiple response questions.
The 33 questions cover the areas of the syllabus in accordance with the weightings set out in the
specification grid.
Specification grid
This grid shows the relative weightings of subjects within this module and should guide the relative
study time spent on each. Over time the marks available in the assessment will equate to the
weightings below, while slight variations may occur in individual assessments to enable suitably
rigorous questions to be set.
4 Management decision-making 25
Key resources
Whether you’re studying the ICAEW CFAB or ACA qualification with an employer, at university,
independently, or as part of an apprenticeship, we provide a wide range of resources and services to
help you in your studies.
ACA students, you can access dedicated exam resources, guidance and information for the ACA
qualification via your dashboard at icaew.com/dashboard.
ICAEW CFAB students, you can also access dedicated exam resources, guidance and information at
icaew.com/cfabstudents.
Exam support
A variety of exam resources and support have been developed to help you through your studies and
each exam. This includes expert guides, sample exams, hints and tips, webinars and more.
Tuition
The ICAEW Partner in Learning scheme recognises tuition providers who comply with our core
principles of quality course delivery. If you are not receiving structured tuition and are interested in
doing so, take a look at ICAEW recognised Partner in Learning tuition providers in your area at
icaew.com/tuitionproviders
Errata sheets
These documents will correct any omissions within the learning materials once they have been
published. You should refer to them when studying.
Student Insights
Access our practical and topical student content on our dedicated online student hub, Student
Insights at icaew.com/studentinsights. You’ll find interviews, guides and features giving you fresh
insights, innovative ideas and an inside look at the lives and careers of our ICAEW students and
members. No matter what stage you’re at in your journey with us, you’ll find content to suit you.
Structuring problems and Structure information from various sources into suitable formats for
solutions analysis and provide creative and pragmatic solutions in a business
environment.
Applying judgement Apply professional scepticism and critical thinking to identify faults,
gaps, inconsistencies and interactions from a range of relevant
information sources and relate issues to a business environment.
The level of skill required to pass each exam increases as ACA trainees progress upwards through
each Level of the ACA qualification. The skills progression embedded throughout the ACA
qualification ensures ACA trainees develop the knowledge and professional skills necessary to
successfully operate in the modern workplace and which are expected by today’s forward-thinking
employers.
At Certificate Level, the ACA Professional Skills which you are expected to demonstrate in the exam
are summarised as follows:
Assimilating and using information
• Understanding the situation and the requirements
• Identifying and using relevant information
• Identifying and prioritising key issues
Structuring problems and solutions
• Structuring data
• Developing solutions
Applying judgement
• Applying professional scepticism and critical thinking
• Relating issues to the broader business environment, including ethical issues
To help you develop your ability to demonstrate competency in each professional skills area, each
chapter of this Workbook includes up to four Professional Skills Guidance points.
Each Professional Skills Guidance point focuses on one of the four ACA Professional Skills areas and
explains how to demonstrate a particular aspect of that professional skill relevant to the topic being
studied. It is advised you refer back to the Professional Skills Guidance points while revisiting specific
topics and during question practice.
Chapter 1
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 What is cost accounting?
2 Basic cost accounting concepts
3 Cost classification for inventory valuation and profit measurement
4 Cost classification for planning and decision making
5 Cost classification for control
6 Ethics and professional scepticism
7 Sustainability, governance and corporate responsibility
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
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Introduction
Learning outcomes
• Recognise the use of cost information for different purposes
• Classify costs as fixed, variable, direct or indirect
• Identify and explain ethical issues relating to the preparation, presentation and interpretation of
financial information for the management of a business
The specific syllabus references for this chapter are: 1a, b, 5a.
1
Syllabus links
An understanding of how costs may be classified in different ways according to the purpose of the
information being prepared is fundamental to this syllabus and underpins many of the learning
outcomes. It also has links to the Accounting syllabus in the context of understanding how costs are
classified for the purposes of inventory valuation and profit measurement.
1
Examination context
Many of the fundamental aspects of costing covered in this chapter do not lend themselves easily to
numerical objective test questions.
Therefore, you are more likely to see the majority of these subjects in narrative questions. For
example, you might be required to pick out correct definitions or statements from a number of
statements supplied in a question, or you might have to identify an appropriate cost unit from a
number of suggestions for a particular organisation to use as the basis of its accounting system.
In the examination, students may be required to:
• understand the purpose of a cost unit
• classify costs as fixed, variable and semi-variable (or semi-fixed)
• understand what is meant by the elements of cost
• understand the difference between a direct cost and an indirect cost, between a controllable cost
and an uncontrollable cost and between a product cost and a period cost
• identify ethical issues relating to the preparation, presentation and interpretation of financial
information
Knowing the various definitions is fundamental to answering questions in this area. For example, it is
essential to determine the ‘cost object’ in a question (ie, the thing being costed), in order to
determine whether costs are direct or indirect as regards that cost object.
1
2 Basic cost accounting Spend time making Objective test IQ1: Cost units
concepts sure that you questions may This question
The cost unit and cost understand the require you to pick tests your
object are important basic concepts in out correct understanding of
terms. Determining section 2. definitions or cost units.
the cost per cost unit statements from a
is vital for planning, number of
Stop and think statements supplied
control and decision
making What are the cost in a question, or you
units in the may have to identify
business you work an appropriate cost
for? unit from a number
of suggestions for a
particular
organisation to use
as the basis of its
accounting system.
4 Cost classification for Once you have You are likely to see IQ2: Fixed,
planning and decision read through cost behaviour variable or semi-
making section 4, practise questions in the variable
This section covers drawing all of the exam. You could, for This is a basic
cost behaviour. If a cost behaviour example, be asked question about
business understands patterns you have to identify the type the cost
how its costs behave learned about. of behaviour of a behaviour of
in relation to particular cost. Or specific costs.
production volumes, it you could be asked
Stop and think to identify a type of
can use this
information for Always look at the cost behaviour from IQ4: Cost
planning (eg, labels on the axes a graph. behaviour graphs
budgeting) and of cost behaviour
sustainability
considerations for
businesses.
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• The management information system provides information to help management with planning,
control and decision making.
• In general terms, financial accounting is for external reporting whereas cost and management
accounting is for internal reporting.
• The financial accounting and cost accounting systems both record the same basic data but each
set of records may analyse the data in a different way. Ultimately, financial results from both
systems can, and should be, reconciled with each other.
Financial accounts detail the performance of an Management accounts are used to aid
organisation over a defined period, including its management to record, plan and control the
cash flows and the state of affairs at the end of organisation’s activities and to help the
that period. decision-making process.
In the UK, limited companies must, by law, There is no legal requirement to prepare
prepare financial accounts. management accounts.
The format of published financial accounts is The format of management accounts is entirely
determined by law (mainly the Companies at management discretion: no strict rules
Acts), and by Financial Reporting Standards. In govern the way they are prepared or presented.
theory the accounts of different organisations Each organisation can devise its own
can therefore be easily compared. management accounting system and format of
reports.
Financial accounts often concentrate on the Management accounts can focus on specific
business as a whole, aggregating revenues and areas of an organisation’s activities such as
costs from different operations, and are wholly operating departments, individual sites or
historical. business streams. Information may be produced
to aid a decision rather than to be an end
product of a decision.
Definition
Management accounting systems: Provide information specifically for the use of managers within an
organisation.
IAS 1 changes the titles of financial statements as they will be used in IFRS Standards.
• ‘Balance sheet’ will become ‘statement of financial position’.
• ‘Income statement’ will become ‘statement of comprehensive income’.
• ‘Cash flow statement’ will become ‘statement of cash flows’.
Entities are not required to use the new titles in their financial statements. Consequently, this
Workbook may use these terms interchangeably.
• A cost object is anything for which we are trying to ascertain the cost.
• Cost units are the basic control units for costing purposes.
• The term ‘cost’ can be used as a noun or as a verb.
• Costs need to be arranged into logical groups or classified in order to facilitate an efficient system
for collecting and analysing costs.
Board of directors
Suppose the organisation above produces chocolate cakes for a number of supermarket chains. The
production function is involved with the making of the cakes, the administration department with the
preparation of accounts and the employment of staff and the marketing department with the selling
and distribution of the cakes.
Within the production function there are three departments, two of which are production
departments (the mixing department and the baking department), which are actively involved in the
production of the cakes, and one of which is a service department (stores department), which
provides a service or back-up to the production departments.
A service business, such as a hotel, may be structured as follows.
Board of directors
Definition
Cost object: Anything for which we are trying to ascertain the cost.
Definition
Cost unit: The basic measure of product or service for which costs are determined.
Businesses are often interested in one particular cost object – the cost unit – and the cost per cost
unit. Determining the cost per cost unit can help with pricing decisions, which you will study in more
detail in Chapter 5.
Hospital Patient/day
Operation
Out-patient visit
Bar
Restaurant
Room/night
Meal served
Conference delegate
Fitness suite
Conference room/day
could not be associated with an individual chair so would be classed as an indirect cost of the chair.
However, if the cost object were the factory itself then the rent is a direct cost of the factory.
Section overview
• The total cost of a cost unit is usually made up of three cost elements: materials, labour and other
expenses. Each of these cost elements can be classified as direct costs or indirect costs.
• A direct cost can be traced in full to the cost unit that is being costed.
• The total direct cost (or ‘prime cost’) is the sum of the direct material cost + direct labour cost +
direct expenses.
• An indirect cost (or overhead) cannot be traced directly and in full to the cost unit that is being
costed.
• Types of indirect cost (or overhead) include production overhead, administration overhead,
selling overhead and distribution overhead.
• Product costs are costs identified with goods produced or purchased for resale. These costs are
allocated to the value of inventory until the goods are sold.
• Period costs are costs deducted as expenses during a particular period. These costs are not
regarded as part of the value of inventory.
In this section we are only concerned with cost units (ie, an individual job or unit of product or unit of
service) as the cost object.
Definitions
Direct cost: A cost that can be traced in full to the cost unit.
Prime cost: The sum of all the direct costs.
• Other direct expenses are those expenses that have been incurred in full as a direct consequence
of making a unit of product, or providing a service, or running a department. For example, the
cost of hiring a special machine for a job is a direct cost of that job.
Another term used to describe the total direct cost is prime cost.
Prime cost = total direct cost = direct material cost + direct labour cost + direct expenses
Definition
Indirect cost (or overhead): A cost that is incurred which cannot be traced directly and in full to the
cost unit.
Examples of indirect costs, where the cost object is a unit of output, might be the cost of supervisors’
wages on a production line or cleaning materials and buildings insurance for a factory. These costs
cannot be traced directly and in full to the cost unit in question.
Total expenditure may therefore be analysed as follows.
Definitions
Period cost: A cost relating to a period of time.
Product cost: The cost of a finished product made up of its cost elements.
For the preparation of financial statements, costs are often classified as either product costs or period
costs. Product costs are costs identified with goods produced or purchased for resale. Period costs
are costs deducted as expenses during a particular period.
Consider a retailer who acquires goods for resale without changing their basic form. The only
product cost is therefore the purchase cost of the goods. Any unsold goods are held as inventory.
The inventory is valued at the lower of purchase cost and net realisable value, which is the valuation
basis stipulated in accounting standards, and included as an asset in the balance sheet. As the goods
are sold, their cost becomes an expense in the form of ‘cost of goods sold’. A retailer will also incur a
variety of selling and administration expenses. Such costs are period costs because they are
deducted from revenue without ever being regarded as part of the value of inventory.
Now consider a manufacturing firm in which direct materials are transformed into saleable goods
with the help of direct labour and factory overheads. All these costs, even the factory overheads, are
product costs because they are allocated to the value of inventory until the goods are sold (see
Chapter 3). As with the retailer, selling and administration expenses are regarded as period costs.
• Costs can be classified according to how they vary in relation to the level of activity.
• A knowledge of how the cost incurred varies at different activity levels is essential to planning and
decision making.
• A fixed cost is not affected by changes in the level of activity.
• A variable cost increases or decreases as the level of activity increases or decreases.
• A semi-variable cost is partly fixed and partly variable and is therefore partly affected by a change
in the level of activity.
• The relevant range is the range of activity levels within which assumed cost behaviour patterns
occur.
Definition
Cost behaviour: The way in which costs are affected by changes in the level of activity where ‘activity’
can be volume of output, number of production runs etc.
A different way of classifying costs is in terms of their behaviour patterns. This means grouping costs
according to how they vary in relation to the level of activity.
The level of activity can be measured in a variety of different ways depending on the circumstances.
Examples of possible ways of measuring the level of activity are as follows.
• The volume of production in a period
• The number of items sold
• The number of invoices issued
• The number of units of electricity consumed
Planning and decision making are concerned with future events and so managers require
information on expected future costs and revenues. A knowledge of how the cost incurred varies at
different levels of activity is essential to planning and decision making.
For our purposes in this chapter, the level of activity will generally be taken to be the volume of
production/output or sales.
Definition
Fixed costs: Costs that, within a relevant range of activity levels, are not affected by increases or
decreases in the level of activity.
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so
too will the fixed costs. The figure below shows a sketch graph of a fixed cost.
Graph of fixed cost
£
Cost
Definition
Variable cost: A cost that increases or decreases as the level of activity increases or decreases.
A variable cost tends to vary directly with the level of activity. The variable cost per unit is the same
amount for each unit produced whereas total variable cost increases as volume of output increases.
The figure below shows a sketch graph of a variable cost.
£
Cost
Volume of output
Definition
Semi-variable, semi-fixed or mixed costs: Costs that are part-fixed and part-variable and are
therefore partly affected by changes in the level of activity.
£
Cost
Variable part
Fixed part
Volume of output
(or, say, value of sales)
produced the fixed cost per unit will be £2; if 5,000 are produced the fixed cost per unit will be only
£1. Thus as the level of activity increases the total costs per unit (fixed cost plus variable cost) will
decrease.
In sketch-graph form this may be illustrated as shown in the figure below.
Variable cost Fixed cost Total cost
Fixed/Variable/Semi-variable?
Telephone bill
Definitions
The relevant range: The range of activity levels within which assumed cost behaviour patterns occur.
Step fixed cost: A cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
For example, a fixed cost is only fixed for levels of activity within the relevant range, after which it
could ‘step up’.
The relevant range also broadly represents the activity levels at which an organisation has had
experience of operating in the past and for which cost information is available. It can, therefore, be
dangerous to attempt to predict costs at activity levels that are outside the relevant range (
extrapolation).
For example, the rent of a factory is generally assumed to be a fixed cost. However, if the volume of
activity increases beyond the relevant range then it may be necessary to rent an extra factory. The
rent cost will then increase to a new, higher level. This is called a step increase in fixed cost and can
be represented graphically as shown in the figure below.
£
Cost
Relevant
range
Level of activity
(3) (4)
Requirement
Match the graphs to the listed items of expense below by writing the relevant graph number in the
box provided.
Note: Each graph may be used more than once.
Electricity bill: a standing charge for each period plus a charge for
each unit of electricity consumed.
One of the professional skills assessed in the ACA exams is the ability to ‘Interpret information
provided in various formats’. This could include graphs.
• For control purposes the most effective classification of costs is by responsibility, ie, according to
whether the costs are controllable or uncontrollable by a particular manager.
• A system of responsibility accounting segregates costs and revenues into areas of personal
responsibility in order to monitor and assess the performance of each part of the organisation.
• A responsibility centre is a part of a business whose performance is the direct responsibility of a
specific manager.
• An uncontrollable cost is a cost that cannot be influenced by a manager within a given time span.
Definitions
Responsibility accounting: A system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an
organisation.
A responsibility centre: A department or function whose performance is the direct responsibility of a
specific manager.
Managers of responsibility centres should only be held accountable for costs over which they have
significant influence. From a motivation or incentivisation point of view this is important because it
can be very demoralising for managers to have their performance judged on the basis of something
over which they have no influence. It is also important from a control point of view that management
reports should ensure that information on costs is reported to the manager who is able to take action
to control them.
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the
managers most capable of controlling them. As a system of accounting, it therefore distinguishes
between controllable and uncontrollable costs.
Definitions
Controllable cost: A cost that can be influenced by management decisions and actions.
Uncontrollable cost: A cost that cannot be affected by management within a given time span.
Most variable costs within a department are thought to be controllable in the short term because
managers can influence the efficiency with which resources are used, even if they cannot do anything
to raise or lower price levels.
A cost that is not controllable by a junior manager might be controllable by a senior manager. For
example, there may be high direct labour costs in a department caused by excessive overtime
working. The junior manager may feel obliged to continue with the overtime to meet production
schedules, but his senior may be able to reduce costs by hiring extra full-time staff, thereby reducing
the requirements for overtime.
A cost that is not controllable by a manager in one department may be controllable by a manager
in another department. For example, an increase in material costs may be caused by buying at
higher prices than expected (controllable by the purchasing department) or by excessive wastage
(controllable by the production department) or by a faulty machine producing rejects (controllable
by the maintenance department).
Some costs are non-controllable, such as increases in expenditure due to inflation. Other costs are
controllable, but in the long term rather than the short term. For example, production costs might be
reduced by the introduction of new machinery and technology, but in the short term, management
must attempt to do the best they can with the resources and machinery at their disposal.
What are the ethical issues relating to the preparation, presentation and interpretation of financial
information? What is professional scepticism?
One of the professional skills assessed in the ACA exams is the ability to ‘Identify ethical dimensions
of possible solutions’.
6.1 Introduction
Cost accountants are often involved in the preparation and reporting of information to help
management with planning, control and decision making. Such information may include forecasts,
budgets and variance analysis which we will consider in detail in later chapters.
6.2 ICAEW ethical guidance for accountants involved in the preparation and reporting
of information
6.2.1 Fundamental principles
ICAEW provides ethical guidance that will ensure professional accountants in business prepare and
report information fairly, honestly and in accordance with relevant professional standards so that
the information will be understood in its context. The guidance is also designed to ensure that
professional accountants in business take reasonable steps to maintain information for which they
are responsible in a manner that:
• describes clearly the true nature of business transactions, assets or liabilities
• classifies and records information in a timely and proper manner
• represents the facts accurately and completely in all material respects
The guidance can be found at icaew.com and much of this is dealt with in the certificate level
Business, Technology and Finance syllabus.
The guidance is applicable to both members in practice and members in business (eg, professional
accountants involved in the preparation and reporting of information to help management).
Fundamental Principle 1 – ‘Integrity’
A member should behave with integrity in all professional and business relationships.
Integrity implies not only honesty but fair dealing, truthfulness and being straightforward. A
member’s advice and work must be uncorrupted by self-interest and not be influenced by the
interests of other parties. A member should not be associated with information that is false or
misleading or supplied recklessly.
Fundamental Principle 2 – ‘Objectivity’
A member should strive for objectivity in all professional and business judgements.
Objectivity is the state of mind which has regard to all considerations relevant to the task in hand but
no other. There should be no bias, conflict of interest or undue influence of others.
Fundamental Principle 3 – ‘Professional competence and due care’
When providing professional services ‘professional competence and due care’ therefore mean:
• having appropriate professional knowledge and skill
• having a continuing awareness and an understanding of relevant technical, professional and
business developments
• exercising sound and independent judgement
• acting diligently, that is:
– carefully
– thoroughly
– on a timely basis
– in accordance with the requirements of an assignment
• acting in accordance with applicable technical and professional standards
• distinguishing clearly between an expression of opinion and an assertion of fact
One of the professional skills assessed in the ACA exams is the ability to ‘Appreciate when more
expert help is required’. This relates to professional competence and due care.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify ethical issues
including public interest and sustainability issues within a scenario’. The fundamental principles
should guide you on ethical issues.
Definition
Professional scepticism: Assessing information, estimates and explanations critically, with a
questioning mind, and being alert to possible misstatements due to error or fraud.
There may be deliberate or accidental mistakes within information and professional scepticism
means being aware of this and accepting that verification may be necessary. This is particularly
important for audit but is also important for management information. For example, if a colleague
provides you with data and asks you to write a report about that data, you should want to verify that
the data is correct, particularly if it came from the internet.
• Sustainability is about maintaining the world’s resources rather than depleting or destroying them.
This will ensure they support human activity now and in the future.
• Corporate responsibility includes the actions, activities and obligations of business in achieving
sustainability.
• Governance refers to the way organisations are directed and controlled by senior officers.
• ESG (environmental, social and governance) is a set of criteria used to measure and report
sustainability.
Definitions
Sustainability: The ability to ‘meet the needs of the present without compromising the ability of
future generations to meet their own needs’ (Brundtland Report 1987).
Sustainable development: The process by which we achieve sustainability.
Corporate responsibility: The actions, activities and obligations of business in achieving
sustainability.
Governance: The way organisations are directed and controlled by senior officers.
Issue Examples
Social Health and safety, workers’ rights (in the business itself and its
supply chain), pay and benefits, diversity and equal opportunities,
Businesses are becoming aware that economic sustainability requires consideration not just of short-
term financial performance, but of the wider impact on society and the environment. The three types
of sustainability are therefore interlinked. The connection to governance is that boards of directors
need to be actively considering what their organisations are doing to try to address sustainability.
Governance factors relate to the procedures in place to manage economic, environmental and social
performance.
Issue Examples
Definition
ESG: ESG (environmental, social and governance) is a set of criteria used to measure and report
sustainability. Therefore, ESG reporting involves disclosing operational data on areas of ESG.
The words sustainability and ESG are sometimes used interchangeably but their meaning is slightly
different. Sustainability is a general term that can mean different things to different people, whereas
ESG is specific and measurable. ESG reporting is still voluntary (apart from certain groups), however,
many organisations publish sustainability reports that aim to show the impact on society and their
commitment to sustainability.
Summary
Financial information
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. Do you know the differences between financial and management accounts? (Topic 1)
2. Can you explain the terms cost object and cost unit? (Topic 2)
5. Can you draw the graphs for the various types of cost behaviour? (Topic 4)
6. What are the fundamental principles in the ICAEW ethical guidance? (Topic 6)
Self-test questions
Yes or no
Telephone bill
5 A company hires its vehicles under an agreement where a constant rate is charged per mile travelled,
up to a maximum monthly payment regardless of the miles travelled. This cost is represented by
which of the following graphs?
(1)
Total
cost
Level of activity
(2)
Total
cost
Level of activity
(3)
Total
cost
Level of activity
(4)
Total
cost
Level of activity
Requirement
Select the correct answer.
A (1)
B (2)
C (3)
D (4)
Suitable or unsuitable?
Sales commission
Order obtained
8 In a factory one supervisor is required for every five employees. Which one of the following graphs
depicts the cost of supervisors?
(1)
Total
cost
Number of employees
(2)
Total
cost
Number of employees
(3)
Total
cost
Number of employees
(4)
Total
cost
Number of employees
Requirement
Select the correct answer.
A (1)
B (2)
C (3)
D (4)
9 Which of the following might describe a cost unit?
A A unit of production or service to which costs can be related.
B A cost incurred in selling a product or service.
C A cost that can be traced in full to the product, service or department that is being costed.
D A cost identified with the goods produced or purchased for resale.
10 Complete the sentence.
Prime cost is:
A all cost incurred in manufacturing a product.
B the total of direct costs.
C the material cost of a product.
D the cost of operating a department.
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
Bar No
Restaurant No
Room/night Suitable
Fitness suite No
Fixed/Variable/Semi-variable?
The fixed cost per unit will fall because the same amount of fixed cost is spread over more units. The
total cost per unit will also fall because the fixed cost per unit included within the total cost will
reduce.
Electricity bill: a standing charge for each period plus a charge for (1)
each unit of electricity consumed.
Photocopier rental costs. The rental agreement is that £80 is paid (1)
each month, plus £0.01 per photocopy taken.
Both the electricity bill and the photocopier rental costs are semi-variable costs, as they have both a
fixed element and a variable element that changes with the level of activity.
The supervisory labour is a fixed cost that remains constant within the relevant range.
Sales commission is a variable cost that varies in direct proportion to the level of activity.
For the equipment rental cost, the graph passes through the origin because at zero activity, no cost is
incurred. There is a variable cost pattern until maximum cost is reached; thereafter, cost is fixed.
1 Correct answer(s):
C (1), (2) and (4) only
Statement (1) is correct. Direct costs are specific and traceable to the relevant product, service or
department.
Statement (2) is correct. For example, a departmental manager’s salary is a direct cost of the
department but it is an indirect cost of the individual cost units passing through the department.
Statement (3) is incorrect. An indirect cost (not a direct cost) might also be referred to as an overhead
cost.
Statement (4) is correct. It is likely that activity will change from period to period, in which case so will
the expenditure on direct costs, as direct costs are traced directly to cost units.
2 Correct answer(s):
B A student
A student is likely to be a cost unit (cost per student per course). The others are all cost objects but
not the most basic unit of product or service for which costs are determined.
3
A cost object is anything for which we are trying to ascertain the cost. It could be a unit of product or
service but it could also be other items such as a department, a function or an item of equipment.
4
Yes or no
Telephone bill No
The royalty payments described and the cost of direct materials for production are likely to increase
in line with output levels and are therefore classed as variable costs.
A telephone bill is a typical example of a semi-variable cost, with a fixed line rental and a variable
cost element that relates to the number of telephone calls made.
Salaries are a typical example of a fixed cost.
5 Correct answer(s):
C (3)
The cost described begins as a linear variable cost, increasing at a constant rate in line with activity.
After a certain level of activity is reached, the total cost reaches a maximum as demonstrated by the
horizontal line on the graph. The cost becomes fixed regardless of the level of activity.
6 Correct answer(s):
A units of a product or service for which costs are ascertained.
Amounts of expenditure attributable to a number of products (Option B) are classed as overheads.
Functions or locations for which costs are ascertained (Option C) are cost objects.
Option D is the definition of a cost object.
7
Suitable or unsuitable?
Either calculating the cost of each order obtained or the cost of each unit of product sold would be
suitable cost units within the sales department.
Sales commission is an expense of the business, and therefore not suitable to use as a cost unit.
8 Correct answer(s):
A (1)
9 Correct answer(s):
A A unit of production or service to which costs can be related.
Cost units are the basic units for costing purposes. Different organisations would use different cost
units, such as patient/day in a hospital or meals served in a restaurant.
A cost incurred in selling a product or service (Option B) describes a period cost.
A cost that can be traced in full to the product, service or department that is being costed (Option C)
describes a direct cost.
A cost identified with the goods produced or purchased for resale (Option D) describes a product
cost.
10 Correct answer(s):
B the total of direct costs.
Prime cost is the total of direct material, direct labour and direct expenses.
Option A describes total production cost, including a share of production overhead. Option C is only
a part of prime cost. Option D is an overhead or indirect cost.
Chapter 2
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Identifying direct and indirect costs for cost units
2 Inventory valuation
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Classify costs as fixed, variable, direct or indirect
• Calculate overhead absorption rates, unit costs and profits/losses from information provided,
using:
– marginal costing
– absorption costing and reconcile the differences between the costs and profits/losses obtained
The specific syllabus references for this chapter are: 1b and c.
2
Syllabus links
A thorough understanding of the valuation of materials inventory will underpin your understanding
of inventory valuation for the Accounting syllabus.
2
Examination context
The context of much of this chapter provides scope for a range of numerical questions. However, you
should also be prepared to deal with narrative questions that examine your understanding of the
implications of the techniques you are using.
Narrative questions on the pricing of materials issues and on the classification of costs have been
popular in past examinations.
In the examination, students may be required to:
• classify costs as direct or indirect
• calculate the prime cost of a cost unit
• calculate the price of materials and the value of inventory using (‘first in, first out’) FIFO, (‘last in,
first out’) LIFO and average pricing methods
It is important to realise that in this chapter and the next, ideas from Chapter 1 are being applied in
determining the cost of a unit of output. The cost object is, therefore, the unit of output and all terms
such as direct and indirect are used in that context. It is also essential to appreciate that direct and
variable costs and indirect and fixed costs are not the same thing. The narrative is as important as the
calculations for FIFO, LIFO and weighted average inventory valuations.
2
This can be achieved test whether you objective test questions indirect costs.
by analysing costs as really understand may ask you to identify
direct costs (direct the concepts. a cost’s classification.
materials, direct labour,
direct expenses) or
indirect costs (indirect Stop and think
materials, indirect Are direct costs and
labour, indirect variable costs the
expenses). same thing?
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• Direct costs are those that can be specifically identified with the cost unit being costed.
• Direct material cost is all material becoming part of the cost unit, unless used in negligible
amounts.
• Direct labour cost is all wages paid to labour that can be identified with a specific cost unit.
• Direct expenses are expenses incurred on a specific cost unit, other than direct material and direct
labour costs.
• Indirect costs are those that cannot be identified directly with the cost unit being costed.
For the purposes of this chapter and Chapter 3, the cost object is a cost unit (eg, a unit of product, a
job, a batch, a unit of service).
• The indirect costs of the repair job will include a share of the overhead costs incurred in the
garage, such as the rent, the buildings insurance, the depreciation of the garage equipment and
so on. These costs cannot be traced to any single job worked on during the period.
For example, a beauty salon carries out a treatment for a customer.
• The direct material cost of the treatment will include the treatment materials, such as a face mask.
• The direct labour cost will be wages paid to the beauticians who carried out the treatment. The
labour is treated as a direct cost in this case, even if the beauticians are paid a fixed amount each
period. This is because it is possible to measure exactly how long each person worked on the
treatment, and their hourly rate of pay.
• The indirect costs of the treatment will include a share of the overhead costs incurred in the salon,
such as the rent, the buildings insurance, the salon cleaning costs and so on. These costs cannot
be traced to any single treatment worked on during the period.
Try the interactive question below to ensure you have understood the principle of how to distinguish
a direct cost from an indirect cost.
(b) Indirect costs are not less important than direct costs. Although they cannot be directly
attributed to individual units of output or to individual jobs, they represent expenditure on
resources that are essential for the units to be made or the jobs to be done. In the example of
the garage repair job, the rent of the garage is an indirect cost, but the rental cost represents a
share of the use of the garage space, without which the job could not have been done.
(c) It is easy to confuse fixed and variable costs with indirect and direct costs. A direct cost is often
also a variable cost: for example, the cost of raw materials that goes into making a unit of
product is both a direct cost and a variable cost. However, a direct cost may be a fixed cost
rather than a variable cost. For example, the direct cost of the labour employed to do a certain
type of work is a fixed cost to the business if the employees are paid a fixed amount of wages or
salary regardless of the amount of work they do. Similarly, an indirect cost may a variable cost.
For example, the cost of heating in a manufacturing plant may rise as more hours are worked.
The cost of heating cannot be directly attributed to an individual job or unit of output. But, it is a
cost that rises with the level of activity, and is a variable cost. Variable indirect costs are more
commonly referred to as variable overheads.
2 Inventory valuation
Section overview
• The pricing of issues of inventory items and the valuation of closing inventory have a direct effect
on the calculation of profit. Several different methods can be used in practice.
• With FIFO all issues are priced at the cost of the earliest delivery remaining in inventory.
• With LIFO all issues are priced at the cost of the most recent delivery remaining in inventory.
• The cumulative weighted average pricing method calculates a weighted average price for all units
in inventory whenever a new delivery of materials is received into store.
• The periodic weighted average pricing method calculates a single weighted average price at the
end of the period. The average is based on the opening inventory plus all units received in the
period.
• Each method of inventory valuation usually produces different figures for the value of closing
inventories and the cost of material issues. Therefore, profit figures using the different inventory
valuations are usually different.
This may seem a little confusing at first, and it may be helpful to explain the point further by looking
at an example.
In September, one unit is issued to production. As it happened, the physical unit actually issued was
B. The accounting department must put a value or cost on the material issued, but the value would
not be the cost of B, £106. The principles used to value the materials issued are not concerned with
the actual unit issued, A, B, or C. However, the accountant may choose to make one of the following
assumptions.
• The unit issued is valued as though it were the earliest unit received into inventory, ie, at the
purchase cost of A, £100. This valuation principle is called FIFO, or first in, first out.
• The unit issued is valued as though it were the most recent unit received into inventory, ie, at the
purchase cost of C, £109. This method of valuation is LIFO, or last in, first out.
• The unit issued is valued at an average price of A, B and C. The three units cost a total of £315, an
average of £105 each.
Market value
per unit on
date of
Quantity Unit cost Total cost transaction
Units £ £ £
Opening balance, 1 May 100 2.00 200
Receipts, 3 May 400 2.10 840 2.11
Issues, 4 May 200 2.11
Receipts, 9 May 300 2.12 636 2.15
Issues, 11 May 400 2.20
Receipts, 18 May 100 2.40 240 2.40
Issues, 20 May 100 2.42
Closing balance, 31 May 200 2.45
1,916
Definition
FIFO (first in, first out): A method of pricing materials based on the cost of the oldest units held
regardless of the sequence in which the issue of the materials takes place.
FIFO assumes that materials are issued out of inventory in the order in which they were delivered into
inventory issues are priced at the cost of the earliest delivery remaining in inventory.
Using a tabular format, as below, is a practical way of tracking items when carrying out a FIFO
calculation:
Notes
1 The cost of materials issued plus the value of closing inventory equals the cost of purchases plus
the value of opening inventory (£1,916).
2 The market price of purchased materials is rising dramatically. In a period of inflation, there is a
tendency with FIFO for materials to be issued at a cost lower than the current market value,
although closing inventories tend to be valued at a cost approximating to current market value.
Advantages Disadvantages
It is a logical pricing method, which probably FIFO can be cumbersome to operate because
represents what is physically happening: in of the need to identify each batch of material
practice the oldest inventory is likely to be used separately.
first.
It is easy to understand and explain to Managers may find it difficult to compare costs
managers. and make decisions when they are charged with
varying prices for the same materials.
The inventory valuation can be near to a In a period of high inflation, inventory issue
valuation based on replacement cost. prices will lag behind current market value.
Receipts Inventory
Unit Unit
Amt Amt Unit
Date Qty price Qty price Qty Amt (£)
(£) (£) price (£)
(£) (£)
Receipts Inventory
Unit Unit
Amt Amt Unit
Date Qty price Qty price Qty Amt (£)
(£) (£) price (£)
(£) (£)
Definition
LIFO (last in, first out): A method of pricing materials based on the cost of the newest units held
regardless of the sequence in which the issue of the materials takes place.
LIFO assumes that materials are issued out of inventory in the reverse order from that in which they
were delivered.
A tabular format similar to that in section 2.5 can also be used in section 2.7.
Notes
1 The cost of materials issued plus the value of closing inventory equals the cost of purchases plus
the value of opening inventory (£1,916).
2 In a period of inflation there is a tendency with LIFO for the following to occur.
• Materials are issued at a price that approximates to current market value.
Advantages Disadvantages
Inventories are issued at a price which is close to The method can be cumbersome to operate
current market value. because it sometimes results in several
batches being only part-used in the
inventory records before another batch is
received.
Managers are continually aware of recent costs LIFO is often the opposite of what is
when making decisions, because the costs being physically happening and can therefore be
charged to their department or products will be difficult to explain to managers.
current costs.
Definition
Average cost: Defined by CIMA as a method ‘used to price issues of goods or materials at the
weighted average cost of all units held.’ (CIMA Official Terminology, 2005)
The cumulative weighted average pricing method calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory remaining would have
the same unit valuation. The average price is determined by dividing the total cost by the total
number of units.
A new weighted average price is calculated whenever a new delivery of materials is received into
store. This is the key feature of cumulative weighted average pricing.
Total
Inventory
Received Issued Balance value Unit cost
Date
Units Units Units
Opening inventory 100 200 2.00
3 May 400 840 2.10
* 500 1,040 2.08
4 May 200 (416) 2.08 416
300 624 2.08
9 May 300 636 2.12
* 600 1,260 2.10
11 May 400 (840) 2.10 840
200 420 2.10
Total
Inventory
Received Issued Balance value Unit cost
Date
Units Units Units
18 May 100 240 2.40
* 300 660 2.20
20 May 100 (220) 2.20 220
Cost of issues 1,476
Closing inventory value 200 440 2.20 440
1,916
* A new inventory value per unit is calculated whenever a new receipt of materials occurs.
Notes
1 The cost of materials issued plus the value of closing inventory equals the cost of purchases plus
the value of opening inventory (£1,916).
2 In a period of inflation, using the cumulative weighted average pricing system, the value of
material issues will rise gradually, but will tend to lag a little behind the current market value at
the date of issue. Closing inventory values will also be a little below current market value.
Advantages Disadvantages
Fluctuations in prices are smoothed out, The resulting issue price is rarely an actual price
making it easier to use the data for decision that has been paid, and can run to several
making. decimal places.
It is easier to administer than FIFO and LIFO, Prices tend to lag a little behind current market
because there is no need to identify each values when there is gradual inflation.
batch separately.
One of the professional skills assessed in the ACA exams is the ability to ‘appraise the effects of
alternative future scenarios’. For example, a question might ask about the differences between FIFO,
LIFO and cumulative weighted average pricing.
One of the professional skills assessed in the ACA exams is the ability to ‘interpret information
provided in various formats’. This could include tables such as the one in the next activity.
Requirements
The values that would be entered on the stores record for A, B, C and D in a cumulative weighted
average pricing system would be:
A=£
B=£
C=£
D=£
The values that would be entered on the stores record for A, B, C and D in a LIFO system would be:
A=£
B=£
C=£
D=£
£
Cost of issues = 700 units × £2.129 1,490
£
426
1,916
Notice that once again the cost of materials issued plus the value of closing inventory equals the cost
of purchases plus the value of opening inventory (£1,916).
One of the professional skills assessed in the ACA exams is the ability to ‘identify a range of possible
solutions based on analysis’. Different methods of inventory valuation will provide different profit
figures.
Each method of inventory valuation usually produces different figures for the value of closing
inventories and the cost of material issues. A summary of the valuations based on the transactions in
section 2.4 is as follows.
Closing
inventory Cost of
Valuation method value issues Total
£ £ £
FIFO (section 2.5) 452 1,464 1,916
LIFO (section 2.7) 410 1,506 1,916
Cumulative weighted average (section 2.9) 440 1,476 1,916
Periodic weighted average (section 2.11) 426 1,490 1,916
Since material costs affect the cost of production, and the cost of production works through
eventually into the cost of sales (which is also affected by the value of closing inventories), it follows
that different methods of inventory valuation will provide different profit figures.
The following example will help to illustrate the point.
A number of the pink satin dresses with orange sashes were sold during November as follows.
Requirements
1 Calculate the gross profit from selling the pink satin dresses with orange sashes in November
20X2, applying the following principles of inventory valuation.
(a) FIFO
(b) LIFO
(c) Cumulative weighted average pricing
2 Calculate gross profit using the formula: gross profit = (sales – (opening inventory + purchases –
closing inventory)).
Solution
1 The answers are as follows.
(a)
Closing
Date Cost of sales Total inventory
£ £
14 November 3 units × £120
+ 2 units × £125
610
21 November 2 units × £125
+ 3 units × £140
670
28 November 1 unit × £140 140
(b)
Closing
Date Cost of sales Total inventory
£ £
14 November 4 units × £125
+ 1 unit × £120
620
21 November 4 units × £140
+ 1 unit × £120
680
28 November 1 unit × £150 150
Closing inventory 3 units × £150
+ 1 unit × £120
570
1,450 570
(c)
Weighted
Profitability FIFO LIFO average
£ £ £
Opening inventory 360 360 360
Purchases 1,660 1,660 1,660
2,020 2,020 2,020
Closing inventory 600 570 587
Cost of sales 1,420 1,450 1,433
Sales (11 × £200) 2,200 2,200 2,200
Gross profit 780 750 767
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and prioritise key
issues and stay on task’. For questions on inventory valuation, stay on task by reading the questions
carefully to establish whether the closing inventory, cost of issues or profit are required.
Summary
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
4. What are the advantages and disadvantages of the FIFO, LIFO and cumulative weighted
average pricing methods? (Topic 2)
5. Under the cumulative weighted average pricing method, when is a new weighted average
price calculated? (Topic 2)
Self-test questions
Requirement
Using the weighted average cost method of valuation, what was the cost of geronimos sold on 24
March? (To the nearest £.)
A £35,320
B £38,016
C £38,448
D £69,660
7 At the beginning of Week 10 there were 400 units of component X held in the stores. 160 of these
components had been purchased for £5.55 each in Week 9 and 240 had been purchased for £5.91
each in Week 8.
On day 3 of Week 10 a further 120 components were received into stores at a purchase cost of £5.96
each.
The only issue of component X occurred on day 4 of Week 10, when 150 units were issued to
production.
Requirement
Using the FIFO valuation method, what was the value of the closing inventory of component X at the
end of Week 10?
A £1,980.45
B £2,070.15
C £2,135.10
D £2,200.55
8 A wholesaler had an opening inventory of 330 units of product T valued at £168 each on 1 April.
The following receipts and sales were recorded during April.
Requirement
Using the LIFO valuation method, what was the gross profit earned from the units sold on 24 April?
A £16,350
B £18,120
C £18,520
D £19,764
9 Are the following statements true or false?
True or false?
10 A business buys and sells boxes of item J. The transactions for the latest quarter are shown below.
Purchases Sales
Boxes Value Boxes
£
July 1,000 2,600 1,100
August 1,200 3,300 900
September 1,000 3,000 800
The business values its inventories using a periodic weighted average price calculated at the end of
each quarter.
Requirement
Complete the sentence.
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
The accountant’s salary and the heating are both overheads, which means they are indirect costs.
The can of engine oil cost can be directly attributed to this particular repair.
The smear of grease is negligible and would not be recorded separately as a direct cost.
The overtime was worked due to a generally heavy workload. This particular repair had not caused
the overtime premium to be incurred. The cost is indirect and must be shared over all the repair jobs
carried out.
The idle time payment cannot be identified with any particular repair job. Similarly, the supervisor is
overseeing all repair jobs being undertaken, so their wages are an indirect cost for this particular job.
Receipts Inventory
Unit Unit
Amt Amt Unit
Date Qty price Qty price Qty Amt (£)
(£) (£) price (£)
(£) (£)
500 1,040.00
Receipts Inventory
Unit Unit
Amt Amt Unit
Date Qty price Qty price Qty Amt (£)
(£) (£) price (£)
(£) (£)
600 1,266.00
300 664.00
B = £ 54
C = £ 15
D = £ 135
WORKING
Cumulative weighted average price working
£
8 June Inventory balance = 30 units × £2.50 75
20 units × £3.00 60
50 135
Weighted average price = 135/50
= 2.70
10 June Issues = 10 units × £2.70 £27
£
14 June Issues = 20 units × £2.70 £54
18 June Inventory balance = remaining 20 units × £2.70 54
receipts 40 units × £2.40 96
60 150
Weighted average price = 150/60
= 2.50
20 June Issues = 6 units × £2.50 £15
Inventory balance = 54 units × £2.50 135
A = £ 30
B = £ 55
C = £ 14.40
D = £ 131.60
WORKING
LIFO working
£
10 June 10 units × £3.00 30.00
4 June Issues 10 units × £3.00 = 30.00
10 units × £2.50 = 25.00
55.00
20 June Issues: 6 units × £2.40 = 14.40
Balance: 34 units × £2.40 81.60
20 units × £2.50 50.00
54 131.60
1 Correct answer(s):
A A packing machine
B The factory canteen
It is possible to ascertain the cost of these first two cost objects.
The other three items are costs that might be attributed to a particular cost object, but they are not
cost objects in themselves.
2 Correct answer(s):
B The depreciation of a machine on an assembly line
D The hire of maintenance tools or equipment for a factory
The cost of overtime worked specifically to complete a one-off project (Option A) is direct labour.
Primary packing materials, eg, cartons and boxes, (Option C) are direct materials.
3 Correct answer(s):
C The accountant’s salary in a factory
The accountant’s salary is an indirect cost because it cannot be traced to a specific cost unit. It would
be classified as an administration overhead.
All of the other costs can be traced to a specific cost unit: the cost of sugar would be a direct
ingredients’ cost of a specific batch of cakes; the lease rental cost would be a direct cost of a
construction project and the cost of drinks served would be a direct cost of a particular train journey.
4 Correct answer(s):
D Factory overhead
Idle time is usually treated as an overhead; in this case it is within the production department and is
therefore a factory overhead.
5 Correct answer(s):
D The closing inventory value will be higher and the gross profit will be higher
The FIFO method prices issues from inventory at the cost of the earliest delivery remaining in
inventory.
The closing inventory will therefore be valued at the higher prices paid.
The charge to cost of sales will be lower than with LIFO, therefore the gross profit will be higher.
6 Correct answer(s):
D £69,660
7 Correct answer(s):
C £2,135.10
Components issued on Day 4 = 150 from Week 8 receipts
Closing inventory Week 10:
£
Remaining 90 Components from week 8 × £5.91 531.90
160 Components from week 9 × £5.55 888.00
120 Components from week 10 × £5.96 715.20
370 2,135.10
8 Correct answer(s):
D £19,764
The LIFO method uses the cost of the most recent batches first.
True or false?
Using LIFO, managers are continually aware of recent costs when True
making decisions, because the costs being charged to their
departments or products will be current costs.
FIFO lets managers value issues at current prices in a period of high False
inflation.
FIFO lets managers value issues at current prices in a period of high inflation is incorrect. Under
FIFO, inventory issues are valued at the cost of the earliest delivery remaining in inventory. In times of
inflation, this will mean that issue prices will be lower than current prices.
10 To the nearest £, the value of the inventory at the end of September is £ 2,200 .
Boxes Value
£
Opening inventory 400 1,000
Purchases: July 1,000 2,600
August 1,200 3,300
September 1,000 3,000
3,600 9,900
Chapter 3
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Absorption costing
2 Activity-based costing
3 Costing methods
4 Other approaches to cost management
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
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Introduction
Learning outcomes
• Calculate overhead absorption rates, unit costs and profits/losses from information provided,
using:
– marginal costing
– absorption costing and reconcile the differences between the costs and profits/losses obtained
• Select the most appropriate method of costing for a given product or service
The specific syllabus references for this chapter are: 1c and d.
3
Syllabus links
A knowledge of the method of determining a full unit cost will underpin your understanding of
inventory valuation for the Accounting syllabus.
3
Examination context
Numerical questions on the calculation of overhead absorption rates and of over- and under-
absorption of overheads have been popular in past exams.
You should also be prepared to tackle narrative questions on overhead absorption as well as on the
selection of the most appropriate costing method in specific circumstances.
You will not be required to answer numerical questions about activity-based costing but you should
be able to demonstrate a general understanding of the underlying principles of this costing system.
In the examination, students may be required to:
• calculate the full cost of a cost unit using absorption costing
• demonstrate an understanding of the basic principles of activity-based costing
• identify the most appropriate costing method in specific circumstances
• demonstrate an understanding of the general principles of target costing, life cycle costing and
just in time
It is essential to appreciate the difference between the allocation and apportionment of overheads,
which links back to the ideas about direct and indirect cost covered earlier.
A common difficulty is failing to allow for under/over absorption when predetermined overhead
rates are used.
3
valuing finished goods give the worked You should also be IQ3:
inventory, example extra prepared to tackle Apportioning
management might attention. Check narrative questions overheads
need to know the full that you on overhead This question
cost of the item, understand the absorption as well provides good
including a share of derivation of all of as on the selection practice at
the indirect costs or the figures in the of the most apportioning
overheads. final table. Think appropriate costing overheads.
Accordingly, a method about the method in specific
apportionment of circumstances. IQ6: Overhead
has to be devised for absorption rates
sharing the indirect service cost centre
costs: why it is and IQ8 Under
costs between all the and over
units that benefit from necessary and how
it is done. Work absorption of
them. overheads
carefully through
the interactive The knowledge
questions and required for these
examples. questions is very
Section 1.4 is of important.
vital importance.
The techniques and
principles that you
learn here will arise
a number of times
throughout this
syllabus so you
must get a firm
grasp of them
before you
continue. Work
carefully through
the example and
interactive
question.
Read quickly
through section 1.5
and then give
section 1.6 extra
attention. Students
often find the
calculation of under
and over
absorption difficult
so spend the time
necessary to gain a
good
understanding of
this topic.
method used by a
company that
manufactures
canned soup? What
aspects of their
operations mean
that a different
costing method will
be required?
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
1 Absorption costing
Section overview
• In absorption costing the full cost of a cost unit is equal to its prime cost plus an absorbed share
of overhead cost.
• The three stages in determining the share of overhead to be attributed to a cost unit are
allocation, apportionment and absorption.
• Overheads are absorbed into product or service costs using a predetermined overhead
absorption rate, usually set annually in the budget.
• The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of
activity. For production overheads, the level of activity is often measured in terms of direct labour
hours or machine hours.
• Over- or under-absorption of overhead arises because the absorption rate is based on estimates.
Definition
Absorption costing: The direct (or prime) cost of an item plus a fair share of the indirect (overhead)
costs.
To calculate the full cost of an item using absorption costing (sometimes referred to as full costing) it
is necessary first to establish its direct cost or prime cost and then to add a fair share of indirect costs
or overhead.
The full or absorption cost per unit is therefore made up as follows.
£
Direct materials X
Direct labour X
Direct expenses (if any) X
Total direct cost (prime cost) X
Share of indirect cost/overhead X
Absorption (full) cost X
There are three stages in determining the share of overhead to be attributed to a cost unit.
• Overhead allocation
• Overhead apportionment
• Overhead absorption
Definition
Allocation: The process by which overheads are charged directly to cost centres.
The first step in absorption costing is allocation. Allocation is the process by which whole cost items
are charged direct to a cost centre. A cost centre acts as a collecting place for costs before they are
analysed further.
Cost centres may be one of the following types.
£
Wages of the supervisor of department A 200
Wages of the supervisor of department B 150
Indirect materials consumed in department A 50
Rent of the premises shared by departments A and B 300
Overhead costs would be allocated directly to each cost centre, ie, £200 + £50 to cost centre 101,
£150 to cost centre 102 and £300 to cost centre 201. The rent of the factory will be subsequently
shared between the two production departments, but for the purpose of day to day cost recording in
this particular system, the rent will first of all be charged in full to a separate cost centre.
Definition
Apportionment: A process where indirect (overhead) costs are spread fairly between cost centres.
The next step in absorption costing is overhead apportionment. This involves apportioning general
overheads to cost centres (the first stage) and then reapportioning the costs of service cost centres to
production departments (the second stage).
Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of buildings
Personnel office, canteen, welfare, wages and Number of employees, or labour hours worked
cost offices, first aid in each cost centre
Heating, lighting (see above) Volume of space occupied by each cost centre
Rent
Heating costs
Insurance of machinery
Cleaning costs
Canteen costs
£’000
Depreciation of factory 100
Factory repairs and maintenance 60
Factory office costs (treat as production overhead) 150
Depreciation of equipment 80
Insurance of equipment 20
Heating 39
Lighting 10
£’000
Canteen 90
549
Information relating to the production and service departments in the factory is as follows.
Department
Production 1 Production 2 Service 100 Service 101
Floor space (square
metres) 1,200 1,600 800 400
Volume (cubic metres) 3,000 6,000 2,400 1,600
Number of employees 30 30 15 15
Book value of
equipment £30,000 £20,000 £10,000 £20,000
The overhead costs are apportioned using the following general formula.
(Total overhead cost/Total value of apportionment base) × Value of apportionment base of cost
centre
For example, heating for department 1 =
(£39,000/13,000) × 3,000 = £9,000
To department
Basis of
Item of cost apportionment Total cost 1 2 100 101
£ £ £ £ £
Factory
depreciation (floor area) 100 30.0 40 20.0 10.0
Factory repairs (floor area) 60 18.0 24 12.0 6.0
Factory office (number of
costs employees) 150 50.0 50 25.0 25.0
Equipment
depreciation (book value) 80 30.0 20 10.0 20.0
Equipment
insurance (book value) 20 7.5 5 2.5 5.0
Heating (volume) 39 9.0 18 7.2 4.8
Lighting (floor area) 10 3.0 4 2.0 1.0
(number of
Canteen employees) 90 30.0 30 15.0 15.0
Requirement
For each of these, decide:
• whether the cost would be allocated or apportioned
• the cost centre(s) to be charged
• a suitable basis, if apportionment is required
Rent
Factory rates
Office stationery
One of the professional skills assessed in the ACA exams covers structuring problems and solutions.
In the context of the MI exam, this means following the format of the questions such as the one
below.
£ £
Rent and rates 8,000
Power 750
Light, heat 5,000
Repairs, maintenance:
Forming 800
Machining 1,800
Assembly 300
Maintenance 200
General 100
3,200
Departmental expenses:
Forming 1,500
£ £
Machining 2,300
Assembly 1,100
Maintenance 900
General 1,500
7,300
Depreciation:
Plant 10,000
Fixtures and fittings (F&F) 250
Insurance:
Plant 2,000
Buildings 500
Indirect labour:
Forming 3,000
Machining 5,000
Assembly 1,500
Maintenance 4,000
General 2,000
15,500
52,500
These overheads are to be allocated and apportioned as fairly as possible to the five departments
using the following information:
Requirement
Allocate and apportion the budgeted overheads to the five departments.
Production planning Direct labour hours worked in each production cost centre
Canteen
Machining department
Offices
Assembly department
A B C Canteen Admin
Floor area (sq metres) 5,000 5,000 4,000 4,000 2,000
Personnel (persons) 10 20 10 10 5
Remuneration per month:
Direct (£) 1,920 3,600 2,240 – –
Indirect (£) 360 480 240 320 870
Direct materials consumed (£) 5,500 250 400 – –
Machine hours per month 600 2,400 200 – –
Power costs per month (£) 50 500 20 80 –
General overheads per month (£) 1,000 2,000 1,200 650 1,230
The monthly takings of the canteen are £600. Food bills for the canteen totalled £470. None of the
administrative staff use the canteen.
The monthly electricity charge for heat and light is £1,000. The monthly rent of the company’s
premises is £6,000.
The administration costs are made up mainly of personnel-related costs.
Requirement
Apportion all overheads to the production cost centres.
Solution
Step 1: Primary allocation and apportionment
Where possible, costs should be allocated directly to each cost centre. Where costs are shared, a fair
basis of apportionment should be selected. Remember that the analysis is concerned only with
overheads. Direct material and direct wages costs are not included.
Basis of
Cost item apportionment A B C Canteen Admin
£ £ £ £ £
Indirect labour Allocation 360 480 240 320 870
Power Allocation 50 500 20 80 0
General overhead Allocation 1,000 2,000 1,200 650 1,230
Canteen takings Allocation (600)
Food Allocation 470
Rent Floor area 1,500 1,500 1,200 1,200 600
Electricity Floor area 250 250 200 200 100
3,160 4,730 2,860 2,320 2,800
Note: The apportionment of rental costs and electricity costs have been made on the basis of floor
area, because this seems ‘fair’. The choice of the fairest basis, however, in practice, is a matter for
judgement.
Step 2: Re-apportion the service centre costs
The next step is to apportion the costs of the service cost centres to the production cost centres. The
method illustrated here is as follows.
• The first apportionment is for the service cost centre with the largest costs. These costs are shared
between all the other cost centres, including the other service cost centre, on a fair basis.
• The costs of the second service cost centre, which will now include some of the first service cost
centre’s costs, are apportioned between the production cost centres, on a fair basis. This is
illustrated below.
Basis of
Cost item apportionment A B C Canteen Admin
£ £ £ £ £
Costs allocated
and
apportioned 3,160 4,730 2,860 2,320 2,800
Number of employees
Apportion admin excluding admin 560 1,120 560 560 (2,800)
Notes
1 The costs of the administration department were taken first because these are the largest service
centre costs. The basis of apportionment selected is number of employees, since administration
costs are largely personnel-related.
2 The costs of the canteen have also been apportioned on the basis of number of employees,
because canteen work is primarily employee-related.
3 Service centre costs must ultimately be apportioned to the production cost centres; otherwise
there will be no mechanism for absorbing the costs into the cost of output units.
WORKINGS
(1) Apportionment of administration department costs
£2,800
= £56.00 per employee
(10 + 20 + 10 + 10)
The apportionment of costs is therefore (10 × £56) = £560 to Department A, (20 × £56) = £1,120
to Department B, (10 × £56) = £560 to Department C, and (10 × £56) = £560 to the canteen.
(2) Apportionment of canteen costs
£2,880
= £72.00 per employee
10 + 20 + 10
The apportionment of costs is therefore (10 × £72) = £720 to Department A, (20 × £72) = £1,440
to Department B, and (10 × £72) = £720 to Department C.
Maintenance works 40% of the time for Machining, 10% for Canteen and 50% for Assembly.
Requirement
Reapportion the service department overheads to the production departments, rounding to the
nearest £.
First reapportionment
Second reapportionment
Definition
Overhead absorption: The process whereby overhead costs allocated and apportioned to
production cost centres (in traditional costing systems) or cost pools (in activity-based costing
systems) are added to direct unit, job or batch costs. Overhead absorption is sometimes called
overhead recovery.
Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add
them to, or absorb them into, the cost of production or sales.
• Production overheads are added to the prime cost (direct materials, labour and expenses), the
total of the two being the factory cost, or full cost of production. Production overheads are
therefore included in the value of inventories of finished goods.
• Administration, selling and distribution overheads are then included. The aggregate of the
factory cost and these non-production overheads is the total cost of sales. These nonproduction
overheads are therefore not included in the value of closing inventory.
• An attempt to calculate overhead costs more regularly (such as each month) is possible, although
estimated costs must be added for periodic expenditure such as rent and rates (usually incurred
quarterly). The difficulty with this approach would be that actual overheads from month to month
could fluctuate therefore overhead costs charged to production would be inconsistent. For
example, a unit made in one week might be charged with £4 of overhead, in a subsequent week
with £5, and in a third week with £4.50. Only units made in winter would be charged with the
heating overhead. Such charges are considered misleading for costing purposes and
administratively inconvenient.
• Similarly, production output might vary each month. For example, actual overhead costs might be
£20,000 per month and output might vary from, say, 1,000 units to 20,000 units per month. The
unit rate for overhead would be £20 and £1 per unit respectively, which would again lead to
administration and control problems.
Production Production
Budget dept 1 dept 2
Production overhead cost £36,000 £5,000
Direct materials cost £32,000
Direct labour cost £40,000
Production Production
Budget dept 1 dept 2
Machine hours 10,000
Direct labour hours 18,000
Units of production 1,000
The production overhead absorption rates using the various bases of apportionment would be as
follows.
• Department 1
– Percentage of direct materials cost = £36,000/£32,000 × 100% = 112.5%
– Percentage of direct labour cost = £36,000/£40,000 × 100% = 90%
– Percentage of prime cost = £36,000/£72,000 × 100% = 50%
– Rate per machine hour = £36,000/10,000 hrs = £3.60 per machine hour
– Rate per direct labour hour = £36,000/18,000 hrs = £2 per direct labour hour
• Department 2
– The department 2 absorption rate will be based on units of output.
– 5,000/1,000 units = £5 per unit produced
The choice of the basis of absorption is significant in determining the cost of individual units, or jobs,
produced. In this example, suppose that an individual product has a material cost of £80, a labour
cost of £85, and requires 36 labour hours and 23 machine hours to complete. The production
overhead cost of the product would vary, depending on the basis of absorption used by the
company for overhead recovery.
• As a percentage of direct materials cost, the overhead cost would be 112.5% × £80 = £90.00
• As a percentage of direct labour cost, the overhead cost would be 90% × £85 = £76.50
• As a percentage of prime cost, the overhead cost would be 50% × £165 = £82.50
• Using a machine hour basis of absorption, the overhead cost would be 23 hrs × £3.60 = £82.80
• Using a labour hour basis, the overhead cost would be 36 hrs × £2 = £72.00
In theory, each basis of absorption would be possible, but the company should choose a basis for its
own costs that seems to be ‘fairest’. In our example, this choice will be significant in determining the
cost of individual products, as the following summary shows, but the total cost of production
overheads is the budgeted overhead expenditure, no matter what basis of absorption is selected. It
is the relative share of overhead costs borne by individual products and jobs that is affected by the
choice of overhead absorption basis.
A summary of the product costs is shown below.
Total
production
cost 255.00 241.50 247.50 247.80 237.00
One of the professional skills assessed in the ACA exams is the ability to ‘Evaluate the relevance of
information provided’. You will need to do this in the next question.
Requirement
Use the information above to determine suitable overhead absorption rates for a company’s three
production cost centres.
For each cost centre, fill in the blanks with the department rate and whether it is per direct labour
hour or per machine hour.
Definition
Blanket absorption rate: An absorption rate used throughout a factory for all products irrespective of
the department in which they were produced.
A blanket or single factory overhead absorption rate is an absorption rate used throughout a factory
and for all jobs and units of output irrespective of the department in which they were produced.
For example, if total overheads were £500,000 and there were 250,000 machine hours during the
period, the blanket overhead rate would be £2 per machine hour and all units of output passing
through the factory would be charged at that rate.
Such a rate is not appropriate, however, if there are a number of departments and units of output do
not spend an equal amount of time in each department.
If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
£560,000/240,000 hours = £2.33 per direct labour hour
If separate departmental rates are applied, these would be:
Department 1 Department 2
£360,000/200,000 hours = £1.80 per direct £200,000/40,000 hours = £5 per direct labour
labour hour hour
Department 2 has a higher overhead cost per hour worked than department 1.
Now let us consider two separate products.
• Product A has a prime cost of £100, takes 30 hours in department 2 and does not involve any
work in department 1.
• Product B has a prime cost of £100, takes 28 hours in department 1 and 2 hours in department 2.
Requirements
What would be the production cost of each product, using the following rates of overhead recovery?
(a) A single factory rate of overhead recovery
(b) Separate departmental rates of overhead recovery
Solution
Using a single factory overhead absorption rate, both products would cost the same. However, since
product A is produced entirely within department 2 where overhead costs are relatively higher, and
product B is produced mostly within department 1, where overhead costs are relatively lower, it is
arguable that product A should cost more than product B. This can be seen to be the case if separate
departmental overhead recovery rates are used to reflect the work done on each job in each
department separately.
(a)
Product A Product B
Single factory rate £ £
Prime cost 100.00 100.00
Production overhead (30 × £2.33) 70.00 70.00
Production cost 170.00 170.00
(b)
Product A Product B
Separate departmental rates £ £
Prime cost 100.00 100.00
Production overhead:
Department 1 (0 × £1.80) 0.00 (28 × £1.80) 50.40
Department 2 (30 × £5) 150.00 (2 × £5) 10.00
Production cost 250.00 160.40
Description Step
£
Overhead incurred (actual) 84,000
Overhead absorbed (45,000 × £2) 90,000
Over-absorption of overhead 6,000
In this example, the cost of produced units or jobs has been charged with £6,000 more than was
actually spent. An adjustment to reconcile the overheads charged to the actual overhead is
necessary and the over-absorbed overhead will be written as a credit to the income statement at the
end of the accounting period. By making this adjustment the total overhead in the income statement
would be reduced to £84,000, matching the overhead cost actually incurred.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and apply relevant
technical knowledge and skills to analyse a specific problem’. You may need to apply this in a
question to establish the reason for under/over absorbed overheads.
Requirement
Using your answer to Interactive question 6 and the information above, determine whether the
overhead in each of the three production departments is under or over absorbed and by how much
for the year.
2 Activity-based costing
Section overview
In applying judgement, you need to be able to ‘Identify assumptions or faults in arguments’. Activity-
based costing aims to rectify the problems with assumptions made in absorption costing.
low proportion of the total costs of a business, the arbitrary nature of overhead apportionment and
absorption may not be a serious issue. However, a significant feature of many modern businesses is
the relatively high level of overhead costs in relation to total costs. In this situation, the traditional
absorption costing system can create a problem for management seeking to accurately identify unit
costs and exert control over these costs. This problem has particular significance given the highly
competitive environment faced by many businesses.
Definition
Activity-based costing: An alternative to traditional absorption costing where overheads are related
to output using multiple cost drivers (activities which cause the overheads).
Activity-based costing (ABC) provides an alternative to the traditional method of absorption costing.
The objective of this method is to establish a better means of relating overheads to output. It is
claimed that the ABC method provides managers with a better basis for both cost control and for
the analysis of profitability.
The major concepts underlying ABC can be demonstrated as follows.
In high-technology production
and in service operations there
Activities include setting up machines and order processing.
are many 'support' activities that
are not related to output.
The costs of an activity are caused The cost of the ordering activity might be driven by the
or driven by factors known as number of orders placed, the cost of the despatching
cost drivers. activity by the number of despatches made.
The costs of an activity are If product A requires five orders to be placed, and product B
assigned to products on the basis 15 orders, ¼ (ie, 5/(5 + 15)) of the ord e ring cost will be
of the number of cost drivers. assigned to product A and ¾ (ie, 15/(5 + 15)) to product B.
Definitions
Cost driver: Something which causes costs to change eg, volume of output, number of production
runs etc.
Cost pool: A grouping of costs relating to a particular activity in an activity-based costing system.
For those costs that vary with production levels in the short term, ABC uses volume-related cost
drivers such as labour hours or machine hours. The cost of oil used as a lubricant on machines would
therefore be added to products on the basis of the number of machine hours, since oil would have
to be used for each hour the machine ran.
For costs that vary with some other activity and not volume of production, ABC uses transaction-
related cost drivers such as the number of production runs for the production scheduling activity.
Note: Although you will not be required to perform numerical calculations using ABC in your exam,
the following example will help to clarify the differences between ABC and traditional absorption
costing.
Direct labour cost per hour is £10. Overhead costs are as follows.
£
Short-run variable costs 3,080
Setup costs 10,920
Production and scheduling costs 9,100
Materials handling costs 7,700
30,800
W X Y Z Total
£ £ £ £ £
Direct material 200 800 2,000 8,000 11,000
Direct labour 101100 300 111,000 3,000 44,400
Overheads * 700 2,100 7,000 21,000 30,800
1,000 3,200 10,000 32,000 46,200
Units produced 10 10 100 100
Cost per unit £100 £320 £100 £320
W X Y Z Total
£ £ £ £ £
Direct material 200 800 2,000 8,000 11,000
Direct labour 100 300 1,000 3,000 4,400
Short-run variable overheads (W1) 70 210 700 2,100 3,080
Set-up costs (W2) 1,560 1,560 3,900 3,900 10,920
Production and scheduling costs
(W3) 1,300 1,300 3,250 3,250 9,100
Materials handling costs (W4) 1,100 1,100 2,750 2,750 7,700
4,330 5,270 13,600 23,000 46,200
Units produced 10 10 100 100
Cost per unit £433 £527 £136 £230
WORKINGS
(W1) £3,080 ÷ 440 machine hours = £7 per machine hour
(W2) £10,920 ÷ 14 production runs = £780 per run
(W3) £9,100 ÷ 14 production runs = £650 per run
(W4) £7,700 ÷ 14 production runs = £550 per run
Summary
Absorption costing
Product unit cost ABC unit cost Difference
£ £ £
W 100 433 + 333
X 320 527 + 207
Y 100 136 + 36
Z 320 230 – 90
The figures suggest that the traditional volume-based absorption costing system is flawed.
• It under allocates overhead costs to low volume products (here, W and X) and over allocates
overheads to higher volume products (here Z in particular).
• It under allocates overhead costs to less time-consuming products (here W and Y with just one
hour of work needed per unit) and over allocates overheads to more time-consuming products
(here X and particularly Z).
3 Costing methods
Section overview
• Contract costing is appropriate when cost units are of relatively long duration. Contracts are
usually undertaken away from the organisation’s own premises.
• The process costing method is appropriate when output consists of a continuous flow of identical
units.
• In a process costing environment unit costs are determined on an averaging basis.
Regardless of the materials pricing method that is selected by management or whatever basis is
used to absorb overheads into cost units, the overall costing method used by an organisation will
ultimately depend on the nature of the organisation’s operations.
Definition
Job costing: The costing method used where work is undertaken to customers’ special requirements
and each order is of comparatively short duration.
Job costing is appropriate where each separately identifiable cost unit or job is of relatively short
duration, such as the plumbing services and the garden bench in the examples above. Each job
would be allocated a separate job number and costs would be accumulated against this number in
order to determine the total cost of the job.
• Issues of direct material would be charged to each job using FIFO or LIFO, etc.
• Direct labour charges would be determined from detailed time records kept for each employee.
• Overhead costs would be absorbed into the total cost of each job using the predetermined
overhead absorption rate for each cost centre through which the job passes.
Job number
XXXX
Definition
Contract costing: A form of specific order costing where costs are attributed to contracts.
Contract costing is appropriate where each separately identifiable cost unit is of relatively long
duration, such as the building of the school or hospital in the examples above. Contracts are often
undertaken away from the organisation’s own premises.
Each contract would be allocated a separate number and costs would be accumulated against this
number in order to determine the total cost of the contract.
• Many direct materials would be delivered straight to the contract but issues of direct material
from stores would be charged to each contract using FIFO or LIFO, etc.
• Many direct employees would be permanently employed on the contract site but direct labour
charges for those employees travelling between sites would be determined from detailed time
records kept for each employee.
• Many overhead costs can be allocated directly to the contract but administrative overhead might
be absorbed into contract costs using some form of absorption basis.
Definition
Batch costing: A costing method applied where a group (batch) of identical items is treated as a cost
unit. The cost per item = total batch cost ÷ number of items in the batch.
Batch costing is similar to job costing except that each separately identifiable cost unit would be a
batch of identical items. For example, batch costing can be applied when production takes the form
of separately identifiable batches of shoes or batches of printed advertising leaflets.
Each batch would be allocated a number to identify it and costs would be accumulated for the batch
in the same way as for a job in job costing. The cost per unit manufactured in a batch is the total
batch cost divided by the number of units in the batch.
Definition
Process costing: A form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
Some organisations have a continuous flow of operations and produce a large number of identical
products. Food processing is one example and oil refining is another.
Such operations often consist of a number of consecutive processes where the output of one
process becomes the input of the subsequent process and so on until the finished output is
produced.
For example, the processes involved in making bottled sauces might be as follows.
Each process usually acts as a cost centre and material, labour and overhead costs are collected to
derive a total cost for each process for each period. The cost per unit of output from each process is
determined by dividing the total process cost by the number of units produced each period. This
unit cost then becomes an input cost for the subsequent process and so on until the final cost of a
completed unit is accumulated.
Additional materials
and labour
Materials
Process 1 input Average total unit
Labour Process 1 Process 2
cost to finished goods
Overhead
Additional overhead
Process costing can also be applied in a service environment. For example, in an organisation that
provides a shirt laundering service the processes involved might be as follows.
The cost per shirt laundered would be determined by the same averaging process as described
earlier.
Fitting kitchens
Manufacturing components
Manufacturing chemicals
Building offices
• Life cycle costing tracks and accumulates the costs and revenues attributable to each product
over its entire life cycle.
• Life cycle costs include those incurred in developing the product and bringing it to market, as well
as the costs incurred after sales of the product have ceased.
• Target costing begins with a concept for a new product for which a required selling price is
determined after consideration of the market conditions.
• The required profit margin is deducted from the selling price to determine the target cost for the
product.
• The costs to be incurred over the product’s entire life cycle are then examined to ensure that the
target cost is achieved.
• Just-in-time (JIT) is an approach to operations planning and control based on the idea that goods
and services should be produced only when they are needed.
Definition
Life cycle costing: A costing method that takes into account all of the costs and revenues of a
product over its entire life span.
A product incurs costs over the whole of its life cycle, from the design stage through development to
market launch, production and sales, and its eventual withdrawal from the market.
Component elements of a product’s costs over its life cycle include the following.
• Research and development costs: design, testing and so on
• Training costs: including initial operator training
• Production costs: materials, labour and so on
• Distribution costs: transportation, handling, inventory cost
• Marketing costs: advertising, customer service
• Retirement and disposal costs: dismantling specialised equipment
Costs
incurred Costs incurred during production
and sales stage, eg, direct materials,
marketing costs
Costs incurred before
production and sales
begin, eg, R&D Costs incurred once
production has ceased,
eg, disposal costs
Time
Figure 3.6: Costs incurred during the life cycle of a product or service
Traditional management accounting systems are based on the accounting year and tend to dissect
the product’s life cycle in a series of annual sections. This means that a product’s profitability over its
entire life is not assessed, but rather its profitability is assessed on a periodic basis.
In contrast, life cycle costing tracks and accumulates actual costs and revenues attributable to each
product over its entire life cycle, hence the total profitability of any given product can be
determined.
Definition
Target costing approach: A process that begins with the development of a product concept followed
by the determination of the price customers would be willing to pay for that concept. The desired
profit margin is deducted from the price, leaving a figure that represents total cost. This is the target
cost.
We have seen how the full cost of a product can be determined using some form of absorption
costing. This full cost is often used as the basis of the selling price decision: a desired profit mark-up
is added to the full cost to determine the product’s selling price.
Target costing works the other way round. It begins with a concept for a new product and, after
considering the situation in the potential market for the product, a required selling price is
determined.
From this price is deducted the desired profit margin, and the resulting acceptable cost becomes the
target cost. Thus the selling price determines the cost rather than the other way round.
Determine Determine
unit cost target cost
Determine Determine
selling price selling price
The costs to be incurred over the product’s entire life cycle are then examined and engineered in
order to ensure that the target cost is achieved.
Of particular importance is the initial design of the product. This is because many of the costs to be
incurred over the product’s entire life cycle are built into the product at the design stage.
4.3 Just-in-time
Definitions
Just-in-time (JIT): A system whose objective is to produce or to procure products or components as
they are required by a customer or for use, rather than for inventory. A JIT system is a ‘pull’ system,
which responds to demand, in contrast to a ‘push’ system, in which inventories act as buffers
between the different elements of the system, such as purchasing, production and sales.
Just-in-time production: A system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing: A system in which material purchases are contracted so that the receipt and
usage of material coincide to the maximum extent possible.
Just-in-time (JIT) is an approach to operations planning and control based on the idea that goods
and services should be produced only when they are needed. They should not be produced too
early, so that inventories build up, nor too late, so that the customer has to wait.
JIT consists of JIT purchasing and JIT production.
• JIT production is driven by demand for a product so that no items are produced until they are
needed by a customer or by the next stage in a production process.
• JIT purchasing requires that material is delivered by the supplier just as it is needed in the
production process.
JIT systems are often referred to as pull systems, whereby demand from a customer pulls products
through the production process. This is in contrast to traditional manufacturing systems, which are
push systems because a delivery from a supplier pushes products through production into inventory.
'Push' systems 'Pull' systems
Summary
Costing Other
Traditional Activity
method approaches
absorption based
to cost
costing costing Depends on nature
management
of operations
Continuous
Overhead allocation operation Life cycle
costing costing
Identify cost drivers
Identical cost units Tracks costs and
that cause costs of
revenues over entire
the major activities
Overhead life cycle
apportionment Process
costing
Unit costs determined
by averaging Target
Overhead costing
Assign activity costs
absorption Determines target
according to number Specific
Usually using a time of cost drivers order costing cost by working
based method generated backwards from
Each costs unit
selling price
different
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. What are the three stages in determining the share of overhead to be attributed to a cost
unit? (Topic 1)
5. Can you explain the reasons for under/over absorbed overheads? (Topic 1)
7. When are process, job, contract and batch costing used? (Topic 3)
8. Can you explain the features of life cycle costing, target costing and just-in-time? (Topic 4)
Self-test questions
2 A company has two production departments and two service departments with production
overheads as shown in the following table.
Service department Y divides its time between the other departments in the ratio 3:2:1 (for W, X and
Z respectively).
Department Z spends 40% of its time servicing department W and 60% of its time servicing
department X.
Requirement
Complete the following statement.
If all service department overheads are apportioned to production departments, the total fixed
overhead cost of department W is £ .
Machining Finishing
cost centre cost centre
Production overheads £38,000 £10,350
Machine hours per unit:
product Bubble 6 2
product Squeak 4 1
Production overheads are absorbed on a machine hour basis. Budgeted production is 800 units of
Bubble and 700 units of Squeak.
Requirement
The budgeted production overhead cost per unit of Bubble is:
A £39.00
B £45.00
C £45.20
D £54.00
5 ABC Co has been using an overhead absorption rate of £6.25 per labour hour in its packing
department throughout the year.
During the year the overhead expenditure amounted to £257,500, and 44,848 labour hours were
used.
Requirement
Which of the following statements is correct?
A Overheads were under absorbed by £27,600.
B Overheads were under absorbed by £22,800.
C Overheads were over absorbed by £27,600.
D Overheads were over absorbed by £22,800.
6 Budgeted and actual data for the year ended 31 December 20X1 is shown in the following table.
Budget Actual
Production (units) 5,000 4,600
Fixed production overheads £10,000 £10,000
Sales (units) 4,500 4,000
Fixed production overheads are absorbed on a per unit basis, based on a normal capacity of 5,000
units per annum.
Requirement
Why did under-absorption of fixed production overheads occur during the year ended 31 December
20X1?
A The company sold fewer units than it produced.
B The company sold fewer units than budgeted.
C The company produced fewer units than budgeted.
D The company budgeted to sell fewer units than produced.
7 A management consultancy absorbs overheads on chargeable consulting hours. Budgeted
overheads were £615,000 and actual consulting hours were 32,150. Overheads were under-
absorbed by £35,000.
Requirement
If actual overheads were £694,075, what was the budgeted overhead absorption rate per hour?
A £19.13
B £20.50
C £21.59
D £22.68
8 Which two of the following statements about traditional absorption costing and ABC are correct?
A Traditional absorption costing tends to assign too small a proportion of overheads to high
volume products.
B ABC costing systems will provide accurate unit costs because cost drivers are used to trace
overhead costs to products and services.
C An ABC system does not use volume-related cost drivers.
D Cost pools in an ABC system are equivalent to cost centres used in traditional absorption
costing.
E A cost driver is the factor that influences the cost of an activity.
9 Which two of the following statements are correct?
A Process costing is the most appropriate costing method when a continuous flow of identical
units is produced.
B Job costing and contract costing can only be applied where work is undertaken on the
organisation’s own premises.
C In process costing the cost per unit is derived using an averaging calculation.
D Process costing cannot be applied in a service environment.
E For batch costing to be applied each unit in the batch must be separately identifiable.
10 Which two of the following statements are correct?
A Life cycle costing is the profiling of cost over a product’s production life.
B The aim of target costing is to reduce life cycle costs of new products in order to achieve a cost
that will produce the target profit.
C Once a product’s target cost has been determined, the desired profit mark up is added to derive
the product’s selling price.
D JIT systems are referred to as ‘push’ systems because they push products through the
production process as quickly as possible.
E JIT purchasing requires small, frequent deliveries from suppliers as near as possible to the time
the raw materials and parts are needed.
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
Rent D
Heating costs A
Insurance of machinery B
Cleaning costs D
Canteen costs C
Factory light and heat Apportion The four factory cost Floor area or volume
centres occupied
Cleaning of workers’ overalls Apportion The four factory cost Number of workers
centres and the using overalls
warehouse
Basis of apportionment:
1 = Floor area
2 = Effective horsepower
3 = Plant value
4 = Fixtures and fittings value
Canteen No Yes
Offices No Yes
Only the machining department and assembly department are directly involved in the manufacture
of units. The other cost centres support the production activity and are therefore service cost centres.
WORKINGS
(1) First reapportionment
Maintenance is larger cost 4:5:1
(2) Second reapportionment
Number of employees 5:4
The relative proportions of labour hours and machine hours in each cost centre can be used to
identify whether the cost centre is labour intensive or machine intensive.
WORKINGS
(1) Forming department rate
£13,705/5,482 = 2.50
Labour intensive
(2) Machining department rate
£28,817/5,240 = 5.50
Machine intensive
(3) Assembly department rate
£9,978/4,989 = 2
Labour intensive
Description Step
WORKINGS
(1) Forming
£
Overhead absorbed (£2.50 × 5,370) 13,425
Overhead incurred 13,900
Under absorbed overhead 475
(2) Machining
£
Overhead absorbed (£5.50 × 6,370) 35,035
£
Overhead incurred 30,300
Over absorbed overhead 4,735
(3) Assembly
£
Overhead absorbed (£2 × 5,400) 10,800
Overhead incurred 8,500
Over absorbed overhead 2,300
Notes
1 Each fitted kitchen would be a separately identifiable cost unit of relatively short duration, hence
job costing is most appropriate.
2 A number of identical components would be manufactured in each separately identifiable batch.
3 Chemical manufacture involves a continuous flow of processes.
4 Each office building would be a separately identifiable cost unit of relatively long duration.
Therefore, contract costing is most appropriate.
Remember that prime cost is the total of all direct costs. The fixed cost of £3.15 per unit is excluded
from the prime cost calculation.
2 If all service department overheads are apportioned to production departments, the total fixed
overhead cost of department W is £ 1,160,000 .
3 Correct answer(s):
C charge overheads to products
A is incorrect because this is overhead apportionment.
B is incorrect because total overheads are found for cost centres by analysing cost information.
D is incorrect because overheads are controlled using budgets and other management information.
4 Correct answer(s):
A £39.00
Machining Finishing
Budgeted machine
hours:
Bubble (6 × 800) 4,800 (2 × 800) 1,600
Squeak (4 × 700) 2,800 (1 × 700) 700
7,600 2,300
Production overhead
absorption rate per
machine hour
(£38,000/7,600) £5.00 (£10,350/2,300) £4.50
Machining Finishing
per unit of Bubble (2 hours × £4.50)
=£39.00
5 Correct answer(s):
D Overheads were over absorbed by £22,800.
6 Correct answer(s):
C The company produced fewer units than budgeted.
Options A and B are incorrect because it is the levels of production that bring about under/over
absorption.
Option D is incorrect because the company was budgeting to produce the normal capacity on which
the absorption rate is based. This would have led to zero under or over absorption, whatever the
level of sales achieved.
7 Correct answer(s):
B £20.50
£
Actual overheads 694,075
Under absorbed overheads 35,000
Overheads absorbed by 32,150 hours 659,075
8 Correct answer(s):
D Cost pools in an ABC system are equivalent to cost centres used in traditional absorption
costing.
E A cost driver is the factor that influences the cost of an activity.
Statement A is incorrect because traditional absorption costing tends to assign too large a
proportion of overheads to high volume products, because it uses volume-related cost drivers.
Statement B is incorrect. ABC costing systems tend to provide more accurate unit costs than
traditional absorption costing systems. However, some arbitrary apportionments and absorptions will
still be necessary, therefore the unit costs are not accurate.
Statement C is incorrect. An ABC system uses volume-related cost drivers such as labour hours or
machine hours for costs that vary with production levels in the short term, such as machine power
costs.
Statement D is correct. Cost pools are used as collecting places to accumulate the costs associated
with each activity.
Statement E is correct. The cost of an activity increases in line with the number of cost drivers.
9 Correct answer(s):
A Process costing is the most appropriate costing method when a continuous flow of identical
units is produced.
C In process costing the cost per unit is derived using an averaging calculation.
Statement A is correct. Process costing is a form of continuous operation costing.
Statement B is incorrect. Both job costing and contract costing can be applied where work is
undertaken on the customer’s premises, for example, a decorating job (job costing) and building an
extension on a school (contract costing).
Statement C is correct because process costs are divided by the number of units produced to derive
an average unit cost for the period.
Statement D is incorrect because process costing can be applied in a service environment where
there is a continuous flow of identical units.
Statement E is incorrect. Each batch must be separately identifiable but the units within each batch
will be identical.
10 Correct answer(s):
B The aim of target costing is to reduce life cycle costs of new products in order to achieve a cost
that will produce the target profit.
E JIT purchasing requires small, frequent deliveries from suppliers as near as possible to the time
the raw materials and parts are needed.
Statement A is incorrect because life cycle costing includes development costs and other cost
incurred before production as well as any costs such as dismantling costs incurred after production
has ceased.
Statement B is correct. The target cost is calculated by deducting the target profit from a
predetermined selling price based on the market situation.
Statement C is incorrect. The target cost is derived by deducting the desired profit margin from a
competitive market price.
Statement D is incorrect. JIT systems are ‘pull’ systems because demand from a customer pulls
products through production.
Statement E is correct. JIT relies heavily on reliable, high quality suppliers.
Chapter 4
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Marginal cost and marginal costing
2 Marginal costing and absorption costing compared
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Calculate overhead absorption rates, unit costs and profits/losses from information provided,
using:
– Marginal costing
– absorption costing and reconcile the differences between the costs and profits/losses obtained
The specific syllabus reference for this chapter is: 1c.
4
Syllabus links
A knowledge of marginal costing and absorption costing will underpin your understanding of
inventory valuation for the Accounting syllabus.
4
Examination context
The calculation of the different profits reported under marginal costing and absorption costing is
likely to be a popular examination topic. You are also likely to be asked to reconcile the difference
between the profits reported under the two systems.
In the examination, students may be required to:
• calculate the profit reported under marginal costing and under absorption costing using the
same basic set of data
• reconcile the difference between the profits reported under the two systems
• derive the marginal costing profit from data provided that is prepared using absorption costing,
and vice versa
4
2 Marginal costing and Use the worked You could be asked IQ4: Marginal
absorption costing example in section to reconcile the and absorption
compared 2 to reinforce your difference between costing
Each costing system, learning from the profits reported You could see
because of the Chapter 3 and to under the two this type of
different inventory compare the two systems. scenario
valuations used, costing systems. question in the
produces a different You need to be able exam, so this is
profit figure. This to calculate good practice.
clearly has practical absorption costing
implications for and marginal
management decision costing profits side
making and control. by side. This is
Each method of shown in interactive
costing has its own question 4.
supporters and can be Work through all
useful in different the examples, learn
situations. the advantages of
each system.
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• In a marginal costing system only variable production costs are included in the valuation of units.
• All fixed costs are treated as period costs and are charged in full against the sales revenue for the
period.
• Contribution towards fixed costs and profit is calculated as sales revenue less variable cost of
sales.
• Marginal costing profit for the period = contribution less fixed costs.
Definition
Marginal cost: The variable cost of one unit of product or service.
Marginal costing is an alternative costing system to absorption costing. With marginal costing, only
variable production costs are included in the valuation of units. All fixed costs are treated as period
costs and are charged in full against the sales revenue for the period.
The marginal production cost per unit usually consists of the following:
• Variable materials
• Variable labour
• Variable production overheads
1.2 Contribution
Definition
Contribution: The difference between the selling price and all the variable costs of a product.
Solution
The first stage in the profit calculation must be to identify the variable costs, and then the
contribution. Fixed costs are deducted from the total contribution to derive the profit. All closing
inventories are valued at marginal or variable production cost (£6 per unit).
Variable cost
of sales 60,000 90,000 120,000
Profit/(loss)
per unit £(0.50) £1 £1.75
Contribution
per unit £4 £4 £4
One of the professional skills assessed in the ACA exams is the ability to ‘Understand the situation
and requirements’. If a business refers to ‘contribution’ then it is using marginal costing.
1.3 Conclusions
The conclusions that may be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost
per unit changes with the volume of sales.
(b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
(c) Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows.
(1) First calculate the total contribution.
(2) Then deduct fixed costs as a period charge in order to find the profit.
This calculation method is much quicker and is therefore useful for certain types of multiple choice
questions in the exam. The contribution and profit figures would be calculated as follows, arriving at
the same answers as above.
However, in the scenario-based questions you will be required to calculate the sales figures and cost
figures separately, so this method is not appropriate for the scenario-based questions.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and apply technical
knowledge and skills to analyse a specific problem’. You can use your knowledge of marginal costing
to calculate the profit in the next question.
Loo Wash
Opening inventory Nil Nil
Production (units) 15,000 6,000
Sales (units) 10,000 5,000
£ £ £
Sales price per unit 20 30
Unit costs
Variable materials 8 14
Variable labour 4 2
Variable production overhead 2 1
Variable sales overhead 2 3
Fixed costs for the month
Production costs 40,000
Administration costs 15,000
Sales and distribution costs 25,000
Requirements
2.1 Using marginal costing principles and the approach in section 1.3, calculate the profit in April
20X1.
2.2 Then calculate the profit again using the format shown below.
Variable production
costs
Opening inventory
Closing inventory
Production cost of
sales
Variable selling
overhead
Contribution
Fixed production
costs
Profit/(loss)
• In a marginal costing system inventories are valued at marginal or variable production cost; all
fixed overhead is charged against sales for the period in which it is incurred.
• In an absorption costing system an amount of absorbed fixed production overhead is included in
the inventory valuation.
• Reported profit figures using marginal and absorption costing will differ if there is any change in
the level of inventories during the period.
• If the fixed production overhead absorption rate per unit is the same each period, the difference
in reported profit is calculated as the change in inventory units × fixed production overhead
absorption rate per unit.
• If the fixed production overhead absorption rate is not the same each period, the difference in
reported profit is equal to the change in the fixed production overhead in the inventory.
• In the long run the total reported profit will be the same whether marginal costing or absorption
costing is used.
• Each of the costing systems has a number of advantages.
£
Sales 16,000
Production costs:
Variable 6,400
Fixed 1,600
Sales and distribution costs:
Variable 3,200
Fixed 2,400
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the
year, and actual fixed costs are the same as budgeted. A predetermined overhead absorption rate is
used for the year.
There were no inventories of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Requirements
1 For the first quarter, calculate the fixed production costs absorbed by Claud if absorption costing
is used.
2 For the first quarter, calculate inventory values per unit using both absorption costing and
marginal costing.
3 For the first quarter, calculate the under/over absorption of overheads.
4 For the first quarter, calculate the profit using absorption costing.
5 For the first quarter, calculate the profit using marginal costing.
6 For the first quarter, explain why there is a difference between the answers to Questions (4) and
(5).
Solution
1 The requirements provide useful steps for analysing the example.
Budgeted fixed production costs/Budgeted output (normal level of activity) = £1,600/800 units
Absorption rate = £2 per unit produced.
During the quarter, the fixed production overhead absorbed would be 220 units × £2 = £440.
2 Inventory values per unit
Absorption Marginal
costing costing
£ per unit £ per unit
Variable production cost (£6,400/800) 8 8
Fixed production cost (£1,600/800) 2 –
Inventory value per unit 10 8
£
Actual fixed production overhead 400 (1/4 of £1,600)
Absorbed fixed production overhead 440
Over absorption of fixed production overhead 40
£ £
Sales (160 × £20) 3,200
Production costs
Variable (220 × £8) 1,760
Fixed (absorbed overhead (220 × £2)) 440
Total (220 × £10) 2,200
Less closing inventories (60 × £10) 600
Production cost of sales 1,600
£ £
Adjustment for over absorbed overhead 40
Total production costs 1,560
Gross profit 1,640
Less sales and distribution costs
Variable (160 × £4) 640
Fixed (1/4 of £2,400) 600
1,240
Net profit 400
Using the ‘short-cut’ calculation method (suitable for multiple choice questions) this answer can
be derived as follows.
£ per unit £
Sales price 20
Less: Full absorption cost (10)
Variable sales and distribution cost (4)
6
× sales volume 160 units 960
Less fixed sales and distribution costs (600)
360
Adjust for over absorbed overhead 40
Net profit 400
£ £
Sales 3,200
Variable production costs 1,760
Less closing inventories (60 × £8) 480
Variable production cost of sales 1,280
Variable sales and distribution costs 640
Total variable costs of sales 1,920
Total contribution 1,280
Less: Fixed production costs 400
Fixed sales and distribution costs 600
1,000
Net profit 280
Using the ‘short-cut’ calculation method (suitable for multiple choice questions) this answer can
be derived as follows.
£ per unit £
Sales price 20
Less: Variable production cost (8)
Variable sales and distribution cost (4)
Contribution per unit 8
× sales volume 160 units = contribution 1,280
Less: Fixed production costs (400)
Fixed sales and distribution costs (600)
Net profit 280
6 The difference in profit is due to the different valuations of closing inventory. In absorption
costing, the 60 units of closing inventory include absorbed fixed overheads of £120 (60 × £2),
which are therefore costs carried over to the next quarter and not charged against the profit of
the first quarter. In marginal costing, all fixed costs incurred in the period are charged against
profit.
£
Absorption costing profit 400
Fixed production costs carried forward in inventory values (60 units × £2)* 120
Marginal costing profit 280
2.2 Conclusions
We can draw a number of conclusions from this example.
(a) Marginal costing and absorption costing are different techniques for assessing profit in a
period.
(b) If there are changes in inventories during a period, marginal costing and absorption costing
give different results for profit obtained.
Assuming that the variable cost per unit and the fixed cost per unit are constant:
(1) if inventory levels increase, absorption costing will report a higher profit because some of
the fixed production overhead incurred during the period will be carried forward in closing
inventory. This reduces cost of sales and carries forward cost to be set against sales revenue
in the following period.
(2) if inventory levels decrease, absorption costing will report a lower profit because as well as
the fixed overhead incurred, fixed production overhead which had been brought forward in
opening inventory is released and is included in cost of sales.
(c) If the opening and closing inventory levels are the same, marginal costing and absorption
costing will give the same profit figure if unit costs remain constant.
(d) In the long run, total profit for a company will be the same whether marginal costing or
absorption costing is used as all inventory is sold. Different accounting conventions merely affect
the profit of individual accounting periods.
One of the professional skills assessed in the ACA exams is the ability to ‘Evaluate the relevance of
information provided’. In the next question you need to identify the relevance of the production and
sales volume.
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
Requirements
What profit would be reported in each period and in total using the following costing systems?
1 Absorption costing
Note: Assume normal output is 1,500 units per period.
2 Marginal costing
Solution
1 Absorption costing: The absorption rate for fixed production overhead is:
£1,500/1,500 units = £1 per unit
Using the ‘short-cut’ method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
£ per unit £ £
Sales price 6
Full absorption cost:
Variable production cost (4)
Absorbed fixed production cost (1)
1
× sales volume 1,200 1,800
Other costs 500 500
Net profit 700 1,300
Using the ‘short-cut’ method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
£ per unit £ £
Sales price 6
Period 1 Period 2
£ per unit £ £
Less variable production costs (4)
Contribution per unit 2
× sales volume = total contribution 2,400 3,600
Less fixed costs 2,000 2,000
Profit 400 1,600
Points to note
The total profit over the two periods is the same for both costing systems, but the profit in each
period is different.
It is important to notice that although production and sales volumes in each period are different
(and therefore the profit for each period using absorption costing is different from the profit
reported by marginal costing), over the full period, total production equals sales volume, the total
cost of sales is the same, and therefore the total profit is the same using either system of
accounting.
£
Variable labour 5
Variable material 8
Variable production overhead 2
Fixed production overhead 5
Standard production cost 20
The fixed production overhead figure has been calculated on the basis of a budgeted normal output
of 36,000 units per annum.
You are to assume that all the budgeted fixed expenses are incurred evenly over the year. March and
April are to be taken as equal period months.
Selling, distribution and administration expenses are as follows.
The selling price per unit is £35 and the number of units produced and sold was as follows.
March April
Units Units
Production 2,000 3,200
Sales 1,500 3,000
Requirements
4.1 Calculate the total value of the closing inventory for each month under marginal costing.
March £
April £
4.2 Calculate the total value of the closing inventory for each month under absorption costing.
March £
April £
4.4 Calculate the profit or loss for March using both absorption costing and marginal costing.
March
Absorption Marginal
£ £ £ £
Sales
Variable production
costs
Fixed production cost
absorbed
Opening inventory
Closing inventory
Production cost of
sales
Under/over
absorption
Variable selling,
distrib’n and admin
Fixed selling, distrib’n
and admin
Fixed production
costs
Profit/(loss)
4.5 Calculate the profit or loss for April using both absorption costing and marginal costing.
April
Absorption Marginal
£ £ £ £
Sales
Variable production
costs
Fixed production cost
absorbed
Opening inventory
Closing inventory
Absorption Marginal
£ £ £ £
Production cost of
sales
Under/over
absorption
Variable selling,
distrib’n and admin
Fixed selling, distrib’n
and admin
Fixed production
costs
Profit/(loss)
One of the professional skills assessed in the ACA exams is the ability to ‘Identify assumptions or
faults in arguments’. The list of advantages of absorption costing should highlight some of the faults
in marginal costing and vice versa.
Summary
Alternative costing
systems
Highlights contribution
= sales value less
variable costs
Fixed production
overhead absorbed
Fixed costs charged in into unit production
full against revenue for costs
period
Inventories valued at
full production cost, ie,
Inventories valued at including a share of
variable production cost fixed production costs
Different inventory valuation may
result in different profit results in
short term
If inventories
If inventories increase: If inventories do not alter:
decrease:
mc profit < ac profit mc profit = ac profit
mc profit > ac profit
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
3. What are the differences between marginal and absorption costing? (Topic 2)
4. If inventory levels increase during the period, will absorption costing report a higher or
lower profit than marginal costing? Why? (Topic 2)
Self-test questions
£
Variable materials 20
Variable labour 40
Production overheads
Variable 10
Fixed 5
Sales and distribution overheads
Variable 5
Fixed 10
Total cost 90
Requirement
Complete the sentence.
2 A new product has a variable material cost of £5.50 per unit, a variable labour cost of £2 per unit and
a fixed overhead absorption rate of £3.50 per unit.
Production during the first month was 23,000 units and sales were 21,000 units.
Requirement
Calculate to the nearest £ the inventory valuation under both marginal costing and absorption
costing.
3 A company manufactures Luxury and Standard items. The following information relates to period 1.
Luxury Standard
Variable materials £16 per unit £12 per unit
Variable labour £21 per unit £9 per unit
Variable production overhead £10 per unit £8 per unit
Requirement
Calculate to the nearest £ the inventory valuation under both marginal and absorption costing.
Luxury Standard
Marginal costing: £ £
Absorption costing: £ £
4 A company has just completed its first year of trading. The budgeted production volume of 26,000
units was achieved and the sales volume was 24,500 units at £40 each.
The following actual cost information is available.
£
Variable cost per unit
Manufacturing 18.50
Selling and administration 9.20
Fixed costs (as budget):
Manufacturing 91,000
Selling and administration 49,000
Requirement
Calculate the net profit figures using both absorption and marginal costing.
5 When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a profit of
£62,100 using marginal costing.
Requirement
Assuming that the fixed overhead absorption rate was £3 per litre, what would be the profit using
absorption costing?
A 41,850
B 56,850
C 67,350
D 82,350
6 Which of the following are arguments in favour of marginal costing?
A Closing inventory is valued in accordance with financial reporting standards.
B It is simple to operate.
C There is no under or over absorption of overheads.
D Fixed costs are the same regardless of activity levels.
E The information from this costing system may be more useful for decision making.
7 Which two of the following statements are correct assuming that unit costs are constant?
A A product showing a positive contribution under marginal costing will always show a profit
under absorption costing.
B If inventory levels increase, marginal costing will report a lower profit than absorption costing.
C If inventory levels decrease, marginal costing will report a lower profit than absorption costing.
D If inventory levels increase, marginal costing will report a higher profit than absorption costing.
E If opening and closing inventory levels are the same, marginal costing and absorption costing
will report the same profit figure.
8 Last period a company reported absorption costing profits of £36,000. Actual fixed production
overheads were £42,000 and the actual production volume of 6,000 units resulted in over absorbed
fixed production overhead of £6,000.
A sales volume of 7,100 units was achieved during the period.
Requirement
Complete the following sentence.
The marginal costing profit for the period would have been £ .
9 Last period 17,500 units were produced at a total cost of £16 each. Three quarters of the costs were
variable and one quarter fixed. 15,000 units were sold at £25 each. There were no opening
inventories.
Requirement
By how much will the profit calculated using absorption costing principles differ from the profit if
marginal costing principles had been used?
A The absorption costing profit would be £10,000 less
B The absorption costing profit would be £10,000 greater
C The absorption costing profit would be £30,000 greater
D The absorption costing profit would be £40,000 greater
10 In a period, a company had opening inventory of 31,000 units and closing inventory of 34,000 units.
Profits based on marginal costing were £850,500 and on absorption costing were £955,500.
Requirement
If the budgeted total fixed costs for the company were £1,837,500 what was the budgeted level of
activity in units?
A 32,500
B 52,500
C 65,000
D 105,000
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
WORKING
Contribution per experience
£ £
Selling price per experience 1,009.99
Marginal cost per experience
Variable material 320
Variable labour 192
Variable overhead 132
644.00
Contribution per experience 365.99
Absorbed fixed overheads are not included in the calculation of marginal cost per unit or
contribution per unit.
£
Contribution from Loos (unit contribution = £20 – £16 = £4 × 10,000 units) 40,000
Contribution from Washes (unit contribution = £30 – £20 = £10 × 5,000 units) 50,000
Total contribution 90,000
Fixed costs for the period 80,000
Profit 10,000
2.2
Variable production
costs 210,000 102,000
Opening inventory 0 0
Closing inventory (70,000) (17,000)
Production cost of
sales (140,000) (85,000)
Variable selling
overhead (20,000) (15,000)
3.1 The absorption costing profit would be greater than the marginal costing profit.
This is because production exceeded sales, therefore the inventory level increased. Some of the
fixed production overhead incurred during the period would be carried forward in the
inventory value with absorption costing, thus reducing the charge to cost of sales.
April £ 10,500
April £ 14,000
4.3 £ 180,000
Absorption Marginal
£ £ £ £
Sales 52,500 52,500
Variable production
costs 30,000 30,000
Fixed production cost
absorbed 10,000 0
Opening inventory 0 0
Absorption Marginal
£ £ £ £
Closing inventory (10,000) (7,500)
Production cost of
sales (30,000) (22,500)
Under/over
absorption (5,000) 0
Variable selling,
distrib’n and admin (7,875) (7,875)
Fixed selling, distrib’n
and admin (10,000) (10,000)
Fixed production
costs 0 (15,000)
Profit/(loss) (375) (2,875)
WORKING
March
Sales revenue = 1,500 × £35 = £52,500
Variable production costs = 2,000 × (£5 + £8 + £2) = £30,000
Fixed production cost absorbed = 2,000 × £5 = £10,000
Closing inventory = see answer to 1 and 2.
Under absorption:
£
Overhead absorbed (2,000 × £5) 10,000
Overhead incurred (£5 × 36,000 × 1/12) 15,000
Under/(over) absorbed 5,000
Absorption Marginal
£ £ £ £
Sales 105,000 105,000
Variable production
costs 48,000 48,000
Fixed production cost
absorbed 16,000 0
Opening inventory 10,000 7,500
Closing inventory (14,000) (10,500)
Production cost of
sales (60,000) (45,000)
Under/over 1,000 0
Absorption Marginal
£ £ £ £
absorption
Variable selling,
distrib’n and admin (15,750) (15,750)
Fixed selling, distrib’n
and admin (10,000) (10,000)
Fixed production
costs 0 (15,000)
Profit/(loss) 20,250 19,250
WORKING
April
Sales revenue = 3,000 × £35 = £105,000
Variable production costs = 3,200 × (£5 + £8 + £2) = £48,000
Fixed production cost absorbed = 2,000 × £5 = £10,000
Opening inventory = March closing inventory – see answer to Questions 1 and 2.
Closing inventory – see answer to Questions 1 and 2.
Over absorption:
£
Overhead absorbed (3,200 × £5) 16,000
Overhead incurred (£5 × 36,000 × 1/12) 15,000
Under/(over) absorbed (1,000)
WORKING
Marginal production cost of product EZ
£ per unit
Variable materials 20
Variable labour 40
Variable production overheads 10
70
Marginal costing: £15,000 (to the nearest £) Absorption costing: £22,000 (to the nearest £)
WORKINGS
(1) Marginal cost of product
= Variable material cost + Variable labour cost
= £5.50 + £2
= £7.50 per unit
In marginal costing, closing inventories are valued at marginal production cost, which includes
the variable material cost of £5.50 and the variable labour cost of £2 for 2,000 units.
Therefore, inventory valuation = £7.50 × 2,000 = £15,000.
(2) Absorption cost of product
= Marginal cost + Fixed production overheads
= £7.50 = £3.50
= £11 per unit
In absorption costing, closing inventories are valued at £11 each (this includes a share of fixed
production overheads).
Therefore, inventory valuation = £11 × 2,000 = £22,000.
3
Luxury Standard
Marginal costing: £13,630 £16,530
Absorption costing: £20,735 £22,515
WORKINGS
(1) Marginal costing
In marginal costing, closing inventories are valued at marginal production cost (variable
materials, variable labour and variable production overhead).
Luxury = £16 + £21 + £10 = £47 per unit.
There are 290 of them, so closing inventory value = 290 × £47 = £13,630.
WORKING
Absorption net profit
Fixed manufacturing cost per unit = £91,000/26,000 = £3.50
Budgeted production = actual production, therefore no under or over absorption of overhead
occurred.
£ £
Sales revenue 24,500 × £40 980,000
Manufacturing cost of sales 24,500 × £(18.50 + 3.50) (539,000)
Gross profit 441,000
Less selling and administration costs:
Variable 24,500 × £9.20 225,400
Fixed 49,000
(274,400)
Absorption costing net profit 166,600
£ per unit
Sales price 40.00
Less: Variable manufacturing cost per unit (18.50)
Variable selling and administration cost per unit (9.20)
Fixed manufacturing cost per unit (3.50)
8.80
£
× sales volume 24,500 units 215,600
Less fixed selling and administration costs 49,000
Absorption costing net profit 166,600
Inventories increased during the period, therefore the marginal costing net profit will be lower.
£
Absorption costing net profit 166,600
Difference in profits (change in inventory 1,500 units × £3.50) (5,250)
Marginal costing net profit 161,350
£
Marginal costing contribution = 24,500 × £(40 – 18.50 – 9.20) 301,350
Less fixed costs (£91,000 + £49,000) (140,000)
Marginal costing profit 161,350
5 Correct answer(s):
B 56,850
Difference in profit = (8,500 – 6,750) × £3 = £5,250
Absorption costing profit = £62,100 – £5,250 = £56,850
Since inventory levels reduced, the absorption costing profit will be lower than the marginal costing
profit. You can therefore eliminate Options C and D.
6 Correct answer(s):
B It is simple to operate.
C There is no under or over absorption of overheads.
D Fixed costs are the same regardless of activity levels.
E The information from this costing system may be more useful for decision making.
The first statement is incorrect. A marginal costing system does not value inventory in accordance
with financial reporting standards because it does not include absorbed fixed production overheads.
The information from an absorption costing system is therefore more useful for external reporting
purposes.
7 Correct answer(s):
B If inventory levels increase, marginal costing will report a lower profit than absorption costing.
E If opening and closing inventory levels are the same, marginal costing and absorption costing
will report the same profit figure.
The first statement is incorrect because a positive contribution will not always show a profit under
either costing system. The level of reported profit will depend on the magnitude of fixed overheads.
The remaining statements can be assessed using the following rules:
• If inventory levels increase, absorption costing profit is higher than marginal costing profit
(because of the fixed overhead carried forward in inventory).
• If inventory levels decrease, absorption costing profit is lower than marginal costing profit
(because of the fixed overhead ‘released’ from inventory).
• If inventory levels remain the same then both costing systems will report the same profit figure.
8 The marginal costing profit for the period would have been £ 44,800 .
WORKING
Marginal costing profit
£
Actual fixed production overhead 42,000
Over absorbed overhead 6,000
Absorbed fixed production overhead 48,000
£
Absorption costing profit 36,000
Profit difference (1,100 units × £8) 8,800
Marginal costing profit 44,800
9 Correct answer(s):
B The absorption costing profit would be £10,000 greater
Fixed costs per unit = £16/4 = £4
Units in closing inventory = 17,500 – 15,000 = 2,500 units
Profit difference = Inventory increase in units × Fixed overhead per unit
= 2,500 × £4 = £10,000
Inventories increased, therefore fixed overhead would have been carried forward in inventory using
absorption costing and the profit would be higher than with marginal costing.
10 Correct answer(s):
B 52,500
Inventory levels increased by 3,000 units and absorption costing profit is £105,000 higher (£955,500
– £850,500).
Therefore, fixed production cost included in inventory increase = £105,000/3,000 = £35 per unit of
inventory.
Budgeted fixed costs/Fixed cost per unit = £1,837,500/35 = 52,500 units
Chapter 5
Pricing calculations
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Full cost-plus pricing
2 Marginal cost-plus pricing
3 Mark-ups and margins
4 Transfer pricing
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Calculate the sales price for a given product or service using cost-based pricing
• Calculate transfer prices for specified sales to internal customers which take account of
appropriate costs
The specific syllabus references for this chapter are: 1e and f.
5
Syllabus links
An understanding of the use of cost information as a basis for pricing decisions will underpin your
studies of strategic choice within the Business Strategy and Technology syllabus.
5
Examination context
Pricing decisions could feature as a narrative question or as a calculation question.
The content of this chapter is deceptively straightforward. A thorough knowledge of this, and earlier
topics such as fixed and variable costs, is required to answer questions in this area.
In the examination, students may be required to:
• calculate a selling price using full cost-plus pricing
• calculate a selling price using marginal cost-plus pricing
• demonstrate an understanding of the difference between mark-up and margin and of the
relationship between them
• derive the mark up percentage that will achieve a desired return on the investment in a product
• calculate a transfer price that will achieve profit maximisation and encourage an alignment of the
goals of groups or individuals with the goals of the organisation as a whole
5
Clearly the
determination of a
selling price is a very
important
management decision.
This section covers one
method of choosing a
price.
3 Mark-ups and margins Section 3 looks The need for an IQ2: Mark-ups
A selling price based deceptively understanding of and margins
on a 20% margin straightforward, but profit margins This question
means that profit is you should devote underpins a number provides useful
20% of selling price. A sufficient time to of other areas of the practice of the
selling price based on understanding the syllabus. Questions calculations that
a 20% mark-up means difference between including you could be
that profit is 20% of mark up and calculations of asked to
cost. margin. Many margins may, perform in the
students get the therefore, not be exam.
principle wrong in exclusive to pricing
the exam so ensure questions.
that you try You could be asked
interactive question to derive the mark
2. up percentage that
will achieve a
Stop and think desired return on
the investment in a
Businesses that use product.
job costing often
use margins and
mark ups to price
jobs.
4 Transfer pricing Learn the aims of a Questions could ask IQ3: Using
The transfer price is the transfer pricing you to calculate a market value as
amount charged by system and work transfer price that the transfer
one part of an through all the will achieve profit price
organisation for the material about the maximisation and Attempt this
provision of goods or behavioural impact encourage an question to
services to another part of transfer prices. alignment of the confirm your
of the same goals of groups or understanding
organisation. individuals with the of transfer
Stop and think goals of the
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• In full cost-plus pricing the sales price is determined by calculating the full cost of the product or
service and then adding a percentage mark-up for profit.
• The full cost may be a fully absorbed production cost only, or it may include some absorbed
selling, distribution and administration overheads. In the former case the mark-up on costs must
be greater in order to recover the other costs.
• The most important criticism of full cost-plus pricing is that it fails to recognise that since sales
demand may be determined by the sales price, there will be a profit-maximising combination of
price and demand.
Definition
Cost-plus pricing: A method of determining the sales price by calculating the full (absorption) cost of
the product and adding a percentage mark-up for profit.
In practice cost is one of the most important influences on price. While in economic theory it is
possible to set a sales price that will maximise profit, in reality there is a lack of precise information
about cost behaviour patterns and the effect of price on sales demand.
This will lead some organisations to base their selling price decision on simple cost-plus rules,
whereby costs are estimated and then a percentage mark-up is added in order to set the price.
£ per unit
Variable materials 14.00
Variable labour at £12 per hour 54.00
Variable overheads at £3 per hour 13.50
£ per unit
Variable service cost per unit 81.50
Fixed production overheads are budgeted to be £69,000 each period. The overhead absorption rate
will be based on 17,250 budgeted direct labour hours each period.
Requirement
The company wishes to add 20% to the full service cost in order to determine the selling price per
unit for service S.
Solution
Step 1
Calculate the fixed overhead absorption rate.
Overhead absorption rate
= £69,000/17,250
= £4 per direct labour hour
Step 2
Calculate the full service cost per unit.
Direct labour hours per unit = £54/£12 = 4.5 hours
£ per unit
Variable production cost per unit 81.50
Fixed overhead absorbed (4.5 hours × £4) 18.00
Full service cost per unit 99.50
Step 3
Add the required mark-up to determine the selling price.
£ per unit
Full service cost per unit 99.50
Mark-up 20% 19.90
Full cost-plus selling price 119.40
(2) The full cost of providing the service increases to £50 per hour. The required mark-up
percentage to achieve the same absolute value of mark-up per hour of service provided is:
%
£ per unit
Full cost 100.00
Mark-up 4.8% 4.80
Selling price of product Z 104.80
One of the professional skills assessed in the ACA exams is the ability to ‘Identify assumptions or
faults in arguments’. This could refer to the advantages and disadvantages of different pricing
methods.
• Marginal cost-plus pricing involves adding a profit mark-up to the marginal or variable cost of
production or sales.
• The chief advantage of marginal cost-plus pricing is that it avoids the arbitrary apportionment and
absorption of fixed costs.
Solution
Step 1
Calculate the total marginal or variable cost of sales per unit.
£ per unit
Variable production cost 7.00
Variable selling and distribution cost 3.80
Total marginal cost 10.80
Step 2
Add the required mark-up to determine the selling price.
£ per unit
Total marginal cost 10.80
Mark-up 30% 3.24
Marginal cost-plus selling price 14.04
Step 3
Determine the total contribution and deduct the fixed costs to derive the period profit.
The mark-up per unit is the same as the contribution earned per unit. It contributes towards the fixed
costs and profit for the period.
£ £
Total mark-up/contribution (26,800 × £3.24) 86,832
Less fixed costs:
Production 17,900
Selling, distribution and administration 24,800
42,700
Profit 44,132
• The mark-up is the profit expressed as a percentage of the marginal cost, total production cost or
total cost.
• The margin is the profit expressed as a percentage of the sales price.
Cost-plus pricing
One of the professional skills assessed in the ACA exams covers evaluating the relevance of
information provided. This could mean noting whether a business uses a mark-up or margin
percentage.
4 Transfer pricing
Section overview
• A transfer price is the amount charged by one part of an organisation for the provision of goods
or services to another part of the same organisation.
• A transfer pricing system has a number of aims, which may conflict with each other.
• Inappropriate transfer prices may lead to sub-optimal decisions and a lack of alignment of
corporate goals (called goal congruence).
• In a perfectly competitive market the optimum transfer price is the market price. This should be
reduced for savings in costs that are not incurred on internal transfers, such as distribution costs,
advertising and marketing costs, and bad debts.
• A problem with cost-plus pricing is that the receiving division will perceive the transfer price to be
a wholly variable cost, whereas it includes some costs which are fixed from the point of view of the
company as a whole. This could lead to sub-optimal decision making.
• With two part transfer prices, all transfers are charged at a predetermined standard variable cost.
A periodic charge for fixed costs would also be made by the supplying division to the receiving
division.
• In a dual pricing system the receiving division is charged with the standard variable cost of all
transfers. The supplying division is credited with the market value or a cost-plus price in order to
provide a profit incentive to make the transfer.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and apply relevant
technical knowledge and skills to analyse a specific problem’. Establishing a transfer price is a
problem for many businesses.
Definitions
Transfer price: The amount charged by one part of an organisation for the provision of goods or
services to another part of the same organisation.
Goal congruence: When individuals’ goals and company goals coincide.
Transfer pricing is used when divisions of an organisation need to charge other divisions of the same
organisation for goods or services that they provide to them. For example, subsidiary A might
manufacture a component that is used as part of a product made by subsidiary B of the same
company. The component can also be bought on or sold to the external market. Therefore, there will
be two sources of revenue for subsidiary A:
• external sales revenue from sales made to other organisations
• internal sales revenue from the transfer prices charged for components supplied to subsidiary B
Division A Division B
£ per unit £ per unit
Variable cost 10 15
Transfer price at market value – 20
Fixed costs 5 10
Profit 5 25
Transfer price/selling price 20 70
Division A can sell externally at £20 per unit or transfer internally to division B at £20 per unit.
Division B receives an offer from a customer of £30 per unit for its final product.
Requirements
Would division B accept the offer of £30 per unit given the existing transfer price?
A Yes
B No
Is this the correct decision from the company’s point of view if division A has surplus capacity?
C Yes
D No
Is this the correct decision from the company’s point of view if division A is operating at full capacity?
E Yes
F No
Division S Division R
£ per unit £ per unit
Variable cost 20 15
Division S Division R
£ per unit £ per unit
Fixed cost absorbed 10
Full cost 30
Requirements
1 Would the transfers be recommended from the point of view of the company as a whole?
2 Would the transfers be recommended from the point of view of the manager of division R?
Solution
1 The transfers would be recommended from the point of view of the company as a whole.
The variable cost incurred by the company as a whole for each unit of product P is £35.
£ per unit
Variable cost:
Division S 20
Division R 15
35
The fixed costs are irrelevant to this analysis because they would be incurred even if the transfers
are not made.
Therefore, from the point of view of the company as a whole, the transfers are worthwhile
because product P earns a contribution of £5 per unit (£40 – £35).
2 The transfer would not be recommended from the point of view of the manager of division R.
Transfer price per unit of component C = £30 + 10% = £33
The manager of division R would view the transfer price of component C as a variable cost, since
it is an extra cost incurred by division R for every unit of product P manufactured.
Therefore, from the point of view of the manager of division R the variable cost of each unit of
product P is £48.
£ per unit
Variable cost:
Component C (perceived variable cost) 33
Extra cost incurred 15
48
Division R would not recommend the transfer of component C and the manufacture of product P,
since the division would record a negative contribution of £8 for each unit manufactured.
£ per unit of P
External market price 40
Division R perceived variable cost (48)
Contribution (8)
In this illustration, the use of a full cost-plus transfer price has led to sub-optimal decision making.
There is a lack of goal congruence because the manager of division R, in pursuing the division’s own
goals, was not at the same time automatically pursuing the goals of the company as a whole.
In the situation depicted in the Interactive question ‘Using market value as the transfer price’,
Question 3, there was also a lack of goal congruence. The divisional manager’s own goals were not
congruent with those of the company as a whole. The transfer pricing system was leading the
manager of division B to make a sub-optimal decision from the point of view of the company as a
whole when division A had spare capacity.
Transfer pricing questions will require you to apply technical knowledge and skills to solve a specific
problem.
Summary
Pricing calculations
Optimal price
in perfectly Fixed and
competitive variable
market charges
separated
Different
Mark-up may price used
be derived to for receiving
earn a required and supplying
return on division
investment
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
2. What are the advantages and disadvantages of using marginal cost-plus pricing? (Topic
2)
Self-test questions
£ per unit
Variable material 8.00
Variable labour at £14 per hour 42.00
Variable production overheads are incurred at the rate of £4 per hour. Fixed production overheads of
£60,000 are absorbed on the basis of 25,000 budgeted direct labour hours. Other overheads are
recovered at 5% of total production cost.
Requirement
If selling prices are set to recover the full cost plus 50% the selling price per unit of product F is:
A £72.66
B £99.62
C £103.80
D £108.99
2 The marginal cost per unit of a product is 70% of its full cost. Selling prices are set on a full cost-plus
basis using a mark-up of 40% of full cost.
Requirement
Which percentage mark-up on marginal cost would produce the same selling price as the full cost-
plus basis described?
A 70%
B 90%
C 100%
D 200%
3 Jay operates a car valeting service and charges £16 per car. He incurs a total cost of £10 per car
valeted.
Requirement
Calculate the mark-up and margin earned per car valeted.
Mark-up %
Margin %
Requirement
The profit margin as a percentage of the sales price of product F is:
A 9.1%
B 10%
C 20%
D 50%
6 When goods are transferred from division A to division B a charge is made to division B at standard
variable cost. Each quarter division B is also charged with a lump-sum as a share of A’s fixed costs.
Requirement
This type of transfer pricing system is a:
A marginal cost-plus system
B dual pricing system
C two-part transfer pricing system
D standard cost transfer pricing system
7 Which two of the following are advantages of marginal cost-plus pricing?
A It is simple to use.
B The percentage mark-up can be varied.
C It pays attention to profit maximisation.
D It ignores fixed overheads in the pricing decision.
8 Division U makes components which it sells to external customers at a price of £24 per unit, earning
a mark-up of 20% of total cost. Variable costs account for 40% of Division U’s total cost.
Division U also transfers components at market value to Division V within the same company. Division
V incurs extra total costs of £8 per unit to convert and pack the component for international sales.
Variable costs account for 70% of Division V’s total cost.
Both divisions currently have surplus capacity.
Division V has an opportunity to sell a batch of components to a customer for £15 per unit.
Requirement
Which of the following statements is correct with regard to this potential order?
A The order is not acceptable from the company’s point of view and the manager of division V will
make a sub-optimal decision.
B The order is not acceptable from the company’s point of view and the manager of division V will
not make a sub-optimal decision.
C The order is acceptable from the company’s point of view and the manager of division V will
make a sub-optimal decision.
D The order is acceptable from the company’s point of view and the manager of division V will not
make a sub-optimal decision.
9 Division M manufactures product R incurring a total cost of £30 per unit. Fixed costs represent 40%
of the total unit cost.
Product R is sold to external customers in a perfectly competitive market at a price of £50 per unit.
Division M also transfers product R to division N. If transfers are made internally then division M does
not incur variable distribution costs, which amount to 10% of the variable costs incurred on external
sales.
The total demand for product R exceeds the capacity of division M.
Requirement
From the point of view of the company as a whole, enter the optimum price per unit at which division
M should transfer product R to division N.
10 The following data relate to the Columba group, a company with several divisions. Division D
produces a single product, which it sells to Division R and also to organisations outside the Columba
group.
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
(2) The full cost of providing the service increases to £50 per hour. The required mark-up
percentage to achieve the same absolute value of mark-up per hour of service provided is: 48
%
WORKINGS
(1) Situation 1
Absolute mark-up per hour of service sold = £(60 – 40) = £20
Mark-up percentage = (20/40) × 100% = 50%
(2) Situation 2
Current absolute value of mark-up per hour of service sold = 60% × £40 = £24
Mark-up percentage required = (£24/£50) × 100% = 48%
If the full cost is £14 per unit, calculate the price to £17.50
achieve a margin of 20% of the selling price.
The selling price is £27 per unit, determined on the basis 50%
of full cost-plus. If the full cost is £18 per unit, calculate
the mark-up percentage.
WORKINGS
(1) Selling price
Cost and selling price structure:
%
Cost 80
Profit 20
Price 100
%
Cost 100.00
Profit 106.25
Price 206.25
%
Cost 100.00
Profit 33.33
Price 133.33
£ per unit
Selling price 30
£ per unit
Variable cost in division A (10)
Forgone contribution in division A (10)
Variable cost in division B (15)
Contribution (5)
Therefore, division B’s decision to reject the offer of £30 per unit would be the correct decision
from the company’s point of view if division A is operating at full capacity. In this situation there
would be goal congruence and the manager of division B would not make a sub-optimal
decision.
1 Correct answer(s):
D £108.99
Labour hours per unit = £42/£14 = 3 hours
Fixed production overhead absorption rate = £60,000/25,000
= £2.40 per hour
£ per unit
Variable material 8.00
Variable labour 42.00
Variable production overhead (3 hrs at £4) 12.00
Fixed production overhead (3 hrs at £2.40) 7.20
Total production cost 69.20
Other overhead at 5% 3.46
Full cost 72.66
Mark-up at 50% 36.33
Selling price 108.99
2 Correct answer(s):
C 100%
%
Marginal cost 70
Absorbed fixed cost 30
Full cost 100
Mark-up 40
Selling price 140
(30 + 40)
Required mark up on marginal cost = × 100%
70
= 100%
3 Mark-up 60.0 %
Margin 37.5 %
WORKINGS
(1) Mark-up
£(16 ಜ 10)
× 100%
£10
= 60.0%
(2) Margin
£(16 ಜ 10)
× 100%
£16
= 37.5%
4 Correct answer(s):
B If the selling price is agreed at the point of sale, then the seller bears the inflation risk during any
credit period offered to the buyer.
A is incorrect because both prices will depend on the mark-up percentage that is added to cost. If a
very large mark-up percentage is added to marginal cost, then a higher selling price may result than
with a full-cost plus sales price.
C is incorrect because the full cost includes fixed costs per unit which have been derived based on
estimated or budgeted sales volumes. If the budgeted volumes are not achieved, then the actual
fixed cost per unit will be higher than estimated and the selling price might be lower than the actual
cost per unit.
D is incorrect because one of the major criticisms of cost-plus pricing is that it fails to recognise that
sales demand may be determined by the sales price.
5 Correct answer(s):
A 9.1%
6 Correct answer(s):
C two-part transfer pricing system
A marginal cost-plus system would involve adding a percentage to marginal cost in order to provide
the selling division with a contribution towards its fixed costs and profit.
A dual pricing system operates by charging the buying division for transfers at marginal cost and
crediting the selling division with either the market value or with a cost-plus transfer price.
The description of a standard cost transfer pricing system is imprecise because it does not specify
whether marginal or full cost is used.
7 Correct answer(s):
A It is simple to use.
B The percentage mark-up can be varied.
The method is simple to use and the mark-up can be adjusted to reflect demand conditions.
Option C is not an advantage. Although the size of the mark-up can be varied in accordance with
demand conditions, it is not a method of pricing which ensures that sufficient attention is paid to
demand conditions, competitors’ prices and profit maximisation.
Option D is not an advantage. Although there is no arbitrary apportionment and absorption of fixed
overheads, these costs are not ignored. They are taken into account in ensuring that the mark-up is
large enough to make a profit after covering fixed costs.
8 Correct answer(s):
C The order is acceptable from the company’s point of view and the manager of division V will
make a sub-optimal decision.
Since both divisions have surplus capacity, no full-price sales will be forgone as a result of accepting
this order. The fixed costs will not alter, therefore provided the order covers the variable costs and
earns a contribution it will be acceptable.
Division U total cost = 100/120 × £24 = £20 per unit
Division U variable cost = 40% × £20 = £8
From the point of view of the company as a whole:
The order earns a contribution therefore it is acceptable from the company’s point of view.
From the point of view of Division V:
The manager of Division V will perceive the transfer price to be a variable cost which is incurred for
each component sold. Therefore, this order will not be accepted. The decision will be sub-optimal
because the profit of the company as a whole will not be maximised.
The total demand for product R exceeds the capacity of division M therefore internal transfers will
displace external sales. The optimum transfer price can be calculated as follows.
Optimum transfer price = External market price – Cost savings with internal transfer
Cost savings with internal transfer = 10% × Variable costs
Fixed costs represent 40% of the total unit cost therefore variable costs are equal to 60% of the total
unit cost.
= £1.80
Therefore, optimum transfer price = £50 – £1.80
£’000
Contribution from external sales 340
Contribution from sales to Division R 48
388
Fixed costs 340
Profit 48
The group as a whole will be paying £(50 – 36) = £14 per unit extra for each unit that Division R
purchases externally, thus reducing Columba’s profits by 3,000 × £14 = £42,000.
Columba’s profit will therefore reduce to £550,000 – £42,000 = £508,000.
Chapter 6
Budgeting
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Why do organisations prepare budgets?
2 A framework for budgeting
3 Steps in the budget preparation
4 The master budget
5 Preparing forecasts
6 Alternative approaches to budgeting
7 Data bias and professional scepticism
Summary
Further question practice
Technical reference
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Recognise how forecasting techniques (including high/low, linear regression and time series
analysis) help management in budgeting and forecasting and perform calculations using these
techniques
• Identify how data analytics can be used in budgeting and forecasting
• Identify issues relating to the collection of data (data bias) and interpretation of data (correlation v
causation; professional scepticism) for budgeting and forecasting
• Prepare budgets or extracts therefrom
• Select the most appropriate of the following budgeting approaches and methods, taking into
account their advantages and disadvantages for planning, control and motivation:
– bottom-up and top-down approaches to generating and managing budgets
– activity-based, responsibility-based and product-based structures
– zero-based and incremental budgeting
The specific syllabus references for this chapter are: 2a, b, c, d and e.
6
Syllabus links
You will need an understanding of how the annual budgeting exercise acts as a step towards the
achievement of an organisation’s longer-term plans when you study the Business Strategy and
Technology syllabus.
6
Examination context
Numerical questions will be limited in scope (eg, individual budgets). Narrative questions need to be
read very carefully, particularly those that ask whether statements are true or false.
In the examination, students may be required to:
• demonstrate an understanding of the:
– objectives of a budgetary planning and control system
– difference between a budget and a forecast
– administrative process of budget preparation
• prepare functional budgets and the income statement and balance sheet elements of a master
budget from data supplied
• calculate the effect on budget outcomes of changes in specified variables
• demonstrate an understanding of a range of budgeting and forecasting approaches and
methods
• demonstrate an understanding of how data analytics can be used in forecasting
• demonstrate an understanding of data bias and how to apply professional scepticism
6
AR manager, to incur
expenditure.
Another main role of a
budget is as a control
tool. The actual
expenditure can be
compared with the
budgeted expenditure
for each period and
variances highlighted.
Monitoring these
variances means that
control action can be
taken if necessary to
correct such deviations
from the budget.
Budgets have other
roles in addition to
authorisation and
control, which we will
also investigate in this
chapter.
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
Definition
Budget: A quantitative statement, for a defined period of time, which may include planned revenues,
expenses, assets, liabilities and cash flows.
An organisation’s budget fulfils many roles. Here are some of the reasons why budgets are used.
Function Detail
Compel planning Budgeting forces management to look ahead, to set out detailed
plans for achieving the targets for each department, each
operation and (ideally) each manager and to anticipate problems.
Traditionally this may have been once a year but now businesses
need to look ahead more frequently.
Communicate ideas and A formal system is necessary to ensure that each person affected
plans by the plans is aware of what he or she is supposed to be doing.
Communication might be one-way, with managers giving orders
to subordinates, or there might be two-way communication.
Means of allocating resources It can be used to decide how many resources are needed (cash,
labour and so on) and how many should be given to each area of
the organisation’s activities. Resource allocation is particularly
important when some resources are in short supply. Budgets
often set ceilings or limits on how much administrative
departments and other service departments are allowed to spend
in the period. Public expenditure budgets, for example, set
spending limits for each government department or other public
body.
Provide a framework for Budgets require that managers are made responsible for the
responsibility accounting achievement of budget targets for the operations under their
personal control.
Function Detail
Establish a system of control Control over actual performance is provided by the comparison
of actual results against the budget plan. Departures from budget
can then be investigated and the reasons can be divided into
controllable and uncontrollable factors.
Provide a means of Budgets provide targets that can be compared with actual
performance evaluation outcomes in order to assess employee performance. They also
provide a means to establish a personal incentive and bonus
scheme.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify assumptions or
faults in arguments’. This could refer to the problems with traditional budgeting methods.
The Beyond Budgeting Round Table (BBRT), an independent research collaborative, was founded in
1998 by Jeremy Hope, Robin Fraser and Peter Bunce. (You may recognise the names Hope and
Fraser, as we mentioned some of the criticisms that Hope and Fraser identified with traditional
budgets in section 1.2.) The BBRT suggests that the traditional ways that businesses prepare budgets
should be abandoned. It suggests that budgets should be more adaptive and agile and that this can
be achieved using its 12 Beyond Budgeting principles.
The principles are split into two categories, leadership principles and management processes, and
the following table is from the brrt.org website:
Purpose – Engage and inspire people around Rhythm – Organise management processes
bold and noble causes; not around short-term dynamically around rhythms and events; not
financial targets around the calendar year only
Values – Govern through shared values and Targets – Set directional, ambitious and relative
sound judgement; not through detailed rules goals; avoid fixed and cascaded targets
and regulations
Transparency – Make information open for self- Plans and forecasts – Make planning and
regulation, innovation, learning and control; forecasting lean and unbiased processes; not
don’t restrict it rigid and political exercises
Autonomy – Trust people with freedom to act; Performance evaluation – Evaluate performance
don’t punish everyone if someone should holistically and with peer feedback for learning
abuse it and development; not based on measurement
only and not for rewards only
Customers – Connect everyone’s work with Rewards – Reward shared success against
customer needs; avoid conflicts of interest competition; not against fixed performance
contracts
(bbrt.org/the-beyond-budgeting-principles/)
These principles and processes may not be easy to implement without a major shift in a business’
culture. However, some of the principles could be applied by using rolling budgets or zero-based
budgets (see section 6). For example, rolling budgets may allow resources to be made available as
needed.
Another criticism of traditional budgeting is that most businesses link employee benefits to the
performance of the business against its budget and that this is unfair if the budgets are not very
accurate. The rewards management process above is a useful solution.
• The budget committee is the coordinating body in the preparation and administration of
budgets.
• The budget period is the period covered by the budget, which is traditionally one year. The
budget is divided into a number of control periods, typically calendar months.
• The budget manual is a collection of instructions relating to the preparation and use of budgetary
data.
Definition
Budget manual: A collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
• The procedures for preparing a budget will differ from organisation to organisation depending on
its size, complexity and use of technology for deriving predicted values and automating budget
production.
• The principal budget factor is that factor which limits an organisation’s activities. The budget for
the principal budget factor must be established first.
• If sales volume is the limiting factor then the sales budget should be prepared first.
• The production budget will then follow by adjusting the sales budget for planned changes in
finished goods inventory.
• The next stage will be the preparation of budgets for production resources such as direct
materials usage and direct labour.
• The direct materials purchases budget is prepared by adjusting the direct materials usage budget
for planned changes in raw materials inventory.
• Overhead cost budgets will be prepared, taking account of the level of activity to be achieved
and the support needed to be given to the ‘direct’ operations. A budgeted income statement can
then be produced.
• A number of budgets such as the capital expenditure budget, the working capital budget and the
cash budget must be prepared in order to provide the necessary information for the budgeted
balance sheet.
• Standard costs provide the basic unit rates to be used in the preparation of a number of
functional budgets.
The preparation of individual budgets and the master budget (budgeted income statement,
budgeted balance sheet and budgeted cash flow) may take weeks or months. Functional budgets
(sales budgets, production budgets, direct labour budgets and so on), which are combined into the
master budget, may need to be amended many times because of discussions between departments,
changes in market conditions and so on during the course of budget preparation. As a result, some
argue that a rolling budget (a budget prepared more frequently) is preferable as it reduces the peaks
of intensity of resource usage (see later in the chapter).
Ideally, a master budget should be finished before the start of the period to which it relates.
One of the professional skills assessed in the ACA exams is the ability to ‘Evaluate the relevance of
information provided’. This may mean identifying the principal budget factor.
Definition
Principal budget factor: The budgeted factor which limits the activities of an organisation.
The budget for the principal budget factor must be prepared first. The principal budget factor is that
factor which limits an organisation’s activities. This factor is usually sales demand. A company is
usually restricted from making and selling more of its products or services because there would be
no sales demand for the increased output at a price that would be acceptable/profitable to the
company. The principal budget factor may alternatively be machine capacity, distribution and selling
resources, the availability of key raw materials or the availability of cash. Once this factor is defined
then the remainder of the budgets can be prepared. For example, if sales are the principal budget
factor then the production manager can only prepare the production budget after the sales budget
is complete.
The following diagram shows the major budgets and their inter-relationships.
Sales budget
Production
budget
Inventory budget
(raw materials)
Recruitment or Production
redundancy budgets overhead budget
Raw materials
purchase budget
Answer
Answer
Definition
Functional budgets: The budgets for the various functions of the business eg, production, marketing,
sales, purchasing budgets.
Functional/departmental budgets include budgets for sales, production, purchases, labour and
administration. Having seen the theory of budget preparation, let us look at functional (or
departmental) budget preparation, which is best explained by an example.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify any information
gaps’. The illustration below highlights how much information is needed to prepare a materials
purchases budget.
Solution
To calculate material purchases requirements it is first necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S Product T
Units Units
Production required
To meet sales demand 8,000 6,000
To provide for inventory loss 50 100
For closing inventory 600 600
8,650 6,700
Less inventory already in hand (1,500) (300)
Budgeted production volume 7,150 6,400
The basic principles for the preparation of each functional budget are similar to those above. Work
carefully through the following question, which covers the preparation of a number of different types
of functional budget.
Requirements
Fill in the blanks.
2.1 Sales budget
Sales quantity
Sales value £ £ £ £
Budgeted
production
Budgeted material
usage
• The master budget consists of the budgeted income statement, the budgeted balance sheet and
the cash budget.
• The master budget provides a consolidation of all the subsidiary budgets and is likely to be of
most interest to senior managers and directors.
• A sensitivity analysis might be carried out on the master budget to show the effect on the
budgeted outcome of changes in the budgeted assumptions.
Solution
Budgeted income statement for six months ended 30 June
£ £
Revenue ((£4,000 × 3) + (£5,000 × 3)) 27,000
Cost of sales (£27,000 × 80/100) 21,600
Gross profit 5,400
Operating expenses (£350 × 6) 2,100
Depreciation ((£12,000/5) × 6/12) 1,200
3,300
Budgeted profit 2,100
£ £
Non-current assets (£12,000 – £1,200 depreciation) 10,800
Current assets
Inventories (July cost of sales = £6,000 × 80/100) 4,800
Receivables (May and June sales) 10,000
Cash 16,700
31,500
Current liabilities
Trade payables (June purchases = July cost of sales) 4,800
Net current assets 26,700
37,500
Owner’s capital 37,500
Definition
Sensitivity analysis: Assesses how sensitive a budget is to changes in the budget assumptions.
Since the master budget provides a summary of all the subsidiary budgets it is likely to be of most
interest to senior managers and directors who may not need to be concerned with the detail of
budgets outside their own areas of responsibility.
Of particular interest to senior managers will be the sensitivity of the budget outcomes to changes
in the budget assumptions. For example, they might like to know the answers to questions such as
the following.
• What will be the budgeted profit if sales revenue is 5% higher or lower than the budget?
• What will be the total budgeted costs if direct material costs are 10% higher or lower than the
budget?
A sensitivity analysis (sometimes called a ‘what if?‘ analysis) might be performed to show the effect
of changes such as these, and to assess the impact on critical areas such as cash resources. ML can
also be incorporated into ‘What if?’ scenario modelling. For example, universities can predict how
different levels of marketing can affect the likelihood of a student applying to their university.
R Ltd manufactures and sells a single product. The budgeted income statement contained in the
master budget for the forthcoming year is as follows.
£ £
Sales revenue (20,000 units) 640,000
Variable materials cost 190,000
Variable labour cost 172,000
Variable overhead 13,000
Fixed overhead 155,000
530,000
Budgeted net profit 110,000
The directors wish to know what the budgeted profit will be if a higher quality material is used. This
will increase material costs per unit by 10% but sales volume will be increased by 5%. There will be
no change in the unit selling price.
Assumptions
The budgeted sales volume will increase to 21,000 units and, in the absence of information to the
contrary, we will assume there will be no changes in the total fixed overhead cost incurred and no
changes in the variable labour and overhead costs per unit.
The revised budgeted income statement will look like this.
£ £
Sales revenue (£640,000/20,000) × 21,000 672,000
Variable materials cost (£190,000/20,000) × 1.1 × 21,000 219,450
Variable labour cost (£172,000/20,000) × 21,000 180,600
Variable overhead (£13,000/20,000) × 21,000 13,650
Fixed overhead 155,000
568,700
Budgeted net profit 103,300
The proposed changes are not worthwhile since the contribution from the increase in sales volume is
not sufficient to compensate for the increase in material costs.
5 Preparing forecasts
Section overview
• Techniques that use past data to forecast future events assume that the past will provide a good
indication of what will happen in the future.
• The high-low method is a technique for analysing the fixed and variable elements of a semi-
variable cost and thus predicting the cost to be incurred at any activity level within the relevant
range.
• A major disadvantage of the high-low method is that it takes account of only two sets of data.
• Linear regression analysis establishes a straight-line equation to represent cost or revenue and
activity data. It takes account of all sets of data that are available.
• Correlation is the degree to which one variable is related to another.
• The coefficient of correlation, r, can take any value between –1 (perfect negative correlation) and
+1 (perfect positive correlation). If r = 0 then the variables are uncorrelated.
• The coefficient of determination, r², is a measure of the proportion of the change in one variable
that can be explained by variations in the value of the other variable.
• Correlation does not necessarily mean causation.
• A time series is a historical sequence of observations. Any pattern found in the data is then
assumed to continue into the future and a forecast is produced.
• Big data refers to the vast array of data available to businesses that can be used to identify trends
and create value.
Step 1
Records of costs in previous periods are reviewed and the costs of the following two periods are
selected.
• The period with the highest volume of activity
• The period with the lowest volume of activity
• (ie, the high/low values of the independent variable)
The difference between the total cost of these two periods will be the total variable cost of the
difference in activity levels (since the same fixed cost is included in each total cost).
Step 2
The variable cost per unit may be calculated from this as (Difference in total costs/Difference in
activity levels).
Step 3
The fixed cost may then be determined by substitution.
Step 4
The linear equation y = a + bx can be used to predict the cost for a given activity level.
Requirement
Calculate the costs that should be expected in Month 5 when output is expected to be 7,500 units.
Ignore inflation.
Solution
Step 1
Units £
High output 8,000 Total cost 115,000
Low output 6,000 Total cost 97,000
Total variable cost 2,000 18,000
Step 2
Step 3
Substituting in either the high or low volume cost:
High Low
£ £
Total cost 115,000 97,000
High Low
£ £
Variable costs (8,000 × £9) 72,000 (6,000 × £9) 54,000
Fixed costs 43,000 43,000
Step 4
Estimated maintenance costs when output is 7,500 units:
£
Fixed costs 43,000
Variable costs (7,500 × £9) 67,500
Total costs 110,500
Requirement
Write the appropriate figures in the boxes below to derive an equation that can be used to represent
the total cost model for a period.
TC = £ +£ V
A major disadvantage of the high-low method is that it takes account of only two sets of data, which
may not be representative of all the data available. In particular, one of them could be a rogue set of
data.
For example, the pattern of data might be as follows.
Cost
£
Level of activity
The straight-line equation derived using the high-low method, as shown in the diagram above using
points H and L, would be inaccurate. It does not take into account all of the recorded combinations
and fails to allow for the fact that the majority of points lie below the line joining the highest and
lowest activity.
Definition
Linear regression analysis: A technique for estimating the equation of a line of best fit.
5.5 Correlation
Correlation is the degree to which one variable is related to another, ie, the degree of
interdependence between the variables.
Y Y
X X
(a) (b)
In the scatter diagrams above, you should agree that the straight-line equation is more likely to
reflect the ‘real’ relationship between X and Y in (b) than in (a). In (b), the pairs of data are all close to
the line of best fit, whereas in (a), there is much more scatter around the line.
In the situation represented in diagram (b), forecasting the value of Y from a given value for X would
be more likely to be accurate than in the situation represented in (a). This is because there would be
greater correlation between X and Y in (b) than in (a).
Perfect correlation
Y Y
X X
All the pairs of values lie on a straight line. An exact linear relationship exists between the two
variables.
Partial correlation
Y Y
X X
In the left-hand diagram, although there is no exact relationship, low values of X tend to be
associated with low values of Y, and high values of X with high values of Y.
In the right-hand diagram, there is no exact relationship, but low values of X tend to be associated
with high values of Y and vice versa.
No correlation
Y
The values of these two variables are not correlated with each other.
There is a relationship between X and Y since the points are on an obvious curve, but it is not a linear
relationship.
True or false?
Definition
Cause and effect relationship: A cause and effect relationship (also known as a causal relationship)
exists between two variables when a change in one causes the change in the other.
For example, if staff are paid hourly, as hours worked increase, wage costs increase. The increase in
hours worked has caused the increase in wage costs. There is a cause and effect relationship and a
correlation exists between the number of hours worked and wage costs.
Correlation does not necessarily mean that a cause and effect relationship exists. However, if there is
a cause and effect relationship, there must be correlation.
The reasons that a correlation between A and B may occur without A causing B are as follows:
(a) A and B are correlated but they’re both actually caused by C.
(b) Rather than A causing B, B actually causes A.
(c) A does cause B, but only if X occurs.
(d) Instead of A simply causing B, A causes Y and this leads Y to cause B.
(a) Correlation may occur by pure chance, and this is more likely to happen with a small set of data.
Alternatively, there may be a reason for the correlation that is not causal. A and B are correlated
but they’re both actually caused by C. For example, when the sales of sun cream increase, the
sales of ice cream also increase. The increase in sun cream sales is not causing the increase in ice
cream sales. There is a third variable, namely the weather, influencing both types of sales. This
variable is known as a confounding variable.
(b) Rather than A causing B, B actually causes A. For example, a supermarket launching a new loyalty
card may conclude that having a loyalty card makes shoppers spend more money. Whereas it
could be that shoppers spending more money is what causes them to apply for a loyalty card.
(c) A does cause B but only if X occurs. For example, having a loyalty card may cause shoppers to
spend more money, but only if the loyalty card rewards are above a certain level.
(d) Instead of A simply causing B, A causes Y and this leads Y to cause B. For example, if a food
product is out of stock, this may lead customers to buy an alternative product elsewhere, which
they then prefer over the original because of the taste. Future sales of the original product may
then fall, as customers have switched to a product which they prefer. The product being out of
stock has caused customers to try an alternative, and this has caused a longer-term decline in
sales.
These examples highlight the need to exercise professional scepticism when analysing data and
drawing conclusions. (We described professional scepticism in Chapter 1 as assessing information,
estimates and explanations critically, with a questioning mind, and being alert to possible
misstatements due to error or fraud.)
One of the professional skills assessed in the ACA exams is the ability to ‘interpret information
provided in various formats’. This could include the interpretation of relationships between two
variables and whether correlation and causation exists.
Definitions
Time series: A time series is a series of observations recorded over time. Any pattern found in the
data is assumed to continue into the future and a forecast is produced. There are four components of
a time series: trend, seasonal variations, cyclical variations and random variations.
Trend: The trend is the long-term underlying movement in the data.
Seasonal variation: Seasonal variations are short-term patterns that occur during different periods,
such as rush hour during the day, weekdays during the week, or warmer months of the year.
Cyclical variations: Cyclical variations are medium- to long-term patterns such as economic booms
and recessions. In practice, they are difficult to predict and model.
Random variations: Random variations are the product of randomness and so cannot be predicted.
The following graph shows the number of passengers at Heathrow airport from January 2015 to
December 2019. (Figures from www.heathrow.com/company/investor-centre/reports/traffic-statistics,
accessed 4 May 2021.)
Figure 6.8: Heathrow airport passenger numbers (Jan 2015 to Dec 2019)
This graph shows some of the important characteristics of a time series including the trend and the
seasonal variation. The dotted line (the trend) rises steadily over the years 2015 to 2019. Every year
there are peaks and troughs of demand, with summer months showing greater demand and a dip in
demand in the winter months (seasonal variations).
If the airport wanted to predict future demand based on this time series, it would need to calculate
the trend and then make adjustments for seasonal variations.
Definition
Moving average: A moving average is an average of the data of a fixed number of periods. The aim
of calculating moving averages is to remove the effect of seasonal variations, for use in forecasting
long-term trends.
Imagine you had not seen the graph above and were just given the following data:
Do you think you would have deduced that there was an upward trend in passenger numbers over
the four years? It’s quite hard to see the trend because of the seasonal variations.
If we take averages of the passenger numbers, we can remove the effect of the seasonal variation.
Moving averages can be taken over an odd number of periods or an even number of periods. The
period over which a moving average should be taken depends on the nature of the time series, but
the most appropriate moving average would be one that covers a full cycle.
July 520
August 430
September 730
October 940
November 1,240
December 1,030
Requirement
Calculate the three-month moving average for the period July to December.
Solution
July 520
December 1,030
Calculating moving averages has smoothed out the data, showing that there is an upward trend in
sales volume.
Definition
Data outliers: Data outliers are observations that are abnormal and can therefore significantly distort
the results. Sometimes outliers are removed from the data set before applying forecasting
techniques.
The following graph shows the number of passengers at Heathrow airport from January 2015 to
January 2021. (Figures from www.heathrow.com/company/investor-centre/reports/traffic-statistics,
accessed 4 May 2021.)
Figure 6.9: Heathrow airport passenger numbers (Jan 2015 to Jan 2021)
Compare this to the graph shown earlier for Heathrow passenger numbers. The trend line is the
dotted line and the Covid-19 lockdown began at the end of March 2020 (month 63). You can see that
the severe drop in passenger numbers from March 2020 has caused a dramatic change in the
direction of the trend. The drop in passenger numbers is not something that could have been
forecast in the 2020 budget. Forecasting passenger numbers for the future will require consideration
about whether the trend seen before March 2020 will resume.
Sometimes outliers are deleted from the data set. However, it is important to have a clear and valid
reason for excluding data outliers, otherwise there is the danger that excluding them will result in
data being manipulated ie, introducing bias.
2000
1500
1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Day
Requirement
Is the trend useful in this situation for forecasting revenue?
Solution
The restaurant closure in week 3 resulted in two days with no revenue and the data for these days are
outliers because they are atypical and are unlikely to occur again. These outliers should be deleted
and the trend should be recalculated to produce a more accurate result. However, as the restaurant is
new and there are only four weeks’ worth of data, the trend may not be a good indication of the
future trend of the business. Although revenue seems to be rising, this could be because the
restaurant is new and customers are trying it out.
This is the graph showing revenue with the outliers removed.
Restaurant revenue
Revenue £
2500
2000
1500
1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Day
Data
+ Insights/deeper Good business
Technology understanding decisions
(Data science/ML/analysis)
Definitions
Big data: The term that describes those ‘datasets whose size is beyond the ability of typical database
software to capture, store, manage and analyse.’ (McKinsey Global Institute, Big data: The next
frontier for innovation, competition and productivity)
An alternative definition is provided by Gartner.
Big data: It concerns ‘high-volume, high-velocity and high-variety information assets that demand
cost-effective, innovative forms of information processes for enhanced insight and decision making.’
(Gartner, www.gartner.com/it-glossary/big-data/)
Data analytics: The process of collecting, organising and analysing large sets of data to discover
patterns and other information which an organisation can use for its future business decisions.
Closely linked to the term data analytics is data mining.
Data mining: The process of sorting through data to identify patterns and relationships between
different items. Data mining software, using statistical algorithms to discover correlations and
patterns, is frequently used on large databases. In essence, it is the process of turning raw data into
useful information. Predictive analytics is a type of data mining that aims to predict future events.
Structured data: Data that is contained within a field in a data record or file (eg, databases and
spreadsheets).
Unstructured data: Data that is not easily contained within structured data fields, such as pictures,
videos, webpages, PDF files, emails or blogs.
(b) Identifying customer preferences. A key benefit of big data is the ability to understand the
preferences and desires of each customer. Consumers are increasingly happy to share
information about themselves with a business, but only if they trust the organisation first. Once
this trust is built, data will come from the customer because they see the benefit of a more
personal experience that is created. This saves the customer time in finding what they want
(because the website knows the products they are interested in) and more relevant promotions
can be created.
Sources of information on customer preferences include past transactions, website data cookies,
responses to emails and online promotions and adverts, and data contained about them on social
networks. This data about a specific person can also be combined with more general demographic
data and trends to generate predictions about the products the customer might be interested in, but
no preference has yet been determined through the available data.
Definitions
Artificial intelligence (AI): Artificial intelligence (AI) is the use of computers to do tasks which are
thought to require human intelligence. It typically refers to tasks such as learning, knowing, sensing,
reasoning, creating things, and generating and understanding language.
Machine learning (ML): Machine learning is a field within AI whereby computers learn to do things
rather than follow pre-programmed rules. Through machine learning techniques, computers find
patterns in data and use statistical models to classify or make predictions about other pieces of data.
There are different types of learning (eg, supervised, unsupervised or reinforced) but all draw on
large sets of training data that enable the computer to learn.
ML has been around for a long time. However, because big data is relatively new, the ability to apply
ML to big data is relatively new. ML, rather than being programmed by people, relies on lots of
examples. It learns what to do from those examples and when it gets good at drawing conclusions, it
can apply its knowledge to new sets of data. ML means that predictions get better and better as
more data is analysed and the forecasting formula is refined.
when there will be someone at home. The AI can plan the optimum delivery route for drivers to
ensure maximum chance of first-time delivery.
(www.japantimes.co.jp/news/2020/02/26/business/tech/ai-solves-problems/#.XpmSqmhKiUm)
• Incremental budgeting involves basing the next year’s budget on the current year’s results, with
adjustments for known changes and inflation.
• An organisation’s budgeting style can be participative (bottom-up) or imposed (top-down).
• Participative budgeting tends to have the most favourable motivational impact but it does have its
disadvantages.
• Budget slack is the intentional overstating of costs or understating of revenues in a budget, in
order to set an ‘easy’ budget target.
• Zero-based budgeting requires all budgets to be prepared from the very beginning or zero.
• Rolling budgets, also known as continuous budgets, are continuously updated by adding a
further month or quarter to the end of the budget as each month or quarter comes to a close.
• The structure of budgets may be designed around one of a number of frameworks, including
product-based budgets, responsibility-based budgets and activity-based budgets.
Definition
Incremental budgeting: Basing this year’s budget on last year’s budget with adjustments for changes
and inflation.
The traditional approach to budgeting is to base the forthcoming year’s budget on the current year’s
results modified for changes in activity levels, for example, by adding an extra amount for estimated
growth or inflation next year. This approach is known as incremental budgeting since it is concerned
mainly with the increments in costs and revenues which will occur in the coming period.
Incremental budgeting is a reasonable approach if the current operations are as effective, efficient
and economic as they can be.
In general, however, it is an inefficient form of budgeting. It encourages slack, which is unnecessary
expenditure built into the budgets. Past inefficiencies are perpetuated because cost levels are rarely
subjected to close scrutiny.
Definition
Imposed budget: A budget set without allowing the budget holder to participate in the budgeting
process.
In this approach to budgeting, top management prepare a budget with little or no input from
operating personnel, which is then imposed upon the employees who have to work to the budgeted
figures.
The times when imposed budgets are effective are:
• in newly-formed organisations
• in very small businesses
• during periods of economic hardship
• when operational managers lack budgeting skills
• when the organisation’s different units require precise coordination
There are, of course, advantages and disadvantages to this style of setting budgets.
(a) Advantages
– Strategic plans are likely to be incorporated into planned activities.
– They enhance the coordination between the plans and objectives of divisions.
– They use senior management’s awareness of total resource availability.
– They decrease the input from inexperienced or uninformed lower-level employees.
– They decrease the period of time taken to draw up the budgets.
(b) Disadvantages
– Dissatisfaction, defensiveness and low morale amongst employees. It is hard for people to be
motivated to achieve targets set by somebody else, particularly if managers consider the
budget targets to be unrealistic.
– The feeling of team spirit may disappear.
– The acceptance of organisational goals and objectives could be limited.
– The budget may be viewed as a punitive device.
– Managers who are performing operations on a day to day basis are likely to have a better
understanding of what is achievable.
– Unachievable budgets could result if consideration is not given to local operating and political
environments. This applies particularly to overseas divisions.
– Lower-level management initiative may be stifled.
Definition
Participative budgeting: Budgeting style which allows all budget holders to participate in setting
their own budget.
In this approach to budgeting, budgets are developed by lower-level managers who then submit
the budgets to their superiors. The budgets are based on the lower-level managers’ perceptions of
what is achievable and the associated necessary resources.
Advantages of participative budgets
• They are based on information from the employees most familiar with the department.
• Knowledge spread among several levels of management is pulled together (ie, information
asymmetry is reduced).
• Morale and motivation are improved.
• They increase operational managers’ commitment to organisational objectives.
• In general, they are more realistic.
• Coordination between units is improved.
• Specific resource requirements are included.
• Senior managers’ overview is mixed with operational level details.
• Individual managers’ aspiration levels are more likely to be taken into account.
Definition
Budget slack: Deliberately underestimating revenues or overestimating costs in order to ensure that
achieving the budget is easy.
Definition
Zero-based budgeting: Involves preparing a budget for each cost centre from a zero base. Every
item of expenditure has to be justified in its entirety in order to be included in the next year’s budget.
Zero-based budgeting (ZBB) is an approach to budgeting that attempts to ensure that inefficiencies
are not concealed.
The principle behind ZBB is that, instead of using the current year’s results as a starting point, each
budget should be prepared from the very beginning or zero. Every item of expenditure must be
justified separately to be included in the budget for the forthcoming period.
Increments of expenditure are compared with the expected benefits received, to ensure that
resources are allocated as efficiently as possible.
ZBB can be particularly useful when applied to discretionary costs such as marketing and training
costs. This type of cost is not vital to the continued existence of an organisation in the way that, say,
raw materials are to a manufacturing business.
A major disadvantage of ZBB is that it is a time-consuming task that involves a great deal of work.
Definition
Rolling budget: A budget continually updated to add a new budget period as the most recent one
has finished.
Rolling budgets are sometimes called continuous budgets. They are particularly useful when an
organisation is facing a period of uncertainty so that it is difficult to prepare accurate plans and
budgets. They are therefore very important for modern businesses and provide an alternative to
traditional annual budgets.
Rolling budgets are an attempt to prepare targets and plans that are more realistic and certain,
particularly with a regard to price levels, by shortening the period between preparing budgets.
Instead of preparing a periodic budget annually for the full budget period, budgets would be
prepared, say, every one, two or three months (4, 6, or even 12 budgets each year). Each of these
budgets would plan for the next 12 months so that the current budget is extended by an extra
period as the current period ends: hence the name rolling budgets. Cash budgets, which are the
subject of the next chapter, are usually prepared on a rolling basis.
Suppose, for example, that a rolling budget is prepared every three months. The first three months of
the budget period would be planned in great detail, and the remaining nine months in lesser detail,
because of the greater uncertainty about the longer-term future.
(a) The first continuous budget would show January to March Year 1 in detail, and April to
December Year 1 in less detail.
(b) At the end of March, the first three months of the budget would be removed and a further three
months would be added at the end for January to March Year 2.
(c) The remaining nine months for April to December Year 1 would be updated in the light of
current conditions, adding more detail to the earliest three months, April to June Year 1.
The detail in the first three months would be principally important for the following.
• Planning working capital and short-term resources (cash, materials, labour and so on).
• Control: the budget for each control period should provide a more reliable yardstick for
comparison with actual results.
The advantages of rolling budgets are as follows.
(a) They reduce the element of uncertainty in budgeting. If a high rate of inflation or major changes
in market conditions or any other change that cannot be quantified with accuracy is likely, rolling
budgets concentrate detailed planning and control on short-term prospects where the degree
of uncertainty is much smaller.
(b) They force managers to reassess the budget regularly, and to produce budgets that are up to
date in the light of current events and expectations.
(c) Planning and control will be based on a recent plan instead of an annual budget that might
have been prepared many months ago and is no longer realistic.
(d) There is always a budget that extends for several months ahead. For example, if rolling budgets
are prepared quarterly there will always be a budget extending for the next 9 to 12 months. If
rolling budgets are prepared monthly there will always be a budget for the next 11 to 12
months. This is not the case when annual budgets are used.
The disadvantages of rolling budgets can be a deterrent to using them.
(a) A system of rolling budgets calls for the routine preparation of a new budget at regular intervals
during the course of the one financial year. This involves more time, effort and money in budget
preparation.
(b) Frequent budgeting might have an off putting effect on managers who doubt the value of
preparing one budget after another at regular intervals, even when there are major differences
between the figures in one budget and the next.
Responsibility-based budgets can have a positive motivational impact, as long as the budget holder
is not held responsible for costs and revenues over which they have no control.
Definition
Activity-based budgeting: An approach to budgeting which uses cost drivers as a basis for
preparing budgets.
Activity-based budgets are based on a framework of activities, and cost drivers are used as a basis
for preparing budgets.
The budget for each activity is derived from the quantity of the activity’s cost driver × the appropriate
cost driver rate.
Implementing ABB leads to the realisation that the business as a whole needs to be managed with
more reference to the behaviour of activities and cost drivers identified.
(a) Traditional budgeting may make managers ‘responsible’ for activities that are driven by factors
beyond their control: the cost of setting up new personnel records and of induction training
would traditionally be the responsibility of the personnel manager even though such costs are
driven by the number of new employees required by managers other than the personnel
manager.
(b) The budgets for costs not directly related to production are often traditionally set using an
incremental approach because of the difficulty of linking the activity driving the cost to
production level. However, this assumes that all of the cost is unaffected by any form of activity
level, which is often not the case in reality. Some of the costs of the purchasing department, for
example, will be fixed (such as premises costs) but some will relate to the number of orders
placed or the volume of production, say. In an ABB framework the budget for the purchasing
department can take account of the expected number of orders.
who, based on their local knowledge and their desired results, use the scenario planning function to
achieve the most accurate budget. Sometimes variables need to be overridden because of one-off
events that the algorithms weren’t aware of.
The lower level of the platform contains the data warehouse and metrics store.
Uber uses different metrics to measure its business depending on the specific market. For example,
in a new market, the measure may be on growth in Uber user numbers and for a more mature market
it may be profit.
(eng.uber.com/transforming-financial-forecasting-machine-learning, accessed 08/04/21)
Businesses use data to produce budgets and forecasts to aid decision making in the face of
uncertainty. The amount of data available is greater than ever, but there is still often a need to make
generalisations about a wider group (eg, the population) based on samples of data available. This
can lead to errors, incorrect conclusions and flawed decision making.
Users of information produced by data analytics should therefore take steps to ensure the analysis is
reliable, and apply some professional scepticism. Scepticism does not mean that the users assume
that the data or its conclusions must be wrong; rather it means being aware that data analysis is not
always accurate for several reasons:
• There may be bias inherent in the data that is analysed. This may be intentional or unintentional.
• The data may have been intentionally manipulated during the analysis process.
• The data may have been analysed accurately, but the presentation of the data, or the conclusions
drawn from it may be flawed or may have been designed to mislead the users.
Definition
Data bias: Data is biased when it is not representative of the population. Data may be biased before
its analysed just because the method of collecting the data means that some members of the
population have a lower (or zero) chance of being included in the sample. People who analyse data
and reach conclusions can also introduce bias.
For example, public opinion is often collected in the form of big data from social media sites, such as
Facebook and Twitter. This can lead to data bias because different population groups are
represented on different platforms and some are barely represented at all. Blank and Lutz (2017)
found that age and socioeconomic status affected the choice of social media platform and whether
people were on social media at all. They concluded that no single social media platform is
representative of the general population.
There are several different types of bias and the following may impact on budgeting and business
performance.
Selection bias This occurs when the data is not selected randomly and leads to a sample that
is not representative of the population. In order to be representative, all items
in the population should have an equal chance of being selected for the
sample.
Observer bias This occurs when observing and recording results, and relates to
interpretation. The researcher allows their assumptions (which may be
unconscious) to influence their observations.
Example – unconscious bias
Managers may be observing labour processes and draw conclusions based
on their unconscious bias towards particular staff members.
Omitted variable This links back to the section on cause and effect, earlier in the chapter.
Omitted variable bias is when a variable is excluded from the data model and
therefore the cause of a change in one variable is incorrectly attributed to
another variable in the model.
Example – sales budgeting
Sales of a product may depend on many variables such as advertising, price
competition, fashion and cost of living. It would be easy to attribute an
increase or decrease in sales volume to the wrong variable.
Cognitive This relates to human perception and includes bias depending on how data is
presented (eg, infographics or the order of presentation, known as the
‘framing effect’) and ‘anchoring’ (eg, being influenced by the first piece of
information offered or ‘stuck’ on last year’s numbers).
Example – budgeting
Budgeting based on last year’s figures is very common but may lead to poor
decision making and underachievement. Opportunities may be missed. This
can be overcome by using zero-based budgeting or by considering what the
budget might be if last year’s figures were unknown, ie, considering market
size, growth, competition etc.
Confirmation This occurs when people see data that confirms their beliefs and they ignore
(consciously or sub-consciously) data that disagrees with their beliefs.
Example – new product/market research
Managers may have an idea for a new product and then ask for market
research to confirm the viability of the idea. If market research is being
performed to assess the popularity of a new product that the company has
spent a lot of time and money developing, there may be pressure on the
market research department to conclude that the product is not likely to fail.
This could affect business performance if the organisation develops a new
product believing there is sufficient customer demand to make the product
viable, when in fact that demand does not exist.
Survivorship This is the tendency towards studying successful outcomes while excluding
unsuccessful outcomes. Only items that survived some previous event are
included in the sample. An accounting firm might decide to do a survey to
find out how good its programme for trainee accountants is, by surveying a
sample of trainees who have worked for the firm for one year. Such a survey
would exclude trainees who left the firm before the end of the first year, who
Competition
Our business
If the chart is redrawn using a scale that starts with zero, it looks like this:
Our sales vs competition's sales
Competition
Our business
Now it’s clear that there isn’t a great deal of difference between the two business’s sales. ‘Our sales’
are roughly 5% more.
0.38
0.36
0.34
0.32
0.3
0.28
0.26
0.24
0.22
Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Date
At first glance, you may think that rates are soaring, but look carefully at the scale and the dates. Only
part of the data has been included and the increase is only about 0.15 percentage points. It would
be useful to include comparative data. For example, here is the graph of UK bank rates over 11
years:
UK bank rates
6
0
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Oct-11
Apr-12
Oct-12
Apr-13
Oct-13
Apr-14
Oct-14
Apr-15
Oct-15
Apr-16
Oct-16
Apr-17
Oct-17
Apr-18
Oct-18
Apr-19
Oct-19
One of the skills tested in the ACA exams is your ability to apply judgement by identifying omissions,
inconsistencies or bias in data. You should therefore apply professional scepticism to data sources
and data capture when interpreting quantitative and qualitative information.
Summary
Budgets
Fulfil many
objectives/roles
Establishing
Budget Responsibility Incremental
linear
committee based budget
relationships
Linear
High-low Activity Zero based
Budget manual regression
method based budget
analysis
Functional
Correlation Rolling budgets
budgets
Sensitivity
Data and
analysis may
technology
be performed
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. Can you summarise the reasons for preparing budgets and the principles of beyond
budgeting? (Topic 1)
Technical reference
Blank, G. and Lutz, C. (2017) Representativeness of social media in Great Britain: Investigating
Facebook, LinkedIn, Twitter, Pinterest, Google, and Instagram. American Behavioral Scientist, 61, 741–
756. Available from: doi.org/10.1177/0002764217717559 [Accessed 15 April 2021].
Self-test questions
£ £ £ £
One month’s credit is allowed to credit customers, who account for 50% of all sales. Other customers
pay cash in the same month the sale occurs.
One month’s credit is received from suppliers.
Month-end inventories are maintained at a level sufficient to meet 50% of the forecast sales for the
next month.
R Ltd adds a profit mark-up of 20% to the cost of purchases in order to derive the selling price.
Requirements
The budgeted balance sheet as at the end of September will show a receivables balance of:
A £75,000
B £82,500
C £150,000
D £165,000
The budgeted balance sheet as at the end of September will show a payables balance of:
E £118,750
F £137,500
G £150,000
H £156,250
3 Which of the following is unlikely to be contained in a budget manual?
A Organisational structures
B Objectives of the budgetary process
C Selling overhead budget
D Administrative details of budget preparation
4 Cassius Ltd manufactures two products, P and Q, from the same material, S.
A finished unit of product P contains three litres of material S and a finished unit of product Q
contains five litres. However, there is a high wastage rate of materials and 25% of the input materials
are lost in production.
The budgeted production volumes for next year are 6,000 units of P and 8,100 units of Q. At the
beginning of the year the company expects to have 20,000 litres of material S in inventory but
intends to reduce inventory levels to 5,000 litres by the end of the year.
The purchase cost of material S is £1.60 per litre.
Requirement
The purchases budget for material S is:
A £63,000
B £93,000
C £100,800
D £148,800
5 A retailing company is preparing its annual budget. It plans to make a profit of 25% on the cost of
sales. Inventories will be maintained at the end of each month at 30% of the following month’s sales
requirements.
Details of budgeted sales are as follows.
Requirement
6 The coefficient of correlation between advertising expenditure and the number of theatre tickets
sold is 0.97.
Requirement
Which two of the following statements are correct?
A 97% of the variation in ticket sales can be explained by variations in advertising expenditure.
B 94% of the variation in ticket sales can be explained by variations in advertising expenditure.
C A 97% increase in advertising expenditure will result in a 97% increase in ticket sales.
D There is a fairly high degree of positive correlation between advertising expenditure and ticket
sales.
7 A transport company has recorded the following maintenance costs for the last two periods.
Period 7 Period 8
Miles travelled 30,000 50,000
Maintenance cost per mile £1.90 £1.30
Requirement
The forecast maintenance cost for period 9, when 38,000 miles will be travelled, is £
.
8 Big data analytics typically involves the analysis of unstructured data. Which of the following is an
example of unstructured data?
A Data tables showing monthly sales figures
B Spreadsheet analysis of fixed asset purchases
C Email communications between a customer and the sales department
D A table of supplier names and addresses
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
Answer
WORKING
Budgeted production
2.3
WORKING
Budgeted material usage
2.4
WORKING
Budgeted material purchases
Budgeted material
purchases 26,300 14,700 13,700
Hours
required per Labour
Product Production unit budget Rate per hour Cost
Units Total hours £ £
X 2,100 4 8,400 9 75,600
Y 4,200 6 25,200 9 226,800
Z 3,100 8 24,800 9 223,200
Budgeted
total
wages 525,600
Although we only have two activity levels in this question, we can still apply the high-low method.
WORKING
High-low method
Number of
valuations Total cost
£
Period 2 515 90,275
Period 1 420 82,200
Change due to variable cost 95 8,075
True or false?
(c) If it is high, this proves that variations in one variable cause False
variations in the other
TS = T × SV SV = TS – T
Therefore SV = 48.8 – 46.2 = 2.6
1 Correct answer(s):
A Preparing functional budgets
The budget committee is not responsible for preparing functional budgets. The manager
responsible for implementing the budget must prepare it, not the budget committee.
Since the committee is a coordinating body it is definitely responsible for timetabling and allocating
responsibility for budget preparation. It is also responsible for monitoring the whole budgetary
planning and control process.
2 Correct answer(s):
B £82,500
The budgeted receivables balance at the end of September is £82,500.
Since one month’s credit is given to credit customers, the outstanding receivables balance at the end
of each month is equal to the credit sales for that month.
Credit sales for September = 50% × £165,000 = £82,500
If you answered £165,000 you did not allow for the fact that only 50% of sales are made on credit.
If you answered £75,000 or £150,000 you based your answer on the sales revenue for August, all of
which will have been received from customers by the end of September.
Correct answer(s):
H £156,250
The budgeted payables balance at the end of September is £156,250.
Since one month’s credit is received from suppliers the payables balance at the end of each month is
equal to the credit purchases for that month.
The budgeted cost of goods sold in each month is derived by multiplying each sales figure by
(100/120) to remove the profit mark-up.
September
£
Budgeted cost of goods sold (£165,000 × 100/120) 137,500
Budgeted closing inventory (£210,000 × 100/120 × 50%) 87,500
225,000
Less budgeted opening inventory (£165,000 × 100/120 × 50%) (68,750)
Budgeted purchases = budgeted payables 156,250
If you answered £118,750 you reversed the budgeted opening and closing inventory.
The option of £137,500 is incorrect because the purchases are not equal to the cost of goods sold
since there are budgeted changes in inventory.
If you answered £150,000 you treated the 20% profit as a margin on the sales price rather than as a
mark-up on the cost of purchases.
3 Correct answer(s):
C Selling overhead budget
The selling overhead budget is unlikely to be contained in a budget manual. All of the other items
are concerned with the organisation and coordination of the budgetary process, therefore they
would be included in the budget manual.
4 Correct answer(s):
C £100,800
Material S
litres
Material S required for production:
Product P: 6,000 units × 3 × 100/75 24,000
Product Q: 8,100 units × 5 × 100/75 54,000
Total material S required for production 78,000
Plus budgeted closing inventory 5,000
83,000
Less budgeted opening inventory (20,000)
Budgeted material purchases in litres 63,000
× purchase cost per litre × £1.60
Budgeted material purchases in £ £100,800
If you answered £63,000 you selected the figure for purchases in litres rather than the value of the
budgeted purchases.
If you answered £93,000 you did not deal correctly with the losses. The 25% loss is based on the
input materials. You calculated a 25% loss based on the output.
If you answered £148,800 you reversed the opening and closing inventory.
WORKINGS
(1) December
= £1,500,000 + £250,000
Sales in January = £1,750,000
Cost of sales (× 100/125) = £1,400,000
= 30% × £1,400,000
End of December inventory = £420,000
(2) January
= £1,700,000 + £350,000
Sales in February = £2,050,000
Cost of sales (× 100/125) = £1,640,000
= 30% × £1,640,000
End of January inventory = £492,000
January
£
Cost of goods sold 1,400,000
Budgeted closing inventory 492,000
1,892,000
Less budgeted opening inventory (420,000)
Budgeted purchases 1,472,000
6 Correct answer(s):
B 94% of the variation in ticket sales can be explained by variations in advertising expenditure.
D There is a fairly high degree of positive correlation between advertising expenditure and ticket
sales.
A is incorrect and B is correct. The coefficient of determination (r2) = (0.97)2 = 0.9409, therefore 94%
of the variation in the value of y (ticket sales) can be explained by a linear relationship with x
(advertising expenditure).
C is incorrect because it misinterprets the meaning of the coefficient of correlation.
D is correct. There is a fairly high degree of positive correlation because r, the coefficient of
correlation, is close to 1.
7 The forecast maintenance cost for period 9, when 38,000 miles will be travelled, is £ 60,200 .
WORKING
Forecast maintenance cost
To use the high-low method, we need to know the total cost incurred at each activity level.
8 Correct answer(s):
C Email communications between a customer and the sales department
Structured data refers to any data that is contained within a field in a data record or file. This includes
data contained in databases and spreadsheets. Therefore, A, B and D are examples of structured
data. Unstructured data is data that is not easily contained within structured data fields: pictures,
videos, webpages, PDF files, emails, blogs etc. C is therefore an example of unstructured data.
9 Correct answer(s):
A In centralised organisations
Participative (bottom-up) budgets might not be effective in centralised organisations. An imposed or
top-down budgeting system is likely to be most effective in this situation.
10 Correct answer(s):
C Professional scepticism
There may be deliberate or accidental mistakes within information, and professional scepticism
means being aware of this and accepting that verification may be necessary.
Chapter 7
Working capital
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 What is ‘working capital’?
2 Balancing liquidity and profitability
3 Assessing the liquidity position via ratios
4 The cash operating cycle
5 Managing inventory
6 Managing trade payables
7 Managing trade receivables
8 Treasury management
9 Cash budgets
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Prepare a cash budget which highlights the quantity and timing of cash surpluses and deficits
• Calculate the cash (operating) cycle for a business and understand its significance
• Identify the constituent elements of working capital and treasury and specify the methods by
which each element can be managed to optimise working capital and cash flows
• Recognise how to manage the surpluses and deficits predicted in cash budgets
The specific syllabus references for this chapter are: 2f, g, h, i.
7
Syllabus links
As with Chapter 6, this chapter will underpin your study of planning within the Business Strategy and
Technology syllabus. You will study working capital again in the Strategic Business Management
syllabus at Advanced level.
7
Examination context
You could be asked to prepare a full cash budget in the exam in a scenario-based question.
Alternatively, you could be asked to prepare an extract from information provided in a shorter
question. For example, you may be asked to calculate the budgeted receipts from customers or the
budgeted payments made to suppliers, taking account of the budgeted activity and planned credit
periods.
In the examination, students may be required to:
• use data supplied to prepare cash budgets or extracts from cash budgets
• select appropriate actions to be taken in the light of information provided by a cash budget
• calculate and interpret the cash cycle for a business
• assess the liquidity of a business using current and quick ratios
Questions on working capital and treasury management could easily appear in the exam. They are
likely to be set in an application context. Knowledge-type questions are also likely, set on particular
principles or definitions.
7
5-8 Managing inventory, Work slowly and Objective test IQ4: Collection
managing trade methodically questions are likely procedures
payables, managing through each of to be set in an
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• The components of working capital are inventory, receivables, cash and payables.
Definition
Working capital: The total of the current assets of a business less its current liabilities.
• All businesses face a trade-off between being profitable (providing a return) and being liquid
(staying in business).
One of the professional skills assessed in the ACA exams is the ability to ‘Identify risks within a
scenario’. A business needs to manage the risk of not being able to pay debts in a timely manner
versus the risk of missing out on profit.
Alternative policies in working capital management need to be reviewed in terms of their relative risk
and return. An important aspect of the risk associated with various options is the effect it has on the
company’s liquidity position. Liquidity is obviously of crucial importance to the financial stability of a
business; mismanagement of a firm’s liquidity position may result in it being unable to pay its debts
which, in turn, may result in corporate insolvency. A business’s liquidity determines its ability to
survive. This can be illustrated by looking at each component of working capital in turn.
• Cash. A business requires a particular level of cash (or overdraft facility) in order to pay debts
when they fall due, and particularly to take advantage of any generous discounts offered for
prompt payment. However, a better return could be earned by investing any cash surplus in a
high-yielding investment. By ensuring that it has sufficient liquid assets (cash), therefore, a
business is reducing its chance of owning more profitable assets.
• Receivables. A business could decide that it does not want to offer credit to customers, because
the delay in payment jeopardises its liquidity position. If it tried to adopt this policy however,
customers would be driven away, revenue would fall and profits would fall.
• Inventory. In order to satisfy customer demand, manufacturing and retailing firms need to
maintain finished goods inventory; to keep production runs moving without disruption, raw
materials inventories also need to be maintained. This means that a business will have money tied
up in inventories that, again, it might feel it could use more profitably elsewhere. However, if
inventories were not available when required, a potential sale might be lost; the cost of a broken
production facility may be higher than the cost of holding inventory.
• Payables. To improve its cash position a business might decide not to pay suppliers until after two
or three months, rather than after the normal one month. Apart from the obvious cost of lost
discount opportunities, the business runs the risk of alienating its suppliers and even losing
sources of supply.
In each of the above instances the business must weigh up profitability versus liquidity. Since
ultimately a business aims to maximise profits, it must establish the financial costs and benefits of
different liquidity positions. Inevitably all working capital decisions reduce to decisions over cash
levels, since current assets should eventually be turned into cash.
Remember that profit and cash flows are not the same. It is possible to make accounting profits
while suffering a dramatic decline in the cash balance (and vice versa). There are many cases of
companies becoming insolvent while reporting accounting profits. Since the consequences of
compulsory liquidations are invariably catastrophic for all concerned, it is crucial for a business to
maintain a sound liquidity position. Cash budgeting and performance measurement are key
techniques in monitoring and controlling that position.
Ratios
For an individual business, we can gain a better understanding of the effects of funding and
operational decisions on its liquidity position by manipulating its ratios.
For the following ratios averages should be used where they are available, but the year-end figure
should be used if not.
The opening inventory, receivables and payables balances are the same as the closing balances.
Requirement
Calculate the division’s year-end cash balance.
Solution
Step 1
Calculate the annual sales revenue
Step 2
Calculate the cost of sales/purchases
Since the opening and closing inventories are equal, the cost of sales is equal to the purchases.
Step 3
Calculate the inventory balance
Step 4
Calculate the trade payables balance
Step 5
Calculate the current assets balance
Step 6
Calculate the cash balance
£ £
Total current assets 207,000
Less: Inventory 45,625
Receivables 90,000
135,625
Cash balance 71,375
Definition
Current ratio: Current assets ÷ current liabilities
This ratio measures the ability to meet short-term liabilities from easily or quickly realisable current
assets. It is calculated as follows.
Current ratio = Current assets/Current liabilities
A higher value for the ratio indicates that the business is more liquid and is able more easily to meet
its current liabilities from its available current assets.
In general, a higher ratio is preferable to a lower one. However, if a business has a very high ratio this
may indicate that funds are tied up in current assets, such as inventory and cash that may be used
more productively elsewhere in the business.
The most appropriate level for the current ratio will depend on the type of business. For example, a
supermarket will have a relatively low current ratio because it does not hold inventories of raw
materials and work in progress and a large proportion of its sales to customers are made for cash,
with consequently a low investment in receivables.
On the other hand, a manufacturer will have a relatively high current ratio because of the need to
invest in inventories of raw materials and work-in-progress and to provide credit to customers.
Definition
Quick ratio: Current assets less inventories ÷ current liabilities
The nature of the inventory in some types of business means that it cannot be easily or quickly
converted into cash. This inventory cannot be relied upon as a liquid asset when it is necessary to
meet short-term liabilities.
The quick ratio therefore excludes inventory from the current assets as follows.
Quick (liquidity) ratio = Current assets less inventories/Current liabilities
Solution
Proposed policy
Current policy days days
£ £
Inventory turnover/Inventory 30 15,000 60 30,000
Payables period/Payables (30) (15,000) (30) (15,000)
Receivables period/Receivables 60 30,000 30 15,000
Proposed policy
Current policy days days
£ £
Cash operating cycle/Net
current assets 60 30,000 60 30,000
£’000
Inventories 982
Receivables 648
Cash 78
Payables 653
Requirement
Complete the table below to compare the current ratio and quick (liquidity) ratio with the average for
businesses in the industry. Comment on the results.
• The cash operating cycle is the length of time between paying out cash for raw materials and
other input costs and receiving the cash for goods or services supplied.
• The length of each element of working capital (receivables, payables and so on) can be calculated
in days and then summed to determine the length of the cash operating cycle.
• Liquidity problems can be caused if the cash cycle becomes too long. The forecasting and control
of working capital requirements is critical to the management of the cash operating cycle.
Definition
Cash operating cycle: The period of time which elapses between the point at which cash begins to
be spent on the production of a product and the collection of cash from the customer who
purchases it.
It is important to note that movements in working capital will have an impact on an organisation’s
cash balance. The efficient control of working capital is therefore vital in the management of an
organisation’s cash.
The measurement of the cash operating cycle focuses on the length of time between an organisation
paying out cash for its raw materials and other input costs and receiving the cash for goods or
services supplied.
The cash operating cycle is normally measured in days and it may be referred to as the working
capital cycle. It can be depicted in Figure 7.2 below.
Cash payment
Cash Payables
Cash
collection Purchases
Raw materials
Receivables
inventory
Sales Production
Days
Raw materials holding
period Annual inventory of raw materials/Annual usage × 365 = X
Average payables
payment period Average trade payables/Annual purchases × 365 = (X)
Average production Average inventory of work in progress/Annual cost
period of sales × 365 = X
Average inventory- Average inventory of finished goods/Annual cost of
holding period sales × 365 = X
Average receivables
collection period Average receivables/Annual sales revenue × 365 = X
Length of cycle X
Where averages cannot be calculated or are not available then period-end balances should be used.
Sales £3,600,000
Average receivables £306,000
Gross profit margin 25% on sales
Average inventories
Finished goods £200,000
Work in progress £350,000
Raw materials £150,000
Average payables £130,000
Cost of sales = =
Days
WIP in inventory =
Period 1 Period 2
Days Days
Inventory turnover
period Cost of sales/Inventory 365/20 18 365/(20 × 1.2) 15
Receivables days Receivables/Revenue 70 70 × 1.1 77
88 92
Investment
£
Finished Receivables
WIP goods
Raw materials (work in progress)
Payables
Business A with inventory days of 50 and receivables days of 60 might appear to have the same
working capital investment (110 days) as Business B with 90 days’ inventory and 20 days’ receivables.
In practice, the level of investment in Business B is lower, as less capital is tied up in inventories
(particularly raw materials) than in receivables.
The total investment is also influenced by:
• growth (see overtrading below)
• inflation. As the price of raw material inputs rises, together with labour and overhead costs in
production, a firm is likely to put up its selling prices. Thus, the monetary investment in inventory +
receivables – payables increases
4.6 Overtrading
The amount of cash required to fund the cash operating cycle will increase as:
• the cycle gets longer
• sales (and hence purchases of inventory required) increase
This can often happen at the start of a new business, since:
• there is no trading record, so suppliers are likely to insist on a very short credit period
• there is no reputation to draw in customers, so a long credit period is likely to be extended to
customers in order to break into the market
• if the business has found a ‘niche market’, rapid sales expansion may occur
This can lead to the cycle being ‘out of balance’, so short-term financing may be necessary to get
over the initial period. If this finance is unavailable, it may be necessary to sell non-current assets to
pay debts or, at the extreme, to go into insolvent liquidation. The forecasting of working capital so as
to avoid overtrading is thus of particular importance for new businesses.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify creative and
pragmatic solutions in a business environment’. For example, you could be asked to identify solutions
to short-term liquidity problems.
5 Managing inventory
Section overview
• There are many, usually non-financial, reasons for a business to hold inventory, but it does so at
considerable cost.
• As a result, businesses try to keep inventory levels down as far as possible, using a variety of
inventory control systems: re-order level, periodic review, ABC, economic order quantity (EOQ),
just-in-time (JIT) and perpetual inventory.
Definition
Opportunity cost: The value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
These costs vary with the number of orders which will increase as inventory levels are reduced.
• Shortage costs:
– Production stoppages caused by lack of raw materials
– Stockout costs for finished goods – anything from a delayed sale to a lost customer
– Emergency re-order costs
The benefits of holding inventory must outweigh the costs.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify assumptions or
faults in arguments’. For example, the benefits of holding inventory must outweigh the costs.
2cd
EOQ =
h
Where:
c = cost of placing one order
d = estimated usage of the inventory item over a particular period
h = cost of holding one unit of inventory for that period
Definition
Economic order quantity (EOQ): The order quantity which minimises inventory costs. The EOQ can
be calculated using a table, graph or formula.
2 × 200 × 2,000
EOQ for material: = 400 kg
5
Annual usage is 2,000 kg, so 2,000/400 = 5 orders per year will be placed.
While EOQ appears to be a satisfactorily precise model, it has some serious limitations:
• It is cumbersome to apply.
• Some simplifying assumptions are made about usage and a constant purchase price that may be
unjustified.
• It ignores the potential benefit of taking advantage of bulk discounts because it does not
consider whether the best price is being obtained.
• It can be very difficult in practice to estimate holding costs and the cost of placing each order.
• Just-in-time (JIT) manufacturing systems. Production and purchasing are linked closely to sales
demand on a week-to-week basis. This means that negligible inventories of raw materials and
finished goods need to be held. Features of JIT systems include:
– the need for flexibility of both suppliers and the workforce to expand and contract output at
short notice
– guaranteed quality of raw materials. There are no inventories in reserve should one batch of
raw materials prove to be faulty, so production would stop until a further delivery can be made
– close working relationship between suppliers and users including geographical proximity in
order to be able to make immediate deliveries
– willingness of the workforce to increase or decrease working hours from one period to another;
This could be done by having a core workforce with a group of part-time or freelance workers
– rationalised factory layout systems to minimise movements between stages
• Perpetual inventory methods. This is a system whereby the inventory records are updated for
each receipt and issue of inventory as it occurs. One advantage of such a system is the data it
provides to management to determine which product lines are moving rapidly. Marketing
managers may also use the data to make tactical decisions on special prices and promotions to
sell slow-moving items.
• Other ways to manage inventory include:
– sub-contracting (outsource) non-core processes, passing on the inventory holding problem to
another business
– obtaining progress payments from customers, thus reducing the net capital required to finance
inventory
– reducing the number of product lines, eg, drop products near the end of their product life
cycle
Credit periods for the buyer are a source of short-term finance. For example, if a buyer decides not to
pay its trade debts for a further month, it has obtained a further month’s use of its cash.
Trade payables are not, however, without cost.
• Credit status may be lost so the supplier gives low priority to the buyer’s future orders, with
consequent disruption of activities.
• The supplier may raise prices in order to compensate for the finance which they are involuntarily
supplying.
• The buyer will lose any cash discount for prompt payment; the cost of the lost discount should be
compared with other short-term sources of finance, eg, overdrafts.
The advantages of trade credit are that:
• it is convenient and informal (ie, it is unusual to tell your suppliers that you do not intend to pay
them on time, though after a while they will realise anyway)
• it can be used by businesses which do not qualify for credit from a financial institution
• it does not prevent advantage being taken of settlement discounts (which can result in a very
cheap source of financing) because a period of time is still allowed before payment has to be
made
• trade credit can represent a virtual subsidy or sales promotion device offered by the seller – for
example, favourable terms may be offered when a new company is set up
• it can be used on a very short-term basis to overcome unexpected cash flow crises
Because of these advantages, a business should:
• consider switching suppliers if better credit terms are available or if better terms exist for sole
supplier relationships
• negotiate better terms for buying large quantities
• reconcile statements (make sure that what the supplier says a company owes agrees with what
the company thinks it owes)
• pay only on completion of correct delivery
• Businesses have the right to receive correct full payment as and when due.
• Payment processes should be clear so that suppliers know when and how much they will be paid.
• Payment periods should not exceed 30 days.
• The cost of granting credit to customers has to be balanced against the benefits of doing so.
• Proper management of trade receivables should ensure an adequate level of collections.
• Trade receivables may be financed by invoice discounting or factoring.
Solution
Cash received
Irrecoverable Discount
Sales Month 1 Month 2 debts allowed
£ £ £ £ £
Current policy 25% 70% 5%
Sales M1 20,000 5,000 14,000 1,000 0
Sales M2 20,000 0 5,000 0 0
Total cash 5,000 19,000 1,000 0
There is a large cash flow benefit of £7,125 in Month 1, and a benefit of £4,125 per month once the
normal pattern is established. The reduction in monthly profits caused by increased irrecoverable
debts is £500, while profits are further reduced by £375 with respect to the discount allowed.
Requirement
Identify three ways in which collection of amounts owed by customers could be speeded up.
Definition
Invoice discounting: The purchase (by the provider of the discounting service) of a company’s trade
debts, at a discount. Invoice discounting enables a company to raise finance based on their expected
invoice receipts. The invoice discounter does not take over the administration of the client’s sales
ledger, so the client remains in control of debt collection.
This involves selling the invoices to a discounting company for a cash sum, then repaying the
discounter when the debtor pays the invoice. Note that the business retains full responsibility for
sales ledger, credit control and collection functions. However, the discounting company may perform
certain credit checks and ratings before entering the agreement. This form of discounting is
effectively a form of overdraft facility as the discounter makes a charge for lending the money.
Definition
Factoring organisation: Takes over the management of the trade debts owed to its client (a business
customer) on the client’s behalf. The factor company collects the debts and provides an immediate
cash advance of a proportion of the money it is due to collect.
November December
20X1 20X1
outstanding % of total outstanding % of total
£ £
0–30 days 10,000 86.2 12,000 80.5
31–60 days 1,000 8.6 2,000 13.4
61–90 days 500 4.3 750 5.0
90+ days 100 0.9 150 1.1
11,600 100.0 14,900 100.0
The changes from November to December show customers taking longer to pay. It might be a
normal seasonal pattern. If not, the customers who are responsible need to be identified.
Gizzard Ltd appears to be one of the problem customers; perhaps it is time to start more aggressive
collection procedures?
8 Treasury management
Section overview
• The risks of running out of cash have to be balanced against the costs of holding cash, just like
with inventory.
• Short term surpluses of cash should be invested; short term shortages of cash need to be funded.
8.1 The basic trade-off: cost of holding v cost of running out of cash
To manage its cash position successfully the business must trade off the cost of holding cash against
the cost of running out of cash.
The cost of holding cash, either as a cash float or in a current account, is the opportunity cost of what
else could be done with the money. Cash is an idle asset and earns little or no return. If the funds
were put to work elsewhere (ie, invested) they could generate profits.
The costs of running out of cash vary, depending upon the circumstances of the business. Cash
shortages result in the business not being able to pay its payables on time, and this could have many
implications. Examples include:
• loss of settlement discounts from trade suppliers
• loss of supplier goodwill, eg, refusal of further credit, higher prices, poor delivery
• poor industrial relations if wage payments are delayed
• creditors petitioning for winding up the business
Although the above costs may be difficult to quantify the business must at all times ensure that it has
sufficient liquidity, in the form of cash balances or overdraft/loan facilities, to maintain its solvency.
• Treasury bills issued by the Bank of England on behalf of the government, which have a minimum
investment of £50,000+, run for three months and are highly secure and liquid, but offer low
returns.
• Deposits, which offer investment periods ranging from overnight to five years. They are available
from banks, local authorities and building societies with yields exceeding that of Treasury bills.
• Gilts (longer-term government debt), which offer a large range of maturities and rates based on
money market rates; they can have capital gains tax advantages.
• Bonds, which are debentures and loans of companies quoted on the stock market; rates fluctuate
with general interest rates and there is good liquidity.
• Equities dealt on the Stock Exchange offer good marketability and liquidity but relatively high
risk.
When choosing investments from the list above the following factors should be considered:
• The amount of funds available
• The length of time for which the funds are available (invest short-term funds in the short-term and
longer-term funds in longer-term projects)
• The likelihood of needing early withdrawal (consider liquidity)
• The notice period for withdrawal, and penalties
• The risk and the return of the investment
9 Cash budgets
Section overview
• A cash budget shows the cash effect of all the decisions taken in the budgetary planning exercise.
• It is a statement tabulating future cash receipts and payments to show the forecast cash balance
of a business at defined intervals.
• The appropriate management action to be taken in response to forecast cash deficits or surpluses
will depend on whether the situation is expected to be short term or longer term.
• Certain non-cash items such as depreciation are not included in a cash budget.
Definition
Cash budget: A cash budget is a statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
In this example the accounts department has calculated that the cash balance at the beginning of the
budget period, 1 January, will be £1,200. Estimates have been made of the cash that is likely to be
received by the business (from cash and credit sales, and from a planned disposal of non-current
assets in February). Similar estimates have been made of cash due to be paid out by the business
(payments to suppliers and employees, payments for rent, rates and other overheads, payment for a
planned purchase of non-current assets in February and a loan repayment due in January).
From these estimates it is a simple step to calculate the net cash movement in each month. In some
months the budgeted cash payments may exceed cash receipts and there will be a deficit for the
month; this occurs during February in the above example because of the large investment in non-
current assets in that month.
The last part of this cash budget shows how the business’s estimated cash balance can then be rolled
along from month to month. Starting with the opening balance of £1,200 at 1 January a cash surplus
of £2,300 is generated in January. This leads to a closing January balance of £3,500, which becomes
the opening balance for February. The deficit of £5,800 in February throws the business’s cash
position into overdraft and the overdrawn balance of £2,300 becomes the opening balance for
March. Finally, the cash surplus of £5,300 in March leaves the business with a favourable cash
position of £3,000 at the end of the budget period.
Preparing a cash budget helps management with forward planning decisions, as explained above.
(1) It is management policy to have sufficient inventory in hand at the end of each month to meet
half of next month’s sales demand.
(2) Suppliers for materials and expenses are paid in the month after the purchases are
made/expenses incurred. Labour is paid in full by the end of each month.
(3) Expenses include a monthly depreciation charge of £2,000.
(4) (1) 75% of sales are for cash
(2) 25% of sales are on one month’s credit.
(5) The company will buy equipment costing £18,000 for cash in February and will pay a dividend of
£20,000 in March. The opening cash balance at 1 February is £1,000.
Requirement
Prepare a cash budget for February and March.
You should make an entry in every box in the cash budget. Enter a zero or a dash where applicable.
Do not leave any boxes blank.
Solution
Cash budget
February March
£ £
Receipts
Receipts from cash sales 45,000 (W1) 120,000 (W2)
Receipts from credit sales 10,000 (W1) 15,000 (W2)
February March
£ £
Payments
Payments to suppliers 37,500 (W3) 82,500 (W3)
Expenses 2,000 (W4) 4,000 (W4)
Labour 3,000 5,000
Equipment purchase 18,000 0
Dividend 0 20,000
Total payments 60,500 111,500
Receipts less payments (5,500) 23,500
Opening cash balance b/f 1,000 (4,500)
Closing cash balance c/f (4,500) 19,000
WORKINGS
(1) Receipts in February
£
Cash 75% of Feb sales (75% × £60,000) 45,000
Credit 25% of Jan sales (25% × £40,000) 10,000
£
Cash 75% of Mar sales (75% × £160,000) 120,000
Credit 25% of Feb sales (25% × £60,000) 15,000
(3) Purchases
January February
£ £
For Jan sales (50% of £30,000) 15,000
For Feb sales (50% of £45,000) 22,500 (50% of £45,000) 22,500
For Mar sales – (50% of £120,000) 60,000
37,500 82,500
Annex A
Nov X1 Dec X1 Jan X2 Feb X2 Mar X2 Apr X2 May X2 June X2
£ £ £ £ £ £ £ £
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 12,000 12,000 17,000 17,000 17,000 22,000 22,000 22,000
Dividends
declared 20,000 40,000
Capital
expend. 30,000 40,000
Requirement
Use the following framework to prepare the cash budget.
You should make an entry in every box in the cash budget. Enter a zero or a dash where applicable.
Do not leave any boxes blank.
Note: The boxes in this question indicate where an answer is required and where marks are available
in the CBE. You can use the ‘add comment’ function to record your workings and answers.
Cash sales
Credit sales
Payments
Purchases
Wages:
75%
25%
Overheads
Dividends
Capital
expend.
Net surplus/
(deficit)
Opening
balance
Closing
balance
Summary
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
3. Do you know the formulae for the inventory, receivables, payables and liquidity ratios?
(Topic 3)
4. Do you know how to calculate the length of the cash operating cycle? (Topic 4)
5. Do you know the formula for the economic order quantity? (Topic 5)
Self-test questions
Present Proposed
Inventory holding period 1.5 months 1.0 month
Trade payable payment period 1.0 month 1.3 months
Requirement
How much extra cash will be generated at the end of the month in which these changes take place?
A £2,500
B £3,750
C £6,250
D £10,000
4 Selected figures from a firm’s budget for next month are as follows:
Sales £450,000
Gross profit on sales 30%
Decrease in trade payables over the month £10,000
Increase in cost of inventory held over the month £18,000
Requirement
What is the budgeted payment to trade payables?
A £343,000
B £323,000
C £307,000
D £287,000
5 A company’s cash budget for next year shows a cash deficit for the months of April and May. For the
remaining months there will be a cash surplus.
Requirement
Which two of the following management actions would be most appropriate in response to the
expected cash position in April and May?
A Increase inventories of raw materials
B Arrange a bank overdraft
C Delay the payment of suppliers as much as possible
D Issue extra share capital
E Offer extra credit to customers
6 The following are items from APC Ltd’s opening and closing balance sheet and income statements
for the year 20X8.
1 January 31 December
£’000 £’000
Receivables 800 900
Inventory 600 700
Payables 200 250
Requirement
What is the approximate length of the cash operating cycle?
A 54 days
B 57 days
C 61 days
D 84 days
7 Gemstrong Ltd is a retail company that has average sales of £14.6 million per annum and earns a
mark-up of 25%. Inventory averages £2 million, receivables average £0.9 million and trade payables
£0.6 million.
Requirement
If all sales and purchases are on credit, how long is the company’s cash operating cycle (to the
nearest day)?
A 58 days
B 66 days
C 69 days
D 104 days
8 A company sells inventory at a profit to a customer on credit. How will this transaction affect each of
the following ratios immediately after the transaction?
Current ratio
9 A subsidiary which sells goods wholesale has a year-end trade payables balance of £192,000. The
remainder of the working capital items consist of trade receivables, inventories and cash.
The inventory, receivables and payables balances were the same at the year end as at the beginning
of the year.
Relevant financial ratios for the year are as follows:
Requirement
The current ratio to the nearest whole number at the year end is .
10 A retailing company’s working capital consists of inventory, trade receivables, cash and trade
payables. All working capital balances were the same at the beginning and the end of the year. The
sales revenue for the year was £900,000.
The financial ratios for the year include the following.
Requirement
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
Days
• Assess whether it may be cheaper to collect debts through the court system than through outside
help.
Any item that is a cash flow will be included. Non-cash items are excluded from a cash budget.
1 Correct answer(s):
A £15,428
Received in March
£
Cash sales (5% × £10,000) × 95% 475.00
February sales (£17,000 × 95%) × 75% 12,112.50
January sales (£13,000 × 95%) × 23% 2,840.50
15,428.00
2 Correct answer(s):
B selling prices increase
A, C and D will cause a fall. B may increase receivables.
3 Correct answer(s):
D £10,000
If you answered A you treated the change in payables as a cause of a reduction in cash. However, if
payables increase this will increase their cash inflow. The other two incorrect options considered
each of the changes separately, but their effects must be combined to derive the correct answer.
4 Correct answer(s):
A £343,000
£’000
Cost of sales for month = £450,000 × 70% 315
Decrease in trade payables 10
£’000
Increase in inventory 18
Budgeted payment to trade payables 343
If you selected an incorrect option you did not treat the change in trade payables and inventory
balances correctly.
An increase in inventory indicates that budgeted purchases are greater than the budgeted cost of
goods to be sold in the month, which would increase the amount payable to suppliers. Since the
balance owed to suppliers is budgeted to decrease, this further increases the amount budgeted to
be paid to suppliers.
5 Correct answer(s):
B Arrange a bank overdraft
C Delay the payment of suppliers as much as possible
The budget forewarns of a short-term deficit and these are the two most appropriate responses to
this situation.
Action taken to increase inventories or to offer extra credit to customers will result in cash outflows.
These are not appropriate actions in the light of a short-term deficit.
Although the issue of extra share capital would help to reduce or eliminate a cash deficit, this would
be a more appropriate action to take if the predicted deficit were expected to continue in the longer
term.
6 Correct answer(s):
B 57 days
If you selected 84 days you added together the days for each element of working capital. However,
the payable period, during which the company takes credit from suppliers, reduces the length of the
cycle and hence should be deducted.
7 Correct answer(s):
B 66 days
Days
Receivable days (0.9/14.6) × 365 22.5
Payable days (0.6/(14.6 ÷ 1.25)) × 365 (18.8)
Inventory days (2.0/(14.6 ÷ 1.25)) × 365 62.5
66.2
If you selected 58 days you based your calculations of payables days and inventory days on the sales
revenue rather than on the cost of sales.
If you arrived at an answer of 69 days you performed your calculations using a margin of 25% of
sales, rather than a mark up of 25% of cost.
If you selected 104 days you added together the days for each element of working capital. The
payables days should be subtracted, since credit from suppliers reduces the cash operating cycle.
8
Both ratios will increase. The current liability figure used as the denominator will stay the same in
both cases. The total of the current assets will increase because of the profit element in receivables,
therefore the current ratio will increase. The total of the liquid assets will also increase therefore the
quick (liquidity) ratio will increase.
9 The current ratio to the nearest whole number at the year end is 3:1 .
WORKING
Current ratio
Payables payment period (in months) = (Average payables/Purchases) × 12
1.5 = (£192,000/Purchases) × 12
Purchases = £1,536,000
Inventory = unchanged cost of sales = Purchases
Rate of inventory turnover = Cost of sales/Average inventory
6 = £1,536,000/Inventory
Inventory = £256,000
From the quick ratio, receivables and cash = 1.7 × £192,000
= £326,400
Current ratio = (£256,000 + £326,400)/£192,000
= 3:1
WORKING
Closing cash balance
Since gross profit margin = 20%
Cost of sales = 80% × £900,000
= £720,000
Inventory = unchanged cost of sales = purchases
Payables payment period (in days) = (Average trade payables/Purchases) × 365
36.5 = (Trade payables/£720,000) × 365
Trade payables = £72,000
Since current ratio = Current assets/Current liabilities = 3.4:1
Current assets = 3.4 × £72,000
= £244,800
Rate of inventory turnover = Cost of sales/Average inventory
15 = £720,000/Inventory
Inventory = £48,000
Receivables collection period (in days) = (Average trade receivables/Sales revenue) × 365
73 = (Trade receivables/£900,000) × 365
Trade receivables = £180,000
Current assets = Inventory + Receivables + Cash
£244,800 = £48,000 + £180,000 + Cash
Cash = £16,800
Chapter 8
Performance management
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Performance evaluation
2 Responsibility centres
3 Performance measures
4 The balanced scorecard
5 Budgetary control
6 Data bias and professional scepticism in performance
management
7 Sustainability and ESG reporting
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Identify the reasons for and key features of effective performance management systems
• Select and calculate appropriate financial and non-financial performance measures which
effectively encourage the business as a whole to meet its objectives
• Identify issues relating to the collection of data (data bias) and interpretation of data (professional
scepticism) for performance management
• Identify the features of cloud accounting and its associated risks and benefits
• Identify the features of shared service centres and their relative merits for the provision of
management information
The specific syllabus references for this chapter are: 3a, b, d, e and f.
8
Syllabus links
Decentralisation and an understanding of responsibility centres also feature in the Business,
Technology and Finance syllabus, in the context of appreciating how these structures help to achieve
business objectives. You will also study internal controls in more depth in the context of your
Assurance syllabus and some of the performance measures covered in this chapter will be met again
when you are studying the interpretation of financial information for the Financial Accounting and
Reporting syllabus.
8
Examination context
It is important to appreciate that both numerical and written questions will be set on performance
measures and a thorough understanding of flexed budgets is required as a basis for variance
analysis in the next chapter.
In the examination, students may be required to:
• identify the most appropriate performance measure in a given situation
• demonstrate an understanding of the effect of management actions on specific performance
measures
• demonstrate an understanding of the purpose and operation of a responsibility accounting
system
• interpret the information provided by specific performance measures
• calculate the flexed cost budget for a given level of activity
• interpret the information provided by a flexed budget comparison
• identify the features, risks and benefits of cloud accounting
• identify the features and benefits of shared service centres
• Identify issues relating to data bias that may impact performance management
8
accounting.
3 Performance measures Learn the formula You need to know IQ2: ROI and RI
There are different for ROI in section how to perform the Questions on
performance measures 3 and work ROI and RI ROI or RI
for different carefully through calculations, as well calculations
responsibility centres the interactive as understanding could appear in
but they may not questions and their advantages and the exam.
always lead to goal worked examples. disadvantages. You
congruence. also need to be
aware of suitable
Stop and think performance
Can you think of measures for each
situations where a type of responsibility
performance centre.
measure might
motivate a
manager to act in
a dysfunctional
way, which is not
in the best
interests of the
organisation?
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
1 Performance evaluation
Section overview
• The term ‘feedback’ is used to describe both the process of reporting back control information to
management and the control information itself.
• Effective feedback information should have the following features.
– Clear and comprehensive
– Use an exception reporting format
– Identify separately the controllable costs and revenues
– Prepared on a regular basis
– Timely
– Sufficiently accurate for the purpose intended (not containing irrelevant detail)
– Communicated to the manager who has authority and responsibility to act on the information
• Inappropriate performance measures can lead to a lack of goal congruence and may introduce
budget bias.
• Hopwood identified three styles of evaluation: budget constrained; profit conscious; non-
accounting. (An Accounting System and Managerial Behaviour, 1973)
Plan, target
or budget Operations
Compare Control
actual results action
with plan
Outputs
Feedback of Measure
(eg, actual output
information outputs
revenues, costs)
The elements in the control cycle, illustrated in Figure 8.1, are as follows.
Step 1 Plans and targets are set for the future. These could be long, medium- or short-term plans.
Examples include budgets, profit targets and standard costs (which we will learn more about
in the next chapter).
Step 2 Plans are put into operation. Then, resources are consumed and costs are incurred.
Step 3 Actual results are recorded and analysed.
Step 4 Information about actual results is fed back to the management concerned, often in the
form of accounting reports. This reported information is feedback.
Step 5 The feedback is used by management to compare actual results with the plan or targets
(what should be or should have been achieved).
Step 6 By comparing actual and planned results, management can then do one of three things,
depending on how they see the situation.
(a) They can take control action. By identifying what has gone wrong, and then finding out
why, corrective measures can be taken.
(b) They can decide to do nothing. This could be the decision when actual results are
going better than planned, or when poor results were caused by something which is
unlikely to happen again in the future.
(c) They can alter the plan or target if actual results are different from the plan or target,
and there is nothing that management can do (or nothing, perhaps, that they want to
do) to correct the situation.
It may be helpful at this stage to relate the control system to a practical example, such as monthly
sales.
Step 1 A sales budget or plan is prepared for the year.
Step 2 Management organises the business’s resources to achieve the budget targets.
Step 3 At the end of each month, actual results are reported back to management.
Step 4 Managers compare actual results against the plan.
Step 5 Where necessary, they take corrective action to adjust the workings of the system, probably
by amending the inputs to the system.
• Sales people might be asked to work longer hours
• More money might be spent on advertising
• Some new price discounts might be decided
• Delivery periods to customers might be reduced by increasing output
Where appropriate the sales plan may be revised, up or down.
high levels of slow-moving inventory, resulting in an adverse effect on the company’s cash flow. Thus
the manager’s behaviour has been distorted by the control system.
The impact of an accounting system on managerial performance depends ultimately on how the
information is used. Research by Hopwood has shown that there are three distinct ways of using
budgetary information to evaluate managerial performance.
Budget constrained ‘The manager’s performance is primarily evaluated upon the basis of his
ability to continually meet the budget on a short-term basis. This criterion
of performance is stressed at the expense of other valued and important
criteria and the manager will receive unfavourable feedback from his
superior if, for instance, his actual costs exceed the budgeted costs,
regardless of other considerations.’
Profit conscious ‘The manager’s performance is evaluated on the basis of his ability to
increase the general effectiveness of his unit’s operations in relation to the
long-term purposes of the organisation. For instance, at the cost centre
level one important aspect of this ability concerns the attention which he
devotes to reducing long run costs. For this purpose, however, the
budgetary information has to be used with great care in a rather flexible
manner.’
Non accounting ‘The budgetary information plays a relatively unimportant part in the
superior’s evaluation of the manager’s performance.’
Style of evaluation
Budget constrained Profit conscious Non accounting
Involvement with costs High High Low
Job related tension High Medium Medium
Manipulation of the
accounting reports (bias) Extensive Little Little
Relations with the
supervisor Poor Good Good
Relations with colleagues Poor Good Good
Research has shown no clear preference for one style over another.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and anticipate
problems that may result from a decision’. One problem that may occur in budgeting is ‘budget
slack’.
In the table above we have indicated that bias or manipulation of accounting reports is more likely
to occur if the manager is under pressure to achieve short-term budget targets.
In the process of preparing budgets, managers might introduce budget slack into their estimates.
This is when a manager deliberately overestimates costs and/or underestimates revenues, so that
they will not be blamed in the future for overspending and/or poor results.
In controlling actual operations, managers might ensure that their spending rises to meet their
inflated budget, otherwise they will be ‘blamed’ for careless budgeting.
A typical situation is for a manager to pad the budget and waste money on non-essential expenses
so that all budget allowances are used. The reason behind the manager’s action is the fear that
unless the allowance is fully spent it will be reduced in future periods, thus making the manager’s job
more difficult as the future reduced budgets will not be so easy to attain. Because inefficiency and
slack are allowed for in budgets, achieving a budget target means only that costs have remained
within the accepted levels of inefficient spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no doubt
feeling the need to make an immediate favourable impact by promising better performance in the
future. They may merely delay problems, however, as the managers may well be censured when they
fail to hit these optimistic targets.
This is another example of management’s reaction to control systems distorting the processes that
the control systems are meant to serve.
2 Responsibility centres
Section overview
• Divisionalisation involves splitting the organisation into separate divisions, for example according
to location or the product or service provided.
• In a decentralised organisation the authority for certain decisions is delegated to less senior
managers. The most appropriate degree of decentralisation depends on a range of factors.
• There are a number of advantages and disadvantages of decentralisation.
• Responsibility accounting is the term used to describe decentralisation of authority, with the
performance of the decentralised units measured in terms of accounting results.
• With a system of responsibility accounting there are four types of responsibility centre: cost
centre, revenue centre, profit centre, investment centre.
• An investment centre manager has responsibility for capital investment in the centre.
• The performance of the responsibility centre manager should be monitored and based only on
those items over which the manager can exercise control:
– Controllable costs and revenues should be separated from non-controllable costs and
revenues.
– Controllable elements of divisional investment should be separated from non-controllable
elements.
• A shared service centre (SSC) is a centre responsible for operational tasks such as accounting, for
multiple parts of the same organisation.
• Cloud computing uses a network of remote servers rather than a local server. Cloud accounting is
an application of cloud computing where accountancy software is provided in the cloud by a
service provider.
2.1 Divisionalisation
As companies grow, and possibly also spread geographically, it is likely that they will consider some
form of divisionalisation. This involves splitting the company into divisions, for example according to
location or according to the product or service provided. Divisional managers are then given the
authority to make decisions concerning the activities of their divisions.
2.2 Decentralisation
In general, a divisional structure will lead to decentralisation of the decision-making process.
Divisional managers may have the freedom to set selling prices, choose suppliers, make output
decisions and so on. Later in this section we will see that the degree of decentralisation depends on
how much freedom managers are given to make decisions.
Efficiency measures
Definition
Cost centre: Any part of an organisation that incurs costs.
A cost centre manager is responsible for, and has control over, the costs incurred in the cost centre.
The manager has no responsibility for earning revenues or for controlling the assets and liabilities
of the centre.
Functional departments such as production and personnel might be treated as cost centres and
made responsible for their costs.
It is important that control reports for a cost centre show a clear distinction between controllable
costs, over which the cost centre manager can exercise some control, and uncontrollable costs,
which cannot be controlled by the cost centre manager.
Definition
Revenue centre: A section of an organisation which creates revenue but has no responsibility for
production. A sales department is an example.
The manager of a revenue centre is responsible only for raising revenue but has no responsibility for
forecasting or controlling costs. An example of a revenue centre is a sales centre where a sales
manager might be responsible for achieving a budgeted level of sales revenue.
Definition
Profit centre: Any section of an organisation, for example, a division of a company, which earns
revenue and incurs costs. The profitability of the section can therefore be measured.
A profit centre is a part of a business accountable for both costs and revenues.
For a profit centre organisation structure to be established it is necessary to identify units of the
organisation to which both revenues and costs can be separately attributed. Revenues might come
from sales of goods and services to external customers, or from goods and services provided to
other responsibility centres within the organisation. These internal ‘sales’ are charged at a transfer
price, which you learned about in Chapter 5.
A profit centre’s performance report, in the same way as that for a cost centre, would identify
separately the controllable and non-controllable costs as well as the controllable and non-
controllable revenues. A profit centre performance report might look like the example below.
Profit Centre Y
Income statement for the period
The budget for the sales revenue and variable cost of sales will be flexed according to the activity
level achieved. You will learn how to do this later in this chapter.
The variances (differences between budgeted and actual results) could be analysed in further detail
for the profit centre manager.
Notice that three different ‘profit levels’ are highlighted in the report.
(a) Contribution, which is within the control of the profit centre manager
(b) Directly attributable gross profit, which is also within the manager’s control
(c) Net profit, which is after charging certain uncontrollable costs and which is therefore not
controllable by the profit centre manager
Definition
Investment centre: A section of an organisation whose manager has some say in investment policy in
their area of operations as well as being responsible for costs and revenues.
Where a manager of a division is allowed some discretion about the amount of investment
undertaken by the division, assessment of results by profit alone (as for a profit centre) is clearly
inadequate. The profit earned must be related to the amount of capital invested. Such divisions are
sometimes called investment centres for this reason.
Performance can be measured by return on capital employed (ROCE), often referred to as return on
investment (ROI) and other subsidiary ratios, or by residual income (RI).
The amount of capital employed attributed to an investment centre should consist only of directly
attributable non-current assets and working capital (net current assets).
(a) Subsidiary companies that are treated as investment centres are often required to remit spare
cash to the central treasury department at group head office. In this situation the directly
attributable working capital would normally consist of inventories and receivables less payables,
but minimal amounts of cash.
(b) If an investment centre is apportioned a share of head office non-current assets, the amount of
capital employed in these assets should be recorded separately because it is not directly
attributable to the investment centre or controllable by the manager of the investment centre.
Non-current assets
Trade receivables
Trade payables
Inventory
Definition
Shared service centre: A centre responsible for operational tasks such as accounting, for multiple
parts of the same organisation.
Basic processing tasks are now often carried out in shared service centres. Shared service centres
consolidate the transaction-processing activities of many operations within a company. Functions
such as human resources, payroll, accounting and IT may be carried out in a shared service centre.
The aim of a shared service centre is to achieve significant cost reductions while improving service
levels through the use of standardised technology and processes and service level agreements. For
example, a multinational business may use shared servicing in its head office to process all
transactions incurred by its overseas operations.
A fair transfer pricing policy (covered in Chapter 5) is vital to ensure that client divisions value the
SSC and that the SSC provides efficient services.
Advantages to using a shared service centre include:
(a) reduced headcount due to economies of scale resulting from the single location centre
(b) associated reduction in premises and other overhead costs
(c) knowledge sharing should lead to an improvement in quality of the service provided
(d) allows standard approaches to be adopted across the organisation leading to more consistent
management of business data
Disadvantages might include:
(a) loss of business specific knowledge. For example, creating a consolidated finance function
which broadly handles financial matters for the entire organisation may lack an understanding of
specific finance issues affecting individual departments or business units.
(b) removed from decision making. Building on from the point above, an SSC finance function is
unlikely to be able to provide meaningful financial information for decision making if finance
personnel are removed from the day to day realities facing a particular department or business
unit.
(c) weakened relationships. Geographical distance between the site of the SSC and the respective
business areas it serves may weaken the relationships between the two.
(d) cost inefficiencies. Cost inefficiencies within the SSC could potentially be passed on to the client
division and this is likely to lead to friction between the two parties.
Another difficulty for shared service centres is performance measurement. In the 1990s the focus was
on lowering costs by increasing processing speed, reducing labour costs and having economies of
scale. More recently the focus has shifted towards quality of service and qualitative measures such as
error rates and efficiency rates have become important. However, qualitative measures are often
difficult to implement and subjective and some organisations abandon these measures.
Definitions
Cloud computing: “Is a model for enabling ubiquitous, convenient, on-demand network access to a
shared pool of configurable computing resources (eg, networks, servers, storage, applications, and
services) that can be rapidly provisioned and released with minimal management effort or service
provider interaction”. (US Department of Commerce, National Institute of Standards and Technology)
Cloud accounting: An application of cloud computing where accountancy software is provided in the
cloud by a service provider.
Cloud accounting applications can be hosted applications or software as a service (SaaS). Hosted
applications involve using your own desktop or server accounting application and accessing the
accounting software using the internet. Using SaaS involves using a cloud accounting supplier’s
server where the accounting software and data are stored.
• There are legislation risks if the cloud supplier operates from a jurisdiction where the laws are
different from the country in which the data is being used (particularly privacy laws).
• Unannounced changes or upgrades to software could be disruptive.
3 Performance measures
Section overview
• Effective performance measures should promote goal congruence, incorporate only controllable
factors and encourage the pursuit of longer term as well as short-term objectives.
• Inappropriate performance measures may lead to sub-optimal behaviour.
• Two performance measures for investment centres that relate the profit earned to the capital
invested are Return on Investment (ROI) and Residual Income (RI).
• In certain circumstances the use of ROI as a performance measure might not lead to goal
congruent decisions.
• ROI tends to focus attention on short-term performance.
• RI is a measure of an investment centre’s profits after deducting a notional or imputed interest
cost of the capital invested in the centre.
• RI is less useful as a comparative measure because it is absolute.
• RI will encourage marginally profitable investments because it will increase if a proposed project
earns a return which is higher than the cost of capital.
One of the professional skills assessed in the ACA exams in the ability to ‘Evaluate the relevance of
information provided’. For example, a question may state the type of responsibility centre and this
will determine which performance measures are appropriate.
Definition
Return on investment (ROI): Also called return on capital employed (ROCE). It is calculated as
(profit/capital employed) × 100% and it shows how much profit has been made in relation to the
amount of resources invested.
ROI is often used as a measure to monitor the performance of an investment centre. It shows how
much profit has been earned in relation to the amount of capital invested in the centre.
ROI = (Controllable divisional profit/Divisional capital employed) × 100%
The main reason for the widespread use of ROI is that it ties in directly with the accounting system
and is identifiable from the income statement and balance sheet.
Use of the ROI facilitates comparisons but ranking is difficult as the measure is a relative percentage.
For example, is a 5% return on £1 (20p) really better than a 1% return on £1 million (£10,000)?
A B
£ £
Profit 60,000 30,000
Capital employed 400,000 120,000
ROI 15% 25%
Investment centre A has generated double the profits of investment centre B, and in terms of profits
alone has therefore been more ‘successful’. However, B has achieved its profits with a much lower
capital investment, and so has earned a much higher ROI. This suggests that B has been a more
successful investment than A.
Solution
ROI using opening carrying amount
3.7.2 Profit
Usually, the profit figure taken as the numerator in the ROI calculation is after depreciation, but this
may lead to distortion, as discussed above.
It is common for divisions and managers to be assessed on pre-tax profit, since the company’s
ultimate tax charge is likely to be significantly affected by central decisions and is therefore not
controllable by divisional managers.
However, it is important that managers are made aware of the tax implications of their operational
decisions.
Requirement
Would the division manager accept a project requiring capital of £100,000 and generating profits of
£25,000, if the manager were paid a bonus based on ROI?
Solution
Although the project ROI is acceptable to the company (25%), the manager would not be motivated
to accept a project which lowers divisional ROI.
A limitation of ROI is that it tends to focus attention on short-term performance, whereas investment
decisions should be evaluated over their full life.
Definition
Residual income: Profit less a notional interest charge for invested capital.
An alternative way of measuring the performance of an investment centre is residual income (RI). RI is
a measure of the centre’s profits after deducting a notional or imputed interest cost of the capital
invested in the centre.
RI can avoid some of the behavioural problems of dysfunctionality that arise with the use of ROI.
Solution
£’000
Divisional RI without the project:
Divisional profit 300
Imputed interest charge (20% × £1m) 200
100
RI of the project
Profit 25
Imputed interest charge (20% × £100,000) 20
5
The RI would increase therefore the manager would accept the project. In this particular
circumstance, RI would lead to the correct decision since the project ROI of 25% is acceptable to the
company.
Note that the ROI and the RI are both based on the same figures for profits and capital employed.
The difference is that ROI is a relative measure whereas RI is an absolute measure.
Division 1 Division 2
Capital employed £1,000,000 £100,000
Controllable profits:
Year 1 £200,000 £20,000
Year 2 £220,000 £40,000
Requirements
Which of the two divisions is performing better, using the following performance measures?
(a) Residual income
(b) Return on investment
Solution
(a)
Division 1 Division 2
£’000 £’000
Year 1
Divisional profit 200 20
Imputed interest charge
(£1,000,000 × 20%) 200
(£100,000 × 20%) 20
RI – –
Year 2
Divisional profit 220 40
Imputed interest charge 200 20
20 20
Using RI the relative performance of the two divisions appears to be the same. Both divisions
have increased the annual RI by £20,000.
(b)
Division 1 Division 2
Year 1 £200,000/£1,000,000 20%
£20,000/£100,000 20%
Return on investment shows that division 2 is out-performing division 1. Despite earning the
same absolute increase in RI, it is much easier for the larger division to generate a further
£20,000 of RI. Hence using RI to compare divisions of different sizes is misleading.
ROI RI
Without investment
% £
With investment
% £
One of the professional skills assessed in the ACA exams is the ability to ‘Interpret information
provided in various formats’. This could include the calculation of ROI or RI to assess performance.
• The balanced scorecard approach to the provision of information focuses on four different
perspectives: customer, innovation and learning, financial and internal business.
• The information provided in the balanced scorecard includes both financial and nonfinancial
elements.
• As with all techniques, problems can arise when the balanced scorecard approach is applied.
4.1 Introduction
Definition
Balanced scorecard approach: An approach to the provision of information to management to help
strategic policy formulation and achievement. It emphasises the need to provide the user with a set
of information which addresses all relevant areas of performance in an objective and unbiased
fashion. The information provided may include both financial and non-financial elements, and cover
areas such as profitability, customer satisfaction, internal efficiency and learning and growth.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify gaps in evidence’.
The balanced scorecard is a performance measure designed to measure more than just profit.
The balanced scorecard was developed to help companies manage the multiple objectives they
have to satisfy to compete in today’s markets. Traditional accounting measures have a number of
weaknesses that make them less relevant today.
• They tend to concentrate on a single factor, eg, profit, revenue, ROI or RI
• They are primarily historical, eg, how have we done compared with last year
• They are capable of distortion
• There is often confusion between measures and objectives
• Traditional accounting performance measures are of little use as a guide to action
4.5 Problems
As with all techniques, problems can arise when the balanced scorecard is applied.
Problem Explanation
Conflicting measures Some measures in the scorecard such as research funding and cost
reduction may naturally conflict. It is often difficult to determine the
balance which will achieve the best results.
Selecting measures Not only do appropriate measures have to be devised but the number of
measures used must be agreed. Care must be taken that the impact of the
results is not lost in a sea of information.
Too many measures The ultimate objective for commercial organisations is to maximise profits
or shareholder wealth. Other targets should offer a guide to achieving this
objective and not become an end in themselves.
5 Budgetary control
Section overview
Definition
Fixed budget: A budget which is set for a single activity level.
The master budget prepared before the beginning of the budget period is known as the fixed
budget. By the term ‘fixed’, we do not mean that the budget is kept unchanged. Revisions to a fixed
master budget will be made if the situation so demands. The term ‘fixed’ means the following.
(a) The budget is prepared on the basis of an estimated volume of production or output and an
estimated volume of sales, but no plans are made for the event that actual volumes of
production and sales may differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to represent a new target for
the new levels of activity.
The major purpose of a fixed budget lies in its use at the planning stage, when it seeks to define the
broad objectives of the organisation.
Fixed budgets (in terms of a pre-set expenditure limit) are also useful for controlling any fixed cost,
and particularly non-production fixed costs such as advertising, because such costs should be
unaffected by changes in activity level (within a certain range).
Definition
Flexible budget: A budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Units of output
produced Cost of factory power
£
20X1 7,900 38,700
20X2 7,700 38,100
20X3 9,800 44,400
20X4 9,100 42,300
• Fixed costs
£
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
• Inflation is to be ignored.
2 Calculate the budget cost allowance (ie, expected expenditure) for 20X6 assuming that 57,000
direct labour hours are worked.
Solution
1
WORKING
Semi-variable costs
Using the high-low method:
£
Total cost of 64,000 hours 20,800
Total cost of 40,000 hours 16,000
Variable cost of 24,000 hours 4,800
Variable cost per hour (£4,800/24,000) 0.20
£
Total cost of 64,000 hours 20,800
Variable cost of 64,000 hours (× £0.20) 12,800
Fixed costs 8,000
£
60,000 hours (60,000 × £0.20) + £8,000 = 20,000
54,000 hours (54,000 × £0.20) + £8,000 = 18,800
48,000 hours (48,000 × £0.20) + £8,000 = 17,600
2 The budget cost allowance for 57,000 direct labour hours of work would be as follows.
£
Variable costs (57,000 × £9.12) 519,840
Semi-variable costs (£8,000 + (57,000 × £0.20)) 19,400
£
Fixed costs 72,000
611,240
Actual
Budget results Variance*
Production and sales of the CL (units) 2,000 3,000
£ £ £
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100 (A)
* The variance is the difference between the budget and the actual results. A favourable variance (F)
indicates that the difference would result in a higher profit (higher sales revenue or lower cost). An
adverse variance (A) indicates that the difference would result in a lower profit (lower sales revenue
or higher cost).
(a) In this example, the variances are meaningless for purposes of control. Costs were higher than
budget because the volume of output was also higher; variable costs would be expected to
increase above the budgeted costs in the fixed budget. There is no information to show whether
control action is needed for any aspect of costs or revenue.
(b) For control purposes, it is necessary to know the answers to questions such as the following.
– Were actual costs higher than they should have been to produce and sell 3,000 CLs?
– Was actual revenue satisfactory from the sale of 3,000 CLs?
Notes
1 Column (b) – Column (a) = £5,400 – £1,900 = £3,500 (F) Volume variance
2 Column (c) – Column (b) = £6,800 – £5,400 = £1,400 (F) Expenditure variance
3 £3,500 (F) Volume variance + £1,400 (F) Expenditure variance = £4,900 (F) Total variance
Notice that the total variance has not altered. It is still £4,900 (F) as before. The flexible budget
comparison merely analyses the total variance into two separate components.
£ £
Budgeted sales revenue increased by 10,000
Budgeted variable costs increased by:
Direct materials 3,000
Direct labour 2,000
Maintenance 500
Variable element of other costs 1,000
6,500
£ £
Budgeted fixed costs are unchanged –
Budgeted profit increased by 3,500
Budgeted profit was therefore increased by £3,500 because sales volume increased. This is the
£3,500 favourable volume variance.
(c) A full variance analysis statement would be as follows.
£ £ £
Fixed budget profit 1,900
Variances
Sales volume 3,500 (F)
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance cost 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and rates 100 (A)
Total expenditure variance 700 (A) 2,100 (F) 1,400 (F)
Actual profit 6,800
If management believes that any of these variances are large enough to justify it, they will investigate
the reasons for them to see whether any corrective action is necessary.
(7) Production and sales of product R in period 6 amounted to 5,500 units. Budgeted output for the
period was 4,000 units. Actual total expenditure was £82,400.
We mentioned in Section 1.4 that bias or manipulation of accounting results is more likely to occur
when a manager is under pressure to achieve short-term budget targets. The fact that companies
report their results on a yearly basis, and may be under pressure from shareholders and market
analysts to deliver results, means they may be forced into measures that boost profits in the short
term, but which may create problems in the longer term and, as a result, could potentially threaten
the sustainability of the business. The focus on the short term can occur when ROI is used for
performance measurement (Section 3.7.3). Using the balanced scorecard (Section 4) can help to
reduce the problem.
Other types of bias, such as those mentioned in Chapter 6 ‘Budgeting’, can also affect performance
management and therefore professional scepticism is required.
Omitted variable bias/cause and For example, attributing performance (good or bad) to the
effect wrong variable.
Environment
Social
Governance
Social Evidence
KPI
Environmental Evidence
KPI
Percentage change in utilities usage since prior Supplier bills for gas, water and electricity to
year compare the cost and volume supplied versus
the previous year
Summary
Decentralisation
Responsibility centres
Performance
Balanced scorecard measures related to
capital employed
Perspectives:
• Financial
• Customer
• Internal business Return on Residual
• Innovation and learning investment (ROI) income (RI)
Budgetary control
• Dysfunctional focus • Reduces
on short-term dysfunctional
performance behaviour
Fixed budget Flexible budget • Most useful as a • Encourages
comparative marginal
For a single Realistic budget measure investments
activity level cost allowance for
actual activity level
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
5. Do you know the performance measures suitable for each type of responsibility centre?
(Topic 3)
7. Do you know the difference between fixed and flexible budgets? (Topic 5)
8. Can you explain how data bias can occur in performance management? (Topic 6)
Self-test questions
Annual
Outlay profit
£’000 £’000
Investment Q 1,400 350
Investment R 600 200
Investment S 400 88
Requirement
Which combination of investments will maximise the division’s return on investment?
A Investment Q only
B Investment R only
C Investments Q and R
D Investments Q, R and S
7 On the last day of the financial year an investment centre has net assets with a total carrying amount
of £1.2 million, with a return on investment (ROI) of 15%.
The manager of this division is considering selling one of its non-current assets immediately before
the year end. The non-current asset has a carrying amount of £105,000 and a net realisable value of
£80,000.
Requirement
What would be the division’s ROI immediately after the sale of the asset at the end of the year?
A 13.2%
B 14.2%
C 15.3%
D 16.4%
8 A divisionalised company uses return on investment (ROI) and residual income (RI) to assess the
performance of its divisions. Straight-line depreciation is used and assets are valued at net book
value. If the cash flows from a new investment in a depreciable non-current asset are likely to be
constant over the life of the investment, what will be the effect of the investment on the ROI and RI
over the life of the asset?
A ROI – Increase; RI – Increase
B ROI – Increase; RI – No change
C ROI – No change; RI – No change
Activity level
80% 90%
£ £
Direct material 3,200 3,600
Direct labour 2,800 2,900
Production overhead 5,400 5,800
Total production cost 11,400 12,300
Requirement
The total production cost in a budget that is flexed at the 88% level of activity will be:
11 Lxt Ltd has used a chart to highlight the difference in performance of two of its divisions, Division A
and Division B. The chart has been presented so that Division A will be perceived as having
performed significantly better than Division B.
Requirement
What type of bias has Lxt Ltd introduced?
A Confirmation bias
B Survivorship bias
C Omitted variable bias
D Cognitive bias
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
ROI RI
WORKING
ROI & RI
RI
£ £
Profit 119,700 128,200
Imputed interest charge:
£570,000 × 15% 85,500
£620,000 × 15% 93,000
34,200 35,200
Customer perspective
• Number of cases won
• Number of new clients won through recommendations
• Cost of key services (eg, conveyancing) compared to other local firms
Innovation and learning
• Continuing Professional Development (CPD) courses attended
• New services offered
• New methods of service delivery introduced (eg, online Wills)
Internal business perspective
• Time taken to process key services (eg, to draft and type Wills)
• Administration cost (eg, courier services, website maintenance)
• Speed of accessing archives
• Ease of access to legislative and case law databases
£ 45,600
WORKING
Budgeted cost of factory power
Units £
20X3 (highest output) 9,800 44,400
20X2 (lowest output) 7,700 38,100
2,100 6,300
£
Total of factory power in 20X3 44,400
Less variable cost of factory power (9,800 × £3) 29,400
Fixed cost of factory power 15,000
£
Fixed cost 15,000
Variable cost of budgeted production (10,200 × £3) 30,600
Total budgeted cost of factory power 45,600
(7) Production and sales of product R in period 6 amounted to 5,500 units. Budgeted output for the
period was 4,000 units. Actual total expenditure was £82,400.
(a) The total expenditure variance for period 6 was £ 2,600 favourable
WORKINGS
(1) Direct material
Direct material is a variable cost of £16,000/4,000 = £4 per unit.
Budget cost allowance for 5,100 units = 5,100 × £4 = £20,400.
(2) Direct labour
Direct labour is a semi-variable cost which can be analysed using the high-low method.
Output
units £
High 5,500 24,500
Low 4,000 20,000
Change 1,500 4,500
£
Variable cost = 5,100 × £3 15,300
Fixed cost 8,000
23,300
Output
units £
High 5,500 9,500
Low 4,000 8,000
Output
units £
Change 1,500 1,500
£
Variable cost = 5,100 × £1 5,100
Fixed cost 4,000
9,100
1 Correct answer(s):
B Head office costs
Head office costs are not controllable by the divisional manager and should be excluded from the
calculation of controllable divisional profit.
2 Correct answer(s):
D Data protection legislation in Ceeland may be less strict than in Beeland
The use of cloud accounting applications is not aimed at reducing staff costs; accounts staff will still
be required so option A is not correct. As a well-established and reputable international supplier, it is
to be expected that Distant Inc can support the requirements of overseas customers so any
questions over accounting standards is unlikely to be a significant consideration (option B). We do
not know in which currency Distant will charge its subscription fee, but again this would not represent
a major consideration in the decision as to which supplier to use (option C) as Slack Ltd could choose
to manage any exposure to foreign currency risk. The major consideration for Slack Ltd is the fact that
data protection legislation may vary between Beeland and Ceeland (option D); if Ceeland is less
strict then Slack Ltd needs to make sure that its company and customer data is properly protected.
3 Correct answer(s):
B ROI – No; RI – Yes
ROI on marginal investment = £45,000/£180,000
= 25%
This is higher than the cost of capital therefore it would be acceptable to the company as a whole.
However, the manager would reject the project based on ROI because it is lower than the current
divisional ROI.
Incremental RI = £45,000 – (£180,000 × 20%)
= £9,000
Therefore, the manager would accept the project if performance was assessed on the basis of
residual income. This would be acting in the interest of the company as a whole.
4 Correct answer(s):
D Sales
The sales perspective is not one of the four perspectives of the balanced scorecard approach. The
four perspectives are financial, innovation and learning, internal business and customer.
5 Correct answer(s):
C 18.5%
Imputed interest is £1,850,000 – £750,000 = £1,100,000. With interest at 11%, capital must be £10m.
ROI = £1,850,000/£10,000,000 = 18.5%.
6 Correct answer(s):
C Investments Q and R
Investment Q only = (£480,000 + £350,000)/(£2,400,000 + £1,400,000) = 21.8%
Investment R only = (£480,000 + £200,000)/(£2,400,000 + £600,000) = 22.7%
Investments Q and R = (£480,000 + £350,000 + £200,000)/(£2,400,000 + £1,400,000 + £600,000) =
23.4%
Investments Q, R and S = (£480,000 + £350,000 + £200,000 + £88,000)/(£2,400,000 + £1,400,00 +
£600,000 + £400,000) = 23.3%
7 Correct answer(s):
A 13.2%
£
Original profits = 15% × £1.2m 180,000
Loss on sale of asset = £105,000 – £80,000 25,000
Revised profits 155,000
8 Correct answer(s):
A ROI – Increase; RI – Increase
If returns are constant and the value of the asset base is falling, both ROI and RI will increase.
9 Correct answer(s):
C The budgeted cost expected for the actual level of activity achieved during the period
A budget cost allowance is the expected expenditure in a budget which has been flexed to the
actual level of activity. It includes a basic, unchanged allowance for fixed costs and an amount for
variable costs according to the level of activity.
Option A describes a functional budget and option B is an imposed or top-down budget. A budget
cost allowance includes an amount for variable overhead therefore option D is not correct.
10 The total production cost in a budget that is flexed at the 88% level of activity will be:
£ 12,120
WORKING
£
Direct labour and production overhead
At 80% activity 8,200
At 90% activity 8,700
Change 10% 500
£
Variable cost = 80 × £50 4,000
Total cost 8,200
Fixed cost 4,200
£
Direct material (88 × £40) 3,520
Direct labour and production overhead: Variable (88 × £50) 4,400
Fixed 4,200
12,120
11 Correct answer(s):
D Cognitive bias
Cognitive bias relates to human perception and includes bias introduced depending on how data is
presented (the framing effect).
Chapter 9
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Standard costing and standard costs
2 Cost variances
3 Sales variances and operating statements
4 Interpreting variances and deriving actual data from variance
detail
5 Data bias in variance analysis
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
Downloaded by V? Lê (k20b.lehoangvu@gmail.com)
lOMoARcPSD|10287105
Introduction
Learning outcomes
• Calculate differences between actual performance and standards or budgets in terms of price
and volume effects and identify possible reasons for those differences
• Identify issues relating to the collection of data (data bias) and interpretation of data (professional
scepticism) for performance management
The specific syllabus reference for this chapter is: 3c, d.
9
Syllabus links
An understanding of variance analysis as a part of the work of the finance function will be necessary
for your Business, Technology and Finance syllabus and as a part of performance measurement
within that syllabus.
9
Examination context
The calculation and analysis of variances lends itself well to numerical exam questions. However, you
are also likely to be presented with narrative questions, perhaps testing your understanding of the
meaning of calculated variances.
The examiner is also likely to ask you to ‘work backwards’ from variance information to derive extracts
from the actual results or the original standards. This requires a thorough understanding of the
methods of variance calculation and of the meaning of the results of the calculations.
In the examination, students may be required to:
• calculate and interpret variances for variable costs
• calculate and interpret contribution-based variances for sales
• derive actual cost and standard cost data from calculated variances
• demonstrate an understanding of the meaning and use of standard cost operating statements
• recognise data bias and know how to apply professional scepticism
Traditionally students find variances a difficult area. They can be approached in a tabular manner or
using formulae – find the one that suits you best. Understanding the meaning can help with
understanding and remembering the calculations.
9
exam.
Stop and think
Why might a selling
price be different
from the budgeted
amount?
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• Standard costing is the preparation of standard costs to use in variance analysis, a key
management control tool.
• Standards for each cost element are made up of a monetary component and a resources
requirement component.
• Standard costing enables the principle of management by exception to be practised.
• If they are to continue to be useful for control purposes, standard costs must be revised whenever
there are changes in required resource inputs or in the price of resources.
Definition
Standard costing: Defined by the Chartered Institute of Management Accountants as a ‘control
technique that reports variances by comparing actual costs to pre-set standards so facilitating action
through management by exception’. (CIMA Official Terminology, 2005)
Standards provide an expected cost for one unit of output. A budget is a financial plan for a period
of time. However, standard costs can be used in the preparation of budgets.
When standard costs are used, budgetary control variance analysis is based on a comparison
between actual results and a flexed budget that uses standard costs. The particular advantage of
standard costs is that the cost information consists of a quantity of resources (units of raw material,
hours of direct labour and variable overheads) and a price per unit of resource (cost per kilogram of
material or cost per hour for labour, etc).
As a result of this extra information, the analysis of the cost variances can be more detailed, and so
can provide more control information to management.
Definition
Management by exception: Defined by CIMA as the ‘practice of concentrating on activities that
require attention and ignoring those which appear to be conforming to expectations. Typically
standard cost variances or variances from budget are used to identify those activities that require
attention.’ (CIMA Official Terminology)
• Establish a measurable cost unit. This is relatively easy in some service organisations. For
example, cost units for transport companies, such as a passenger-mile or a tonne-mile, or for
hotels, such as a guest-night. (You might recall that these are referred to as composite cost units.)
• Attempt to reduce the heterogeneity of services. If every service provided to the customer is the
same as the last, then it will be possible to set a standard cost for the service and use this to
maximise efficiency and reduce waste.
• Reduce the element of human influence. This can be achieved by swapping machines for humans
wherever possible.
2 Cost variances
Section overview
• Variances measure the difference between actual results and expected results. The process by
which the total difference between standard and actual results is analysed is known as variance
analysis.
• The material total variance can be divided into the material price variance and the material usage
variance.
• Since material inventories are usually valued at standard cost in a standard costing system,
material price variances are usually extracted at the time of purchase of the materials, rather than
at the time of usage.
• The labour total variance can be divided into the labour rate variance and the labour efficiency
variance.
• The variable overhead total variance can be divided into the variable overhead expenditure
variance and the variable overhead efficiency variance.
• If the variable overhead rate is stated in terms of a rate per labour hour, then the variable
overhead efficiency variance, in hours, is exactly the same as the labour efficiency variance in
hours, and it occurs for the same reasons.
• The fixed overhead expenditure variance is the difference between the budgeted and actual fixed
overhead expenditure in the period.
2.1 Variances
Definitions
Variance: Defined by CIMA as ‘the difference between a planned, budgeted, or standard cost and
the actual cost incurred. The same comparisons may be made for revenues.’ (CIMA Official
Terminology, 2005)
Variance analysis: Defined as the ‘evaluation of performance by means of variances, whose timely
reporting should maximise the opportunity for managerial action’. (CIMA Official Terminology, 2005)
As we saw in Chapter 8, when actual results are better than expected results, we have a favourable
variance (F). If, on the other hand, actual results are worse than expected results, we have an adverse
variance (A).
One of the professional skills assessed in the ACA exams is the ability to ‘Evaluate the relevance of
information provided’. Technical knowledge of variance analysis can be used to evaluate
performance.
Definitions
Material total variance: ‘Measures the difference between the standard material cost of the output
produced and the actual material cost incurred.’ (CIMA Official Terminology, 2005)
Material price variance: The difference between the standard cost and the actual cost for the actual
quantity of material used or purchased.
Material usage variance: The difference between the standard quantity of materials that should have
been used for the number of units actually produced, and the actual quantity of materials used,
valued at the standard cost per unit of material.
The material total variance can be divided into the material price variance and the material usage
variance.
(a) The material price variance
This is the difference between the standard cost and the actual cost for the actual quantity of
material used or purchased. In other words, it is the difference between what the material did
cost and what it should have cost.
(b) The material usage variance
This is the difference between the standard quantity of materials that should have been used for
the number of units actually produced, and the actual quantity of materials used, valued at the
standard price per unit of material. In other words, it is the difference between how much
material should have been used and how much material was used, valued at standard price.
Solution
Summary
£
Price variance 18,369 (F)
Usage variance 17,000 (A)
Total variance 1,369 (F)
£
1,000 units should have cost (× £100) 100,000
but did cost 98,631
Material total variance 1,369 (F)
The variance is favourable because the units cost less than they should have cost.
Now we can break down the material total variance into its two constituent parts: the material
price variance and the material usage variance.
2 The material price variance
This is the difference between what 11,700 kg should have cost and what 11,700 kg did cost.
£
11,700 kg of Y should have cost (× £10) 117,000
but did cost 98,631
Material Y price variance 18,369 (F)
The variance is favourable because the material cost less than it should have.
3 The material usage variance
This is the difference between how many kilograms of Y should have been used to produce 1,000
units of X and how many kilograms were used, valued at the standard cost per kilogram.
The variance is adverse because more material was used than should have been used.
= £18,369 (F)
Materials usage variance = (SQ – AQ) × SP
= [(1,000 × 10 kg) – 11,700 kg] × £10
= £17,000 (A)
£
6,000 metres of material P purchased should cost (× £3) 18,000
but did cost 18,600
Price variance 600
Definitions
Labour total variance: Measures the difference between the standard labour cost of the output
produced and the actual labour cost incurred.
Labour rate variance: The difference between the standard cost and the actual cost for the actual
number of labour hours paid.
Labour efficiency variance: The difference between the hours that should have been worked for the
number of units actually produced, and the actual number of hours worked, valued at the standard
labour rate per hour.
The labour total variance can be divided into the labour rate variance and the labour efficiency
variance.
Solution
Summary
£
Rate variance 5,175 (F)
Efficiency variance 3,000 (A)
Total variance 2,175 (F)
£
1,000 units should have cost (× £20) 20,000
but did cost 17,825
Labour total variance 2,175 (F)
The variance is favourable because the units cost less than they should have done.
Again, we can analyse this total variance into its two constituent parts.
2 The labour rate variance
This is the difference between what 2,300 hours should have cost and what 2,300 hours did cost.
£
2,300 hours of work should have cost (× £10) 23,000
but did cost 17,825
Labour rate variance 5,175 (F)
The variance is favourable because the labour cost less than it should have cost.
3 The labour efficiency variance
The variance is adverse because more hours were worked than should have been worked.
Labour rate = (Standard rate of pay per hour – Actual rate of pay per hour) × Actual
variance labour hours
= (SR – AR) × AH
Labour efficiency = (Standard labour hours for actual output – Actual labour hours) ×
variance Standard rate of pay per hour
= (SH – AH) × SR
As with the materials variances, the total labour cost variance can be shown algebraically to be (SR ×
SH) – (AR × AH).
Definitions
Variable production overhead total variance: Measures the difference between the variable
production overhead that should be used for actual output and the variable production overhead
actually used.
Variable production overhead expenditure variance: Measures the actual cost of any change from
the standard variable overhead rate per hour.
Variable production overhead efficiency variance: The standard variable production overhead cost
of any change from the standard level of efficiency.
The variable overhead total variance can be subdivided into the variable overhead expenditure
variance and the variable overhead efficiency variance.
Solution
Summary
£
Variable overhead expenditure variance 532 (A)
Variable overhead efficiency variance 60 (F)
Variable overhead total variance 472 (A)
£
400 units of product X should cost (× £3) 1,200
but did cost 1,672
Variable overhead total variance 472 (A)
£
760 hours of variable overhead should cost (× £1.50) 1,140
but did cost 1,672
Variable overhead expenditure variance 532 (A)
If the variable overhead rate is stated in terms of a rate per labour hour, the variable overhead
efficiency variance is exactly the same, in hours, as the labour efficiency variance, and occurs for
the same reasons.
However, the variable overhead rate is sometimes stated in terms of a rate per machine hour, in
which case the difference must be calculated between the actual machine hours and the standard
machine hours for the output achieved.
The difference in hours, whether expressed in terms of labour hours or in terms of machine hours,
is evaluated at the standard variable overhead rate per hour.
Variable overhead expenditure = (Standard variable overhead rate per hour – Actual
variance variable overhead rate per hour) × Actual hours
= (SR – AR) × AH
Variable overhead efficiency variance = (Standard hours for actual output – Actual hours) ×
Standard variable overhead rate per hour
= (SH – AH) × SR
The standard rate per hour, and the actual and standard hours, can be expressed in terms of labour
or in terms of machine hours.
The same algebraic breakdown of variable overhead variances can be derived as for materials and
labour variances.
Definition
Fixed overhead expenditure variance: The difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
The fixed overhead expenditure variance is (Budgeted fixed overhead cost – Actual fixed overhead
cost)
The fixed overhead expenditure variance is simply the difference between the budgeted and actual
fixed overhead expenditure in the period. By definition, fixed overheads should remain the same,
regardless of the volume of production and sales. Any difference between budget and actual
spending must be due to higher-than-expected or lower-than-expected spending, and can have
nothing to do with differences in volume of activity.
• The sales price variance is a measure of the effect on expected contribution of charging a
different selling price from the standard selling price.
• The sales volume variance measures the increase or decrease in standard contribution as a result
of the actual sales volume being higher or lower than budgeted.
• Operating statements used in a standard marginal costing system show how the combination of
variances reconcile the budgeted contribution and the actual contribution for a period.
Definition
Sales price variance: A measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and the actual sales revenue.
The sales price variance is a measure of the effect on expected contribution of charging a different
selling price from the standard selling price.
Definition
Sales volume variance: The difference between the actual units sold and the budgeted (planned)
quantity, valued at the standard contribution per unit.
The sales volume variance is the difference between the actual units sold and the budgeted quantity,
valued at the standard contribution per unit. In other words, it measures the increase or decrease in
standard contribution as a result of the sales volume being higher or lower than budgeted.
£
Sales revenue from 7,700 units should have been (× £12) 92,400
but was (7,700 × £12.50) 96,250
Sales price variance 3,850 (F)
The variance is favourable because the actual price was higher than standard.
The sales volume variance is calculated as follows.
The variance is adverse because actual sales volume was less than budgeted.
Sales price variance = (Actual selling price per unit – Standard selling price per unit) ×
Actual sales quantity
= (AP – SP) × AQ
Sales volume variance = (Actual sales quantity – Budgeted sales quantity) × Standard
contribution per unit
= (AQ – BQ) × SC
Definition
Operating statement: A regular report for management of actual costs and revenues, usually
showing variances from budget.
So far, we have considered how variances are calculated in a standard marginal costing system
without considering how they combine to reconcile the difference between budgeted contribution
and actual contribution during a period. This reconciliation is usually presented as a report to senior
management at the end of each control period. The report is called an operating statement or
statement of variances.
An operating statement might look like this.
Operating statement for Period 8
£
Budgeted contribution 928,000
Sales volume variance 17,320 (A)
Sales price variance 11,830 (F)
£
cost of sales
Variable cost variances Favourable Adverse
£ £
Material price 7,120
Material usage 6,190
Labour rate 5,340
Labour efficiency 4,140
Variable overhead
expenditure 4,920
Variable overhead
efficiency 2,870
Note that favourable variances are added to the budgeted contribution and adverse variances are
subtracted, in reaching the actual profit figure.
However, in the case of the adverse fixed overhead expenditure variance, this is added to the
budgeted expenditure because the actual expenditure was higher than budgeted.
One of the professional skills assessed in the ACA exams is the ability to ‘Work effectively within time
constraints’. This is a skill required for questions on operating statements, such as the following one,
where you have lots of calculations to perform.
£ £
Materials:
P (8 kg at £0.40 per kg) 3.20
Q (4 kg at £0.70 per kg) 2.80
6.00
Labour (3 hours at £7.50) 22.50
Variable overhead (3 labour hours at £0.50) 1.50
£ £
30.00
Requirement
Complete the operating statement for Period 7 shown below. For the cost variances, make one entry
(adverse or favourable) for each variance and enter a zero or a dash in the other column. For the
sales variances, indicate in the box whether they are adverse (A) or favourable (F).
Note: The boxes in this question indicate where an answer is required and where marks are available
in the CBE. You can use the ‘add comment’ function to record your workings and answers.
Operating statement for Period 7
£
Budgeted contribution 30,000
£
£
Budgeted fixed overhead 8,600
There are several ways in which an operating statement may be presented. A common format is one
which reconciles budgeted profit to actual profit.
£
Direct materials 0.5 kg at £4 per kg 2.00
Direct wages 2 hours at £2.00 per hour 4.00
Variable overheads 2 hours at £0.30 per hour 0.60
Fixed overhead 2 hours at £3.70 per hour 7.40
Standard cost 14.00
Standard selling price 20.00
Budgeted output for the month of June Year 7 was 5,100 units. Actual results for June Year 7 were as
follows.
Production of 4,850 units was sold for £95,600.
Materials consumed in production amounted to 2,300 kg at a total cost of £9,800.
Labour hours paid for amounted to 8,500 hours at a cost of £16,800.
Variable overheads amounted to £2,600.
Fixed overheads amounted to £42,300.
Requirement
Complete the table to generate a marginal costing operating statement for the month ended 30
June Year 7.
Make one entry (adverse or favourable) for each variance and enter a zero or a dash in the other
column. Enter the net total of adverse and favourable variances as either a positive number
(favourable total) or negative number (adverse total) in the fourth column.
Solution
Operating statement for June
Favourable Adverse
£ £ £
Budgeted profit 30,600
Sales volume variance 0 3,350
Favourable Adverse
£ £ £
Sales price variance 0 1,400
Cost variances
Materials price 0 600
Materials usage 500 0
Labour rate 200 0
Labour efficiency 2,400 0
Variable overhead rate 0 50
Variable overhead efficiency 360 0
Fixed overhead expenditure 0 4,560
Total variances 3,460 9,960 (6,500)
Actual profit 24,100
WORKINGS
(1) Selling price variance
£
Revenue from 4,850 boomerangs should be (× £20) 97,000
but was 95,600
Selling price variance 1,400 (A)
£
2,300 kg of material should cost (× £4) 9,200
but did cost 9,800
Material price variance 600 (A)
£
8,500 hours of labour should cost (× £2) 17,000
but did cost 16,800
Labour rate variance 200 (F)
£
8,500 hours incurring variable o/hd
expenditure should cost (× £0.30) 2,550
but did cost 2,600
Variable overhead expenditure variance 50 (A)
£
Budgeted fixed overhead (5,100 units × 2 hrs × £3.70) 37,740
Actual fixed overhead 42,300
Fixed overhead expenditure variance 4,560 (A)
Important note
If you use the formula approach to calculate variances in a scenario-based question, make sure
that you do not round your calculations. Leave the figures unrounded in your calculator. For
example, using the formula approach, the variable overhead expenditure variance above would
be calculated like this:
If you rounded £2,600/8,500 to say, three decimal places, you would get 0.306 and you would
end up with a variance of £51 instead of £50. As these questions are computer marked, it is
important to leave the figures in your calculator.
• There is a wide range of possible reasons for the occurrence of sales and cost variances.
• Individual variances should not be looked at in isolation. It is possible that one variance is inter-
related with one or more other variances.
• Variances can be manipulated to derive actual data from standard cost details.
One of the professional skills assessed in the ACA exams is the ability to ‘Structure and analyse
financial and non-financial data to enhance understanding of business issues and their underlying
causes.’ For example, you could be asked about the reasons for certain variances in a particular
scenario.
There is a wide range of reasons for the occurrence of adverse or favourable sales and cost
variances.
The following list is not exhaustive, but it should give you an idea of the type of circumstance that
could give rise to each of the variances.
Labour efficiency
Variable overhead • As for labour efficiency (if based • As for labour efficiency (if based
efficiency on labour hours) on labour hours)
Fixed overhead • Fixed overheads include a wide range of different items of expense. Any
expenditure of these might be higher or lower than budgeted. For example, rent, rates
or insurance for the period might be higher or lower than budgeted
Sales price • Supply shortages meant customers • Supply surplus meant customers
prepared to pay higher prices wished to pay lower price
• Quantity discounts given to • Quantity discounts given to
customers were lower than customers were higher than
expected expected
• Original standard selling price set • Original standard selling price
too low set too high
One of the professional skills assessed in the ACA exams is the ability to ‘Assess interaction of
information from different sources’. For example, the interaction of information from different sources
may highlight inter-relationships between variances.
Quite possibly, individual variances should not be looked at in isolation. One variance might be
inter-related with another, and much of it might have occurred only because the other, inter-related,
variance occurred too.
Here are some examples of inter-related variances.
(a) Materials price and usage
It may be decided to purchase cheaper, lower quality materials for a job in order to obtain a
favourable price variance, possibly with the consequence that materials wastage is higher and
an adverse usage variance occurs. If the cheaper materials are more difficult to handle, there
might also be an adverse labour efficiency variance and an adverse variable overhead efficiency
variance.
If a decision is made to purchase more expensive materials, which perhaps have a longer service
life, the price variance will be adverse but the usage variance might be favourable.
(b) Labour rate and efficiency
If employees are paid higher rates for experience and skill, using a highly skilled team to do
some work would incur an adverse rate variance, but should also obtain a favourable efficiency
variance. In contrast, a favourable rate variance might indicate a larger than expected proportion
of inexperienced workers in the workforce, which could result in an adverse labour efficiency
variance, and perhaps poor materials handling and high rates of wastage or product rejections
(adverse material usage variance).
(c) Sales price and sales volume
The inter-relationship between sales price and sales volume variances should (hopefully) be
obvious to you. A reduction in the sales price might stimulate bigger sales demand, so that an
adverse sales price variance might be offset by a favourable sales volume variance. Similarly, a
price rise would give a favourable price variance, but possibly at the cost of a fall in demand and
an adverse sales volume variance.
(d) Cost and sales variances
(1) If there are favourable cost variances (perhaps cheaper labour or material have been used,
say, so that there are favourable labour rate or material price variances), the possible drop in
quality of the product could lead to an adverse sales volume variance because customers
don’t wish to buy the lower quality product.
(2) If product quality is improved this might result in an adverse cost variance.
◦ If more expensive material is used (adverse material price variance)
◦ If labour are more careful in production of the product and hence take longer than standard
(adverse labour efficiency variance)
◦ If more skilled labour is used (adverse labour rate variance)
(3) If costs have risen (resulting in adverse labour rate, material price and variable overhead
expenditure variances), the sales price might have to be increased to cover the extra costs.
This would result in a favourable sales price variance, but could lead to an adverse sales
volume variance.
4.3 Deriving actual data from standard cost details and variances
Variances can be manipulated to derive actual data from standard cost details.
£
Material 16 kg × £6 per kg 96
Labour 6 hours × £12 per hour 72
168
Solution
1
£
Total wages cost 171,320
Adjust for variances:
Labour rate (10,598)
Labour efficiency 8,478
Standard wages cost 169,200
£
Total wages cost 171,320.0
Less rate variance (10,598.0)
Standard rate for actual hours 160,722.0
× Standard rate per hour ÷ £12.0
Actual hours worked 13,393.5 hrs
3 Average actual wage rate per hour = Actual wages/actual hours = £171,320/13,393.5 = £12.79
per hour.
4 Number of kg purchased and used = x
£
x kg should have cost (× £6) 6.0x
but did cost (× £5.50) 5.5x
Material price variance 0.5x
Summary
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. Do you understand what a standard cost is and how management by exception works?
(Topic 1)
7. Do you understand the need for comparative information when variances are being
reported? (Topic 5)
Self-test questions
£
Material X 2 kg at £1.00 2
Material Y 6 kg at £1.50 9
11
There were no opening and closing inventories, and materials X and Y are not substitutable.
Requirements
Identify the correct total material price variance, including whether it is adverse or favourable.
A £150 Adverse
B £150 Favourable
C £162 Adverse
D £162 Favourable
E £210 Adverse
F £210 Favourable
G £278 Adverse
H £278 Favourable
Identify the total materials usage variance, including whether it is adverse or favourable.
I £150 Adverse
J £150 Favourable
K £162 Adverse
L £162 Favourable
M £210 Adverse
N £210 Favourable
O £278 Adverse
P £278 Favourable
2 S Limited has extracted the following details from the standard cost card of one of its products.
Labour standard = 4.5 hours @ £6.40 per hour
During March, S Limited produced 2,300 units of the product and incurred wages costs of £64,150.
The actual hours worked were 11,700.
Requirement
The labour rate and efficiency variances were:
A Rate = £10,730 (F); Efficiency = £8,640 (F)
B Rate = £10,730 (F); Efficiency = £8,640 (A)
C Rate = £10,730 (A); Efficiency = £8,640 (A)
D Rate = £10,730 (F); Efficiency = £7,402 (A)
3 The following diagram represents the standard and actual material costs incurred in manufacturing a
product.
R
Actual Z V
Standard Y U
T
Material
prices
0 Material W X
quantities Standard Actual
Requirements
Identify the area corresponding to the conventional price variance.
A WXRV
B WXTU
C YZVU
D YZRT
Identify the area corresponding to the conventional usage variance.
E WXRV
F WXTU
G YZVU
H YZRT
4 A firm incurred a total adverse labour variance of £750. The standard pay rate was £7.50 per hour,
while the actual pay rate was £8 per hour. The labour rate variance was £2,250.
Requirement
What are the flexed budgeted hours for labour?
A 4,300 hours
B 4,500 hours
C 4,600 hours
D 4,700 hours
5 Identify the most likely labour variance to arise under each of the circumstances described. Select
one option for each circumstance.
Requirements
Labour more skilled than expected
A Adverse rate
B Adverse efficiency
C Favourable rate
D Favourable efficiency
More machine breakdowns than expected
E Adverse rate
F Adverse efficiency
G Favourable rate
H Favourable efficiency
Pay increase less than expected
I Adverse rate
J Adverse efficiency
K Favourable rate
L Favourable efficiency
6 Using the table, identify the most likely impact of the following on the fixed overhead expenditure
variance. For each item, choose one of the following:
• Adverse
• Favourable
• No impact
Impact
7 The budgeted sales revenue of Thorold Ltd for August was £210,000 with an estimated selling price
of £84 and estimated variable cost per unit of £70. Actual sales in August were 2,650 units,
amounting to £219,950 revenue with a total resultant profit of £35,775.
Requirement
Indicate the monetary value of the sales volume variance, including whether it is adverse or
favourable.
A £2,025 Adverse
B £2,025 Favourable
C £2,100 Adverse
D £2,100 Favourable
E £12,450 Adverse
F £12,450 Favourable
G £12,600 Adverse
H £12,600 Favourable
8 A company had budgeted contribution of £26,700 for the latest period. The variances reported to
managers at the end of the period were as follows.
£
Material price 3,020 (A)
Labour efficiency 310 (A)
Variable overhead efficiency 217 (A)
Variable overhead total 149 (F)
Sales volume 2,700 (F)
Requirement
9 The following sales data are available for product P for the last period.
Budget Actual
Sales revenue £69,000 £79,530
Sales volume (units) 4,600 4,820
Requirement
The sales price variance for the period was:
A £3,300 (F)
B £6,900 (F)
C £7,230 (F)
D £10,530 (F)
10 Which two of the following will help to prevent bias in variance analysis?
A Neutral transfer prices
B Large management bonuses
C Variance trend information
D Focus on short-term results
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
£
Budgeted contribution 30,000
(1) Sales volume variance 2,000 (A)
(2) Sales price variance 1,120 (F)
£
Budgeted fixed overhead 8,600
(9) Fixed overhead expenditure variance 350 (F)
Actual fixed overhead 8,250
Actual profit 18,433
WORKINGS
(1) Sales volume
£
Revenue from 2,800 units should have been (× £40) 112,000
but was 113,120
Sales price variance 1,120 (F)
£ £
19,000 kg of P should cost (× £0.40) 7,600
but did cost 7,410
Material P price variance 190 (F)
14,000 kg of Q should cost (× £0.70) 9,800
but did cost 10,220
Material Q price variance 420 (A)
Total material price variance 230 (A)
Material P
2,800 units of SK should use
(× 8 kg) 22,400 kg
but did use 19,000 kg
Material P usage variance in
kg 3,400 kg (F)
× Standard price per kg × £0.40
Material P usage variance in £ £1,360 (F)
Material Q
2,800 units of SK should use
(× 4 kg) 11,200 kg
but did use 14,000 kg
Material Q usage variance in
kg 2,800 kg (A)
× Standard price per kg × £0.70
Material Q usage variance in £ £1,960 (A)
Total material usage variance
(£1,960 – £1,360) £600 (A)
£
8,300 hours of labour should cost (× £7.50) 62,250
£
but did cost 64,740
Labour rate variance 2,490 (A)
£
8,300 worked hours should cost (× £0.50) 4,150
but did cost 4,067
Variable overhead expenditure variance 83 (F)
£
100 hrs (F) × Standard rate (£0.50) 50 (F)
£
Budgeted expenditure 8,600
Actual expenditure 8,250
Fixed overhead expenditure variance 350 (F)
1 Correct answer(s):
H £278 Favourable
£ £
Material X
2,200 kg should cost (× £1.00) 2,200
but did cost 2,530
Materials price variance 330 (A)
Material Y
6,080 kg should cost (× £1.50) 9,120
but did cost 8,512
Materials price variance 608 (F)
Total materials price variance 278 (F)
Correct answer(s):
M £210 Adverse
kg £
Material X
1,010 units produced should
use (× 2 kg) 2,020
but did use 2,200
Variance in kg 180 (A)
× Standard price per kg (×
£1.00) 180 (A)
Material Y
1,010 units produced should
use (× 6 kg) 6,060
but did use 6,080
Variance in kg 20 (A)
× Standard price per kg (×
£1.50) 30 (A)
2 Correct answer(s):
B Rate = £10,730 (F); Efficiency = £8,640 (A)
£
11,700 hours should cost (× £6.40) 74,880
£
but did cost 64,150
Labour rate variance 10,730 (F)
If you selected Options A or C, you calculated the correct monetary values of the variances but
misinterpreted their direction.
If you selected Option D, you valued the efficiency variance in hours at the actual rate per hour
instead of the standard rate per hour.
3 Correct answer(s):
C YZVU
The material price variance is based on the actual quantity purchased.
Correct answer(s):
F WXTU
The usage variance is evaluated at the standard price.
4 Correct answer(s):
D 4,700 hours
The flexed budgeted hours for labour are the standard hours allowed for the actual production.
Labour rate variance = Actual hours worked × difference in labour rate
2,250 = Actual hours worked × (£8.00 – £7.50)
Actual hours worked = 4,500
Since total labour variance = Efficiency variance + rate variance
Therefore, £750 (A) = Efficiency variance + £2,250 (A)
Therefore, efficiency variance = £1,500 (F)
1,500 (F) = Saving in labour hours compared with standard × standard rate per hour
Saving in labour hours = £1,500/£7.50
= 200 hours
Therefore, standard hours for actual production = 4,500 hours worked + 200 hours saved
= 4,700 hours
5 Correct answer(s):
D Favourable efficiency
More skilled workers would work at a faster rate.
Correct answer(s):
F Adverse efficiency
Labour hours would still be recorded but there would be no output.
Correct answer(s):
K Favourable rate
The hourly rate of pay would be lower than that used in the standard cost calculation.
6
Impact
Fixed overhead expenditure would not be affected by a marginal increase in the volume of activity.
Energy costs related to consumption are variable overheads.
7 Correct answer(s):
D £2,100 Favourable
£
Budgeted contribution 26,700
Variances
Material price (3,020)
Labour efficiency (310)
Variable overhead total 149
(Excluding variable overhead efficiency because included within the total
variance) –
Sales volume variance 2,700
Actual contribution 26,219
9 Correct answer(s):
C £7,230 (F)
Standard sales price per unit = £69,000/4,600
= £15
£
4,820 units should sell for (× £15) 72,300
but did sell for 79,530
Sales price variance 7,230 (F)
10 Correct answer(s):
Chapter 10
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Breakeven analysis and contribution
2 Breakeven charts
3 Limiting factor analysis
Summary
Further question practice
Self-test questions
Answers to Interactive questions
Answers to Self-test questions
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Introduction
10
Learning outcomes
• Calculate the breakeven point, contribution and margin of safety for a given product or service
• Allocate scarce resource to those products and services with the highest contribution per limiting
factor
The specific syllabus references for this chapter are: 4a and b.
10
Syllabus links
You will study the identification and management of limiting factors in more depth in the context of
the Business Strategy and Technology syllabus.
10
Examination context
Examination questions about breakeven analysis and limiting factor analysis can be quite
complicated but there are strict decision rules which can be applied in every question of this type.
For example, unless otherwise stated, the absolute amount of expenditure on fixed costs and the
variable cost per unit remain the same for every level of activity.
Questions on this area of the syllabus will usually involve some calculations.
In the examination, students may be required to:
• calculate the breakeven point, margin of safety and contribution ratio for a product or service
• calculate the volume of sales or level of activity required to achieve a target profit for the period
• calculate the effect on profit, breakeven point, etc, of changes in the major decision variables
• identify the optimum production plan or similar when a resource is in limited supply, and when:
– there is a maximum and/or minimum limit on the demand for individual products or services;
and/or
– it is possible to alleviate the resource restriction by subcontracting work to parties outside the
business.
This area involves students following a logical series of steps (or rules) which must be learned. The
most difficult type of question in this area normally involves consideration of the possibility of sub
contracting or outsourcing work.
10
3 Limiting factor analysis In section 3 learn This area requires you IQ4: Limiting
An understanding of the series of steps to follow a logical factors
the contribution required to series of steps (or The first step in
earned by different maximise rules) which must be limiting factor
products and services contribution in a learned. The most decisions is to
will also help managers limiting factor difficult type of establish which
to determine how best situation. Section question in this area resources are
to allocate a restricted 3.4 is particularly normally involves limiting factors.
resource in order to important because consideration of the
maximise contribution. a make or buy possibility of
If you are managing a decision with scarce subcontracting or IQ5: Limiting
team of auditors you resources often outsourcing work. factor analysis
might at times have causes difficulty for This question
more work available students. A definite provides good
decision rule is
ICAEW 2023 10: Breakeven analysis and limiting factor analysis 355
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Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
1.1 Contribution
Definition
Breakeven analysis: An analysis of costs, volume and profit at various levels of activity. Also known as
cost-volume-profit (CVP) analysis.
Definition
Breakeven point: Number of units sold at which neither a profit nor a loss is made.
The management of an organisation usually wishes to know the profit likely to be made if the aimed
for production or activity and sales for the year are achieved. Management may also be interested to
know the activity level at which there is neither profit nor loss. This is known as the breakeven point.
The breakeven point (BEP) can be calculated as:
Breakeven point = Number of units of sale required to break even
= Total fixed costs/Contribution per unit
= Contribution required to breakeven/Contribution per unit
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Requirement
Compute the breakeven point.
Solution
The contribution per unit is £(8 – 5) = £3
Contribution required to break even = fixed costs = £21,000
Breakeven point (BEP) = £21,000/3
= 7,000 units
In revenue, BEP = (7,000 × £8) = £56,000
Sales above £56,000 will result in profit of £3 per unit of extra sales and sales below £56,000 will
mean a loss of £3 per unit for each unit by which sales fall short of 7,000 units. In other words, profit
will improve or worsen per unit of sales by the level of contribution per unit.
If the selling price is £10 per unit, the number of units of W that must be sold is .
Definition
Margin of safety: The difference in units between the budgeted sales volume and the breakeven
sales volume. It is sometimes expressed as a percentage of the budgeted sales volume.
As well as being interested in the breakeven point, management may also be interested in the
amount by which actual sales can fall below anticipated sales without a loss being incurred. This is
the margin of safety.
The margin of safety is the difference in units between the budgeted or expected sales volume and
the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales
volume. Alternatively, the margin of safety can be expressed as the difference between the budgeted
sales revenue and breakeven sales revenue, expressed as a percentage of the budgeted sales
revenue.
Solution
Breakeven point = Total fixed costs/Contribution per unit = £70,000/£(40 – 30)
= 7,000 units
Margin of safety = 8,000 – 7,000 units = 1,000 units
which may be expressed as (1,000 units/8,000 units) × 100% = 12½% of budget
The margin of safety indicates to management that actual sales can fall short of budget by 1,000
units or 12½% before the breakeven point is reached and no profit is made.
Solution
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£ per unit
Materials 10
Labour 8
Production overhead 6
24
The sales price is £30 per unit, and fixed costs per annum are £68,000. The company wishes to make
a profit of £16,000 per annum.
Requirement
Determine the sales required to achieve this profit.
Solution
Since the contribution earned in a period is literally the contribution towards fixed costs and profit, in
order to achieve a certain target profit the contribution required is equal to the fixed costs plus the
target profit.
Required contribution = fixed costs + profit = £68,000 + £16,000 = £84,000
Required sales can be calculated in one of two ways.
(1) Required contribution/Contribution per unit = £84,000/£(30 – 24) = 14,000 units, or £420,000 in
revenue
(2) Required contribution/Contribution ratio = £84,000/20%* = £420,000 of revenue, or 14,000
units
* Contribution ratio = £(30 – 24)/£30 = £6/£30 = 0.2 = 20%
Solution
The volume of sales required is one which would leave total profit the same as before, ie, £3,000 per
month. Required profit should be converted into required contribution, as follows.
£
Monthly fixed costs 2,600
Monthly profit required 3,000
Current monthly contribution 5,600
The volume of sales required after the price rise will be an amount which earns a contribution of
£5,600 per month, the same as before. The contribution per cake at a sales price of £0.29 would be
(£0.29 – £0.15) = £0.14.
Required sales = Required contribution/Contribution per unit = £5,600/£0.14 = 40,000 cakes per
month
Solution
1 The current unit contribution is £(18 – (8 + 2)) = £8
£
Current contribution (6,000 × £8) 48,000
Less current fixed costs 40,000
Current profit 8,000
With the new machine fixed costs will increase by £10,000 to £50,000 per annum. The variable
cost per unit will reduce to £(6 + 2) = £8, and the contribution per unit will increase to £10.
£
Required profit (as currently earned) 8,000
Fixed costs 50,000
Required contribution 58,000
£
Profit at 5,800 units of sale (see 1) 8,000
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£
Contribution from sale of extra 200 units (× £10) 2,000
Profit at 6,000 units of sale 10,000
2 Breakeven charts
Section overview
• A breakeven chart is a chart that indicates the profit or loss at different levels of sales volume
within a limited range.
• A traditional breakeven chart has a line for sales revenue, for fixed costs and for total costs.
• The breakeven point is at the intersection of the sales line and the total costs line.
• A contribution breakeven chart depicts variable costs, so that contribution can be read directly
from the chart.
• Despite the usefulness of breakeven analysis, the technique has some serious limitations.
One of the professional skills assessed in the ACA exams is the ability to ‘Interpret information
provided in various formats’. This could include breakeven charts.
The breakeven point can be determined graphically using a breakeven chart. A breakeven chart is a
chart that indicates the profit or loss at different levels of sales volume within a limited range.
A breakeven chart has the following axes.
• A horizontal axis showing the sales/output (in value or units).
• A vertical axis showing £ for sales revenues and costs.
Solution
We begin the construction of the breakeven chart by calculating the profit at the budgeted annual
output.
£
Sales (120,000 units) 120,000
Variable costs 60,000
Contribution 60,000
Fixed costs 40,000
Profit 20,000
£
Fixed costs 40,000
Variable costs 120,000 × 50p 60,000
Total costs 100,000
(4) The sales line is also drawn by plotting two points and joining them up.
– At zero sales, revenue is nil.
– At the budgeted output and sales of 120,000 units, revenue is £120,000.
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£'000
120
Budgeted profit
100
Breakeven point
80
ts Budgeted variable costs
60 al cos
Tot
Fixed costs
40
s Margin
ale
20 S of safety Budgeted fixed costs
0
0 20 40 60 80 100 120 '000 Units
120
Budgeted
profit
100
Budgeted
Breakeven point
contribution
80
s
ost
60 al c
Tot
s
40
cost
l es i a ble
20 Sa Var
0
0 20 40 60 80 100 120 '000 Units
If you look back at the traditional breakeven chart shown in the previous Worked example, you will
see that the breakeven point is the same, but that the budgeted contribution can now be read more
easily from the chart.
Breakeven point
sts c
co
Total
Fixed costs
s
le
Sa d
a
Units
Budgeted sales
One of the professional skills assessed in the ACA exams is the ability to ‘Identify assumptions or
faults in arguments’. For example, you could be asked about the assumptions made in CVP analysis.
CVP analysis is a useful technique for managers. It can provide simple and quick estimates, and
breakeven charts provide a graphical representation of breakeven arithmetic. It does, however, have
a number of limitations.
• It can only apply to a single product or a constant mix of a group of products.
• A breakeven chart may be time-consuming to prepare.
• It assumes fixed costs are constant at all levels of output.
• It assumes that variable costs are the same per unit at all levels of output.
• It assumes that sales prices are constant at all levels of output.
• It assumes production and sales are the same (inventory levels are ignored – effectively marginal
costing is used).
• It ignores the uncertainty in the estimates of sales prices, fixed costs and variable cost per unit.
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Questions on limiting factors will require you to ‘Identify and apply relevant technical knowledge and
skills to analyse a specific problem’. For example, you could be asked to produce the optimum
production plan.
Definition
Limiting factor: Anything that limits the activity of a business.
One of the more common problems faced by management is a situation where there are insufficient
resources to meet the potential sales demand. In this situation a decision has to be made about what
mix of products to manufacture or services to provide, using the available resources as effectively as
possible. The resource that limits the organisation’s ability to meet sales demand is called a limiting
factor or key factor.
A limiting factor or key factor is ‘anything which limits the activity of an entity’. An entity seeks to
optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a
resource or a restriction on sales demand at a particular price.
A limiting factor could be sales if there is a limit to sales demand but any one of the organisation’s
resources (labour, materials and so on) may be insufficient to meet the level of production
demanded.
It is assumed in limiting factor analysis that management wishes to maximise profit and that since
there is no change in the fixed cost incurred profit will be maximised when contribution is
maximised.
Ay Be
£ £
Materials 1 3
Labour (£9 per hour) 18 9
Overhead 1 1
20 13
The sales price per unit is £26 per Ay and £17 per Be. During July 20X2 the available labour is
limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for
Bes.
Requirement
Determine the profit-maximising production mix, assuming that monthly fixed costs are £20,000, and
that no inventories are held.
Solution
Step 1
Confirm that the limiting factor is something other than sales demand.
Ay Be Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs
Ay Be
£ £
Sales price 26 17
Variable cost 20 13
Unit contribution 6 4
Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to
make one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.
Step 3
Determine the optimum production plan. Sufficient Bes will be made to meet the full sales demand,
and the remaining labour hours available will then be used to make Ays.
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Hours Contribution
Product Units needed per hour Total
£ £
Bes 5,000 5,000 4 20,000
Ays 1,500 3,000 3 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000
£
Variable material (£3 per kg) 12
Variable labour (£8 per hour) 72
Production overhead 48
Total production cost 132
Demand for next period will be 20,000 units. No inventories are held and only 75,000 kg of material
and 190,000 hours of labour will be available.
Requirement
Indicate which resource or resources represent a limiting factor for LF Ltd.
Materials
Labour
X Y Z
£’000 £’000 £’000
Sales 1,000 1,125 625
X Y Z
£’000 £’000 £’000
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Fixed overheads (200) (315) (130)
Profit/(loss) 50 60 (5)
Annual sales demand (units) 5,000 7,500 2,500
Machine hours per unit 20 21 26
However, after the budget had been formulated, an unforeseen condition has meant that during the
next period the available machine capacity has been limited to 296,500 hours.
Requirement
Complete the following.
(1) The shortfall in available machine hours for next period is hours.
(3) The number of units of each product that should be manufactured next period is:
X1 Y2 Z3
Maximum demand (units) 10,000 12,000 8,000
Optimum planned production (units) 7,000 12,000
Contribution (per unit) £15 £20 £10
Material cost per unit (@ £3 per kg) £9 £6 £7.5
The planned production is based on optimising the use of the current supply of materials at £3 per
kg. A new supplier has offered to supply an additional 25,000 kg of material.
Requirement
Calculate the maximum total price that HMF Ltd should pay for the extra 25,000 kg of materials.
Solution
Step 1
Identify the contribution earned by each product per unit of limiting factor, that is per kg of material,
and rank products.
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In this case, the question states that the planned production is based on the optimal use of materials.
We can therefore conclude that Y2 has the highest contribution per kg as 12,000 units are produced
to meet the maximum demand. We can also conclude that Z3 has the lowest contribution per kg as
no units are produced.
Step 2
Determine the optimum production plan using the extra resource. 12,000 units of Y2 and 7,000 units
of X1 will be made from the existing materials available. The additional materials purchased from the
new supplier will be used to make the outstanding demand of X1s and Z3s.
Step 3
Determine the contribution earned from the extra resource and add back resource cost already
accounted for within the contribution per unit.
*This is the cost from the old supplier. The cost was included in the contribution calculation but will
no longer be paid due to purchasing materials from the new supplier.
The unit selling price and cost structure of each product is budgeted as follows.
Variable costs:
Labour 24 48 6
Materials 26 7 8
Overhead 10 5 6
60 60 20
The labour rate is budgeted at £6 per hour, and fixed costs at £1,300,000 per annum. The company
has a maximum production capacity of 228,000 labour hours.
A meeting of the board of directors has been arranged to discuss the budget and to resolve the
problem as to the quantity of each product which should be made and sold. The sales director
presented the results of a recent market survey which reveals that market demand for the company’s
products will be as follows.
Product Units
Beta 24,000
Delta 12,000
Gamma 60,000
The production director proposes that since Gamma only contributes £12 per unit, the product
should no longer be produced, and the surplus capacity transferred to produce extra quantities of
Beta and Delta. The sales director does not agree with the proposal. Gamma is considered necessary
to complement the product range and to maintain customer goodwill. If Gamma is not offered, the
sales director believes that sales of Beta and Delta will be seriously affected. After further discussion
the board decided that a minimum of 10,000 units of each product should be produced. The
remaining production capacity would then be allocated so as to achieve the maximum profit
possible.
Requirement
Prepare a budget statement which clearly shows the maximum profit which could be achieved in the
year ending 30 September 20X2.
Solution
Step 1
Ascertain whether labour hours are a scarce resource
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Since only 228,000 hours are available we need to establish which product earns the greatest
contribution per labour hour.
Step 3
Determine a production plan
The optimum production plan must take into account the requirement that 10,000 units of each
product are produced, and then allocate the remaining hours according to the above ranking.
Hours
Beta 10,000 units × 4 hours 40,000
Delta 10,000 units × 8 hours 80,000
Gamma 10,000 units × 1 hour 10,000
130,000
Gamma 50,000 units × 1 hour (full demand) 50,000
Beta 12,000 units × 4 hours (balance) 48,000
228,000
Step 4
Draw up a budget.
Budget statement
£
Contribution
Beta (22,000 units × £40) 880,000
Delta (10,000 units × £64) 640,000
Gamma (60,000 units × £12) 720,000
Total contribution 2,240,000
Fixed costs 1,300,000
Profit 940,000
Definition
Outsourcing: The use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
An organisation might want to do more things than it has the resources for, and so its alternatives
would be as follows.
(a) Make the best use of the available resources and ignore the opportunities to buy help from
outside.
(b) Combine internal resources with subcontracting externally so as to do more and increase
profitability.
Buying help from outside is justifiable if it adds to profits. A further decision is then required on how
to split the work between internal and external effort. What parts of the work should be given to
suppliers or subcontractors so as to maximise profitability?
In a situation where a company must subcontract work to make up a shortfall in its own in-house
capabilities, its total costs will be minimised if those units bought have the lowest extra variable cost
of buying per unit of scarce resource saved by buying.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and apply technical
knowledge and skills to analyse a specific problem’. For example, you could be asked to apply your
technical knowledge to decide which products should be outsourced.
Machine
hours Variable cost
£
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 100
Only 24,000 hours of machine time will be available during the year, and a subcontractor has quoted
the following unit prices for supplying components: S £29; A £40; T £34.
Requirement
Advise MM on its most profitable plan.
Solution
The organisation’s budget calls for 36,000 hours of machine time, if all the components are to be
produced in-house. Only 24,000 hours are available, and so there is a shortfall of 12,000 hours of
machine time, which is therefore a limiting factor. The shortage can be overcome by subcontracting
the equivalent of 12,000 machine hours’ output to the subcontractor.
The assembly costs are not relevant costs because they are not affected by the decision.
The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce
resource saved (that is, per machine hour saved).
S A T
£ £ £
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
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S A T
£ £ £
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved £3 £2 £2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S. The
priority for making the components in-house will be in the reverse order: S, then T, then A. There are
enough machine hours to make all 4,000 units of S (12,000 hours) and to produce 3,000 units of T
(another 12,000 hours). 12,000 hours’ production of T and A must be subcontracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows.
Summary
Contribution =
Sales price – Variable cost
Breakeven chart
Depicts the profit or
loss over a range of activities
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1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. Do you know the formulae for the breakeven point, contribution ratio and margin of
safety? (Topic 1)
2. Do you know how to incorporate a target profit into the breakeven formula? (Topic 1)
3. Can you identify the total costs line, sales line, fixed cost line and breakeven point on a
breakeven chart? (Topic 2)
5. When a business needs to subcontract work in a limiting factor situation, how is total cost
minimised? (Topic 3)
Self-test questions
£ per unit
Selling price 6.00
Variable production cost 1.20
Variable selling cost 0.40
Fixed production cost 4.00
Fixed selling cost 0.80
Budgeted production and sales for the year are 10,000 units.
Requirements
What is the company’s breakeven point, to the nearest whole unit?
A 8,000 units
B 8,333 units
C 10,000 units
D 10,909 units
How many units must be sold if K Limited wants to achieve a profit of £11,000 for the year?
E 2,500 units
F 9,833 units
G 10,625 units
H 13,409 units
It is now expected that the variable production cost per unit and the selling price per unit will each
increase by 10%, and fixed production costs will rise by 25%. Other costs are expected to remain the
same.
Requirement
What will be the new breakeven point, to the nearest whole unit?
I 8,788 units
J 11,600 units
K 11,885 units
L 12,397 units
2 W Limited sells one product for which data is given below:
£ per unit
Selling price 10
Variable cost 6
Fixed cost 2
The fixed costs are based on a budgeted level of activity of 5,000 units for the period.
Requirements
How many units must be sold if W Limited wishes to earn a profit of £6,000 for one period?
A 1,500
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B 1,600
C 4,000
D 8,000
What is W Limited’s margin of safety for the budget period if fixed costs prove to be 20% higher than
budgeted?
E 29%
F 40%
G 50%
H 662/3%
If the selling price and variable cost increase by 20% and 12% respectively by how much must sales
volume change compared with the original budgeted level in order to achieve the original budgeted
profit for the period?
I 24.2% decrease
J 24.2% increase
K 39.4% decrease
L 39.4% increase
3 Review the chart below.
£
s A
le
Sa s
D ost
al c C
Tot
B
s
ec ost
iabl
Var
x Units
Requirement
In the above breakeven chart, the contribution at level of activity x can be read as:
A Distance A
B Distance B
C Distance C
D Distance D
4 R Limited manufactures three products, the selling price and cost details of which are given below.
Requirement
In a period when materials are restricted in supply, the most and least profitable uses of materials
are:
A R – most profitable; P – least profitable
B Q – most profitable; R – least profitable
C Q – most profitable; P – least profitable
D R – most profitable; Q – least profitable
5 JJ makes two products, the K and the L. The K sells for £50 per unit, the L for £70 per unit. The
variable cost per unit of the K is £35, that of the L £40. Each unit of K uses 2 kg of raw material. Each
unit of L uses 3 kg of material.
In the forthcoming period the availability of raw material is limited to 2,000 kg. JJ is contracted to
supply 500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
Requirement
What is the profit-maximising product mix?
A K – 250 units; L – 625 units
B K – 1,250 units; L – 750 units
C K – 625 units; L – 250 units
D K – 750 units; L – 1,250 units
6 B has insufficient workshop capacity to carry out all the repair work currently required on its fleet of
delivery vehicles. In such circumstances certain repair jobs will be sub-contracted to local garages.
Set out below are the routine repair jobs scheduled for the coming week.
Job A B C D E F
Cost of parts £1,200 £1,375 £1,450 £500 £375 £690
Labour hours 150 100 200 50 150 100
Equipment hours 170 30 70 30 70 70
Sub-contract cost (including
parts) £3,950 £2,700 £4,900 £1,800 £2,700 £2,400
Labour is paid £6 per hour. Overtime is not worked on routine jobs. Labour-related variable
overheads are £2 per labour hour. Equipment-related variable overheads are £1 per equipment-
hour. Depreciation on workshop equipment is £960 per week. Other workshop fixed overheads are
£1,540 per week.
Requirement
Which of the following jobs should be subcontracted if the amount of workshop labour available in
the week is fixed at 400 hours and there is no restriction on equipment availability?
A Job A
B Job B
C Job C
D Job D
E Job E
F Job F
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Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
WORKING
Number of units
Required contribution/Contribution ratio = £50,000/20% = £250,000
Number of units = £250,000 ÷ £10 = 25,000.
WORKING
Required sales price
Required contribution = fixed costs plus profit
= £47,000 + £23,000
= £70,000
Required sales = 14,000 units
Required contribution per unit = £70,000/14,000 = £5 per unit
£
Required contribution per unit sold 5
Variable cost per unit 15
Required sales price per unit 20
WORKINGS
(1) Materials
Material required = 20,000 units × (£12/£3) = 80,000 kg
Material is therefore a limiting factor, since 75,000 kg are available.
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(2) Labour
Labour required = 20,000 units × (£72/£8) = 180,000 hours
Labour is not a limiting factor, since 190,000 labour hours are available.
(1) The shortfall in available machine hours for next period is 26,000 hours.
(2) The contribution earned per machine hour used on product X is £ 2.50 .
(3) The number of units of each product that should be manufactured next period is:
WORKINGS
(1) Shortfall
Machine hours required to satisfy annual sales demand:
Hours
Product X 5,000 units × 20 hrs 100,000
Product Y 7,500 units × 21 hrs 157,500
Product Z 2,500 units × 26 hrs 65,000
Total machine hours required 322,500
Machine hours available 296,500
Shortfall in available machine hours 26,000
X Y Z
£’000 £’000 £’000
Sales revenue 1,000 1,125 625
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Contribution 250 375 125
WORKING
Production plan
D E
£ per unit £ per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kg 8 kg
Extra variable cost of buying per kg saved £2 £1.25
Priority for internal manufacture 1 2
The remaining 5,000 units of E should be purchased from the sub contractor.
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1 Correct answer(s):
D 10,909 units
Breakeven point = Fixed costs/Contribution per unit
= (10,000 × (£4.00 + £0.80))/(£6.00 – (£1.20 + 0.40)) = £48,000/£4.40 = 10,909 units
If you selected option A you divided the fixed cost by the selling price, but the selling price also has
to cover the variable cost. Option B ignores the selling costs, but these are costs that must be
covered before the breakeven point is reached. Option C is the budgeted sales volume, which
happens to be below the breakeven point.
Correct answer(s):
H 13,409 units
Contribution required for target profit = Fixed costs + Profit
= £48,000 + £11,000
= £59,000
Contribution per unit (from question 1) = £4.40
Sales units required = £59,000/£4.40 = 13,409 units
If you selected option A you divided the required profit by the contribution per unit, but the fixed
costs must be covered before any profit can be earned. If you selected option B you identified
correctly the contribution required for the target profit, but you then divided by the selling price per
unit instead of the contribution per unit. Option C ignores the selling costs, which must be covered
before a profit can be earned.
Correct answer(s):
K 11,885 units
£ per unit
New selling price (£6 × 1.1) 6.60
New variable cost (£1.20 × 1.1) + £0.40 1.72
Revised contribution per unit 4.88
2 Correct answer(s):
C 4,000
£
Target profit 6,000
Fixed costs (5,000 × £2) 10,000
Target contribution 16,000
If you selected option A you divided £6,000 target profit by the £4 contribution per unit, but the
fixed costs must be covered before any profit can be earned. If you selected option B you divided
by the selling price, but the variable costs must also be taken into account. If you selected option D
you divided by the profit per unit instead of the contribution per unit, but the fixed costs are taken
into account in the calculation of the target contribution.
Correct answer(s):
F 40%
£
Original budgeted profit:
Contribution (5,000 × £4) 20,000
Fixed costs 10,000
Profit 10,000
£ per unit
New sales price (£10 × 1.20) 12.00
New variable cost (£6 × 1.12) 6.72
New contribution 5.28
This is 1,212 units or 24.24% less than the original budgeted level of 5,000 units of sales.
If you selected option B you identified the correct percentage change but you misinterpreted it as a
required increase. If you selected options C or D you took £6,000 as your figure for the original
budgeted profit. However, the budgeted profit would be based on the budgeted level of activity of
5,000 units for the period.
3 Correct answer(s):
C Distance C
Contribution at level of activity x = Sales value less variable costs, which is indicated by distance C.
Distance A indicates the profit at activity x, B indicates the fixed costs and D indicates the margin of
safety in terms of sales value.
4 Correct answer(s):
B Q – most profitable; R – least profitable
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5 Correct answer(s):
C K – 625 units; L – 250 units
K L
Contribution per unit £15 £30
Contribution per unit of limiting factor £15/2 = £7.50 £30/3 = £10
Ranking 2 1
Raw materials
used
kg
Contracted supply of K (500 × 2 kg) 1,000
Meet demand for L (250 × 3 kg) 750
Remainder of resource for K (125 × 2 kg) 250
2,000
6 Correct answer(s):
B Job B
E Job E
F Job F
WORKINGS
(1) Ranking of jobs to subcontract
A B C D E F
Extra cost of subcontracting (W2) £1,380 £495 £1,780 £870 £1,055 £840
Labour hours required 150 100 200 50 150 100
Cost per labour hour saved by
subcontracting £9.20 £4.95 £8.90 £17.40 £7.03 £8.40
Ranking of jobs to subcontract 5 1* 4 6 2* 3*
* Subcontracted jobs
As labour capacity is restricted to 400 hours per week there is only enough capacity for jobs C, A
and D. Jobs B, E and F should therefore be subcontracted as they have the lowest incremental
cost per labour hour saved.
A B C D E F
£ £ £ £ £ £
Cost of doing work in-house
Parts 1,200 1,375 1,450 500 375 690
Labour (labour hours × £6 per hour) 900 600 1,200 300 900 600
Labour-related overhead (labour
hours × £2 per hour) 300 200 400 100 300 200
Equipment-related overhead
(equipment hours × £1 per hour) 170 30 70 30 70 70
Total cost of doing work in-house 2,570 2,205 3,120 930 1,645 1,560
Cost of subcontracting (including
parts) 3,950 2,700 4,900 1,800 2,700 2,400
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Chapter 11
Investment appraisal
techniques
Introduction
Learning outcomes
Syllabus links
Examination context
Chapter study guidance
Learning topics
1 Making investment appraisal decisions
2 The payback method
3 The accounting rate of return method
4 The net present value method
5 The internal rate of return method
6 Environmental costing
Summary
Further question practice
Self-test questions
Answers to Interactive questions
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Introduction
11
Learning outcomes
• Calculate the net present value, internal rate of return, payback period or accounting rate of
return for a given project
• Identify the advantages and disadvantages of the investment appraisal techniques specified
above
The specific syllabus references for this chapter are: 4c and d.
11
Syllabus links
You will be using the techniques you learn in this chapter when you study the Financial Management
syllabus. In that syllabus you will explore further the investment decision-making process and
associated issues.
11
Examination context
Since most of this part of your syllabus is concerned with calculation techniques you can expect to
encounter predominately numerical questions about these topics.
In the examination, students may be required to:
• calculate the net present value, internal rate of return, payback period or accounting rate of return
from data supplied
• interpret information about the net present value, internal rate of return, payback or accounting
rate of return for a project or projects
• demonstrate an understanding of the advantages and disadvantages of the investment appraisal
techniques specified above
• manipulate simple data involving annuities, perpetuities and non-conventional cash flows
• demonstrate an understanding of the derivation and meaning of the net terminal value of a
project
While most of the questions in this area of the syllabus will be numerical (where such issues as the
timing of cash flows will be critical) it is vital to understand what each of the techniques involves (and
their weaknesses) in order to be able to tackle narrative questions.
11
over a long
period of time,
usually well over
a year and often
over very long
time periods. In
such
circumstances
the benefits
cannot all be set
against costs in
the current year’s
income
statement
For these reasons any
proposed capital
expenditure should be
properly appraised,
and found to be
worthwhile, before the
decision is taken to go
ahead with the
expenditure. Formal
procedures should
therefore be in place
for the appraisal and
monitoring of
investment projects
before they are
undertaken, while they
are in progress, and
after they have been
completed.
3 The accounting rate of In section 3 learn Objective test IQ1: The ARR
return both formulae for questions may require and mutually
calculating the ARR, you to pick out correct exclusive
4 The net present value Section 4 is very Objective test IQ3: Non-
method important and questions may require standard
It is worth really getting explains a number you to calculate a net discount
to grips with the net of techniques and present value or pick factors
present value method their advantages out correct definitions This question
as you will need it and disadvantages. or statements from a covers the
again later in your It is crucial that you number of statements calculation of
studies. work carefully supplied in a question – NPV and how
through all the for example, to calculate
examples and statements about an discount
narrative NPV graph or about factors.
information in this the advantages and (However,
section. disadvantages of NPV. always use
the discount
Stop and think tables if you
can.)
What are the cost
units in the business
you work for?
5 The internal rate of Study all the graphs Objective test IQ4: IRR
return method in section 5 and questions may require You must
The internal rate of learn the formula for you to calculate the IRR learn how to
return is the discount calculating the IRR. or pick out correct calculate the
rate that gives an NPV In section 5.6 use statements from a IRR.
of zero. The main the interactive number of statements
advantage of this question to practice supplied in a question,
appraisal method is sketching NPV for example statements
that it gives a profiles. This is a about the advantages
percentage, this may useful technique and disadvantages and
be more easily which might come comparisons with IRR
understood by non- in handy in the and NPV.
financial managers exam. Although you
than NPV. would not be
required to produce
a sketch you might
need to be able to
do so for your own
workings in order to
select the correct
option in a multiple
choice question.
Once you have worked through this guidance you are ready to attempt the further question practice
included at the end of this chapter.
• A typical model for investment decision making has a number of distinct stages.
• These stages are typically: the origination of proposals, project screening, analysis and
acceptance, and monitoring and review.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify the solution which is
the best fit with acceptance criteria and objectives.’ This chapter covers methods to help
management make investment decisions based on acceptance criteria.
You will study the investment decision-making process in more detail in your Financial Management
syllabus so we will review the process in outline only here, to set the financial investment appraisal
techniques in context.
A typical model for investment decision making has a number of distinct stages.
• Origination of proposals. It has been suggested that good ideas for investment are likely to occur
in environments in which staff feel free to present and develop ideas. Some alternatives will be
rejected early on. Others will be more thoroughly evaluated.
• Project screening. Before a detailed financial analysis is undertaken a qualitative evaluation of the
project will be made. For example, questions will be asked such as whether the project ‘fits’ with
the organisation’s long-term objectives and whether all possible alternatives have been
considered. Only if the project passes this initial screening will more detailed financial analysis
begin.
• Analysis and acceptance. This will include a financial analysis, using the organisation’s preferred
investment appraisal techniques. You will be studying the most common techniques in the
remainder of this chapter. Qualitative issues will also be considered before a decision is made
whether to proceed and the project is implemented.
• Monitoring and review. During the project’s progress it will be necessary to ensure that capital
spending does not exceed the amount authorised, that the implementation of the project is not
delayed and that the anticipated benefits are eventually obtained.
• The payback period is the time it takes for a project’s net cash inflows to equal the initial cash
investment.
• The payback period is often used as an initial screening process.
• If a project’s payback period is shorter than a defined maximum period then the project should
be evaluated further using a more sophisticated project appraisal technique.
• A major disadvantage is that the timing of cash flows within the payback period are ignored and
therefore no account is taken of the time value of money.
Definition
Payback: The time required for the cash inflows from a capital investment project to equal the cash
outflows.
Payback is often used as a ‘first screening method’. By this, we mean that when a capital investment
project is being subjected to financial appraisal, the first question to ask is: ‘How long will it take to
pay back its cost?’ The organisation might have a target payback, and so it would reject a capital
project unless its payback period was less than that target payback period.
However, a project should not be evaluated on the basis of payback alone. Payback should be a first
screening process, and if a project gets through the payback test, it ought then to be evaluated with
a more sophisticated project appraisal technique, such as those presented later in this chapter.
You should note that when payback is calculated, we use profits before depreciation in the
calculation, because we are trying to estimate the cash returns from a project and profit before
depreciation is likely to be a rough approximation of cash flows.
Definition
Mutually exclusive: If two events are mutually exclusive, it means that they cannot both occur at the
same time.
Project P Project Q
£ £
Capital cost of asset 60,000 60,000
Profits before depreciation
Year 1 20,000 50,000
Year 2 30,000 20,000
Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000
Project P pays back in Year 3 (one quarter of the way through Year 3). Project Q pays back halfway
through Year 2. Using payback alone to judge projects, project Q would be preferred. But the
returns from project P total £200,000 over its life and are much higher than the returns from project
Q which totals just £85,000.
Definitions
Residual value: The disposal value of equipment at the end of its life, or its disposal cost.
Scrap: Discarded material having some value.
Year £
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000
Requirement
Calculate the payback period to the nearest month.
Solution
Cash flows, ie, profits before depreciation should be used.
One of the professional skills assessed in the ACA exams is the ability to ‘Evaluate the relevance of
information provided’. For example, you may be given profits instead of cash flows in a question on
payback, as well as information on depreciation. The depreciation is provided so that you can work
back to the cash flow amount from the profit.
Definition
Time value of money: Recognises that £1 today is worth more than £1 at a future time, because the
£1 can be reinvested today to earn more money over time.
• It ignores the time value of money (a concept incorporated into more sophisticated appraisal
methods). This means that it does not take account of the fact that £1 today is worth more than £1
in one year’s time. This is because an investor who has £1 today can either consume it
immediately or alternatively can invest it at the prevailing interest rate, say 10%, to get a return of
£1.10 in a year’s time.
There are also other disadvantages.
• The method is unable to distinguish between projects with the same payback period.
• The choice of any cut-off payback period by an organisation is arbitrary.
• It may lead to excessive investment in short-term projects.
• It takes account of the risk of the timing of cash flows but does not take account of the variability
of those cash flows.
• The accounting rate of return (ARR) expresses the average accounting profit as a percentage of
the capital outlay.
• The capital outlay (the denominator in the ARR calculation) may be expressed as the initial
investment or as the average investment in the project.
• The decision rule is that projects with an ARR above a defined minimum are acceptable; the
greater the ARR, the more desirable the project.
• The main advantage of the ARR is that it is simple to calculate and understand. However, it does
have a number of major disadvantages.
• The main disadvantage of the ARR is that it does not take account of the timing of the profits from
a project.
Definition
Accounting rate of return: A measure of the expected average annual accounting profits from an
investment expressed as a percentage of the value of that investment. Either the initial or average
value of the investment can be used. Also called return on investment (ROI) or return on capital
employed (ROCE).
The accounting rate of return (ARR) method of appraising a project involves estimating the
accounting rate of return that a project should yield. If it exceeds a target rate of return then the
project is acceptable.
There are two different ways of calculating the ARR.
ARR = (Average annual accounting profit/Initial investment) × 100%
ARR = (Average annual accounting profit/Average investment) × 100%
Solution
Using initial investment
Average profit = (Profits before depreciation – Depreciation)/5
= ((£24,000 × 5) – (£110,000 – £10,000))/5
= £4,000 p.a.
ARR = (£4,000/£110,000) × 100% = 3.6%
Using average investment
£4,000
× 100% = 6.7%
£(110,000 + 10,000)/2
Equipment Equipment
item X item Y
Capital cost £100,000 £175,000
Life 5 years 5 years
Profits before depreciation
Year 1 £50,000 £50,000
Year 2 £50,000 £50,000
Year 3 £30,000 £60,000
Year 4 £20,000 £60,000
Year 5 £10,000 £60,000
Disposal value for equipment £20,000 £25,000
ARR is measured as the average annual profits divided by the average investment.
Requirement
Fill in the boxes below to determine which equipment item should be purchased, if the company’s
target ARR is 25%.
Note: The boxes in this question indicate where an answer is required and where marks are available
in the CBE. You can use the ‘add comment’ function to record your workings and answers.
Item X Item Y
£ £
Total profit over life of equipment:
Before depreciation
After depreciation
Average investment
3.3 The advantages and disadvantages of the ARR method of project appraisal
The ARR method has the serious disadvantage that it does not take account of the timing of the
profits from a project. Whenever capital is invested in a project, money is tied up until the project
begins to earn profits which pay back the investment. Money tied up in one project cannot be
invested anywhere else until the profits come in. Management should be aware of the benefits of
early repayments from an investment, which will provide the money for other investments.
There are a number of other disadvantages.
• It is based on accounting profits rather than cash flows, which are subject to a number of different
accounting policies.
• It is a relative measure rather than an absolute measure and hence takes no account of the size of
the investment.
• It takes no account of the length of the project.
• Like the payback method, it ignores the time value of money.
There are, however, advantages to the ARR method.
• It is quick and simple to calculate.
• It involves a familiar concept of a percentage return.
• Accounting profits can be easily calculated from financial statements.
• It looks at the entire project life.
• Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method
which employs profit may be more easily understood.
• It allows more than one project to be compared.
• The terminal value of an investment is its value at some point in the future, including an allowance
for interest.
• Discounting converts a sum of money receivable or payable in the future to its present value,
which is the cash equivalent now of the future value.
• Discounted cash flow (DCF) techniques discount all the forecast cash flows of an investment
proposal to determine their present value.
• The net present value (NPV) of a project is the difference between its projected discounted cash
inflows and discounted cash outflows.
• The decision rule is to accept a project with a positive NPV.
• An annuity is a constant cash flow for a number of years.
• The net terminal value (NTV) is the cash surplus remaining at the end of a project after taking
account of interest and capital payments.
• One of the principal advantages of the DCF appraisal method is that it takes account of the time
value of money.
• The payback method can be combined with DCF to calculate a discounted payback period.
• A perpetuity is a constant cash flow forever. The present value of a perpetuity is £a/r, where a is
the constant annual amount and r is the discount rate.
and so on.
* This means that interest is earned each year on the previous years’ interest.
This is compounding. The formula for the future value or terminal value of an investment plus
accumulated interest after n time periods is V = X(1 + r)n
Where:
• V is the future value or terminal value of the investment with interest
• X is the initial or ‘present’ value of the investment
• r is the compound rate of return per time period, expressed as a decimal (so 10% = 0.10, 5% =
0.05 and so on)
• n is the number of time periods
• Usually r is an annual rate of return and n is the number of years
Solution
Terminal value = £200 × (1.07)10 = £393
Terminal values can cause difficulties when trying to compare or choose between projects because:
• the projects may not end on the same future date (or may not end at all)
• decision makers are more likely to be interested in the effect of the project on shareholder wealth
now, rather than in the future
It is therefore more common to look at present values. The present value of a future sum shows what
that future sum is worth today. This is in effect the reverse of compounding.
4.2 Discounting
Definition
Discounted cash flow: Converting future sums of money to their present value, which is the cash
equivalent now of those future sums.
Discounting starts with the future value (a sum of money receivable or payable at a future date), and
converts the future value to a present value, which is the cash equivalent now of the future value.
For example, if a company expects to earn a (compound) rate of return of 10% on its investments,
how much would it need to invest now to have the following investments?
(a) £11,000 after 1 year
(b) £12,100 after 2 years
(c) £13,310 after 3 years
The answer is £10,000 in each case, and we can calculate it by discounting.
The discounting formula to calculate the present value (X) of a future sum of money (V) at the end of
n time periods is X = V/(1 + r)n
(a) After 1 year, £11,000/1.10 = £10,000
(b) After 2 years, £12,100/1.102 = £10,000
(c) After 3 years, £13,310/1.103 = £10,000
The timing of cash flows is taken into account by discounting them. The effect of discounting is to
give a bigger value per £1 for cash flows that occur earlier: £1 earned after one year will be worth
more than £1 earned after two years, which in turn will be worth more than £1 earned after five years,
and so on.
The discount rate (r) used when calculating the present value is the relevant interest rate (or cost of
capital) to the entity in question. In the exam this will always be made clear.
Multiplied by 12%
Year Cash flow discount factor Present value
£ £
Definition
Net present value: The sum of the present value of the benefits (revenues or savings) from an
investment, less the present value of expenditures.
Discounted cash flow (DCF) techniques are used in calculating the net present value of a series of
cash flows. This measures the change in shareholder wealth now as a result of accepting a project.
NPV = present value of cash inflows less present value of cash outflows
• If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of
the cost of capital, and so the project should be undertaken if the cost of capital is the
organisation’s target rate of return.
• If the NPV is negative, it means that the cash inflows from a project will yield a return below the
cost of capital, and so the project should not be undertaken if the cost of capital is the
organisation’s target rate of return.
• If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the
same as the cost of capital, and so if the cost of capital is the organisation’s target rate of return,
the project will have a neutral impact on shareholder wealth and therefore would not be worth
undertaking because of the inherent risks in any project.
One of the professional skills assessed in the ACA exams is the ability to ‘Identify and apply relevant
technical knowledge and skills to analyse a specific problem’. For example, you could calculate the
NPV of a project and use it to decide whether the project is worthwhile or not.
Requirement
Calculate the NPV of the project and assess whether it should be undertaken.
Solution
Present
Year Cash flow Discount factor value
£ 15% £
0 (100,000) 1.000 (100,000)
1 60,000 1/1.15 = 0.870 52,200
2
2 80,000 1/1.15 = 0.756 60,480
3 40,000 1/1.153 = 0.658 26,320
4 30,000 1/1.154 = 0.572 17,160
NPV = 56,160
Tutorial Note
The discount factor for any cash flow ‘now’ (time 0) is always 1, whatever the cost of capital.
The present value (PV) of cash inflows exceeds the PV of cash outflows by £56,160, which means
that the project will earn a discounted cash flow (DCF) yield in excess of 15%. It should therefore
be undertaken.
discount table in the Appendix at the back of this Workbook. These tables will be provided in the
exam.
4.7 Annuities
Definition
Annuity: A constant annual cash flow, for a number of years.
An annuity is a series of constant cash flows for a number of years. For example, a college might
enter into a contract to provide training courses for a firm for a fixed annual fee of £30,000 payable at
the end of each of the next three years. This would be a three-year annuity.
Present value of
Year Cash flow Present value factor cash values
£ 20% £
1 30,000 0.833 24,990
2 30,000 0.694 20,820
3 30,000 0.579 17,370
2.106 63,180
Where there is a constant cash flow from year to year (in this case £30,000 per annum for Years 1–3)
it is quicker to calculate the present value by adding together the discount factors for the individual
years. These total factors could be described as ‘same cash flow per annum’ factors, ‘cumulative
present value’ factors or ‘annuity’ factors. They are shown in the final column of the discount tables
in the Appendix at the back of this Workbook (2.106, for example, is in the final column for 20% per
annum and the row for Year 3).
The calculation could then be performed in one step:
£30,000 × 2.106 = £63,180
Year £
0 (5,000)
1 3,000
2 2,600
3 6,200
The project has an NPV of £4,531 at the company’s cost of capital of 10% (workings not shown).
Requirement
Calculate the net terminal value of the project.
Solution
The net terminal value can be determined directly from the NPV, or by calculating the cash surplus at
the end of the project.
Assume that the £5,000 for the project is borrowed at an annual interest rate of 10% and that cash
flows from the project are used to repay the loan.
£
Loan balance outstanding at beginning of project 5,000
Interest in Year 1 at 10% 500
Repaid at end of Year 1 (3,000)
Balance outstanding at end of Year 1 2,500
Interest Year 2 250
Repaid Year 2 (2,600)
Balance outstanding Year 2 150
Interest Year 3 15
Repaid Year 3 (6,200)
Cash surplus at end of project 6,035
Year £
0 (280,000)
1 149,000
2 128,000
3 84,000
Year £
4 70,000
Requirement
Using two decimal places in all discount factors, complete the following table to calculate the net
present value of the project at a cost of capital of 16.5%.
£ £
Years
1 2 3 4
£ £ £ £
NBV of investment at start of year 200,000 150,000 100,000 50,000
Definition
Discounted payback method: How long it will take for a project to pay back the capital outlay on a
discounted cash flow basis.
The payback method can be combined with DCF to calculate a discounted payback period (DPP).
The discounted payback period is the time it will take before a project’s cumulative NPV turns from
being negative to being positive.
Discount factor
Year Cash flow 10% Present value Cumulative NPV
£ £ £
0 (100,000) 1.000 (100,000) (100,000)
1 30,000 0.909 27,270 (72,730)
2 50,000 0.826 41,300 (31,430)
3 40,000 0.751 30,040 (1,390)
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV = 31,520
Solution
1 Present value = £1,000 × annuity factor for five years at 15%
= £1,000 × 3.352 = £3,352
2 Only the cash flows at the end of Years 1 to 4 need discounting.
Present value = £1,000 received now + (£1,000 × annuity factor for four years at 15%)
= £1,000 + (£1,000 × 2.855)
= £3,855
3 This can be solved in two possible ways.
(1) Present value = £1,000 × (annuity factor for seven years – annuity factor for two years)
This leaves the cash flows for Years 3, 4, 5, 6 and 7 being discounted.
= £1,000 × (4.160 – 1.626)
= £2,534
(2) Present value of annuity at end of Year 2 = £1,000 × 3.352
= £3,352
Now this must be discounted again to bring it back to the present value at year 0 (now).
Present value = £3,352 × PV factor for Year 2 at 15%
= £3,352 × 0.756
= £2,534
Definition
Perpetuity: A constant annual cash flow that continues forever (a perpetual annuity).
A perpetuity is an equal annual cash flow forever, ie, an annuity that lasts forever.
The present value of a perpetuity of £a per annum forever is calculated as £a/r, where r is the annual
discount rate. This formula finds the present value of the perpetuity stream one year before the first
cash flow.
Solution
1 Present value = £3,000/0.10
= £30,000
2 Present value one year before the first cash flow = at end of Year 3
= £3,000/0.10
= £30,000
Present value at year 0 = £3,000 × Year 3 10% discount factor
= £30,000 × 0.751
= £22,530
Where:
r1 = interest rate for Year 1
r2 = interest rate for Year 2
Requirement
Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.
Solution
£6m £8m
NPV = (£10m) + + = £1.52m
1.10 1.10 × 1.20
• The internal rate of return (IRR) is the DCF rate of return that a project is expected to achieve. It is
the discount rate at which the NPV is zero.
• If the IRR exceeds a target rate of return, the project would be worth undertaking.
• The IRR can be estimated from a graph of the project’s NPV profile. The IRR can be read from the
graph at the point on the horizontal axis where the NPV is zero.
• The IRR interpolation formula is:
NPVa
IRR = a + (bಜa)
NPVaಜNPVb
• The IRR method has a number of disadvantages compared with the NPV method.
– It ignores the relative size of the investments.
– There are problems with its use when a project has non-conventional cash flows or when
deciding between mutually exclusive projects.
– Discount rates which differ over the life of a project cannot be incorporated into IRR
calculations.
Definition
Internal rate of return: The discount rate at which a project has a zero NPV.
Another discounted cash flow (DCF) technique for appraising capital projects involves calculating
the internal rate of return (IRR). The IRR is a relative measure (%) in contrast to the absolute (£)
measure resulting from NPV calculations.
The IRR is the DCF rate of return (DCF yield) that a project is expected to achieve, in other words the
discount rate at which the NPV is zero.
If the IRR exceeds a target rate of return, the project would be worth undertaking.
NPV
£'000
6
0
5 10 15 20 Discount
–1 rate %
–2
–3
–4
The IRR can be estimated as 13%. The NPV should then be recalculated using this interest rate. The
resulting NPV should be equal to, or very near, zero. If it is not, extra NPVs at different discount rates
should be calculated, the graph resketched and a more accurate IRR determined.
Positive
IRR
0
Cost of capital %
Negative
If we determine a cost of capital where the NPV is (slightly) positive, and another cost of capital
where it is (slightly) negative, we can estimate the IRR – where the NPV is zero – by drawing a
straight line between the two points on the graph that we have calculated.
NPV
Q
Positive P
A
B
0
Cost of capital %
True IRR
Negative
P
Q
• If we establish the NPVs at the two points P, we would estimate the IRR to be at point A.
• If we establish the NPVs at the two points Q, we would estimate the IRR to be at point B.
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
The interpolation method assumes that the NPV rises in linear fashion between the two NPVs close
to zero. The real rate of return is therefore assumed to be on a straight line between the two points at
which the NPV is calculated.
The IRR interpolation formula to apply is:
NPVa
IRR = a + (bಜa)
NPVaಜNPVb
Where:
• a is the first discount rate giving NPVa
• b is the second discount rate giving NPVb
Solution
The first step is to calculate two net present values, both as close as possible to zero, using rates for
the cost of capital which are whole numbers. Ideally one NPV should be positive and the other
negative although the formula will work with two positive or two negative NPVs (extrapolation).
Choosing rates for the cost of capital which will give an NPV close to zero (that is, rates which are
close to the actual rate of return) is a hit and miss exercise, and several attempts may be needed to
find satisfactory rates. As a rough guide, try starting at a return figure which is about two thirds or
three quarters of the ARR.
Annual depreciation would be £(80,000 – 10,000)/5 = £14,000.
The ARR would be (£20,000 – depreciation of £14,000)/(½ of £(80,000 + 10,000)) = £6,000/£45,000
= 13.3%.
Two thirds of this is 8.9% and so we can start by trying 9%. The discounted tables do not provide
discount factors for an interest rate of 9% therefore we need to calculate our own factors.
Using the formula provided at the top of the final column in the tables:
1 1
PV of an annuity
=
r[1ಜ
(1 + r)n ]
1 1
PV factor for 5 years at 9%
=
0.09
1ಜ
[
(1.09)5 ]
= 3.89
1
=
PV factor at 9% for year 5 (1.09)5
= 0.65
Try 9%
This is fairly close to zero. It is also positive, which means that the internal rate of return is more than
9%. We can use 9% as one of our two NPVs close to zero, although for greater accuracy, we should
try 10% or even 11% to find an NPV even closer to zero if we can. As a guess, it might be worth trying
12% next, to see what the NPV is. Again, we will need to calculate our own discount factors.
1 1
PV factor for 5 years at 12%
=
0.12
1ಜ
[
(1.12)5 ]
=3.605
PV factor at 12% for year 5 = 1/(1.12)5 = 0.567
Try 12%
This is fairly close to zero and negative. The internal rate of return is therefore greater than 9%
(positive NPV of £4,300) but less than 12% (negative NPV of £2,230).
Note: If the first NPV is positive, choose a higher rate for the next calculation to get a negative NPV.
If the first NPV is negative, choose a lower rate for the next calculation.
4,300
So IRR = 9 +
[ 4,300 + 2,230
× (12ಜ9) % = 10.98%, say 11%
]
If it is company policy to undertake investments which are expected to yield 10% or more, this
project would be undertaken. An alternative approach would be to calculate the NPV at 10%. As it
would be positive it would tell us that the IRR is greater than 10% and therefore the project should be
accepted.
Time £
0 Investment (4,000)
1 Receipts 1,200
2 Receipts 1,410
3 Receipts 1,875
4 Receipts 1,150
Requirement
Calculate the IRR of the project above and complete the box below.
Project A Project B
£ £
Cost, year 0 350,000 35,000
Annual savings, Years 1–6 100,000 10,000
Clearly, project A is bigger (10 times as big) and so more ‘profitable’, but if the only information on
which the projects were judged were to be their IRR of 18%, project B would be made to seem just as
beneficial as project A, which is not the case.
• When discount rates are expected to differ over the life of the project, such variations can be
incorporated easily into NPV calculations, but not into IRR calculations.
• There are problems with using the IRR when the project has non-conventional cash flows (see
section 5.5) or when deciding between mutually exclusive projects (see section 5.6).
One of the professional skills assessed in the ACA exams is the ability to ‘Identify inconsistencies and
contradictory information.’ This could include non-conventional cash flows, where the IRR method is
not recommended.
The projects we have considered so far have had conventional or normal cash flows (an initial cash
outflow followed by a series of inflows) and in such circumstances the NPV and IRR methods give
the same accept or reject decision. When flows vary from this, they are termed non-conventional. The
following project has non-conventional cash flows.
Year Project X
£’000
0 (1,900)
1 4,590
2 (2,735)
30
Positive
20
10
0
5 10 20 30 40 Cost of
–10 capital %
–20
Negative
–30
–40
Suppose that the required rate of return on project X is 10%, but that the IRR of 7% is used to decide
whether to accept or reject the project. The project would be rejected, since it appears that it can
only yield 7%. The diagram shows, however, that between rates of 7% and 35% the project should
be accepted. Using the IRR of 35% would produce the correct decision to accept the project. Lack of
knowledge of multiple IRRs could therefore lead to serious errors in the decision of whether to
accept or reject a project.
In general, if the sign of the net cash flow changes in successive periods (inflow to outflow or vice
versa), it is possible for the calculations to produce up to as many IRRs as there are sign changes.
The use of the IRR is therefore not recommended in circumstances in which there are non-
conventional cash flow patterns (unless the decision maker is aware of the existence of multiple
IRRs). The NPV method, on the other hand, gives clear, unambiguous results whatever the cash flow
pattern.
Before moving on to the worked example you might like to check that the IRRs of project X are
indeed 7% and 35%. Apply the relevant discount factors to the project cash flows and on both
occasions you should arrive at an NPV of approximately zero.
To clear up the confusion about whether the projects are acceptable when using IRR draw a graph.
To find the starting point on the vertical axis find the NPV at 0% (ie, add up the cash flows).
NPV +
600 D
0% Discount rate
25% 400%
NPV –
4,000
The NPV of each project is calculated below. Use the formula 1/(1+r)n to calculate the discount
factors.
Option A Option B
Year Discount factor Cash flow Present value Cash flow Present value
16% £ £ £ £
0 1.000 (10,200) (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = + 610 NPV = + 1,026
The IRR of Option A is 20%, while the IRR of Option B is only 18% (workings not shown).
On a comparison of NPVs, Option B would be preferred, but on a comparison of IRRs, Option A
would be preferred.
The preference should go to Option B because with the higher NPV it creates more wealth than
Option A.
Cash flows
NPV at NPV at NPV at
Project Year 0 Year 1 IRR 0% 10% 30%
£ £ £ £ £
A (1,000) 1,250 25%
B (100) 140 40%
NPV
250
200
100
0
10 20 30 40 50 Discount
-50 rate %
5.3 At what discount rate do the two projects earn the same NPV?
6 Environmental costing
Section overview
• The impact on the environment of new ventures should be considered as part of the investment
appraisal process.
• Environmental costs can be classified as prevention, appraisal, internal failure and external failure
costs.
• Poor environmental behaviour can result in fines, increased liability to environmental taxes and
damage to the business’ reputation.
• Recording environmental costs is important, as some may require regulatory compliance. Most
Western countries now have laws to cover land-use planning, smoke emissions, water pollution
and destruction of animals and natural habitats.
• Saving energy generally leads to cost savings.
Management information should include the identification of environmental costs and monitoring of
resource usage and consideration of environmental impacts should be accounted for as part of
capital investment decisions.
Summary
Investment appraisal
Discounted
Allowing for the
payback Accounting
time value of money period Payback rate of
method return (ARR)
Inconsistency between
NPV and IRR as
decision tools
Superiority of NPV
1 Knowledge diagnostic
Before you move on to question practice, confirm you are able to answer the following questions
having studied this chapter. If not, you are advised to revisit the relevant learning from the topic
indicated.
1. Can you calculate and list the advantages and disadvantages of the payback period?
(Topic 2)
2. Can you calculate and list the advantages and disadvantages of the ARR? (Topic 3)
7. Can you calculate and list the advantages and disadvantages of the IRR? (Topic 5)
Self-test questions
Year £
0 (40,000)
1 15,000
2 15,000
3 15,000
4 15,000
Requirement
If the company were to discover that the cash inflow in year 4 had been overestimated, what would
be the effect on the project’s internal rate of return (IRR) and payback period if the error were
corrected?
A IRR: Decrease; Payback period: No change
B IRR: Decrease; Payback period: Increase
C IRR: Increase; Payback period: No change
D IRR: Increase; Payback period: Increase
3 A project requires an initial investment in equipment of £100,000 and will produce eight equal
annual cash flows of £40,000. The investment has no scrap value and straight-line depreciation is
used.
Requirement
What are the payback period and accounting rate of return (ARR), based on the initial investment?
A Payback: 2 years 6 months; ARR: 27.5%
B Payback: 2 years 6 months; ARR: 40%
C Payback: 3 years 6 months; ARR: 27.5%
D Payback: 3 years 6 months; ARR: 40%
4 £50,000 is to be spent on a machine having a life of five years and a residual value of £5,000.
Operating cash inflows will be the same each year, except for Year 1 when the figure will be £6,000.
The accounting rate of return on the initial investment has been calculated at 30% pa.
Requirement
What is the payback period?
A 2.75 years
B 2.55 years
C 2.54 years
D 2.33 years
5 A firm has two projects available. Project 1 has two internal rates of return of 15% and 30%, and
project 2 has two internal rates of return of 10% and 20%. At a zero discount rate project 1 has a
positive NPV and project 2 has a negative NPV. The appropriate discount rate for both projects is
25%.
Requirement
Which of the following decisions about projects 1 and 2 should be taken?
A Project 1: Accept; Project 2: Accept
B Project 1: Accept; Project 2: Reject
C Project 1: Reject; Project 2: Accept
D Project 1: Reject; Project 2: Reject
6 A project has a normal pattern of cash flows (ie, an initial outflow followed by several years of
inflows).
Requirement
What would be the effects of an increase in the company’s cost of capital on the internal rate of
return (IRR) of the project and its payback period?
A IRR: Increase; Payback period: Increase
B IRR: Increase; Payback period: No change
C IRR: No change; Payback period: Increase
D IRR: No change; Payback period: No change
7 Which two of the following statements about the use of IRR as an investment appraisal method are
incorrect?
A It always establishes if a single project is worthwhile
B It always establishes which of several projects to accept
C It ignores the relative size of the investment
8 Consider the following graph.
NPV
Pro
ject
X
Proj
ectY
Requirement
Which of the following statements is true?
A Project Y has a higher internal rate of return than project X
B At a discount rate of less than 15%, project Y is preferred to project X
C Project X is preferred to project Y irrespective of the discount rate
D Project Y is preferred to project X irrespective of the discount rate
9 A firm is evaluating the following four mutually-exclusive projects. All four projects involve the same
initial outlay and have positive net present values. The projects generate the following cash inflows
during their lives:
Requirement
Which project should be chosen?
A Project A
B Project B
C Project C
D Project D
10 An investment of £100,000 now is expected to generate equal annual cash flows to perpetuity of
£15,000 pa, commencing in five years’ time.
Requirement
If the discount rate is 10% pa, what is the net present value of the investment (to the nearest £10)?
A –£15,330
B –£6,860
C +£2,450
D +£50,000
Now go back to the Introduction and ensure that you have achieved the Learning outcomes listed for
this chapter.
Both projects would earn a return in excess of 25%, but since item X would earn a bigger ARR, it
would be preferred to item Y, even though the profits from Y would be higher by an average of
£10,000 a year.
Item X Item Y
£ £
Total profit over life of equipment:
Before depreciation 160,000 280,000
After depreciation 80,000 130,000
Average annual accounting profit 16,000 26,000
Average investment = (capital cost + disposal value)/2 60,000 100,000
Multiplied by 12%
Year Cash flow discount factor Present value
£ £
£ £
The total receipts are £5,635 giving a total profit of £1,635 and average profits of £409. The average
investment is £2,000. The ARR is £409 ÷ £2,000 = 20%. Two thirds of the ARR is approximately 14%.
The initial estimate of the IRR that we shall try is therefore 14%.
The IRR must be less than 16%, but higher than 14%. The NPVs at these two costs of capital will be
used to estimate the IRR.
Using the interpolation formula:
83
IRR = 14% +
( 83 + 81
× (16%ಜ14%)
) = 15.01%
The IRR is, in fact, exactly 15%.
Cash flows
NPV at NPV at NPV at
Project Year 0 Year 1 IRR 0% 10% 30%
£ £ £ £ £
A (1,000) 1,250 25% 250 136 (38)
B (100) 140 40% 40 27 8
NPV
250
200
100
40
10 20 30 40 B 50 Discount
–50 A rate %
5.3 The two projects earn the same NPV at the point where the lines intersect, which is at a discount
rate of approximately 23%.
1 Correct answer(s):
C placing the same value on £1 receivable up to the payback period and no value on subsequent
receipts.
Statement A describes how DCF methods account for the time of money. Statement B is the reverse
of statement A and is incorrect because it is not taking account of the time value of money at all.
Statement D is incorrect because the payback method ignores cash flows after the payback period.
2 Correct answer(s):
A IRR: Decrease; Payback period: No change
The payback period is not affected because the Year 4 cash flow occurs after the payback period,
however the IRR would be reduced because of the lower cash inflow in Year 4.
3 Correct answer(s):
A Payback: 2 years 6 months; ARR: 27.5%
4 Correct answer(s):
C 2.54 years
5 Correct answer(s):
D Project 1: Reject; Project 2: Reject
The NPV profiles can be sketched as follows.
NPV Project 1 NPV Project 2
15 30 i 10 20 i
At a discount rate of 25%, both projects have a negative NPV therefore they should be rejected.
6 Correct answer(s):
D IRR: No change; Payback period: No change
Both the internal rate of return and the payback period are independent of the cost of capital.
7 Correct answer(s):
A It always establishes if a single project is worthwhile
B It always establishes which of several projects to accept
A is not true because IRR cannot be used to assess projects that do not have an IRR.
B is not true because NPV is used for mutually exclusive projects.
8 Correct answer(s):
A Project Y has a higher internal rate of return than project X
Statement A is correct because the NPV profile of project Y crosses the horizontal axis at a higher
discount rate than that for project X.
Statement B is incorrect because at discount rates less than 15% project X has a higher NPV and is
therefore preferred.
Statements C and D are incorrect because at discount rates less than 15% project X is preferred,
whereas at rates greater than 15% project Y is preferred.
9 Correct answer(s):
A Project A
By a comparison of the cash flows A is better than C (it gives the same inflows in Year 1 and Year 3,
but returns £100 higher in Year 2 and £100 lower in Year 4).
B is also better than D (same flows in Years 1 and 4, but returns £100 more in Year 2, and £100 less in
Year 3).
By a similar argument A is better than B; therefore, A is the preferred project.
10 Correct answer(s):
C +£2,450
–£100,000 + (£15,000/0.1) × 0.683 (Year 4 factor at 10%) = £2,450
Appendices
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lOMoARcPSD|10287105
Discount tables
Interest rate p.a. Number of years Present value of £1 Present value of £1
receivable at the end of receivable at the end of
n years each of n years
r n
1 1
r[1ಜ
(1 + r)n ]
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
r n
1 1
r[1ಜ
(1 + r)n ]
9 0.424 5.759
10 0.386 6.145
2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
10 0.162 4.192
Notes
You can use this section in the ePub reader to add your own further comments or content. To do this,
highlight a number from the list below and use the ‘add comment’ function to include your own text.
Chapter 1 1 2 3 4 5 6 7 8 9 10
Chapter 2 1 2 3 4 5 6 7 8 9 10
Chapter 3 1 2 3 4 5 6 7 8 9 10
Chapter 4 1 2 3 4 5 6 7 8 9 10
Chapter 5 1 2 3 4 5 6 7 8 9 10
Chapter 6 1 2 3 4 5 6 7 8 9 10
Chapter 7 1 2 3 4 5 6 7 8 9 10
Chapter 8 1 2 3 4 5 6 7 8 9 10
Chapter 9 1 2 3 4 5 6 7 8 9 10
Chapter 10 1 2 3 4 5 6 7 8 9 10
Chapter 11 1 2 3 4 5 6 7 8 9 10
Glossary of terms
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A responsibility centre:
A department or function whose performance is the direct responsibility of a specific manager.
Absorption costing: The direct (or prime) cost of an item plus a fair share of the indirect (overhead)
costs.
Accounting rate of return: A measure of the expected average annual accounting profits from an
investment expressed as a percentage of the value of that investment. Either the initial or average
value of the investment can be used. Also called return on investment (ROI) or return on capital
employed (ROCE).
Activity-based budgeting: An approach to budgeting which uses cost drivers as a basis for
preparing budgets.
Activity-based costing: An alternative to traditional absorption costing where overheads are related
to output using multiple cost drivers (activities which cause the overheads).
Allocation: The process by which overheads are charged directly to cost centres.
Apportionment: A process where indirect (overhead) costs are spread fairly between cost centres.
Artificial intelligence (AI): Artificial intelligence (AI) is the use of computers to do tasks which are
thought to require human intelligence. It typically refers to tasks such as learning, knowing, sensing,
reasoning, creating things, and generating and understanding language.
Average cost: Defined by CIMA as a method ‘used to price issues of goods or materials at the
weighted average cost of all units held.’ (CIMA Official Terminology, 2005)
The cumulative weighted average pricing method calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory remaining would have
the same unit valuation. The average price is determined by dividing the total cost by the total
number of units.
A new weighted average price is calculated whenever a new delivery of materials is received into
store. This is the key feature of cumulative weighted average pricing.
Batch costing: A costing method applied where a group (batch) of identical items is treated as a cost
unit. The cost per item = total batch cost ÷ number of items in the batch.
Big data: The term that describes those ‘datasets whose size is beyond the ability of typical database
software to capture, store, manage and analyse.’ (McKinsey Global Institute, Big data: The next
frontier for innovation, competition and productivity)
An alternative definition is provided by Gartner.
Big data: It concerns ‘high-volume, high-velocity and high-variety information assets that demand
cost-effective, innovative forms of information processes for enhanced insight and decision making.’
(Gartner, www.gartner.com/it-glossary/big-data/)
Blanket absorption rate: An absorption rate used throughout a factory for all products irrespective of
the department in which they were produced.
Breakeven analysis: An analysis of costs, volume and profit at various levels of activity. Also known as
cost-volume-profit (CVP) analysis.
Breakeven point: Number of units sold at which neither a profit nor a loss is made.
Budget: A quantitative statement, for a defined period of time, which may include planned revenues,
expenses, assets, liabilities and cash flows.
Budget manual: A collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
Budget slack: Deliberately underestimating revenues or overestimating costs in order to ensure that
achieving the budget is easy.
Cash budget: A cash budget is a statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
Cash operating cycle: The period of time which elapses between the point at which cash begins to
be spent on the production of a product and the collection of cash from the customer who
purchases it.
Cause and effect relationship: A cause and effect relationship (also known as a causal relationship)
exists between two variables when a change in one causes the change in the other.
Cloud accounting: An application of cloud computing where accountancy software is provided in the
cloud by a service provider.
Cloud accounting applications can be hosted applications or software as a service (SaaS). Hosted
applications involve using your own desktop or server accounting application and accessing the
accounting software using the internet. Using SaaS involves using a cloud accounting supplier’s
server where the accounting software and data are stored.
Cloud computing: “Is a model for enabling ubiquitous, convenient, on-demand network access to a
shared pool of configurable computing resources (eg, networks, servers, storage, applications, and
services) that can be rapidly provisioned and released with minimal management effort or service
provider interaction”. (US Department of Commerce, National Institute of Standards and Technology)
Contract costing: A form of specific order costing where costs are attributed to contracts.
Contribution: The difference between the selling price and all the variable costs of a product.
Controllable cost: A cost that can be influenced by management decisions and actions.
Cost behaviour: The way in which costs are affected by changes in the level of activity where ‘activity’
can be volume of output, number of production runs etc.
Cost driver: Something which causes costs to change eg, volume of output, number of production
runs etc.
Cost object: Anything for which we are trying to ascertain the cost.
Cost pool: A grouping of costs relating to a particular activity in an activity-based costing system.
Cost unit: The basic measure of product or service for which costs are determined.
Cost-plus pricing: A method of determining the sales price by calculating the full (absorption) cost of
the product and adding a percentage mark-up for profit.
Cyclical variations: Cyclical variations are medium- to long-term patterns such as economic booms
and recessions. In practice, they are difficult to predict and model.
Data analytics: The process of collecting, organising and analysing large sets of data to discover
patterns and other information which an organisation can use for its future business decisions.
Closely linked to the term data analytics is data mining.
Data bias: Data is biased when it is not representative of the population. Data may be biased before
its analysed just because the method of collecting the data means that some members of the
population have a lower (or zero) chance of being included in the sample. People who analyse data
and reach conclusions can also introduce bias.
Data mining: The process of sorting through data to identify patterns and relationships between
different items. Data mining software, using statistical algorithms to discover correlations and
patterns, is frequently used on large databases. In essence, it is the process of turning raw data into
useful information. Predictive analytics is a type of data mining that aims to predict future events.
Data outliers: Data outliers are observations that are abnormal and can therefore significantly distort
the results. Sometimes outliers are removed from the data set before applying forecasting
techniques.
Direct cost: A cost that can be traced in full to the cost unit.
Discounted cash flow: Converting future sums of money to their present value, which is the cash
equivalent now of those future sums.
Discounted payback method: How long it will take for a project to pay back the capital outlay on a
discounted cash flow basis.
ESG: ESG (environmental, social and governance) is a set of criteria used to measure and report
sustainability. Therefore, ESG reporting involves disclosing operational data on areas of ESG.
Economic order quantity (EOQ): The order quantity which minimises inventory costs. The EOQ can
be calculated using a table, graph or formula.
FIFO (first in, first out): A method of pricing materials based on the cost of the oldest units held
regardless of the sequence in which the issue of the materials takes place.
FIFO assumes that materials are issued out of inventory in the order in which they were delivered into
inventory issues are priced at the cost of the earliest delivery remaining in inventory.
Factoring organisation: Takes over the management of the trade debts owed to its client (a business
customer) on the client’s behalf. The factor company collects the debts and provides an immediate
cash advance of a proportion of the money it is due to collect.
Fixed costs: Costs that, within a relevant range of activity levels, are not affected by increases or
decreases in the level of activity.
Fixed overhead expenditure variance: The difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
The fixed overhead expenditure variance is (Budgeted fixed overhead cost – Actual fixed overhead
cost)
Flexible budget: A budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Functional budgets: The budgets for the various functions of the business eg, production, marketing,
sales, purchasing budgets.
Governance: The way organisations are directed and controlled by senior officers.
Imposed budget: A budget set without allowing the budget holder to participate in the budgeting
process.
Incremental budgeting: Basing this year’s budget on last year’s budget with adjustments for changes
and inflation.
Indirect cost (or overhead): A cost that is incurred which cannot be traced directly and in full to the
cost unit.
Internal rate of return: The discount rate at which a project has a zero NPV.
Investment centre: A section of an organisation whose manager has some say in investment policy in
their area of operations as well as being responsible for costs and revenues.
Invoice discounting: The purchase (by the provider of the discounting service) of a company’s trade
debts, at a discount. Invoice discounting enables a company to raise finance based on their expected
invoice receipts. The invoice discounter does not take over the administration of the client’s sales
ledger, so the client remains in control of debt collection.
Job costing: The costing method used where work is undertaken to customers’ special requirements
and each order is of comparatively short duration.
Just-in-time production: A system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing: A system in which material purchases are contracted so that the receipt and
usage of material coincide to the maximum extent possible.
LIFO (last in, first out): A method of pricing materials based on the cost of the newest units held
regardless of the sequence in which the issue of the materials takes place.
LIFO assumes that materials are issued out of inventory in the reverse order from that in which they
were delivered.
Labour efficiency variance: The difference between the hours that should have been worked for the
number of units actually produced, and the actual number of hours worked, valued at the standard
labour rate per hour.
Labour rate variance: The difference between the standard cost and the actual cost for the actual
number of labour hours paid.
Labour total variance: Measures the difference between the standard labour cost of the output
produced and the actual labour cost incurred.
Life cycle costing: A costing method that takes into account all of the costs and revenues of a
product over its entire life span.
Linear regression analysis: A technique for estimating the equation of a line of best fit.
Machine learning (ML): Machine learning is a field within AI whereby computers learn to do things
rather than follow pre-programmed rules. Through machine learning techniques, computers find
patterns in data and use statistical models to classify or make predictions about other pieces of data.
There are different types of learning (eg, supervised, unsupervised or reinforced) but all draw on
large sets of training data that enable the computer to learn.
Management accounting systems: Provide information specifically for the use of managers within an
organisation.
Margin of safety: The difference in units between the budgeted sales volume and the breakeven
sales volume. It is sometimes expressed as a percentage of the budgeted sales volume.
Material price variance: The difference between the standard cost and the actual cost for the actual
quantity of material used or purchased.
Material total variance: ‘Measures the difference between the standard material cost of the output
produced and the actual material cost incurred.’ (CIMA Official Terminology, 2005)
Material usage variance: The difference between the standard quantity of materials that should have
been used for the number of units actually produced, and the actual quantity of materials used,
valued at the standard cost per unit of material.
Moving average: A moving average is an average of the data of a fixed number of periods. The aim
of calculating moving averages is to remove the effect of seasonal variations, for use in forecasting
long-term trends.
Mutually exclusive: If two events are mutually exclusive, it means that they cannot both occur at the
same time.
Net present value: The sum of the present value of the benefits (revenues or savings) from an
investment, less the present value of expenditures.
Operating statement: A regular report for management of actual costs and revenues, usually
showing variances from budget.
Opportunity cost: The value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
Outsourcing: The use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
Overhead absorption: The process whereby overhead costs allocated and apportioned to
production cost centres (in traditional costing systems) or cost pools (in activity-based costing
systems) are added to direct unit, job or batch costs. Overhead absorption is sometimes called
overhead recovery.
Participative budgeting: Budgeting style which allows all budget holders to participate in setting
their own budget.
Payback: The time required for the cash inflows from a capital investment project to equal the cash
outflows.
Perpetuity: A constant annual cash flow that continues forever (a perpetual annuity).
Principal budget factor: The budgeted factor which limits the activities of an organisation.
Process costing: A form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
Product cost: The cost of a finished product made up of its cost elements.
Profit centre: Any section of an organisation, for example, a division of a company, which earns
revenue and incurs costs. The profitability of the section can therefore be measured.
Random variations: Random variations are the product of randomness and so cannot be predicted.
Residual income: Profit less a notional interest charge for invested capital.
Residual value: The disposal value of equipment at the end of its life, or its disposal cost.
Responsibility accounting: A system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an
organisation.
Return on investment (ROI): Also called return on capital employed (ROCE). It is calculated as
(profit/capital employed) × 100% and it shows how much profit has been made in relation to the
amount of resources invested.
Revenue centre: A section of an organisation which creates revenue but has no responsibility for
production. A sales department is an example.
Rolling budget: A budget continually updated to add a new budget period as the most recent one
has finished.
Sales price variance: A measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and the actual sales revenue.
Sales volume variance: The difference between the actual units sold and the budgeted (planned)
quantity, valued at the standard contribution per unit.
Seasonal variation: Seasonal variations are short-term patterns that occur during different periods,
such as rush hour during the day, weekdays during the week, or warmer months of the year.
Semi-variable, semi-fixed or mixed costs: Costs that are part-fixed and part-variable and are
therefore partly affected by changes in the level of activity.
Sensitivity analysis: Assesses how sensitive a budget is to changes in the budget assumptions.
Shared service centre: A centre responsible for operational tasks such as accounting, for multiple
parts of the same organisation.
Step fixed cost: A cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
Structured data: Data that is contained within a field in a data record or file (eg, databases and
spreadsheets).
Sustainability: The ability to ‘meet the needs of the present without compromising the ability of
future generations to meet their own needs’ (Brundtland Report 1987).
Target costing approach: A process that begins with the development of a product concept followed
by the determination of the price customers would be willing to pay for that concept. The desired
profit margin is deducted from the price, leaving a figure that represents total cost. This is the target
cost.
The relevant range: The range of activity levels within which assumed cost behaviour patterns occur.
Time series: A time series is a series of observations recorded over time. Any pattern found in the
data is assumed to continue into the future and a forecast is produced. There are four components of
a time series: trend, seasonal variations, cyclical variations and random variations.
Time value of money: Recognises that £1 today is worth more than £1 at a future time, because the
£1 can be reinvested today to earn more money over time.
Transfer price: The amount charged by one part of an organisation for the provision of goods or
services to another part of the same organisation.
Uncontrollable cost: A cost that cannot be affected by management within a given time span.
Unstructured data: Data that is not easily contained within structured data fields, such as pictures,
videos, webpages, PDF files, emails or blogs.
Variable cost: A cost that increases or decreases as the level of activity increases or decreases.
Variable production overhead efficiency variance: The standard variable production overhead cost
of any change from the standard level of efficiency.
Variable production overhead expenditure variance: Measures the actual cost of any change from
the standard variable overhead rate per hour.
Variable production overhead total variance: Measures the difference between the variable
production overhead that should be used for actual output and the variable production overhead
actually used.
Variance: Defined by CIMA as ‘the difference between a planned, budgeted, or standard cost and
the actual cost incurred. The same comparisons may be made for revenues.’ (CIMA Official
Terminology, 2005)
Variance analysis: Defined as the ‘evaluation of performance by means of variances, whose timely
reporting should maximise the opportunity for managerial action’. (CIMA Official Terminology, 2005)
Working capital: The total of the current assets of a business less its current liabilities.
Zero-based budgeting: Involves preparing a budget for each cost centre from a zero base. Every
item of expenditure has to be justified in its entirety in order to be included in the next year’s budget.
Index
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