Mac3701 2024 TL103 3 B

MAC3701/103/3/2024
Tutorial Letter 103/3/2024
APPLICATION OF MANAGEMENT
ACCOUNTING TECHNIQUES
MAC3701
Semesters 1 and 2
Department of Management Accounting
This tutorial letter contains important information

about the module.
BARCODE
CONTENTS
Page
PURPOSE OF THE MODULE ................................................................................................................. 5
PREREQUISITE AND PRIOR KNOWLEDGE.......................................................................................... 5
OVERVIEW OF THE MODULE ................................................................................................................ 6
STRUCTURE OF THE TUTORIAL LETTERS FOR THE MODULE ......................................................... 7
LECTURERS’ CONTACT DETAILS ........................................................................................................ 7
STRUCTURE OF THIS TUTORIAL LETTER ........................................................................................... 7
PRESCRIBED STUDY MATERIAL.......................................................................................................... 8
ASSESSMENTS AND SCOPE ................................................................................................................ 8
LEARNING UNIT 8: PROCESS COSTING .............................................................................................. 9
8.1 Introduction ................................................................................................................................... 9
8.2 Learning outcomes ....................................................................................................................... 9
8.3 Topic outline ............................................................................................................................... 10
8.4 Losses identified at the inspection point ...................................................................................... 11
8.5 Accounting for the proceeds and costs of normal scrap .............................................................. 11
8.6 The short-cut method for allocating normal losses ...................................................................... 11
8.7 The suitability of process costing in a service organisation ......................................................... 17
8.8 Batch or operation costing .......................................................................................................... 17
8.9 Summary .................................................................................................................................... 18
8.10 Self-review exercises .................................................................................................................. 19
LEARNING UNIT 9: STANDARD COSTING ......................................................................................... 20
9.1 Introduction ................................................................................................................................. 20
9.2 Learning outcomes ..................................................................................................................... 20
9.3 Topic outline ............................................................................................................................... 21
9.4 Sales volume variances: levels to use in MAC3701 .................................................................... 22
9.5 Further illustration of idle time and labour efficiency variances .................................................... 22
9.6 Fixed manufacturing overheads variances .................................................................................. 25
9.7 Sales and distribution cost rate and volume variances ................................................................ 26
9.8 Further aspects in respect of reconciling actual and standard profit ............................................ 27
9.9 General ledger accounts and journal entries ............................................................................... 28
9.10 Summary .................................................................................................................................... 33
LEARNING UNIT 10: RELEVANT COSTING ........................................................................................ 35
10.1 Introduction ................................................................................................................................. 35
10.3 Topic outline ............................................................................................................................... 36
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MAC3701/103/3/2024
10.4 Using data and technology in linear programming ...................................................................... 37

10.5 Summary .................................................................................................................................... 38
LEARNING UNIT 11: PERFORMANCE MANAGEMENT ...................................................................... 39
11.1 Introduction ................................................................................................................................. 39
11.3 Topic outline ............................................................................................................................... 40
11.4 Determining ‘investment’ ............................................................................................................. 40
11.5 A divisionalised organisational structure ..................................................................................... 41
11.6 Applying the principle of controllability to performance management .......................................... 43
11.7 Further aspects of non-financial performance measures ............................................................. 44
11.8 Summary .................................................................................................................................... 44
LEARNING UNIT 12: PRICE SETTING ................................................................................................. 46
12.1 Introduction ................................................................................................................................. 46
12.3 Topic outline ............................................................................................................................... 47
12.4 General guidelines for the calculation of the minimum- and maximum transfer price per unit...... 47
12.5 Intermediate versus final products .............................................................................................. 51
12.6 Cost-plus pricing method: customised and non-customised products ......................................... 51
12.6 Target rate of return on invested capital approach ...................................................................... 52
12.7 The role of different levels of fixed cost in discontinuation decisions of price takers .................... 52
12.8 Price elasticity: further aspects.................................................................................................... 53
12.9 Summary .................................................................................................................................... 54
LEARNING UNIT 13: OTHER ANCILLARY TOPICS ............................................................................ 55
13.1 Introduction ................................................................................................................................. 55
13.3 Topic outline ............................................................................................................................... 56
13.4 Further aspects of life-cycle costing ............................................................................................ 57
13.5 Big data ...................................................................................................................................... 58
13.6 Costing digital products ............................................................................................................... 61
13.7 Digital costing systems ............................................................................................................... 64
13.8 Non-financial performance indicators .......................................................................................... 64
13.9 Summary .................................................................................................................................... 65
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LEARNING UNIT 14: INVENTORY MANAGEMENT AND PLANNING TECHNIQUES ......................... 66
14.1 Introduction ................................................................................................................................. 66
14.3 Background................................................................................................................................. 66
14.4 Three motives for holding inventory ............................................................................................ 67
14.5 Application of the EOQ technique to determine the optimal number of units to order .................. 68
14.6 Applying the EOQ to determine the production run size .............................................................. 70
14.7 Decision making: Quantity discounts and the EOQ ..................................................................... 72
14.8 Decision making: When to place an order ................................................................................... 74
14.9 Calculating elementary safety stock levels .................................................................................. 76
14.10 Just-in-time (JIT) purchasing ...................................................................................................... 77
BIBLIOGRAPHY .................................................................................................................................... 79
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MAC3701/103/3/2024
PURPOSE OF THE MODULE
This module (MAC3701) is intended to equip you (as a student) with specific competencies in
management decision making and control. The module will enable you to demonstrate integrated
knowledge in these competencies, including pervasive skills, ethics and professional practice,
and other accounting competencies.
This module is designed to facilitate your acquisition of these competencies through knowledge
of and engagement in relevant management accounting topics at the forefront of the field,
including an understanding of the theories, methods and techniques relevant to the field, and of
how to apply this knowledge in a particular context.
The syllabus includes the following main topics: cost accounting, planning and control, and
decision making.
PREREQUISITE AND PRIOR KNOWLEDGE

To a large extent, this module builds upon prior knowledge you would have obtained from your
second year (NQF level 6) of management accounting studies. The prerequisite for this module
is MAC2601 (Principles of management accounting) and therefore, this module is designed on
the premise and assumption that you have already completed this prerequisite (or its equivalent)
and that you have achieved the necessary prior learning. MAC2601 study guides are also posted
on myModules, in the event that you need to revisit some principles already covered in second
year management accounting.
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OVERVIEW OF THE MODULE
Tutorial letter (TL) 101

General information, planning and administrative matters
QB001 QUESTION BANK

TL102 TL103
Learning units: Learning units:
1. Cost classification and behaviour 8. Process costing
2. Cost estimation 9. Standard costing
3. Budgets, planning and control 10. Relevant costing
4. Cost volume-profit relationships 11. Performance management
5. Direct and absorption costing systems 12. Price setting
6. Overheads allocation 13. Other ancillary topics
7. Joint and by-product costing 14. Inventory management and
planning techniques
15.
TL104
Examination Guidance
Assignment 1 (MCQ)
(Assignment 1 covers Learning units 1–7)
Written Assignment 2
(Assessment based on all the learning units in TL102 and TL103)
Final written examination

(The examination is based on all the learning units in TL102 and TL103)
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MAC3701/103/3/2024
STRUCTURE OF THE TUTORIAL LETTERS FOR THE MODULE

The following tutorial letters will be made available to you during the semester. Two tutorial letters
(TL102 and TL103) which contain a total of 14 learning units to study, two tutorial letters which
contain solutions to Assignments 01 and 02 (TL201 and TL202), and one tutorial letter containing
information about the examination (TL104). You will also receive one question bank (QB001).
Other study resources, including the assignment questions, will be made available online. Kindly
note that Tutorial letters 102 to 103 act as guides to help you navigate the prescribed book and
therefore no separate study guide is issued for this module.
SERIES CONTENT OVERVIEW

TL101 General information, planning and administrative matters
TL102 Technical contents – Learning units 1 to 7
TL103 Technical contents – Learning units 8 to 14
TL104 Examination guidance
TL201 Suggested solution to compulsory Assignment 01
TL202 Suggested solution to compulsory Assignment 02
QB001 Question bank and suggested solutions
LECTURERS’ CONTACT DETAILS

For an effective and efficient turnaround time, refer to the MAC3701 site on myModules for the
relevant lecturers’ contact details.
STRUCTURE OF THIS TUTORIAL LETTER

This tutorial letter (TL103) provides a “learning compass” to the prescribed study material(s)
concerning learning units 8 to 14 (all inclusive) of the module. This learning compass is outlined
in the “Topic outline” section of each learning unit, and it specifies the concepts you must learn
from each learning unit.
This tutorial letter consists of the following seven learning units:
LEARNING UNIT TITLE

Learning unit 8 Process costing
Learning unit 9 Standard costing
Learning unit 10 Relevant costing
Learning unit 11 Performance management
Learning unit 12 Price setting
Learning unit 13 Other ancillary topics
Learning unit 14 Inventory management and planning techniques
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PRESCRIBED STUDY MATERIAL
The prescribed study material for this part of the module (tutorial letter) is as follows:
STUDY MATERIAL REFERENCE

Principles of management accounting: A TL101, section 5.1
South African perspective (2020, 3rd edition)
Question bank QB001
Additional notes myModules/Additional Resources
ASSESSMENTS AND SCOPE

In preparation for the summative assessment (examination), you will be assessed continuously
throughout the semester. For this reason, your knowledge of the learning units covered in this
tutorial letter (TL103) will be assessed in the second assignment. It is therefore important that you
are fully aware and cognisant of the scope of each assessment throughout the year.
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MAC3701/103/3/2024
LEARNING UNIT 8: PROCESS COSTING
8.1 Introduction
In the second-year costing module, you learnt about process costing systems. Specifically, you
learnt how to calculate equivalent units of production in cases where work-in-progress (WIP)
exists at the beginning and/or end of a certain period. You also learnt how to assign an equivalent
cost per unit to inventory, production and abnormal losses, using different inventory valuation
methods. Furthermore, you learnt how to account for normal losses. Many of the principles you
learnt in the second-year module are revised in this learning unit. However, some additional
principles, such as the treatment of scrap values and consecutive processes with WIP, are
presented in this learning unit. Also, a greater degree of integration of this topic with other topics
is prevalent in questions (refer to the question bank).
8.2 Learning outcomes

After you have studied learning unit 8, you should be able to
▪ calculate and account for abnormal gains/losses in a process costing system
▪ discuss the impact of normal losses, abnormal losses and abnormal gains on cost
▪ account for the proceeds of the sale of normal and abnormal scrap and to discuss the effect
of the sale of normal and abnormal scrap
▪ discuss the differences between the first-in-first-out (FIFO) and weighted average methods
of inventory valuation within a process costing context, as well as when to make use of
which method
▪ account for transfers from previous processes in completed and WIP inventories
▪ prepare a statement of profit or loss and other comprehensive income (income statement),
applying direct or absorption costing principles in the context of a process costing system
▪ apply process costing principles to render relevant costing information in a decision-making
context
▪ apply the short-cut method for allocating normal losses in appropriate circumstances
▪ discuss the suitability of process costing in a service organisation
▪ describe the principles of batch or operation costing
Assumed prior knowledge

You can
▪ describe the uses of a process costing system
▪ calculate unit costs in a system with a single manufacturing process and in a system with
two or more consecutive manufacturing processes (all units completed)
▪ calculate completed units and the equivalent units for WIP
▪ calculate the normal and abnormal losses for a period, depending on the wastage point
▪ prepare a quantity statement, a production cost statement and a cost allocation statement
(all of which include losses) based on the weighted average method and the FIFO method
of inventory valuation
▪ record and allocate process costs in the general ledger
▪ identify and explain whether job costing or process costing will be more suitable to use in a
specified scenario
▪ record costs in a job costing system and calculate the profit or loss per job
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8.3 Topic outline
This learning unit builds on the principles and concepts of process costing you learnt in your
second-year studies. It is very important to note that the Principles of management accounting
(3rd edition) textbook uses different terms for the process costing statements than the terms used
in MAC2601. For the purposes of MAC3701, you can continue using the MAC2601
terminology if you prefer. Below is a table depicting the terminology differences between
MAC2601 and Principles of management accounting (3rd edition):
Term used in MAC2601 Term used in Principles of

management accounting
(3rd edition)
Quantity statement Equivalent production statement
Production cost statement Unit cost statement
Allocation statement/cost allocation statement Production cost statement
The section of the (cost) allocation statement that Production reconciliation statement
reconciles the total cost allocated to the total cost per
production cost statement
Wastage point or inspection point (as applicable in a Inspection point
specific scenario)
Study the following sections in chapter 8 of the prescribed textbook:

Concepts Principles of management accounting
(3rd edition)
Theoretical basis Revision/prescribed
exercises
Introduction Section 8.1 none
Calculations in a process costing system Section 8.2 Example 8.1
▪ Work-in-progress
o Closing work-in-progress Section 8.2.1
o Opening work-in-progress Example 8.2
▪ Losses and gains in the process Example 8.3
o Normal losses identified at the end of Section 8.2.2
the process Example 8.4
o Losses identified before the end of the
process Example 8.5
o Opening and closing work-in-progress
and abnormal losses Example 8.6
o Normal and abnormal loss units sold as
scrap Examples 8.7 and 8.8
o Process costing using the first-in, first-
out (FIFO) method Example 8.9
o FIFO method and weighted average
method compared Example 8.10
Consecutive processes Section 8.3 none
Decision-making Section 8.4 Example 8.11
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MAC3701/103/3/2024
8.4 Losses identified at the inspection point

Section 8.2.2 states that losses in a process are identified by inspection. Although this is generally
the case, it is not always correct. Take note that losses in a process can be identified at any
particular point of the process, even if that point is not necessarily an inspection point.
8.5 Accounting for the proceeds and costs of normal scrap

Although the textbook addresses four different “methods of dealing with the proceeds from the
sale of normal loss units” (Williams et al 2020:236–237), the default method we expect you to
apply for purposes of the MAC3701 module is to set off these proceeds against the material
costs in your production cost statement before you calculate the equivalent cost per unit.
A MAC3701 question will specify if you need to apply any other method than this default method.
In other words, always subtract the proceeds from the sale of normal scrap in the materials
column of your production cost statement before dividing the total by equivalent units, unless a
question specifically instructs you to do otherwise. If there is a cost involved in disposing of
normal scrap, this cost will have to be added to the current material costs again, unless the
question specifically instructs you to do otherwise.
8.6 The short-cut method for allocating normal losses

In the second-year costing module, you learnt that the rand value of a normal loss has to be
allocated to units completed and transferred, abnormal losses/gains and closing WIP in the ratio
of the units that passed the wastage point in the current period as reflected in the output column
of the quantity statement. However, when all the units in the output column of the quantity
statement have reached or passed the wastage point during (i.e., are subject to normal wastage
in) the current period, we can apply what is referred to as the short-cut method, as long as
abnormal loss/gain units also share in the normal loss of the current period. Abnormal loss/gain
units always share in the normal loss of the current period, except abnormal/gain loss units linked
to a specific event that takes place at a point in the process earlier than the normal loss wastage
point.
It should also be noted that units that are both started and completed in the current period will
automatically also pass this wastage point in the current period as they move from 0% completion
to 100% completion in this period. This means that the short-cut method may only be used
when all output units pass the wastage point in the current period (Raath & Berry 2019;
Drury 2015; Coetzee et al. 2012a). What the short-cut method involves is that, in the quantity
statement, only in the equivalent unit columns (for both materials and conversion), normal loss
units are represented by zero values. Refer to the following example:
Physical units Equivalent units
Input Details Output Direct Conversion
units units raw materials costs
Units % Units %
5 000 Opening work-in-progress (WIP)
55 000 Put into production
Completed and transferred 55 000 55 000 55 000
Normal loss 3 600 0 100 0 60
Abnormal loss 400 400 100 240 60
Closing work-in-progress (WIP) 1 000 1 000 100 700 70
60 000 60 000 56 400 55 940
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The implication is that you will still have to calculate the normal loss in units for purposes of the
output column of your quantity statement as you normally would have done. However, the
calculated normal loss units are not transferred to the “equivalent units” columns. As a result, the
equivalent cost per unit will be higher than it would have been. Furthermore, the cost allocation
statement will be affected in that the cost of the normal loss will not have to be directly allocated
to the current period completed and transferred, abnormal loss and/or closing WIP sections (as
applicable). Nevertheless, by virtue of a higher equivalent cost per unit, the cost of the normal
loss is indirectly allocated. Although we will have a different equivalent cost per unit using the
two methods, in the end, the result is the same in terms of the valuation of completed goods and
closing WIP and the amount of the abnormal loss.
Take note: In MAC3701 you must always apply the short-cut method when the conditions
for its application are met. You will lose marks if you apply the normal (longer) method in
MAC3701 if you could have used the short-cut method.
Self-practice exercise 8.6.1: longer method vs short-cut method

Assume that an entity uses a process costing system in which materials are added at the
beginning of the process and conversion costs are incurred evenly over the process. The first-
in-first-out (FIFO) method of inventory valuation is applicable, and the company adopted an
absorption costing system. The wastage occurs when the process is 56% complete. Normal
losses amount to 5% of the inputs that reach the wastage point. The organisation applies
absorption costing principles. No finished goods inventory is kept.
All completed units were sold at a selling price of R20 per unit and selling and administrative costs
of R52 000 were incurred in the period under review.
The following information is also available regarding the period under review:
Item Units Direct Conversion
material costs
costs
Opening WIP at the beginning of the period – 52% 25 000 R125 000 R104 000
complete
Units put into production in the current period 100 000 R587 250 R900 558
Units completed and transferred in the period 109 250 ? ?
Closing WIP at the end of the period – 60% complete 5 700 ? ?
REQUIRED:
(a) Apply the method taught in MAC2601 (the longer method) and calculate the equivalent
cost per unit.
▪ Show all the calculations.
(b) Prepare the statement of profit or loss and other comprehensive income (income
statement) for the period under review.
(c) Determine if the short-cut method applies to self-practice exercise 8.6.1.
(d) If the short-cut method is applicable, calculate the equivalent cost per unit using the short-
cut method and prepare the accompanying income statement for the period under review.
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MAC3701/103/3/2024
Self-practice exercise 8.6.1: suggested solution

(a) Equivalent cost per unit (applying the longer method)
Quantity statement
Input Details Output Raw materials Conversion
(units) (units) Units % Units %
25 000 Opening WIP
Completed from:
Opening WIP 23 750 – 0 11 400 48
Current production 85 500 85 500 100 85 500 100
Completed and
transferred 109 250 85 500 96 900
Normal loss 6 250 6 250 100 3 500 56
Abnormal loss 3 800 3 800 100 2 128 56
Closing WIP 5 700 5 700 100 3 420 60
125 000 125 000 101 250 105 948
Material Conversion
Production cost statement Total cost costs
R R R
Opening WIP 229 000
Current production costs 1 487 808 587 250 900 558
Total 1 716 808
Divided by: Equivalent units per
quantity statement 101 250 105 948
Equivalent cost per unit R14,30 = R5,80 + R8,50
(b) Statement of profit or loss and other comprehensive income

R
Sales (109 250 x R20) 2 185 000
Less: Cost of sales 1 609 314
Opening WIP (given) 229 000
Plus: Current production (W3) 1 380 314
Plus: Closing WIP production (W3) 65 298
Less: Closing WIP (W3) 65 298
Gross profit 575 686
Less: Period costs 94 196
Abnormal loss (W3) 42 196
Selling and administrative costs (given) 52 000
Net profit before taxation 481 490
Workings:
W1. Calculation of the rand value of the normal loss
NLR = (6 250 x R5,80) + (3 500 x R8,50)
= R36 250 + R29 750 = R66 000
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W2. Allocation of the rand value of the normal loss
Material Units Calculations R
Completed and transferred 85 500 85 500 / 95 000 x R36 250 32 625
Abnormal loss 3 800 3 800 / 95 000 x R36 250 1 450
Closing WIP 5 700 5 700 / 95 000 x R36 250 2 175
TOTAL 95 000 R36 250
Conversion Units Calculations R

Completed and transferred 96 900 96 900 / 102 448 x R29 750 28 139
Abnormal loss 2 128 2 128 / 102 448 x R29 750 618
Closing WIP 3 420 3 420 / 102 448 x R29 750 993
TOTAL 102 448 R29 750
W3. Allocation statement

R
Opening WIP 229 000
Material 125 000
Conversion 104 000
Current period equivalent production activities 1 380 314
Material 495 900
(R5,80 x 85 500)
Conversion cost 823 650
(R8,50 x 96 900)
Normal loss 60 764
(R32 625 + R28 139) (W2)
Completed and transferred 1 609 314
Abnormal loss 42 196
Material 22 040
(R5,80 x 3 800)
(R8,50 x 2 128)
Normal loss 2 068
(R1 450 + R618) (W2)
Closing WIP 65 298
Material 33 060
(R5,80 x 5 700)
(R8,50 x 3 420)
Normal loss (2 175 + 993) (W2) 3 168
Total cost allocated 1 716 808
Rounding difference 0
Total cost per production cost statement 1 716 808
Take note: It is not necessary to prepare the allocation statement unless it is specifically required
by the question. If the allocation statement is not required, all the amounts needed for the income
statement can simply be reflected as brief calculations.
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MAC3701/103/3/2024
(c) Determining if the short-cut method is applicable

For the short-cut method to be applicable, the opening WIP units, the current production units,
the closing WIP units and the abnormal loss/gain units – all of which are from the output column
of the quantity statement – should have been subjected to the wastage point of 56% in the current
period. At the beginning of the current period, opening WIP was only 52% complete, meaning that
it would have passed the wastage point of 56% in the current period. During the period, the current
production would have started at 0% and subsequently passed the 56% wastage point en route
to 100% completion. The abnormal loss point is at the same point as the wastage point (56%).
Lastly, at the end of the current period, closing WIP would already be 60% complete and,
therefore, would also have passed the 56% mark in the current period. It, therefore, follows that
all the units in the output column of the quantity statement would have passed the 56% wastage
point in the current period. As a result, we will have to apply the short-cut method.
(d) Applying the short-cut method in calculating equivalent cost per unit
Quantity statement
The quantity statement, using the short-cut method, will be as follows:

Input Details Output Raw materials Conversion
(units) (units) Units % Units %
25 000 Opening WIP
Completed from:
Opening WIP 23 750 – 0 11 400 48
Current production 85 500 85 500 100 85 500 100
Completed and transferred 109 250 85 500 96 900
Normal loss 6 250 – 0 – 0
Abnormal loss 3 800 3 800 100 2 128 56
Closing WIP 5 700 5 700 100 3 420 60
125 000 125 000 95 000 102 448
Conversion
Production cost statement Total Material cost
R R R
Opening WIP 229 000
Current production cost 1 487 808 587 250 900 558
Total 1 716 808
Divided by: Equivalent units per
quantity statement 95 000 102 448
Equivalent cost per unit R14,97 = R6,18 + R8,79
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Income statement
R
Sales (109 250 x R20) 2 185 000
Less: Cost of sales 1 609 141
Opening WIP (given) 229 000
Plus: Current production (W4) 1 380 141
Plus: Closing WIP production (W4) 65 288
Less: Closing WIP (W4) 65 288
Gross profit 575 859
Less: Period costs 94 189
Abnormal loss (W4) 42 196
Selling and administrative costs (given) 52 000
Net profit before taxation 481 670
Calculation of the rand value of the normal loss

Not applicable when the short-cut method is used.
Allocation of the rand value of the normal loss

Not applicable when the short-cut method is used.
W4. Allocation statement

R
Opening WIP 229 000
Material 125 000
Conversion 104 000
Current period equivalent production activities 1 380 141
Material (R6,18 x 85 500) 528 390
Conversion cost (R8,79 x 96 900) 851 751
Completed and transferred 1 609 141
Abnormal loss 42 189
Material (R6,18 x 3 800) 23 484
Closing WIP 65 288
Material (R6,18 x 5 700) 35 226
Total cost allocated 1 716 618
Rounding difference 190
Total cost per production cost statement 1 716 808
Notes:
Can you see that the cost of current period equivalent production activities, abnormal loss and
closing WIP, as well as the gross and net profits, are the same for the longer method and the
short-cut method, except for some rounding differences?
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MAC3701/103/3/2024
Self-practice exercise 8.6.2

Attempt self-practice exercise 8.6.1 on your own by applying the weighted average method
instead of the FIFO method.
8.7 The suitability of process costing in a service organisation

In the second-year module, you learnt about job costing – and how it differs from process costing.
You may refer to chapter 7 of the textbook for purposes of revision or to get another perspective.
According to Williams et al (2020:196), job costing can also be used to cost services in cases
where each service delivered is unique – a job does not necessarily have to be a manufactured
“product”. For example, an accounting advisory firm will perform different jobs for different clients
as well as different jobs for the same client – the individual jobs will not consume the same amount
of resources. Different combinations of inputs will be applicable to different jobs, for example,
certain tasks to be carried out may require more (or less) time from advisory staff, different skills
and so forth.
But can process costing also be applicable in a service organisation?
You may remember from second-year costing that a process costing system is normally used
when products are homogeneous (all the same) (Coetzee et al. 2012a). Certain services,
however, can also be “repetitive” and consume similar resources (Drury 2015). To provide these
services, an organisation can make use of one process, or consecutive processes. In such cases,
a process costing system may be appropriate.
An example would be where the accounting advisory firm that we referred to above assists clients
in applying for the registration of new companies. Unless there is specific additional work to be
done in certain cases, the administrative processes and resources used should probably be
standard for each application for registration. The cost of each unit of this “standard” service may
then be determined by dividing the total cost of all the work done in this regard by the total units
of the service. If, for instance, some extent of unique work needs to be done in addition to the
standard service aspects in order to assist a certain client with the application, a “combination” of
process costing and job costing may be appropriate (Drury 2015). This brings us to the next
section of this learning unit: batch or operation costing.
8.8 Batch or operation costing

You were introduced to batch or operation costing in the second-year module when a “costing
system that combines process costing and job costing” was discussed (Coetzee et al 2012a).
Examples provided were motor vehicles and computers, where “[S]imilar models (products) are
manufactured in batches (or production runs)”. Within a specific batch, all the units are the same;
however, batches differ from one another since the specifications of a particular batch could
require different resources. The individual batches, therefore, will not carry the same cost
although the units in a specific batch will each be allocated the same cost.
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8.9 Summary
In this learning unit we revised how a process costing system works and how the statements that
are usually associated with such a system are prepared (also refer to section 8.3 above). We
further looked at how a process costing system differs from a job costing system, but how it is
“closely linked to joint and by-products” (Williams et al 2020:249). You learnt, among other things,
how to calculate and/or treat the following in a process costing system: equivalent production
units and equivalent production cost per unit in terms of a specific period; losses, gains and the
sale of “lost” units; and the value of WIP, finished goods and abnormal losses – all in terms of
both the FIFO method and the weighted average method of inventory valuation. Additionally, the
concept of the short-cut method, as it applies to process costing, was introduced.
As with the other MAC3701 topics, you have to be able to integrate process costing with other
topics. Refer to the section “Conclusion: Process costing and other topics in this book” in the
textbook, Principles of management accounting (3rd edition), for examples of topics that can be
combined with process costing.
Furthermore, process costing is often integrated with direct and absorption costing. Using process
costing statements (quantity statement, production cost statement and/or cost allocation
statement) as a basis, you should also be able to prepare a statement of profit or loss and other
comprehensive income (income statement), applying direct or absorption costing principles, as
applicable.
What you learnt and/or revised in this learning unit is graphically summarised as follows:
PROCESS COSTING STATEMENTS
Quantity Production cost Cost allocation Income

statement statement statement statement
Input Normal loss Sales of
Total cost per calculation and
units equivalent unit finished
allocation/short-cut goods
Output method
units Material cost per
equivalent unit Opening WIP and Opening and
Equivalent current period closing
units for equivalent production inventory
material activities (FIFO)
Conversion cost
per equivalent
unit Completed and Current
Equivalent transferred production
units for cost: direct
conversion materials
Abnormal loss and
conversion
Closing WIP costs
Period costs
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MAC3701/103/3/2024
8.10 Self-review exercises

8.10.1 View the video about processing costing that can be found on myModules.
8.10.2 Attempt the following basic questions (BQs): BQ3, BQ9 and BQ10 in chapter 8 of the
prescribed textbook.
8.10.3 Attempt the following long question (LQ): LQ2 in chapter 8 of the prescribed textbook,
including the following additional sub-questions:
“(c) Prepare the production costs statement.”
“(d) Prepare the allocation cost statement.”
8.10.4 Attempt LQ3 in chapter 8 of the prescribed textbook.
8.10.5 Attempt Appendix example 8.1 (Minerva Ltd) and Appendix example 8.2 (Minerva Ltd)
in chapter 8 of the prescribed textbook.
8.10.6 ▪ Do an internet search on whether process costing can be applied by service
organisations.
▪ Can you find examples of types of service organisations that could potentially apply
process costing?
19
LEARNING UNIT 9: STANDARD COSTING
9.1 Introduction
The use of a standard costing system, as you have learnt in the second-year costing module,
could offer several advantages. If it is efficient, such a system could enable its users to perform
effective performance management, to have more control over costs and income and to gather
important information for use in budgeting, decision-making and the valuation of different types
of inventory (Williams et al 2020).
Learning unit 9 elaborates on the standard costing principles you were taught in the second-year
costing module by extending their application to an absorption costing system and scenarios in
which there is a difference between the actual and the budgeted volumes of sales and production.
The learning unit, furthermore, demonstrates the calculation and interpretation of more detailed
variances (e.g., mix and yield variances). Critical to your understanding of these more advanced
or detailed applications of standard costing principles are the basic concepts of flexible budgeting
and the difference between a budget and a standard, both of which were dealt with in the second-
year costing module.

After you have studied learning unit 9, you should
▪ be able to explain how a standard costing system is designed and how standards are set
▪ understand the aspects of inventory valuation in a standard costing system
▪ be able to perform detailed variance calculations in
(a) a direct costing system
(b) an absorption costing system
▪ be able to analyse these detailed variances, to identify their (possible) causes within the
context of one another and the scenario presented and to determine when and how to
investigate a variance further and to take corrective action
▪ be able to prepare a set of accounts with appropriate journal entries for a standard costing
system, including detailed variances
▪ be able to reconcile the budgeted profit with the actual profit
Assumed prior knowledge

▪ You understand and can describe the concept of a standard costing system, the
aims/purpose of such a system and the operations of an efficient standard costing system.
▪ You can describe the advantages and characteristics of an efficient standard costing
system, as well as the industries best suited for the use of a standard costing system.
▪ You can differentiate between budget and standard data.
▪ You can establish cost standards and compile a standard cost card.
▪ You can calculate selected variances using a standard costing system.
▪ You can analyse and present plausible reasons for selected variances.
▪ You can reconcile the budgeted direct costing profit with the actual direct costing profit.
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MAC3701/103/3/2024
9.3 Topic outline

As mentioned in the introduction, this topic builds on your prior learning. Study the following
sections in chapter 13 of the prescribed textbook:
Chapter 13 Principles of management accounting
(3rd edition)
Concepts Theoretical basis Revision/prescribed
exercises
Standards and the interrelationship Section 13.2 none
between standards and budgets
Standard costing and inventory valuation Section 13.3 none
Determination of cost standards Section 13.4 none
▪ Historic records versus engineering studies Section 13.4.1 none
▪ Level of difficulty Section 13.4.2 none
Calculation of variances Section 13.5 none
▪ The static budget variance, volume variance Section 13.5.1 Examples 13.1 and 13.2
and flexed budget variance
▪ Revenue variances Section 13.5.2 Example 13.3
▪ Direct materials variance Section 13.5.3 Examples 13.4 and 13.5
▪ Direct labour variance Section 13.5.4 Example 13.6
▪ Variable overhead variance Section 13.5.5 Example 13.7
▪ Fixed overhead variances Section 13.5.6
o Variable costing system none
o Absorption costing system Example 13.8
Reconciliation of actual profit to standard Section 13.6 Standard costing
profit reconciliation for
Specialised Cycles
Investigation of variances Section 13.7 none
▪ Rule of thumb models Section 13.7.1 none
▪ Cost-benefit models Section 13.7.2 none
▪ Statistical models Section 13.7.3 none
Interpretation of variances Section 13.8 Example 13.9
Possible causes of variances Section 13.9 none
▪ Inflationary effects Section 13.9.1
▪ Materials-related effects Section 13.9.2
▪ Labour-related effects Section 13.9.3
Planning and operating variances Section 13.10 Example 13.10
Revision of standards Section 13.11 none
Accounting entries Section 13.12 Example 13.11
Balances in the variance accounts Section 13.13 Example 13.12
Criticisms of standard costing Section 13.14 none
Variance analysis in modern mechanised Section 13.15 none
environments
Standard costing in service organisations Section 13.16 none
Standard costing and benchmarking Section 13.17 none
21
(3rd edition)
exercises
Advanced standard costing concepts Appendix 13.1
▪ Revenue variances: sales mix and sales Appendix example 13.1
quantity variances
▪ Market share and market size variances Appendix example 13.2
▪ Production mix and yield variances
o Direct materials mix and yield variances Appendix example 13.3
o Labour variances: mix and yield none
o Labour variances: idle time Appendix example 13.4
You also have to work through the following selected sections of chapter 7 of the prescribed
textbook. Although the larger part of section 7.3 relates to prior learning and may be used for
revision purposes, take specific note of how the subsection called “Standard costs” in section
7.3.1, as well as sections 7.3.2 and 7.3.3, relate to standard costing. You must study these
sections.
(3rd edition)
exercises
The elements of cost in a job-costing Section 7.3 none
system
▪ Determining the cost of materials Section 7.3.1 Example 7.4
(subsection on “standard costs” only)
▪ Determining the cost of labour Section 7.3.2 Examples 7.5–7.7
▪ Overhead expenses Section 7.3.3 Example 7.8
9.4 Sales volume variances: levels to use in MAC3701

In MAC3701, we expect you to use
(i) standard gross profit in the calculation of the sales volume variances in a standard
absorption costing system
(ii) standard contribution in the calculation of the sales volume variances in a standard
direct (variable) costing system
9.5 Further illustration of idle time and labour efficiency variances

When idle time is applicable, the labour quantity variance can be further analysed into idle time
variance and (operating) labour efficiency variance.
9.5.1 Selected key terms within labour variances

The following adapted extracts from Raath and Berry (2019) should help you gain a better
understanding of labour efficiency variance, when based on productive work hours, and idle time
variance:
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MAC3701/103/3/2024
Key terms Explanation

clock hour(s) Clock hour(s) refer to the time that workers are physically present at
work. These hours are usually recorded when workers swipe personnel
cards or clock in by other means. “Gross remuneration is normally based
on clock hours worked” (Coetzee et al 2012a).
clock hour This is the standard (budgeted) or actual rate/tariff paid to employees for
rate/tariff every clock hour.
work(ing) hours Working/operating/productive hours refer to the time that an employee
is productive (“physically working in the production process or on jobs”
(Coetzee et al 2012a)). This time is usually recorded on job cards.
idle time Idle time is the difference between clock hours and
working/operating/productive hours.
work hour rate This is how much it would normally cost an organisation for one
productive hour, that is, the cost per hour after an adjustment was made
to the standard clock hour rate to allow for standard (budgeted) idle time.
Work hour rate = Clock hour rate ÷ (1 – idle time %)
Example:
If the clock hour rate is R48 and the standard idle time is 25%, then the
work hour rate would be calculated as R48 ÷ (1 – 25%) = R48/0,75 =
R64.
standard labour Depending on the nature of the given information, standard labour cost
cost is calculated by using either clock hours or work hours. However, in this
regard, it is important to note that standard clock hours must be applied
to the standard clock hour rate, or standard work hours must be applied
to the standard work hour rate. Refer to appendix example 13.4
(chapter 13) in the textbook – the standard skilled labour rate is
calculated as:
2 x R150 = R300 per bicycle or 2 x 0,8 x R187,5 (R150 ÷ 0,8)
= R300 per bicycle.
9.5.2 Idle time variance and labour efficiency variance formulae

(a) Formulae: idle time variance
The idle time variance should be calculated by applying either of the following two formulae:
➢ Idle time variance = (Actual productive hours – Standard productive hours allowed for actual
input) x Standard work hour rate
or
➢ Idle time variance = (Actual idle time – standard or normal idle time allowed for actual input)
x Standard work hour rate
23
(b) Formulae: labour efficiency variance (when there is idle time in the question)
This variance is sometimes referred to as operating labour efficiency variance. (Operating) labour
efficiency variance should be calculated by applying either of the following two formulae:
➢ (Operating) labour efficiency variance = (Actual productive hours – Standard productive
hours allowed for actual output) x Standard work hour rate
or
➢ (Operating) labour efficiency variance = (Actual production at standard cost) – (Actual work
hours x Standard work hour rate)
9.5.3 Idle time variance and labour efficiency variance example

Let us now apply the above formulae to calculate the idle time variance and the (operating) labour
efficiency variance for appendix example 13.4 in the prescribed textbook.
(a) Idle time variance

Idle time variance = (Actual productive hours – Standard productive hours allowed for actual
input) x Standard work hour rate
= ([2 860* x 0,65] – [2 860 x 0,8]) x (R150 ÷ 0,8)
= (1 859 – 2 288) x R187,50
= 429 x R187,50
= R80 437,50 Adverse (A)
*From example 13.6 in the prescribed textbook

or
Idle time variance = (Actual idle time – Standard or normal idle time allowed for actual input) x
Standard work hour rate
= ([2 860 x 0,35] – [2 860 x 0,2]) x R187,50
= (1 001 – 572) x R187,50
= 429 x R187,50
= R80 437,50 Adverse (A)
Why is the variance adverse? The skilled labourers were productive for a smaller-than-expected
proportion of the time that they were on the premises due to the “go-slow”.
(b) (Operating) labour efficiency variance
(Operating) labour efficiency variance = (Actual productive hours – Standard productive hours
allowed for actual output) x Standard work hour rate
= ([2 860 x 0,65] – [0,8 x 2 x 1 300*] x R187,50
= (1 859 – 2 080) x R187,50
= 221 x R187,50
= R41 437,50 Favourable (F)
*1 300 is the actual number of bicycles produced as per previous examples
or
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MAC3701/103/3/2024
(Operating) labour efficiency variance = (Actual production at standard cost) – (Actual work
hours x Standard work hour rate)
= (1 300* x R300) – (2 860 x 0,65 x R187,50)
= R390 000 – R348 562,50
= R41 437,50 Favourable (F)
*1 300 is the actual number of bicycles produced as per previous examples
Why is this (operating) labour efficiency variance favourable? It is favourable because fewer work
hours than expected were used to produce the bicycles (actual output). Various factors could
explain a favourable labour efficiency variance (e.g., the result of the learning curve, rushing with
fitting the components onto the frames).
9.6 Fixed manufacturing overheads variances

What you have learnt from section 9.5.6 can be summarised as follows:
▪ In general, there are four fixed manufacturing overheads variances. Of these four, only one,
the fixed manufacturing overheads expenditure variance is applicable to a variable costing
system while all four are applicable to an absorption costing system.
▪ In an absorption costing system, we can either have two or four fixed manufacturing overheads
variances. If the fixed manufacturing overheads are allocated based on the budgeted units,
we will then have the expenditure and the quantity variances only. However, if the fixed
manufacturing overheads are allocated on a base other than the units, for example, machine
hours, then we will have all four fixed manufacturing overhead variances.
The above summary can be represented graphically as follows:
Variable costing system Absorption costing system
1. Fixed 2. Fixed manufacturing

manufacturing overheads volume
overheads spending (quantity) variance
1. Fixed manufacturing variance
overheads spending variance
2.1. Fixed manufacturing 2.2. Fixed manufacturing
overheads capacity overheads effeciency
variance variance
Based on example 13.8 in the prescribed textbook, the following fixed manufacturing overheads
variances are now calculated for illustrative purposes:
Take note: In example 13.8, the company uses an absorption costing system and the fixed
manufacturing overheads are allocated based on the semiskilled labour hours. Therefore, we will
have all four fixed manufacturing overheads variances, as follows:
1. Fixed manufacturing overheads expenditure variance = R250 000 (U)
2. Fixed manufacturing overheads volume variance = R120 000 (F), made up of:
2.1. fixed manufacturing overheads (volume) capacity variance = R94 000 (F)
2.2. fixed manufacturing overheads (volume) efficiency variance = R26 000 (F)
25
(a) Fixed manufacturing overheads volume (quantity) variance
Formula: = (Actual units x Standard hours* – Budget units x Standard hours*) x Standard fixed
allocation rate per hour*
= [(1 300 x 4 hours) – (1 000 x 4 hours)] x R100
= (5 200 – 4 000) x R100
= R120 000 (F)
(b) Fixed overheads volume capacity variance

Formula: = (Actual hours* of input – Budgeted hours* of input) x Standard fixed overheads
allocation rate per hour*
= (4 940 – 4 000) x R100
= R94 000 (F)
(c) Fixed overheads volume efficiency variance

Formula: (Standard quantity of input hours* for actual production – Actual hours* of input)
x Standard fixed overheads allocation rate per hour*
= [(4 hours x 1 300 bicycles) – 4 940 hours] x R100
= (5 200 – 4 940) x R100
= R26 000 (F)
*Take note: The above demonstrations are based on the assumption that the company uses
direct labour hours as its allocation base. Allocation bases such as units, machine hours, kilowatts
and flying hours can also be used.
9.7 Sales and distribution cost rate and volume variances

In the MAC2601 module, you learnt about the variable sales and distribution costs expenditure
variance, which arises if there is a difference between the actual and standard variable sales and
distribution costs per unit.
The following additional, but related, two variances are now introduced:
(a) Variable sales and distribution costs volume variance
A difference between the budgeted and the actual number of units sold can give rise to a variable
sales and distribution costs volume variance (Coetzee et al 2012b). This variance is calculated
as follows:
Formula: (Actual sales volume – Budgeted sales volume) x Standard variable sales and
distribution costs per unit
(b) Fixed sales and distribution costs expenditure variance

A difference between the budgeted and the actual expenditure.
Formula: (Actual fixed sales and distribution expenditure – Budgeted fixed sales and distribution
expenditure)
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MAC3701/103/3/2024
9.8 Further aspects in respect of reconciling actual and standard profit

The example of a reconciliation between actual profit and standard profit in section 13.6 of the
prescribed textbook does not deal with the sub-variances in the same detail that they are taught
in this module. Therefore, we generally recommend that you use the following reconciliation layout
adapted from Raath and Berry (2019) when an absorption costing system is in use:
Details Reconciliation F or U
R
Budgeted profit XXXXX
Plus/Less: Sales margin volume variance
- Sales mix variance
- Sales quantity variance
Standard gross profit XXX
Plus/Less: Sales margin price variance
Plus/Less: Direct material variance
- Material purchase price variance
- Material usage variance
o Material mix variance
o Material yield variance
Plus/Less: Direct labour variance
- Direct labour price variance
- Direct labour efficiency variance
o Direct labour idle time variance
o Direct labour efficiency variance
Plus/Less: VMOH variance
- VMOH expenditure variance
- VMOH efficiency variance
Plus/Less: FMOH variance
- FMOH expenditure variance
- FMOH volume variance
o FMOH capacity variance
o FMOH efficiency variance
Plus/Less: Fixed selling and distribution cost spending variance
Plus/Less: Variable selling and distribution cost spending variance
Plus/Less: Variable selling and distribution cost volume variance
Actual profit XXXXX
Adapted from Raath and Berry (2019)
Take note: All the variances in the layout must be shown unless it is not possible to calculate
them, or the specific question requires less detail.
27
If a direct costing system is in use, it should require the following amendments to the proposed
reconciliation “format” given above:
(i) Calculate standard contribution instead of standard gross profit.
(ii) Remove the fixed overheads volume variance and its subcomponents since they will not
be applicable in a direct costing system (Williams et al 2020).
(iii) The variable selling and distribution cost volume variance will not be shown separately
because it will form part of the sales margin volume variance.
Regarding point (iii) above, theoretically, (standard) contribution is the net of all (standard)
variable costs, including variable non-production costs. Therefore, the sales (margin) volume
variance in a standard direct costing system would effectively have the variable sales and
distribution costs volume variance incorporated in it.
Take note: Non-production costs are never included in inventory valuation, whether in terms of
direct costing principles or absorption costing principles.
9.9 General ledger accounts and journal entries

In MAC2601 you learnt how to account for selected variances in the general ledger. You have
now been introduced to additional variances that also need to be accounted for in the financial
records.
The following table provides information on where you can find the accounting treatment for most
of the variances that you will be taught in your undergraduate costing studies:
Abbreviations used in the table:

MAC2601 = MAC2601 course content (assumed prior knowledge)
TL103 = MAC3701 Tutorial Letter 103 additional content
POMA = Principles of management accounting textbook
n/a = not applicable
Variance Calculation* Journal General

entry ledger
reference reference
Direct material purchase price variance if MAC2601; POMA POMA MAC2601;
materials inventory is kept at standard price POMA
Direct material purchase price variance if MAC2601 TL103 MAC2601
materials inventory is kept at actual price
Direct material usage/quantity variance MAC2601; POMA POMA MAC2601;
POMA
Direct material mix variance POMA TL103 TL103
Direct material yield variance POMA TL103 TL103
Direct labour rate variance MAC2601; POMA MAC2601;
TL103; POMA POMA
Direct labour efficiency variance MAC2601; POMA POMA MAC2601;
POMA
Direct labour mix variance TL103; POMA TL103 TL103
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MAC3701/103/3/2024
Variance Calculation* Journal General

entry ledger
reference reference
Direct labour yield variance TL103; POMA TL103 TL103
Direct labour idle time variance TL103; POMA TL103 TL103
Direct labour efficiency variance based on TL103; POMA TL103 TL103
productive work hours (also referred to as
direct labour operating efficiency variance)
Variable production overheads expenditure MAC2601; POMA POMA MAC2601;
variance POMA
Variable production overheads efficiency MAC2601; POMA POMA MAC2601;
variance POMA
Fixed production overheads expenditure MAC2601; POMA POMA POMA
variance
Fixed production overheads volume POMA POMA POMA
variance
Fixed production overheads volume TL103 TL103 TL103
capacity variance
Fixed production overheads volume TL103 TL103 TL103
efficiency variance
Sales margin price variance MAC2601; POMA n/a n/a
Sales margin volume variance POMA n/a n/a
Sales mix variance POMA n/a n/a
Sales quantity variance POMA n/a n/a
Market share variance POMA n/a n/a
Market size variance POMA n/a n/a
Variable sales and distribution cost rate MAC2601 n/a n/a
variance
Variable sales and distribution cost volume TL103 n/a n/a
variance
Fixed non-manufacturing overheads POMA POMA POMA
spending variance (includes fixed sales and
distribution cost rate variance)
* Resource in which the variance calculation is performed and/or described.
9.9 General ledger accounts and journal entries (continued)

The journal entries and/or associated general ledger accounts that were not demonstrated in
either the applicable second-year study guide or the MAC3701 textbook are shown below. Note
that the general ledger accounts shown below only incorporate the selected journal entries and
are neither complete nor balanced accounts. Also, note that some of the debits and credits will
have to be exchanged when the variance in the example is favourable instead of adverse, or
adverse instead of favourable, as applicable.
29
Take note: General ledger account entries are transferred from journal entries. Therefore, in the
following section, only general ledger accounts are illustrated from which you can deduce the
related journal entries.
(a) Direct material purchase price variance if materials inventory is kept at actual price
Materials and consumables can be kept either at actual cost or standard cost (Coetzee et al
2012b; Raath & Berry 2019). In a MAC3701 standard costing question, however, the default
position is that the direct materials and consumable inventories are kept at standard cost unless
the question specifies otherwise. With the default position, the direct material general ledger
account balance will always be at the standard cost and will therefore not include the purchase
price variance.
Now, assume it is specified that direct materials are held at actual cost. The following is an
example of how to prepare a journal entry for the material purchase price variance when direct
materials are held at actual cost (for an example of a journal entry when the materials are held at
standard cost, refer to the textbook):
Journal entry (assume an R300 adverse variance)
Dr Direct materials price variance (at time of issue) R300

Cr Direct materials inventory account at actual price R300
(Recording the price difference at time of issue for actual quantity issued.)
Adapted from Coetzee et al (2012b)
(b) Direct materials mix variances

Assume the numbers in appendix example 13.3 in the textbook apply.
Dr Cr
R R
Variances account
DM mix variance – Carbon fibre 240 000 DM mix variance – Aluminium 60 000
Work-in-progress account
Variances account 60 000 Variances account 240 000
(c) Direct materials yield variances

Assume the numbers in appendix example 13.3 in the textbook apply.
Dr Cr
R R
Variances account
DM yield variance – C/fibre 60 000
DM yield variance – Aluminium 30 000
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MAC3701/103/3/2024
Dr Cr
Variances account 60 000
Take note: The direct material mix variance and yield variance are subvariances of the direct
material efficiency variance. In this example, R180 000 (U) + R90 000 (F) = Direct material
efficiency variance of R90 000 (U). Therefore, if the direct material efficiency variance journal
entry is posted, then, to avoid double-counting, the subvariances (direct material mix variance
and yield variance) must not also be posted.
(d) Direct labour mix variances

Use the information provided below to calculate the direct labour mix variance and the direct
labour yield variance:
With respect to the Saneone XXI bicycle from the examples in the textbook, chapter 13 (Williams
et al 2020), assume that a mix of skilled labour and semiskilled labour is used, where the two
types of labour “are interchangeable to some extent” but used in the standard proportion of 2:1.
The standard cost per hour of skilled labour is R80 and the standard cost per hour of semiskilled
labour is R60 in a particular period, and the actual hours of skilled labour (1 485 hours) used
during the period were 495 more than the hours of semiskilled labour used during the period.
(e) Direct labour mix variances

Labour type Actual hours in Actual hours in Diff. Standard Labour mix
std. mix actual rate per variance
proportions proportions hour
Skilled 2 475 x 2/3 = 1 650 1 485 165 R80 R13 200 (F)
Semiskilled 2 475 x 1/3 = 825 1 485 – 495 = 990 (165) R60 R9 900 (A)
Total 2 475 2 475 R3 300 (F)
General ledger accounts

Dr Cr
R R
Variances account 13 200 Variances account 9 900
Variances account
Semiskilled labour mix variance 9 900 Skilled labour mix variance 13 200
(f) Direct labour yield variances

Assume the same information as in the direct labour mix variance example above. Also assume
that 2 000 Saneone XXI bicycles were produced and sold during the period and that the standard
semiskilled labour time was 0,4 hours.
31
The direct labour yield variance can be calculated as follows:
Labour type Input allowed for Actual hours in Diff. Standard Labour
actual output std. mix rate per yield
proportions hour variance
Skilled 2 000 x (0,4 x 2) 1 650 (50) R80 R4 000 (A)
= 1 600
Semiskilled 2 000 x 0,4 = 800 825 (25) R60 R1 500 (A)
Total 2 400 2 475 R5 500 (A)
General ledger accounts

Dr Cr
R R
Variances account
Skilled labour yield variance 4 000
Semiskilled labour yield 1 500
variance
(g) Direct labour idle time variance

Assume the numbers in section 9.5.2 above apply.
Dr Cr
R R
Variances account 80 437,50
Variances account
Idle time variance 80 437,50
(h) Direct labour efficiency variance

Assume the numbers in section 9.5.2 above apply.
Dr Cr
R R
Variances account 41 437,50
Variances account
Labour efficiency variance 41 437,50
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MAC3701/103/3/2024
Take note: The labour idle time variance and (operating) labour efficiency variance are
subvariances of the labour efficiency variance. In this example, using the skilled labour only,
R80 437,50 (U) + R41 437,50 (F) = Total labour efficiency variance of R39 000 (U). Therefore, if
the total labour efficiency variance journal entry is posted, then, to avoid double-counting, the
subvariances (labour idle time variance and (operating) labour efficiency variance) must not also
be posted.
(i) Fixed manufacturing overheads capacity and efficiency variances

Assume the numbers in section 9.6 above apply.
Dr Cr
R R
Variances account
Fixed overheads volume 94 000
capacity variance
Fixed overheads volume 26 000
efficiency variance
Take note: The fixed overheads volume capacity variance and the fixed overheads volume
efficiency variance are subvariances of the fixed manufacturing overheads volume (quantity)
variance. In this example, R94 000 (F) + R26 000 (F) = R120 000 (F) fixed manufacturing
overheads volume (quantity) variance. Therefore, if the fixed manufacturing overheads volume
(quantity) variance journal entry is posted, then, to avoid double-counting, the subvariances (the
fixed overheads volume capacity variance and the fixed overheads volume efficiency variance)
must not also be posted.
(j) Variable sales and distribution costs volume and rate variances
Journal entry and general ledger accounts
Not applicable.
Why? “[B]ecause standard costing is essentially an inventory valuation technique” and variable
sales and distribution costs are non-inventoriable costs. Therefore, similar to the sales variances
that are only calculated for “informational purposes” (Williams et al 2020:406 and 427) – to
analyse performance, perform budgetary control and for decision-making purposes – the variable
sales and distribution costs variances are also for “informational purposes” and thus not adjusted
for in the accounting records.
9.10 Summary
In this learning unit you learnt how to calculate detailed variances in a standard costing system,
whether combined with direct (variable) costing or absorption costing and whether the actual and
33
budgeted sales and production volumes are equal or different. You also learnt how these
variances can be used to reconcile actual profit with budgeted profit and how they are dealt with
in the accounting records of an organisation. In addition, you learnt about criteria that
organisations use to decide when such variances need to be investigated, as well as how to
interpret and analyse them so that appropriate corrective action, if applicable, can be taken.
Ultimately, if used correctly, standard costing can be a helpful performance management tool for
organisations (Williams et al. 2020).

9.11.1 View the video about standard costing that can be found on myModules.
9.11.2 Attempt BQ1, BQ3, BQ4 and BQ5 in chapter 13 of the prescribed textbook.
9.11.3 Attempt LQ1, LQ2, as well as requirements (a) and (b) of LQ4, in chapter 13 of the
▪ For LQ4, ignore the “Portion of variance absorbed in closing stock” in the suggested
solution. This section is generally covered in postgraduate studies.
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MAC3701/103/3/2024
LEARNING UNIT 10: RELEVANT COSTING

10.1 Introduction
In several of the module’s learning units, for instance learning unit 4, “Cost–volume–profit (CVP)
relationships”, learning unit 7, “Joint and by-product costing” and learning unit 8, “Process
costing”, we have already looked at some ways in which management accountants could use
financial information for purposes of decision-making. Learning unit 10, “Relevant costing” delves
deeper into the topic of decision-making by addressing advanced scenarios regarding short-term
decision-making. Pivotal to recommending an appropriate decision in a given scenario is an
understanding of the concepts of relevant costing, such as sunk costs, incremental costs and
opportunity costs. Qualitative factors could also have an effect on whether a decision would be
appropriate under a specific set of circumstances.

▪ distinguish whether a specific decision has a short-term or long-term timeframe
▪ perform appropriate calculations to support preliminary recommendations in relevant
costing scenarios, including but not limited to the following advanced scenarios:
o special pricing (special orders)
o product mix when capacity constraints exist
o outsourcing vs insourcing (making or buying)
o discontinuation of products, product lines or divisions (“closing-down decisions”)
▪ identify, to list and/or to discuss qualitative issues relating to each decision, including but
not limited to ethical, environmental, social, legislative and governance factors
▪ evaluate linear programming and to describe the different uses of this technique
▪ solve the allocation of resources problem by applying linear programming (using either the
graphical method or the simultaneous equation method)
▪ calculate the shadow price and the maximum price for additional supplies of the limited
resources per input unit
Assumed prior knowledge:
You can
▪ identify the characteristics that make information relevant
▪ distinguish between relevant and irrelevant information with regard to a specific decision
▪ calculate relevant incremental cash flows in a given scenario
▪ identify qualitative factors that may affect decision-making in a specific scenario
▪ identify the preconditions for a special price
▪ determine an appropriate price of a special order
▪ define and identify limiting factors in a given scenario
▪ identify the need for calculating contribution per unit of the limiting factor
▪ calculate contribution per unit of the limiting factor in a given scenario
▪ determine the optimal allocation of available resources and the optimal product mix
▪ recommend optimal decisions in basic scenarios of uncertainty and risk
▪ use decision trees to recommend appropriate decisions under conditions of risk and
uncertainty and to determine the sensitivity of profit to and the expected outcome of
decisions and events
35
10.3 Topic outline
Some of the sections outlined below, were already covered in your second-year costing module
and, therefore, comprise revision material. The remainder of the learning unit, however, builds
further on what you have learnt in second year. Study the following sections in chapters 10 and
11 of the prescribed textbook:

(3rd edition)
Concepts Theoretical basis Revision/
prescribed exercises
Understanding the concept of relevance Section 10.2 none

▪ What is relevance? Section 10.2.1 Example 10.1
Decisions under conditions of certainty Section 10.3 none
▪ Special order decisions Section 10.3.1 Examples 10.2–10.4
▪ The make-or-buy decision Section 10.3.2 Example 10.5
▪ The closing-down decision Section 10.3.3 Example 10.6
Applying the concept of relevance to basic Section 10.4 none
cost elements
▪ Materials Section 10.4.1 Example 10.7
▪ Labour Section 10.4.2 Example 10.8
Decisions under conditions of uncertainty Section 10.5 none
▪ Probabilities Section 10.5.1 Example 10.9
▪ Expected values Section 10.5.2 none
▪ Decision trees Section 10.5.3 Example 10.10

(3rd edition)
exercises
The importance of contribution Section 11.2 none
Limiting factors Section 11.3
▪ A single limiting-factor Section 11.3.1 Examples 11.1 and 11.2
▪ Two potentially limiting factors Section 11.3.2 Examples 11.3 – 11.5
Make-or-buy decisions and scarce Section 11.4 Example 11.6
resources
Limiting factors and shadow prices Section 11.5 Example 11.7
Linear programming: the graphical method Section 11.6 none
▪ Introduction Section 11.6.1 none
▪ Steps in the graphical method Section 11.6.2 Example 11.8
▪ Slack Section 11.6.3
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(3rd edition)
exercises
Shadow prices and linear programming Section 11.7 none
▪ Calculating the shadow price: adding one Section 11.7.1
unit to the available limited resource
▪ Calculating the shadow price: alternative
method Section 11.7.2
Concluding on operational constraints Section 11.9 none
scenarios
Linear programming in practice Section 11.10 none
▪ Introduction Section 11.10.1 none
▪ Practical application of linear programming Section 11.10.2 none
▪ Limitations of linear programming Section 11.10.3 none
Take note: Simplex tableaus (section 11.8 in the textbook) fall outside the scope of this module.
10.4 Using data and technology in linear programming

You are now familiar with the underlying principles of linear programming. This section serves to
draw your attention to technology at your disposal to perform linear programming exercises. For
example, a widely used spreadsheet software package such as Excel® gives you access to a
‘Solver’ tool which can assist you to formulate and solve a linear programming model.
Excel® also enables you to compare various scenarios through the ‘What-if analysis’ tool, to
support the decision-making process regarding the determination of optimal product mix. Both
these tools can be used in conjunction with other software to help visualise problems in, and
solutions to, scenarios.
While the use of technology can be an efficient way to perform linear programming exercises, one
should also be cognisant of both the advantages and issues associated with using software in
this regard. These include the following:
10.4.1 Advantages associated with using software for optimisation

▪ Allows for working with more complex scenarios and more data.
▪ Enables users to execute tasks quicker and more efficiently.
▪ A visual display of information may make it easier for users to understand problems and
solutions.
▪ Software may be helpful in conducting sensitivity analysis because formulae and lookup tables
may be used to perform underlying calculations. This means that if any figure is amended, all
relevant figures will be updated and recalculated automatically.
▪ The results can be distributed to other decision-makers and users easily and efficiently, either
in printed or electronic format.
37
10.4.2 Issues associated with using software for optimisation
▪ Off-the-shelf programmes may not be equipped with the capability to solve all potential
problem scenarios, which may require more advanced software programmes.
▪ The cost associated with these software programmes may not match the benefit in the
instance of an organisation where optimal product mix decisions are not made on a regular
basis.
▪ The principle of “garbage-in-garbage-out” also applies in using technology in this context. The
quality of output provided by the software will only be as good as the input. For example, if an
error regarding the total of constraints occur during the input phase, the output delivered will
result in an incorrect solution to the organisation’s problem.
▪ A visual display of information in the form of graphs and figures may provide a simpler, more
user-friendly version of the data. However, some of detail and subtleties of the raw data may
be lost in the process, which may negatively impact decision-makers.
The following resources are recommended for further reading relating to section 10.4:
https://www.excel-easy.com/data-analysis/what-if-analysis.html
https://www.excel-easy.com/data-analysis/solver.html
Source: Section 10.4 is adapted from CIMA P1 (Kaplan Publishing, 2020:480–481)
10.5 Summary
Let us summarise what you learnt in this learning unit. First, you learnt how to apply relevant
costing principles in advanced decision-making scenarios. In some of these scenarios, conditions
of uncertainty existed. You also learnt how to apply linear programming, using the graphical and
algebraic (simultaneous equation) methods, to optimise the use of two or more limited resources
when contribution per limiting factor calculations do not provide a unanimous ranking.

10.6.1 View the relevant costing and special pricing videos that can be found on myModules.
10.6.2 Attempt BQ2, BQ3, BQ4, BQ5, BQ9, BQ13 and BQ14 in chapter 10 of the prescribed
textbook.
10.6.3 Attempt LQ3, LQ4 and LQ5 in chapter 10 of the prescribed textbook.
10.6.4 Attempt BQ3 and BQ8 in chapter 11 of the prescribed textbook.
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MAC3701/103/3/2024
LEARNING UNIT 11: PERFORMANCE MANAGEMENT
11.1 Introduction
In learning unit 9, “Standard costing”, we mentioned that a standard costing system could provide
information that is useful in performance management. Thereafter, in learning unit 10, “Relevant
costing”, we recommended appropriate decisions for management to make under specific
conditions. If managers and divisions make the right decisions, this could influence the
organisation that they form part of in a positive way so that performance can be maintained or
improved. The questions that now arise are: How should the performance of managers and
divisions be measured and rewarded? Should they be held accountable for that which is not under
their control? Will an organisation without separate and autonomous divisions necessarily perform
better than its counterparts that delegate their decisions to those on “lower organisational levels”
(Williams et al. 2020:480)? Learning unit 11 explores these and other potential questions about
performance management.

▪ explain performance measurements concepts
▪ determine appropriate responsibility centres for control purposes at different levels in an
organisation
▪ explain the concept of a divisionalised organisational structure
▪ identify and to explain the advantages and disadvantages of decentralisation and the
prerequisites for a successful divisional control structure
▪ describe the principles of controllability and traceability and their impact on performance
measurement
▪ distinguish between the performance of a division and that of a manager
▪ compute return on investment and residual income and identify the advantages and
disadvantages of each
▪ identify and to compute the impact of certain factors, such as asset base and depreciation,
on the performance of the divisions and/or managers in an organisation
▪ identify and to explain multidimensional performance measures that can be used to
overcome the problems of considering only short-term and financial performance measures
▪ recommend appropriate performance measures and targets within the context of a given
scenario
▪ identify and to explain potential non-financial performance indicators in a scenario
39
11.3 Topic outline
Most of the learning outcomes covered in this topic were not addressed in the second-year costing
module. It is therefore important that you pay careful attention when studying the following
sections in chapter 14 of the prescribed textbook:

(3rd edition)
Concepts Theoretical basis Prescribed exercises
▪ Performance management and objectives Section 14.1.1 none
▪ Information for performance evaluation Section 14.1.2 none
▪ Management accounting information Section 14.1.3 none
Responsibility accounting Section 14.2 none
▪ Performance of units and managers Section 14.2.1 Example 14.1
Centralised and decentralised Section 14.3 none
organisational structures
▪ Potential benefits from decentralisation Section 14.3.1 none
▪ Potential negative consequences of Section 14.3.2 none
decentralisation
▪ Requirements for successful Section 14.3.3 none
decentralisation
Financial performance measures* Section 14.4 Example 14.2
▪ Return on investment Section 14.4.1 14.2 (continued)
▪ Residual income Section 14.4.2 14.2 (continued)
▪ Determining ‘investment’ Section 14.4.5
o Definition of investment
o Point in time
o Depreciation Example 14.3
▪ Determining ‘required rate of return’ Section 14.4.6 none
▪ Determining ‘income’ Section 14.4.7 none
▪ Multinational considerations Section 14.4.8 none
*Ignore all references to:
- Return on sales
- EVA®
Multidimensional performance measures Section 14.5 none
▪ Balanced scorecard Section 14.5.1 none
Agreeing on targets and rewarding Section 14.6 none
performance
11.4 Determining ‘investment’

According to section 14.4.5 (“definition of investment” paragraph) of the textbook, in defining
‘investment base’, three definitions are proposed, namely Total assets held, Total assets
employed and Total assets less current liabilities. In MAC3701 we require you to use Total
controllable assets less Total controllable liabilities, when determining the investment base/
controllable investment.
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MAC3701/103/3/2024
Furthermore, the “point in time” paragraph states that, in determining ‘investment’, average
balances of controllable items should be used. However, for this module, the default position is
to always use closing balances of controllable items unless otherwise stated.
11.5 A divisionalised organisational structure

In section 14.3 of the textbook, reference is made to the term “strategic business units”, which
refers to units of an organisation that are (i) autonomous, and (ii) responsible for the development
and marketing of their own products and/or services. If strategic business units exist within an
organisation, it implies that a divisionalised organisational structure is in place. To explain what
divisionalised organisational structure is, reference is made to the Chartered Institute of
Management Accountants (CIMA) research report on divisional performance measurement by
Professor Colin Drury and Hatem EL-Shishini (2005). According to this report and consistent with
the textbook, organisational structures can be classified into two main groups: decentralised and
centralised (Drury & EL-Shishini 2005:8; Williams et al 2020:480). The report further states that
“a structure can either be functional or divisionalised” (Drury & EL-Shishini 2005:8).
The table below provides an overview of some of the characteristics of these two types of
organisational structures:
Aspect Organisational structure
Divisionalised Functional
Units are ▪ Divisions; ▪ Functions
generally ▪ Business units; or
referred to as: ▪ Strategic business units
Basis for Each unit (“division”) has its A unit has a specific function, role
segregation into own/distinct product(s) and/or or task (not including the
units service(s) or is situated in a development and marketing of its
separate geographical area or own products and/or services) that
market. is performed for various/all
products and services in the
organisation.
Relationship Each distinct product/group of Each distinct function services
between products is in its own division, and different products/services.
products/services various functions are carried out in
and functions each division.
Responsibility Generally, there is a head office or a There is one investment centre
centre type(s) similar central administrative section (the entity as a whole) and cost
(investment centre) and several centres on the level below this
investment and profit centres below investment centre.
the head office. The investment and
profit centres that are on the level
below the head office can have cost
centres below them (a functional
structure can exist on a lower level
of the divisionalised structure).
41
Aspect Organisational structure
Divisionalised Functional
Autonomy ▪ There is a greater level of Unit managers have much less
autonomy for managers. authority and
▪ Each unit is autonomous to some responsibility/accountability/control
extent. than in a divisionalised structure;
▪ Managers of individual units have they are generally only held
a higher level of authority and accountable for the costs of the
responsibility/accountability/control units.
than in a functional structure.
▪ Varying levels of authority in terms
of revenue, profit and investment
apply.
▪ Authority is delegated to divisional
managers to various degrees.
Decision-making Decision-making is normally Decision-making is normally
decentralised. (Divisional managers centralised. (Central management
make most of the decisions about makes/controls decisions on all
their products/services; decision- levels.)
making is delegated to divisional
managers to a relatively large
extent.)
Independence of ▪ Much more than functional ▪ Much less than divisional
managers of the managers managers
units ▪ Some profit responsibility ▪ No profit responsibility
Sources: Drury and EL-Shishini (2005), Drury (2015), Williams et al (2020), Els et al (2017) and Raath
and Berry (2019)
Below are examples of divisionalised and functional organisational structures. The examples are
based on a fictitious accounting university (say, UNIqueSA) that offers a total of four modules.
11.5.1 Example of a divisionalised organisational structure
UNIqueSA Head
Office
Investment centre
MAC FAC AUD TAX

investment centre investment centre investment centre investment centre
MAC3701 FAC3761 AUD3761 TAX3761
Functional cost Functional cost Functional cost Functional cost
centres centres centres centres
Marketing Marketing Marketing Marketing
HR HR HR HR
Finance Finance Finance Finance
Despatch Despatch Despatch Despatch
Adapted from Drury and EL-Shishini (2005), Drury (2015) and Raath and Berry (2019)
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MAC3701/103/3/2024
In this highly simplified divisionalised structure, UNIqueSA has four divisions (MAC, FAC,
AUD and TAX), which are all investment centres. Each division has its own marketing manager,
HR manager, finance manager and despatch manager, who report to the divisional manager.
11.5.2 Example of a functional organisational structure example
UNIqueSA
Investment centre
Marketing Finance HR Despatch

Services: Services: Services: Services:
MAC3701 MAC3701 MAC3701 MAC3701
FAC3761 FAC3761 FAC3761 FAC3761
AUE3761 AUE3761 AUE3761 AUE3761
TAX3761 TAX3761 TAX3761 TAX3761
Adapted from Drury and EL-Shishini (2005), Drury (2015) and Raath and Berry (2019)
In this highly simplified functional structure, UNIqueSA has four functions (Marketing, Finance,
Human Resources and Despatch), which are all cost centres. Each function services all four
modules.
11.6 Applying the principle of controllability to performance management

It is generally argued that the evaluation of managerial and/or divisional performance is only fair
to an extent that the evaluation is based on aspects that the manager and/or division can control.
In this regard, for MAC3701, two financial performance measures are noteworthy, namely,
(i) return on investment (ROI) and (ii) residual income (refer to sections 14.4.1 and 14.4.2 of the
textbook). The textbook outlines the ROI formula as: Income/Investment and further outlines the
residual income formula as: Income less (Required rate of return X Investment). It is important
to note that in these two formulae, the principle of controllability must be taken into account in the
calculation of “income” and “investment” (refer to section 14.2.1). It is for this reason that in the
MAC3701 question banks, questions that relate to performance management, where applicable,
reference is made to “controllable profit” and “controllable investment” instead of “income”
and “investment”. Although you can use the terms “income” and “investment”, calculations
thereof must always be based on the controllability principle (Williams et al. 2020:479).
Furthermore, in this module, we expect you to use the book values of “controllable assets”
and “controllable liabilities” at the end of the period under review in the calculation of
“controllable investment”, unless specifically required otherwise. Take note that some of the
suggested solutions to exercises in the textbook and/or the question book might follow a slightly
different approach to the approach we require in MAC3701.
43
11.7 Further aspects of non-financial performance measures
You have now learnt about some aspects of both financial performance measures and non-
financial performance measures. In the main, financial measures are concerned with evaluating
the performance of managers and/or divisions based on the monetary aspects that fall within the
control of the manager and/or division in question. However, performance measurement is a
multifaceted phenomenon that goes beyond monetary aspects. In this regard, you were
introduced to non-financial performance measures such as those used in the “balanced
scorecard” and the “triple bottom line”. Below are a number of examples of non-financial
performance measures that organisations can use (in conjunction with financial performance
measures) to evaluate and manage the performance of their managers and/or divisions:
▪ Downtime of the plant (for the manufacturing manager [or division])*

▪ Percentage of existing clients retained, and new clients obtained (for the marketing manager)*
▪ Percentage of uncollected debtors written off (bad debts) as an expense (for the credit
manager)*
▪ The actual output of the product in comparison with the budgeted output (for the production
manager)*
▪ The environmental impact of the division, for example, CO2 emissions*
▪ Compliance of the managers with ethical standards, for example, compliance with the South
African Institute of Chartered Accountants’ Code of Professional Conduct
▪ Percentage of defective products
▪ Number of safety-related incidents, for example, number of injuries on duty on a construction
site
*Source: Raath and Berry (2019)
Take note: The above list is not meant to be exhaustive but intends to give you an idea of the
difference between financial and non-financial performance measures. Furthermore, not all non-
financial measures will necessarily apply in all circumstances and/or scenarios. In this regard,
you should guard against verbosity and “memory dump”. You are expected to address non-
financial performance measures with reference to the scenario and the circumstances in question.
11.8 Summary
In summary, this learning unit taught you about divisionalisation and how it can, on the one hand,
benefit organisations and, on the other hand, lead to increased risks and other issues (Williams
et al 2020). You learnt about the different types of responsibility centres that a divisionalised
organisation can consist of and how the performance of the individual centres (“units”) and their
managers and/or other staff members (“individuals”) can be managed. As part of the process of
managing performance, performance needs to be evaluated using financial performance
measures, such as return on investment and residual income, and interpreted. However, the use
of short-term financial measures should be combined with the use of other, longer-term measures,
as well as non-financial measures. If the performance targets and the reward structure of an
organisation are fair and appropriate, they are likely to encourage better performance by
individuals and units and lead to a better-performing organisation on the whole.
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MAC3701/103/3/2024

Take note: In our (the lecturers’) view, the following prescribed questions are of an acceptable
standard but some of them do not necessarily adequately address the concept of controllability.
To overcome this shortcoming, you must also attempt the performance management questions
in the question bank.
11.9.1 Review the performance management video that can be found on myModules.
11.9.2 Attempt BQ2, BQ3 and BQ7 in chapter 14 of the prescribed textbook.
▪ Ignore all references to EVA®.
45
LEARNING UNIT 12: PRICE SETTING
12.1 Introduction
In learning unit 11 you learnt about how to manage performance in organisations. Many of the
financial performance measures described made use of profit figures in their calculations. Profit,
in turn, is dependent on several and diverse factors. Selling prices of products (or services) are
important determinants of these factors. If an organisation sets its selling prices too low, it may
lose out on contribution and be less profitable than it potentially could. However, if it sets its selling
prices too high, customers may choose to buy from competitors (if its product is price elastic), it
could lose out on sales volumes and thereby contribution and, again, it may be less profitable
than it potentially could. This learning unit deals with the setting of prices when products or
services are transferred between divisions of the same organisation (internally), as well as
external pricing in the long term. Short-term external pricing has already been addressed in
learning unit 10 in the discussion of “special orders”.

▪ explain and to discuss transfer pricing and related concepts, including those pertaining to
strategy and ethics
▪ describe the different purposes of a transfer-pricing system
▪ explain the difference between intermediate and final products
▪ identify, to describe and to apply the appropriate transfer-pricing method in a specified
scenario
▪ identify the need for the inclusion of opportunity costs in the transfer price
▪ calculate minimum and maximum transfer prices using a transfer-pricing method that is
appropriate for the specified scenario
▪ calculate and to discuss a transfer price range and the optimal combination of internal
transfers and external sales that will encourage goal congruence in an organisation, taking
into account whether the markets are perfect or imperfect
▪ discuss potential solutions to transfer-pricing problems
▪ discuss qualitative issues relating to transfer pricing, including but not limited to ethical
factors
▪ discuss the pricing decision and related concepts
▪ differentiate between price-setting and price-taking organisations
▪ distinguish between customised and non-customised products and their pricing
▪ explain the relevant cost information that should be included in the long-term external pricing
decisions for price-setting organisations
▪ identify the role that different levels of fixed cost play in a price-taking organisation when the
decision is made to discontinue a product or product line from the product mix
▪ describe different cost-plus pricing methods for setting a long-term selling price and
compare cost-plus pricing with target costing
▪ explain the limitations and benefits of cost-plus pricing
▪ compare long-term pricing with short-term pricing
▪ identify and to describe different pricing policies (strategies) from a marketing perspective
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MAC3701/103/3/2024
12.3 Topic outline

This learning unit mostly contains new principles that you might not have studied before. However,
it does build on some of the principles of cost behaviour and relevant principles of costing that
you were exposed to on second-year level. Study the following sections in chapters 15 and 10 of
the prescribed textbook:
(3rd edition)
Introduction Section 15.1 Example 15.1
Decentralisation and transfer pricing Section 15.2 none
Principles of transfer pricing Section 15.3 Example 15.2
Market price-based transfer prices Section 15.4 Example 15.3
Cost-based transfer prices Section 15.5 Example 15.4
Negotiated transfer prices Section 15.6 none
▪ General guidelines Section 15.6.1 Example 15.5
Strategic and ethical considerations Section 15.10 none
Determining transfer prices in perfect and Appendix 15.1 Appendix examples
imperfect markets 15.1 – 15.3

(3rd edition)
The pricing decision Section 10.6 none
▪ Price takers versus price setters Section 10.6.1 none
▪ Price elasticity Section 10.6.2 none
▪ Cost-plus pricing versus target costing Section 10.6.3 none
▪ Short-term pricing Section 10.6.4 none
▪ Long-term pricing Section 10.6.5 none
▪ Pricing strategies Section 10.6.6 none
12.4 General guidelines for the calculation of the minimum- and maximum
transfer price per unit
Section 15.6.1 in the textbook “Principles of Management Accounting (POMA) indicates the
general guidelines for calculating the minimum and maximum transfer price per unit of a product
or a service.
You can use any of the two methods below to calculate the minimum transfer price per unit
(MTPU):
• Method 1: MTPU = (Total incremental cost of all units to be transferred + Total incremental
opportunity cost from external sales forfeited) ÷ Total number of units to be transferred
• Method 2: MTPU = Incremental cost per unit + (Total incremental opportunity cost from
external sales forfeited ÷ Total number of units to be transferred)
47
Please take note that in both methods above you should always consider the
incremental/differential costs and not the variable manufacturing costs only. This is the same
principle used in relevant decision-making (learning unit 10). Incremental costs include any
additional costs flowing from the decision to transfer the units. This will automatically include the
variable production costs, but it might also include some once-off costs that are not traceable to
individual units. The manager of the transferring division at least wants to recoup all his costs
arising from the transfer transaction.
Below is a simplistic example of how to calculate the minimum- and maximum transfer prices per
unit.
Division Flour
Division Flour has the capacity to manufacture 1 500 units of flour. The Division currently sells 1
250 units of flour to the external market at a selling price of R900 per unit. The Head Office
requires Division Flour to transfer 750 units of flour to Division Cookie. Only flour units that are
sold externally are packaged at a cost of R20 per unit. Division Flour provided you with the
information below:
Details Cost per unit

Direct raw material R300
Direct labour R200
Variable manufacturing overheads R80
External variable selling costs R30
Fixed manufacturing overheads R90
Division Cookie
Division Cookie currently buys flour on the external market at R910 per unit and will save R27 per
unit on ordering costs if the flour is transferred from Division Flour.
Required:
(a) Determine the minimum transfer price per unit (MTPU) of flour that Division Flour will be
willing to transfer the flour to Division Cookie.
(b) Determine the maximum transfer price per unit that Division Cookie will be willing to pay for
one unit of flour transferred from Division Cookie.
Solution
(a) Minimum transfer price per unit of Flour:
Step 1: Calculate the number of sales units forfeited
For both methods, we first need to calculate the number of sales units that will be forfeited if the
transfer takes place.
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MAC3701/103/3/2024
Capacity 1 500 units

Units currently sold to the external market 1 250 units
Spare capacity available (1 500 - 1 250) 250 units
Units to be transferred 750 units
Sale units forfeited (250 - 750) 500 units
Step 2: Calculate the incremental/differential costs per unit

Details R per unit
Direct raw material R300
Direct labour R200
Variable manufacturing overheads R80
External variable selling costs R0 Not differential costs - only incurred
Packaging costs R0 on sales to external customers.
Fixed manufacturing overheads R0 Not a differential cost – incurred
irrespective if the units are produced
or not.
Total incremental cost per unit R580
Step 3: Calculate the contribution per unit on external sales

Details R per unit
Selling price per unit R900.
Incremental cost per unit (see step 2) (R580)
External variable selling costs (R30)
Packaging costs (R20)
External sales contribution per unit R270
Method 1:
MTPU = (Total incremental costs of all units to be transferred + Total incremental opportunity
cost from external sales forfeited) ÷ Total number of units to be transferred
MTPU = (R435 000 + R135 000) ÷ 750 units
= R 760 per unit
 R580 per unit x 750 units transferred = R435 000
 R270 per unit x 500 units forfeited = R135 000
Method 2:
MTPU = Incremental costs per unit + (Total incremental opportunity cost from external sales
forfeited ÷ Total number of units to be transferred)
MTPU = R580 per unit + (R135 000 ÷ 750 units)
= R580 per unit + R180
= R 760 per unit
 R270 x 500 units forfeited = R135 000
49
(b) Maximum transfer price per unit of Flour:
Maximum transfer price per unit = Market purchase price less Internal savings
= R910 – R27
= R883 per unit
Example 15.5 (Williams et al. 2020:516) in the textbook calculates two minimum transfer prices,
the first for the 12 000 boxes for which sales are forfeited and the second minimum transfer price
for the remaining 8 000 boxes. If you were however required to calculate one minimum transfer
price per unit for the whole transfer of the boxes to Unit B the calculation will be as follows:
Step 1: Calculate the number of sales boxes forfeited

For both methods, we first need to calculate the number of sales boxes that will be forfeited
from external sales if the internal transfer takes place.
Capacity 20 000 boxes
Boxes sold to AfriWrite 12 000 boxes
Spare capacity available (20 000 – 12 000) 8 000 boxes
Boxes to be transferred to Unit B 20 000 boxes
Sale boxes forfeited (8 000 – 20 000) 12 000 boxes
Step 2: Calculate the incremental/differential costs per box

Details R per box
Variable manufacturing costs R65
Total incremental costs per unit R65
Step 3: Calculate the contribution per unit on external sales

Details R per box
Selling price per box R81.
Variable manufacturing costs (R65)
External sales contribution per unit R16
Method 1:
MTPU = (Total incremental costs of all boxes to be transferred + Total incremental opportunity
cost from external sales forfeited) ÷ Total number of boxes to be transferred
MTPU = (R1 300 000 + R192 000) ÷ 20 000 boxes
= R 74,60 per box
 R65 per box x 20 000 boxes transferred = R1 300 000
 R16 per box x 12 000 boxes forfeited = R192 000
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MAC3701/103/3/2024
Method 2:
MTPU = Incremental costs per box + (Total incremental opportunity cost from external sales
forfeited ÷ Total number of boxes to be transferred)
MTPU = R65 per box + (R192 000 ÷ 20 000 boxes)
= R65 per box + R9,60
= R 74,60 per box
 R16 per box x 12 000 boxes forfeited = R192 000
12.5 Intermediate versus final products

Williams et al. (2020) define an intermediate product or service as a “product or service that is
transferred from one unit of an organisation to another unit in the same organisation” (Williams et
al 2020:512). A final product or service, in turn, is a product or service that is sold in the external
market (Drury 2015).
Raath and Berry (2019) note that it “is important to understand the difference between an
intermediate and a final product, as this determines who the transferring(selling) and the
receiving(buying) divisions are. The costs incurred by the receiving division to complete the final
product are called further processing costs. Further processing costs are incurred irrespective of
whether the intermediate product is sourced from another division in the group or from an external
source.”
Take note that transfer pricing could also apply within the context of a group of companies, where
one company transfers a product to another company in the same group (Williams et al.
2020:510).
12.6 Cost-plus pricing method: customised and non-customised products

Customised products are products that are made based on the specific requirements of an
individual customer or a small number of customers, whereas non-customised products are
standardised products that are sold in the mass market. From a pricing perspective, in cases
where products are tailor-made according to customer specifications, it is possible to negotiate
the price directly with the buyer using the product’s cost plus the desired mark-up as a starting
point (the so-called cost-plus pricing method). From the perspective of a price setter, the cost-
plus pricing method is usually simpler to apply in cases where the product (or service) involved is
customised because of the ability to negotiate the price directly with the buyer. In respect of
non-customised products, a complex interrelationship between selling prices, sales volumes,
costs and unlimited buyers makes it cumbersome to use the cost-plus pricing method. In these
instances, products are generally homogeneous and sold in large volumes, and the price asked
will often affect the volume sold to a significant extent (refer to section 10.6.2, “Price elasticity”).
Determining the cost base to use in pricing now becomes difficult because the cost per unit will
change as volumes change due to the element of fixed costs included in the total costs. Often,
the information available in the market is also limited, complicating pricing further. However, these
decisions can normally be based on which selling price is estimated to result in the highest profit
(Raath & Berry 2019; Drury 2015).
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What further complicates the cost-plus method is the question of what to use as a cost base.
Should the cost base be direct variable costs alone, both variable and fixed direct costs or a
combination of both direct and indirect costs (which we refer to as “full cost” or “long-term cost”)?
The answer to this question depends on the extent of detail that an organisation’s costing system
can provide and, therefore, how accurately costs can be allocated to products. The more
comprehensive the cost base, the smaller the mark-up that the organisation needs to add. On the
contrary, the larger the demand for a customised product, the higher the mark-up that the
organisation can add (Raath & Berry 2019; Drury 2015).
12.6 Target rate of return on invested capital approach

In accordance with the cost-plus pricing method (refer section 12.5), the selling price can be
determined by adding a percentage mark-up to the cost of an item. In this regard, an entity can
choose to use the “target rate of return on invested capital” approach to determine the target
mark-up (that is, required contribution margin) to be added to the cost of an item (Drury 2015:240).
According to Drury (2015:240), “[t]his approach seeks to estimate the amount of investment
attributable to a product and then set a price that can ensure a satisfactory return on investment
for a given volume”. With this approach, the target selling price per unit is thus determined by
adding the target mark-up to the total manufacturing costs per unit.
Consider the following explanatory example:

Omega Pty (Ltd) manufactures and sells leather-based sandals. In an attempt to keep up with the
latest fashion trends, the company launched its latest sandal (MaZe-Ndal) made of the Massaaai
Zeebra-leather. A total of R5 million capital was invested in the manufacturing and launch of
MaZe-Ndal, and the company has a target rate of return on invested capital of 12% per annum.
The total manufacturing costs per unit are estimated to be R800. The company estimated a total
annual demand of 25 000 units.
Based on the target rate of return on invested capital approach, the selling price is determined
as follows:
= Target mark-up per unit plus total manufacturing costs per unit:
= The target mark-up for the MaZe-Ndal is R24: ((R5 million x 12%) ÷ 25 000)).
The target selling price per unit of MaZe-Ndal is, therefore, R824 (R800 + R24).
12.7 The role of different levels of fixed cost in discontinuation decisions of

price takers
In learning unit 10 you learnt about product discontinuation and product mix decisions. These
decisions are particularly applicable to price takers since these organisations have to consider
whether the given market price for their products or services will justify selling those products or
services or groups of them (Raath & Berry 2019). Drury (2015) and Raath and Berry (2019)
explain that profitability analyses could assist in making appropriate discontinuation decisions in
the long term – in situations where an organisation has the option to reallocate previously tied-up
resources if necessary – but these analyses should not be the only inputs considered in making
such decisions. These analyses should rather be used to “flag” products, services or product lines
that seem to be problematic because a product should not necessarily simply be discontinued if
it is not profitable on its own. There could be several other reasons – qualitative and/or quantitative
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– for continuing with the sale of a non-profitable product. Examples are (i) when the product is
bundled with other products (refer to section 10.6.6, “Product bundling/optional extras” in Williams
et al. 2020:317) and the specific group of products is an important, profitable “package” offered
by the organisation and (ii) when cost-cutting can make the product profitable again (Drury 2015;
Raath & Berry 2019; and Williams et al. 2020).
In reassessing whether it is still useful to sell a product, one should also consider whether a direct
costing system or an absorption costing system has been used to determine profitability. The
costing system will influence the profitability perspective since the amount (or level) of fixed costs
allocated to a specific product will differ and some of the fixed costs may simply have been
assigned to the product arbitrarily and not because there is a cause-and-effect relationship
between the product and the cost (Coetzee et al 2012a; Drury 2015).
Furthermore, some of the costs are assigned to products for purposes of decision-making even
if they would not form part of the inventory valuation under International Financial Reporting
Standards (IFRS) (Coetzee et al. 2012a).
12.8 Price elasticity: further aspects

A number of additional aspects that you should be aware of in respect of price elasticity are
outlined below.
Take note: In MAC3701 we use the terms “price elasticity” (Williams et al. 2020:314), “demand
elasticity” (Raath & Berry 2019) and “(price) elasticity of demand” interchangeably.
Price elasticity refers to the sensitivity of demand to factors such as price and buying power, as
well as supply sensitivity (Inglesi-Lotz & Blignaut 2011; Breytenbach & De Villiers 2012). However,
for MAC3701, the focus is on the sensitivity of demand to price changes only.
Bread is used as an example of an elastic product in the textbook (refer to section 10.6.2).
However, bread is often seen as a necessary food item for which demand is usually inelastic
(Raath & Berry 2019). For this reason, we would rather like to use chocolate as an example of a
product for which the demand could be expected to be elastic. If the price of chocolate increases,
customers are likely to buy significantly less chocolate. They might decide to buy chips or other
sweets instead or they might simply eat less chocolate. If it is only the price of a specific make of
chocolate that increased, customers might decide to buy a different make of chocolate.
In general terms, when an increase in selling price leads to a significant decrease in demand,
such demand is deemed elastic (Williams et al. 2020:314). In this instance, the demand is
deemed to be sensitive to the change in price, in that a relatively small change in price will result
in a higher percentage change in the demand. In contrast, if the percentage change in quantity
demanded is less than the percentage change in price, we deem the demand to be inelastic for
the purposes of this module (Raath & Berry 2019). Refer to the graphs below, where P1, P2 and
P3 are different price levels while Q1, Q2 and Q3 are different demand levels:
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Elastic demand Inelastic demand
Williams et al. (2020:316) refer to several pricing strategies (refer to section 10.6.6). One of these
strategies is price skimming, which involves charging a “high initial price”. Price skimming is
more suitable when the initial demand for a product is inelastic (Drury 2015). However, if the
demand for the product is elastic in the early stages, penetration pricing is more suitable. Based
on the explanations of these strategies in the textbook, why would you say this is the case? (Hint:
compare how the pricing of the following two cell phone apps is, for example, likely to differ when
each app is originally released:
1. App A is based on an innovative, fresh idea. Currently, no similar app is available for
download. Market research shows that the app could create quite a hype among cell phone
users.
2. App B is introduced a year later than App A by a rival developer and is an adaptation of the
idea or concept used in App A. Although the concept is still popular, when one searches for
the keyword that is used to identify App A only, several apps now appear among the search
results.
12.9 Summary
In this learning unit, you learnt about the principles of transfer pricing that may have to be applied
when a transferring division (or company) transfers a product to a receiving division (or company)
within the same company (or group of companies). You learnt that the minimum transfer price
that should be set by a transferring division (or company) is often the sum of (i) the total
opportunity cost of losing contribution on forfeited external sales and (ii) the total of all incremental
costs associated with transferring the units, divided by (iii) the total number of units transferred.
Furthermore, you learnt about different approaches that organisations could follow in respect of
external selling prices in the long term, which may differ from the short-term approaches followed
when a special order is applicable, as well as between price-setting and price-taking
organisations.

12.10.1 Review the transfer pricing and pricing decision video that can be found on
myModules.
12.10.3 Attempt LQ1 – intermediate and LQ2 – intermediate in chapter 15 of the prescribed
textbook.
12.10.4 Attempt LQ6 – advanced in chapter 10 of the prescribed textbook.
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LEARNING UNIT 13: OTHER ANCILLARY TOPICS
13.1 Introduction
One of the techniques that you learnt about in learning unit 10 was optimisation when resources
are constrained. Often, you would use the contribution per limiting factor to rank products in the
order that they should be produced to maximise profits. However, in learning unit 13, you will
learn about the theory of constraints as an alternative “management accounting system” (Raath
& Berry 2019) that can be used to address constraints, specifically by maximising throughput
when bottlenecks exist (Williams et al 2020). The concepts of throughput (and throughput
accounting) and bottlenecks will be explained in this learning unit.
In addition, you will be introduced to various concepts, techniques, philosophies, practices and
systems of management accounting, most of which emanate from the continuous developments
in the field of management accounting. The world of business is dynamic and ever-changing.
Concepts, techniques, systems and so on relating to the field of management accounting ought
to develop continuously to keep abreast of changes in the business environment.
▪ explain the operation of a just-in-time (JIT) system and to apply JIT principles to a particular
scenario
▪ describe how the principles of JIT purchasing differ from those of traditional purchasing
▪ explain the concept of benchmarking and to apply it to a particular scenario
▪ explain the concepts of materials requirement planning (MRP) and enterprise resource
planning (ERP) and to apply them to a particular scenario
▪ explain and to apply the concepts and steps associated with the theory of constraints and
to apply them to a particular scenario
▪ compare the theory of constraints with activity-based costing (ABC)
▪ explain and to apply the concept of throughput accounting and to apply it to a particular
scenario
▪ describe Porter’s generic strategies from a management accounting perspective
▪ describe activity-based management (ABM) from a management accounting perspective
▪ describe total quality management (TQM) from a management accounting perspective
▪ describe target costing from a management accounting perspective
▪ describe life-cycle costing (LCC) from a management accounting perspective
▪ describe supply chain management (SCM) from a management accounting perspective
▪ describe value chain analysis from a management accounting perspective
▪ understand the basic aspects of big data and digitisation from a management accounting
perspective
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13.3 Topic outline
Study the following sections in chapters 16 and 17 of the prescribed textbook:
Chapter 16 Principles of management
accounting (3rd edition)
exercises
Theory of constraints Section 16.2 Example 16.1
▪ Constraints Section 16.2.1 Example 16.2
▪ Steps in the theory of constraints Section 16.2.2 none
▪ Theory of constraints reports Section 16.2.3 none
▪ Theory of constraints and activity-based Section 16.2.4 none
costing
Business process re-engineering (BRP) Section 16.3 none
Just-in-time systems Section 16.4 none
▪ The just-in-time environment Section 16.4.1
▪ Performance measurement in a just-in-time Section 16.4.2
environment
Benchmarking Section 16.5 none

exercises
Porter’s generic strategies Section 17.2 none
Activity-based management Section 17.3 none
Total quality management Section 17.4 none
▪ Definition of quality Section 17.4.1
▪ Dimensions of quality Section 17.4.2
▪ Elements of total quality management Section 17.4.3
▪ Cost of quality Section 17.4.4
Target costing Section 17.5 none
▪ Definition of target costing Section 17.5.1
▪ Establishing a selling price Section 17.5.2
▪ Determining the desired profit margin Section 17.5.3
▪ Product-level target costs Section 17.5.4
▪ Component-level target costs Section 17.5.5
▪ Environmental management accounting Section 17.5.6
Life-cycle costing Section 17.6 none
▪ Pre-production costs Section 17.6.1
▪ Production costs Section 17.6.2
▪ Marketing, service and support costs Section 17.6.3
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exercises
Supply chain management Section 17.7 none
▪ How supply chain management confers Section 17.7.1
competitive advantage
Value chain analysis Section 17.8 none
13.4 Further aspects of life-cycle costing

13.4.1 The use of management accounting systems
In section 17.6 of the prescribed textbook, life-cycle costing was described as “the maintenance
of cost records that accumulate the costs incurred over the lifespan of a product, service, or
physical asset” (Williams et al. 2020:576). Although some entities still maintain cost records
manually, the majority of entities make use of technology (management accounting systems) to
maintain their cost records. The costs associated with a product’s life cycle are incurred
throughout the various stages of the life cycle, however, the majority of the costs are incurred in
the beginning phase, namely the development and design stage. In this regard, management
accounting systems should be designed to include the tightest controls around spending at the
beginning phase of a product’s life cycle. As such, the management of an organisation should
further take into consideration the below factors when implementing cost control measures to
ensure that a product generates maximum return over its life-cycle:
▪ Design costs out of the product: About 80% to 90% of a product’s costs are incurred at the
design and development phase of its life-cycle and should therefore be thoroughly planned
and closely monitored. The design team should further work with a cross-functional team, to
ensure that the organisation does not commit to unnecessary future costs over the life-cycle
of the product.
▪ Minimise the time to market: Competitors monitor each other closely. It is therefore important
to launch a newly developed product as quickly as possible, as it is often wasted time, rather
than costs, which reduces profits.
▪ Maximise the length of the product’s life-cycle: The longer the life-cycle of the product, the
more profit may be generated. The product’s life-cycle may be maximised in various ways.
One is by introducing the product to the market as quickly as possible, and another is by
finding more than one use or market for a product. A staggered entry into the market, such as
launching the product at different times in different world markets, may also reduce costs,
increase revenue and extend the life-cycle of the product. A staggered approach may also
mean that income from one product may be available to fund another product.
13.4.2 The life-cycle cost budget

Life-cycle costing may only be applied upon the establishment of a life-cycle cost budget once
the costs associated with a particular product have been identified. Life-cycle costs are classified
into the following categories: (i) development costs, (ii) design costs, (iii) manufacturing costs, (iv)
57
marketing costs, and (v) distribution costs. Actual costs are monitored against budgeted costs
throughout the product’s life-cycle. Management needs to consider whether the anticipated cost-
savings resulting from the application of life-cycle costing, were actually achieved. Actual costs
incurred should therefore be closely monitored against budgeted costs.
In determining the life-cycle budget of a product, an organisation should also consider the different
stages of the life of that product. As mentioned earlier, regarding the life-cycle of a product, the
majority of costs are incurred in the development and design phase. As such, only having
products in the growth phase could be costly since the organisation’s cash resources may be
‘locked’ in the product’s early development or design stages. On the flip side, only commencing
with the development of a new product once an old product’s life-cycle has ended, may result in
cash inflow constraints. Therefore, from a costing perspective, an organisation needs to ensure
that its products are in various phases of the life-cycle to stagger costs and plan cash flow.
Therefore, the organisation needs to introduce new products as old products are nearing the end
of their life-cycles, to ensure a healthy balance between cash outflow and cash inflow.
13.4.3 Asset lifecycle costing

You will remember from Financial Accounting modules that an asset is an economic resource
controlled, and mainly, used by the same entity for the purpose of generating income/economic
benefits. For an entity that owns and uses the asset, only the initial purchase price may form part
of the cost of ownership. However, other costs of operating the asset over its life such as repairs,
maintenance, storage, energy consumption, disposal etc., may sometimes outstrip the initial
purchase price. The asset life-cycle costing is therefore concerned with ensuring that all costs,
be it acquisition or subsequent operating costs associated with the asset are incorporated in the
decision-making process about investing in an asset. This is done by comparing the ownership
costs of the asset with the discounted cash flows of the subsequent operational costs of the same
asset.
13.4.4 Customer life-cycle costing

One of the critical success factors of an organisation is to retain customers, and more importantly,
to retain (or invest in) profitable customers. As such, it is therefore evident that not all investment
decisions relate to significant initial capital outflows or the buying of physical assets. A decision
to retain or cut ties with a customer can also be a capital budgeting decision, albeit a small initial
outlay. In deciding whether or not to retain a customer, an organisation can review the associated
costs in relation to the revenue generated over the “life” of that customer. These costs include
amongst other: “initial costs due to paperwork, “checking credit worthiness” opening policies, etc.
for new customers”. Customer life-cycle costing is therefore concerned with a decision of whether
to retain a customer through an assessment of costs vs. benefits over the “life” of a customer.
Source: Section 13.4 is adapted from CIMA P2 (Kaplan Publishing, 2020:100–105).
13.5 Big data

Organisations rely on the availability of and access to information to make decisions about their
entities. Although various sources of information are available, a growing phenomenon within
business environments is the use of big data analytics to source information.
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What is big data

“Big data is used to refer to the large volume of data, both structured and unstructured, that is
available to organisations on a day-to-day basis. This information is often in digital form and
created outside the organisation and available to everyone. Big data can be analysed in order
to provide insights that lead to better decisions based on more informed knowledge. Big data
analytics has become the catch-all term for gathering, analysing, and using massive amounts
of digital information to improve business operations. Big data analytics enable organisations
to make decisions based on data instead of business instinct.” CIMA P1 (Kaplan Publishing,
2020:256).
In the following few subsections, we look at big data as source of information for budgeting,
sources of big data, features of big data, benefits of big data, and as well as problems associated
with big data.
13.5.1 Big data as source of information for budgeting

In chapter 12 (“Budgets, planning and control”) of the prescribed textbook, section 12.13,
reference is made to the preparations of projections (budgets) using historical data. In this regard,
the sources of the data used in the budgeting process typically include general economic data,
public announcements, sales trends, market research and business units within an organisation.
In preparation of budgets, some of the required information can be sourced from big data.
13.5.2 Sources of big data

Although big data is a useful source of information, it should not be viewed in isolation, but rather
as a supplementary source which may enhance data generated from other sources. Incorporating
big data into the budgeting process may result in more accurate and attainable end results. In this
regard, big data has the potential to reduce uncertainty in cost estimations and other budget
assumptions; fill in the gaps for missing data; create expectations for business and environment
changes and identify correlations in those changes.
Big data may be sourced from:

▪ Media: Press reports, podcasts, industry briefings and social media in the form of YouTube,
Twitter or Facebook. Through tracking engagements on these platforms, the organisation
may obtain a deeper understanding of consumer behaviour and preferences, to predict
trends.
▪ The web: Data on the web is easily accessible and often rather structured when obtained
from sites such as Wikipedia or Investopedia.
▪ Machine generated: The organisation may program a machine to collect data, for example
in the form of web server logs or satellite imagery.
▪ Databases: The organisation may utilise software to structure its internal unstructured and
unanalysed data from its own databases such as customers and suppliers, in such a way
that it turns into useful information.
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13.5.3 Features of big data
Big data is characterised by three features referred to as the 3V’s (sometimes extended to include
a fourth V):
▪ Volume: Vast amounts of data need to be stored and processed by the organisation.
▪ Variety: Big data may come from several sources.
▪ Velocity: The data changes regularly and is therefore updated by the second.
▪ Veracity: The fourth V refers to the ‘truthfulness’ of the data. The organisation needs to
collect accurate data which can be trusted.
13.5.4 Benefits of big data

Some of the benefits associated with the use of big data include the following:
▪ Competitive advantage: Organisations may achieve a competitive edge in being able to
react quicker on consumer trends identified in the marketplace than their competitors.
▪ Response time to change: Big data may prepare organisations to be more proactive
regarding changes in the industry.
▪ Stream-lined activities and systems: Through tracking customer feedback, non-value-
adding elements in activities and systems may be identified and removed.
▪ Improved customer loyalty: More repeat business as a result of improved customer
interactions and relationship management.
▪ New product ideas: Since customer preferences are more easily identified, new product
ideas can be more easily formulated and tested to be launched in the market.
▪ Cost reductions and improved efficiency: Business operations can be analysed,
streamlined and simplified.
▪ Empowered employees: Employees can make better local and operational decisions
through access to better information.
▪ Business performance: The organisation’s business performance can be tracked and
analysed against a wider set of criteria.
13.5.5 Problems associated with big data

According to CIMA P1, Kaplan Publishing (2020:257–258), the benefits associated with big data
are endless. Real-life examples include a highly personalised customer experience provided by
Walmart1 for tracking, amongst other things, the spending patterns, and Twitter2 interactions of
60% of adults in the United States of America. However, there are some issues which need to be
overcome by big data users. These are explained by revisiting the features of big data, namely
the 3V’s:
1
An American multinational retail corporation that operates a chain of hypermarkets, discount department stores, and grocery
stores, headquartered in Bentonville, Arkansas. (Source: https://en.wikipedia.org/wiki/Walmart)
2
An American microblogging and social networking service on which users post and interact with messages known as "tweets".
(Source: https://en.wikipedia.org/wiki/Twitter)
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▪ Volume: The amount of data is often too much to analyse. All of the data may not be relevant
to the organisation, which means someone in the organisation will need to decide what data
to collect and store, and how to analyse and structure the often-messy data into useful
information.
▪ Variety: The data comes in various forms such as tweets, texts and pictures. It makes it
difficult to compare and analyse the data since it is presented in an inconsistent format and
therefore needs to be organised and interpreted first.
▪ Velocity: The data is created and changed at great speed, calling for it to be uploaded and
updated on a second-by-second basis. Software plays a key role in collecting, organising
and changing data at a great speed to enable organisations to analyse the data.
Other problems encountered in big data analytics:
▪ The data is freely available and may therefore also be analysed by rivals, bringing an early
end to the organisation’s competitive edge.
▪ A significant investment in IT is required to store, organise and manage these vast amounts
of data.
▪ The fourth V (“veracity”) which is often listed as one of the features of big data (see section
13.5.3 above), also comes into play in the form of users questioning the accuracy of the data
and whether it can be trusted.
▪ The data may be distorted by data outliers, presenting users with a very different impression
of the overall data.
What is a data outlier?
“Data outliers are pieces of information that do not appear to fit into the pattern of normal
results. Outliers are often more easily spotted through the use of data graphs. Data outliers
give a very different impression of the overall data, but should not be ignored. The outliers
themselves could contain valuable data.” (CIMA P1, Kaplan Publishing, 2020:260).
13.6 Costing digital products

In today’s business environment, especially on the back of the Fourth Industrial Revolution3, the
use of technology is central to many organisations. To this point, from a management accounting
perspective, you learnt some of the basic use of technology such as (i) performing linear
programming exercises (refer to section 10.4); (ii) managing some aspects of life-cycle costing
(refer to section 13.4); and (iii) budgeting in conjunction with the use of big data (refer to
section 13.5). However, the business environment has many complexities which require solutions
that go beyond the basic use of technology. Technological solutions range from basic solutions
3
The Fourth Industrial Revolution (or Industry 4.0) is the ongoing automation of traditional manufacturing and industrial
practices, using modern smart technology. (Source: https://en.wikipedia.org/wiki/Fourth_Industrial_Revolution)
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such as digitisation (conversion of traditional physical information into virtual content) to more
advanced solutions such as digitalisation (delivering solutions via the application of digital
technologies). In many instances, both digitisation and digitalisation often use digital product(s).
Organisations are therefore expected to understand how to cost digital products.
What is a digital product?
“A digital product typically refers to a product that is stored, delivered and consumed in an
electronic format. The products can be delivered in many ways such as through a website, a
mobile phone application or email. One digital product may be offered in various forms. For
example, a company may release a game that can be played on its website or via IOS or
Android apps. A digital product can also refer to digital media that will be distributed such as a
television programme or music album. Digital products can sometimes be seen as a gathering
together of individual product features. Features can be added and changed by individual
consumers giving each user a bespoke experience through choosing the features that they
want and don’t want.” (CIMA P1, Kaplan Publishing, 2020:100).
13.6.1 Difficulties in costing digital products

On the back of increasing utilisation of digital products, it is important for organisations to be
aware of the difficulties associated with the costing of such products. In some instances, the
individual features which were originally grouped together to form one digital product may often
be unbundled to form products in their own right, for example, Facebook’s Messenger feature
which may be downloaded as a separate application (app). This is but one example of why it may
be more difficult to cost digital products than traditional products, further reasons include:
▪ The initial cost of producing digital products is often high, but the unit cost of reproduction
may be insignificant. Marginal costs may therefore be negligible and future costs may be
fixed.
▪ Standard costing is often irrelevant as there may be no standard cost or time required to
produce a digital product.
▪ It may be difficult to determine drivers for overheads.
▪ The timing of costs may be hard to predict, and costs may extend over a number of
accounting periods.
▪ The lifespan of a digital product may be difficult to determine, which means it may be hard
to compare the total costs over the product’s lifetime with the expected benefits associated
with increased revenue.
▪ Product features and functions may be shared by several products, which will necessitate
the finance department to determine how to absorb the costs associated with mentioned
features into individual products.
13.6.2 Typical costs and cost patterns associated with digital products
▪ Staff costs: Many costs will be specific to a digital project or product. For example, when
developing an app, the majority of the staff costs will be incurred upfront before the app is
launched, with almost no costs incurred once the app has been launched.
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▪ Infrastructure, platform and payment types: This typically includes costs associated with
the platform on which the product is launched, infrastructure services such as where the app
is hosted, where the data is stored and the number of payment methods accepted.
▪ Functionality: Individual product functions may be costed separately, especially where
functionalities may be used separately in other products as well.
▪ Design and development: Similar to functionality, design elements may also be shared
amongst products. This should be taken into consideration in the costing of the product in
the form of overheads. Design and development costs unique to the individual product would
be a direct cost which would probably be incurred during the pre-launch phase.
▪ Marketing: Marketing costs may be incurred during all phases of the lifespan of the product.
A fixed marketing budget may also be allocated to a digital product.
▪ IT support services and testing: This typically includes costs such as ongoing technical
support, IT-specific maintenance costs for infrastructure, and testing before the product is
launched, but also post-launch to provide application programming interfaces (API) and fix
bugs.
▪ Royalty and licencing costs: Royalties may be difficult to budget for since it is often based
on sales, whereas licence fees may be a fixed amount incurred before the launch of the
product.
▪ Inventory costs: There is no inventory holding cost associated with a digital product and
therefore no need to perform an inventory valuation for accounting purposes.
▪ Administrative services: The organisation will need to administer the developed apps
through an administration dashboard. The dashboard will, amongst others, serve to manage
the content of the apps, update the apps, manage functional services and manage user
profiles. Costs associated with the administration are difficult to determine since it is based
on individual apps.
13.6.3 Digital products and decision-making

Similar to other (traditional) products, a cost-benefit analysis should also be conducted before
launching a new digital product. This analysis is however rather difficult due to problems such as:
▪ Difficulties in determining the timing and frequency of costs: Some costs are incurred
pre-launch, like development costs, others are continuous, like royalties and others are only
incurred as a once-off future cost, like moving between platforms.
▪ Some functionalities are shared across several products: It may be difficult to determine
a driver to absorb these costs into individual products.
▪ The lifespan of the product is often unknown: As a result, it may be difficult to determine
the benefits associated with the product, and it is even further complicated by the fact that
the same product may often be sold more than once, for example, an e-book.
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13.7 Digital costing systems
Digital costing systems are a useful tool in the costing process of complicated products consisting
of thousands of components, for example, an airplane such as a Boeing. For example, a digital
costing system may use technology to understand and read complicated designs and plans to
indicate which are the best components to use to achieve product goals.
13.7.1 Benefits and features of digital costing systems

▪ Digital costing systems collect information from the internet in real-time: This allows
for automatic comparison of prices and suppliers, and significant cost savings.
▪ The system will constantly reflect current information: This makes it easier for the
organisation to adapt to changes.
▪ Access to more suppliers: As a result, the organisation may reduce lead times and
improve scarcity problems.
▪ Low operational costs: Digital costing systems may be expensive to implement, but cost
savings due to full automation may outweigh the initial capital outlay.
▪ Built-in analytics and intelligence capabilities: This may enable organisations to
understand the changing nature of costs and may also assist to achieve more efficient
operations.
▪ The ability to cope with hundreds of purchasing decisions at the same time: Digital
costing systems understand cost drivers which will result in more accurate product costing.
▪ Makes it easier to understand cost behaviour: This allows for a more accurate split of
semi-variable costs and ultimately better customer profitability.
▪ Digital costing systems allow for granular decisions: Seemingly insignificant details
which would be ignored by traditional costing systems, are taken into consideration in a
digital costing system. For example, a fraction of a cent should not be ignored in an
organisation where very large volumes of components are moved from one supplier to
another.
▪ Adaptive or dynamic pricing is facilitated by digital costing: This allows selling prices
to be updated quickly based on the most recent cost information about the product.
▪ Target costing becomes more accurate: Digital costing may enable the organisation to
determine whether and how a target cost can be achieved to reach a target level of profit.
13.8 Non-financial performance indicators

You learnt about non-financial performance indicators/measures in several of the previous
learning units, for instance, learning unit 3, “Budgets, planning and control”, learning unit 11,
“Performance management” and even learning unit 12, “Price setting”. In this learning unit,
Porter’s generic strategies, total quality management and benchmarking are some examples of
sections that also address both financial and non-financial measures. Non-financial performance
indicators are also covered in some sections of the finance component of this module. We will,
therefore, not repeat the information here but would like you to take note of how closely integrated
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this area is with many, if not most, of the learning units in the study material. In the main, non-
financial performance indicators can measure various aspects, such as the quality of products or
services provided, environmental impacts, societal impacts, how satisfied customers are,
governance and how ethically an organisation is managed (Raath & Berry 2019; Drury 2015).
Furthermore, note that, technically, there is a difference between the following two comparisons:
(1) financial versus non-financial measures and (2) quantitative versus qualitative measures. A
non-financial measure is not necessarily qualitative; for example, the number of customer
complaints is a non-financial performance indicator but is still a quantitative measure (Raath &
Berry 2019; Williams et al 2020).
13.9 Summary
In this learning unit you were introduced to contemporary management accounting concepts, and
“techniques, practices and philosophies” that “support competitive advantage” (Williams et al
2020). Many, if not all, of these, could assist an organisation with planning and control, decision-
making and strategy. Furthermore, in line with the Fourth Industrial Revolution, this learning unit
highlighted the importance of technology from a management accounting perspective. In this
regard, you were introduced to concepts such as big data, digital products, and digital costing
systems.
Lastly, take note that in MAC3701 you should not use throughput accounting or the theory of
constraints unless you are specifically instructed to do so.

13.10.2 Attempt LQ3 – advanced, LQ4 – advanced and LQ5 – advanced in chapter 16 of the
13.10.4 Attempt LQ1 and LQ2 in chapter 17 of the prescribed textbook.
13.10.5 Reflect on how the use of big data can improve decision-making within the medical
insurance industry.
13.10.6 Reflect on how the costing of an e-book as a form of a digital product can be performed.
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LEARNING UNIT 14: INVENTORY MANAGEMENT AND PLANNING
TECHNIQUES
14.1 Introduction
The EOQ was introduced at the second-year level management accounting studies. In this regard
you can refer to section 4 Inventory planning and control in Study unit 4: Material of Study guide
one of two for MAC2601 (Coetzee, Jordaan, Sithole & Verster 2012a:65), which is loaded on
myModules. The EOQ technique is used as a tool for managing inventory levels (Coetzee,
Jordaan, Sithole & Verster 2012a:72) and can be applied to determine the “optimum order
quantity” (Correia, Flynn, Uliana & Wormald 2000:459).

Although your prescribed textbook (Williams, Cairney, Chivaka, Joubert, Pienaar, Pullen, Roos
& Streng 2020) does not specifically address EOQ, the following learning outcomes form part
of your MAC3701 module and should be addressed in addition to the learning outcomes that
were addressed in MAC2601. In terms of the learning outcome that relates to the JIT
“philosophy” (Drury 2015:575; Williams et al 2020:625), we recommend that you only pay
attention to the relationship between EOQ principles and the JIT approach to purchasing or
production once you have studied MAC3701 Learning unit 13: Other ancillary topics. Learning
unit 13 also addresses some JIT principles.
After studying Learning unit 14, you should be able to
▪ Describe the three motives for holding inventory;
▪ Apply the EOQ to determine the production run size;
▪ Decide about quantity discounts and the EOQ;
▪ Decide when to place an order; and
▪ Calculate elementary safety stock levels (no probabilities used).
▪ Describe and/ or discuss how just-in-time (JIT) purchasing differs from traditional purchasing
principles.
Assumed prior knowledge:
▪ Calculated the EOQ using various methods
14.3 Background
First, let us briefly discuss inventory in general, as EOQ and JIT purchasing or production are all
about planning and controlling inventory.
At some stage, a Google search on "inventory definition" rendered an astonishing number of

about 366 million results (Google 2019). You would probably be able to formulate your own
definition from what you have learnt in Financial Accounting and other Management Accounting
modules. Maybe you would base it on IAS 2.6 (Iasplus.com 2019), which groups inventory into
three categories, namely:
• "Assets held for sale in the ordinary course of business";
• "Assets in the production process for sale in the ordinary course of business"; and
• "Materials and supplies that are consumed in production".
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Keeping in mind the different types of inventory, for which reasons, do you think, do companies
hold inventory?
Let's look at each of these categories in a bit more detail:

• "Assets held for sale in the ordinary course of business".
From your MAC2601 studies, you will also remember that we often refer to these as finished
goods (Coetzee et al 2012a:138). We can either manufacture our own finished goods
internally or buy them externally for resale if we are a merchandiser (Kleynhans 2017:17).
• "Assets in the production process for sale in the ordinary course of business".
In MAC2601, you learnt that we refer to these assets as work-in-progress, or simply WIP
(Coetzee et al 2012a:138). They are not yet 100% complete in terms of the production
process and can be further converted into finished goods. This means that inventory
management techniques like EOQ can easily be integrated with other Management
Accounting topics, such as process costing, direct and absorption costing, etcetera.
• "Materials and supplies that are consumed in production".
In a manufacturing entity, materials are converted to WIP and finished goods using labour,
machines and/or other resources (Kleynhans 2017:16; Coetzee et al 2012a:9). Often this
will require that materials are purchased, either from another division in the same group
(also refer to Transfer Pricing in Learning Unit 12: Price Setting) or from an external supplier.
Alternatively, a division or entity can potentially produce its own materials for input in another
manufacturing process (also refer e.g. Learning Unit 8: Process Costing and The Make-or-
Buy decision in Learning Unit 10: Relevant Costing). The materials inventory that we keep
to use in production, is held based on what your Study guide one of two for MAC2601
(Coetzee et al 2012a:65) refers to as the "transaction" motive for inventory-holding. This
brings us to our first learning outcome, namely "describe the three motives for holding
inventory", which is discussed in section 1.2 below.
14.4 Three motives for holding inventory

As indicated in MAC2601 Study unit 4: Material (Coetzee et al 2012a:65), companies hold
inventory because of the following:
(a) The transaction motive

“This refers to holding inventory for day-to-day use in the production process or for sales, where
the supplier might not be able to supply at short notice” (Coetzee et al 2012a:65). In section 1.1,
it is mentioned that keeping materials inventory for production purposes is due to the transaction
motive; however, keeping finished goods inventory to meet regular or certain demand is also
because of the transaction motive (Drury 2015:653). A bit later we will discuss how we can
potentially reduce inventory holding and, therefore, save some holding costs by using a just-in-
time approach.
(b) The precautionary motive

The second motive for holding inventory is the precautionary motive, which refers to “holding extra
inventory when future demand is uncertain and/or the supply is unreliable” (Coetzee et al
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2012a:65). When we are unsure as to how many units our customers would like to buy from us,
or when we are unsure as to whether our suppliers will be able to provide sufficient finished goods
or raw materials as and when we require these, we might want to keep some extra inventory as
a "backup". Here the key term is "uncertainty", which was also addressed in more detail in your
MAC2601 topic 12: Sensitivity Analysis. Conditions of uncertainty compel us to keep safety stocks
(Drury 2015:660-661), which we will be addressing a little bit later in this document. We will not
expect you to apply probabilities in calculating safety stock in this module; however, what you
have learnt in MAC2601 about uncertainty (including Study unit 30: Probabilities in Study guide
two of two for MAC2601 (Coetzee, Ntuli & Verster 2012b)) is still relevant and is examinable.
(c) The speculative motive

The third motive for holding inventory is the speculative motive, which refers to “holding more or
less inventory than usual, because a change in the supplier’s price is anticipated” (Coetzee et al
2012a:65). To speculate is basically to take risk(s) in anticipation of a reward (Merriam-Webster
online dictionary 2019). If we believe we can gain from buying inventory now at a cheaper price
than later at a more expensive price, or from postponing our order until when prices are expected
to drop, we are speculating. This gain can be fully or partially offset by increased holding costs as
we will now have to keep the inventory for a longer period of time. It is indeed to balance costs
like these with the "advantages" of having inventory in store that we use the EOQ method.
At this point, we have briefly outlined some key concepts within inventory management and
planning, including the different types of inventory and the reasons, or motives, why companies
keep inventory. The next section of this document deals with the mechanism of the EOQ
technique as an inventory management tool.
14.5 Application of the EOQ technique to determine the optimal number of

units to order
In MAC2601, you learnt how to use the EOQ technique to calculate the optimal number of units
to be ordered each time an order is placed. Revise your MAC2601 Study unit 4: Material, section
4 Inventory planning and control and the self-assessment activity questions 1 and 3. Although
only a brief discussion of some of the basic EOQ concepts is included in this MAC3701 document,
remember that all the MAC2601 contents are important to MAC3701.
As a recap, you should be aware that the formula to use in calculating EOQ is:
The symbols used in the EOQ formula explained further:

• U represents the annual usage of – or the demand for – a certain item of inventory. U is a
quantity, in other words, U is measured in units, kilograms, litres, packs or whichever
measurement of quantity is applicable in the specific scenario or circumstances.
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• C, in turn, represents the variable costs of placing an order, thus the incremental costs we
incur each time that we place one additional order. Based on the cost behaviour of a
variable cost that you have learnt about, this means that the variable costs per order – or C
in your EOQ formula – remain constant, but the total (ordering) costs will increase if we place
more orders.
• H represents the variable holding costs of carrying one unit in inventory for a period of one
year, but excludes the interest portion (P x i) of the holding costs if the above formula is
used. We then go and also include in the total variable inventory holding costs, the return
or interest that we expect on the purchase price of the inventory item. Holding costs, in
principle, therefore include both the required return on the purchase price ((P x i) in the
above formula) and “other” holding costs (H if the above formula is used). See below for
clarification of using H as the denominator versus using H + (P x i) as the denominator in
the EOQ formula.
• Remember that the EOQ is rounded up because generally items cannot be purchased in
partially-completed units and if rounded down we will then not have sufficient inventory.
Using H as the denominator versus using H + (P x i) as the denominator in the EOQ formula
It is important to note that although the symbol H is often used to represent “other variable
inventory holding cost (excl. interest) per annum per unit” (Coetzee, Jordaan, Sithole & Verster
2012:70, own emphasis), “H” can also be used to represent the total variable inventory holding
costs per annum per unit, i.e., including interest or the required return, if applicable. We mostly
follow the convention of using H for the total variable inventory holding costs per annum per
unit in this document, but both depictions of the denominator are correct as long as the
principles are applied correctly.
The principle is that the denominator in the EOQ formula should be the total variable inventory
holding costs per annum per unit, i.e., including interest (or required annual return on
investment in inventories).
This implies that the following two EOQ formulae should result in the same answer:
Formula 1
(where H excludes interest and this interest (P x i) is then added to H)

and
Formula 2
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Using H as the denominator versus using H + (P x i) as the denominator in the EOQ formula
(where H already incorporates the calculation of the interest, which is P x i)

The two formulae are the same in principle, it is just the symbols used that differ slightly.
Please refer to activity 4.5 in Study unit 4: Material of your Study guide one of two for MAC2601
for an example of where “H” is used without the “+ (P x i)”. Students often enquire about this
example.
In activity 4.5, the H already includes the interest. As you will see, the “interest” has already
been added to the other holding costs to arrive at the total holding costs (per annum per unit)
of R6. The principle remains that annual interest per unit + other annual variable inventory
holding costs (excluding interest) per unit = total annual variable inventory holding costs
(including interest) per unit and that interest (if applicable) will be part of the total holding costs.
It is important for you to understand what we are calculating when using the EOQ formula: we are
calculating how many units of a specific inventory item we will have to order at a time so that we
will minimise the total ordering costs plus holding costs for the year.
Remember, the fewer units we order at a time, the more the number of orders that we will have
to place during the year and, therefore, the higher our total ordering costs will be. C (variable
cost of placing an order), however, remains constant as it relates only to the ordering costs of a
single order.
Also, the fewer units we order at a time, the less our average inventory in store will be, which,
in turn, will lead to lower holding costs in total. EOQ thus seeks to find an order size at which
the total ordering costs added to the total holding costs are as little as possible.
This brings us to a recap of how to calculate the number of orders that we need to place during
a year:
Number of orders = Annual demand (in units) ÷ EOQ
For example, if our EOQ is 100 units and our planned usage of the associated inventory item is
2 000 units for the year, we will need to place 20 orders per year, that is, 2 000 divided by 100.
In the next section of this tutorial letter, we will discuss how the same EOQ principles that we use
for inventory purchases can be applied to calculate the optimal size of a production run.
14.6 Applying the EOQ to determine the production run size

The EOQ technique can also be used to determine the optimal number of units to produce per
production run. Within the MAC3701 context, the optimal number of units to produce per
production run is the production level at which we minimise the related annual set-up and holding
costs in total.
Previously, we used the EOQ technique to determine how many units (e.g. of materials, to meet
our manufacturing requirements) we had to order each time – now we use the same formula to
calculate how many product units we need to manufacture at a time. To do this, we replace the
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C ("variable cost of placing an order") in the EOQ formula by the set-up costs per batch (Drury
2015:658). Take note that although more complex models for batch size optimisation also exist,
such as the extended model discussed by Berlec, Kušar, Zerovnik & Starbek (2014:37), the
following basic formula will suffice for purposes of MAC3701:
In the formula above, the set-up costs per batch are represented by an “S”, and the “U” and “H”
remain the annual demand and the holding costs per unit per annum, respectively.
An example of setup costs per batch may be the incremental cost of labour (wages) of the
employees getting the production machinery ready for a new batch (Berlec et al 2014:35).
“Inventory carrying or holding costs” have already been discussed in MAC2601 (Coetzee et al
2012a:66) and can apply in both the context of keeping inventory of materials for use in production
and the context of keeping finished goods inventory for sale.
Example 1: Calculating the optimal batch size for production

• On average, an entity’s monthly production and sales demand is 3 000 units of a product X.
• Three employees are needed to set up a production run at 30 direct labour minutes per
employee. The direct labour rate is R40 per hour.
• Machine oil of three litres at a cost of R330 per container of five litres is used each time the
machines are set up for a production run.
• Storage costs amount to R50 per completed unit of product X per year.
• The company insures its completed product X units at R1 per unit per year.
• The current required return per unit per year is R149.
Although no marks will be allocated to the EOQ formula in your third-year module, we always
write down the formula we are using.
R330
2 𝑥 [3 000 x 12] x [(0,5 x 3 x R40)+(3 x )]
5
=√ [R50+R1+R149]
= √2 x 36 000 x [R60 + R198]/R200
= √R18 576 000/R200
= √92 880
= 304,76
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= 305 (optimal) production units per batch (rounded up)
For this example:
• Remember that the production units per batch are rounded up as we cannot produce
batches with partially-completed units in a scenario like this (there is no indication in this
question that we keep WIP inventory) and the answer cannot be rounded down as we will
then not meet the production requirements for the year.
• We have replaced the ordering costs with set-up costs (S). Set-up costs include all the
(additional) costs that the entity incurs each time it prepares for a new production run
(Drury 2015:658), i.e. the more the number of set-ups, the more the total set-up costs will
be. Can you see that this relates to cost behaviour and relevant costing (specifically
incremental costs) as well?
• The number of production batches that we will have in the above scenario can be
calculated as the annual production of 36 000 units, divided by the batch size of 305 units
(the answer is again rounded up). This means we will have 119 production batches/runs
during the year.
• The total set-up costs for the year, assuming there were no other set-up costs than those
indicated, can be calculated as the number of set-ups (119), multiplied by the incremental
costs per set-up, which we already calculated as R60 + R198 = R258. The total set-up costs
will thus be R30 702.
• Assuming the same example required the calculation of optimal order size ("normal" EOQ)
instead of the optimal production batch size, we would have used a C instead of an S in the
formula above, representing the incremental costs per order.
14.7 Decision making: Quantity discounts and the EOQ

When we buy materials for the production process, we are sometimes faced with potential
discounts, for instance, quantity discounts on large orders. To determine whether we should
accept the offer or not, the advantage of the discount, as well as having to pay less total ordering
costs (there will be fewer orders per annum), will have to be compared to the additional holding
costs of keeping more inventory (Drury 2015:658-659). This relates to both the EOQ technique
and the topic of Relevant Costing to which you were exposed in MAC2601 topic 11.
Let's look at an example (take note that the example given below is, henceforth, further expanded
to explain and illustrate some of the concepts of this tutorial letter):
Example 2A: Deciding about a quantity discount

Brezie (Pty) Ltd ("Brezie") needs to decide whether to take up an offer from its supplier to increase
its order size to at least 750 units of a required raw material at a time. Brezie currently pays R15
per unit but can save 1% of the purchase price per unit if they take up the offer. The supplier has
also decided to increase the purchase price per unit to R17 if order sizes are smaller than 300
units. Brezie applies the EOQ technique to manage its raw materials inventory.
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For this example, you may assume the following:

• The supplier charges an administrative fee of R120 per order placed.
• Brezie needs 22 500 units of raw material to meet its production requirements for the year.
• Brezie’s holding costs per unit of raw material per annum is R21,60. This amount is relatively
high due to the specific temperature and humidity requirements for the material to be safely
stored.
Where do we start in tackling this question?

Step 1: Calculate the current economic order quantity (if not already given).
Step 2: Apply relevant costing to calculate the net relevant cost or income.
Step 3: Make a recommendation.
Step 1: Calculate the current economic order quantity (if not already given).
= √(2 x 22 500 x R120)/R21,60
= √R5 400 000/R21,60
= √250 000
= 500 units
Step 2: Apply relevant costing to calculate the net relevant cost or income
Cost/income Relevant/ Reason Amount

irrelevant R
Increase in the purchase price to R17 per Irrelevant EOQ exceeds 300 0
unit units
Discount on the purchase price Relevant Incremental income/ +3 375
R15 per unit x 1% x 22 500 units cost saving
Decrease in ordering costs Relevant Incremental income/ +1 800
(45 – 30)* orders x R120 per order cost saving
Increase in holding costs Relevant Incremental cost -2 700
(750 – 500) units ÷ 2# x R21,60 per unit)
Net relevant income of ordering 750 units instead of 500 units at a time +R2 475
* The 45 orders that we have used in the answer are the total annual demand of 22 500 units
divided by the EOQ of 500 units per order. If we now place orders of 750 units per order instead
of 500 units, it will mean that we will have to place only 30 orders (22 500 ÷ 750) instead of the
original 45. Therefore, at a level of 750 units per order, we are placing 15 fewer orders than we
would have placed if we used the original economic order quantity of 500 units.
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#The increase in total holding costs amounts to the holding costs per unit of R21,60, multiplied
by the increase in average inventory level. The average inventory levels are calculated as EOQ
(or simply the order size where EOQ is not used) divided by two.
Step 3: Make a recommendation

The potential benefit of the larger order size outweighs the associated increase in holding costs
and Brezie should, therefore, take up the offer to order 750 units at a time at a discounted price
of R14,85 per unit.
We will now move on to a discussion of deciding when to place an order and how to calculate
safety stock, and then conclude with a section on the Just-In-Time (JIT) approach, specifically
focusing on JIT purchasing.
14.8 Decision making: When to place an order

In a perfect world, our suppliers will be able to deliver immediately when we order our inventory.
But we all know that this is not always possible, so an entity has to plan properly and order in
advance to ensure that they do not run out of inventory at a critical point in time. We refer to “the
time gap between sending an order and receiving it” as the lead time (Li, Fei, Zhou, Gajpal, &
Chen 2019:6457).
In the following examples, let's extend on the Brezie’s example that was used earlier in this
document. We will outline the logic of the re-order point and show you how this fits in with some
of the formulas you need to know.
Example 2B: The re-order point if not safety stock is kept

Brezie will order 500 units at a time as calculated earlier on (the EOQ). Let us assume a year of
360 days and a constant daily usage of the material. Also assume that the supplier only delivers
five days after Brezie places and order, meaning that there is a lead time of five days.
Brezie will require 22 500 ÷ 360 = 63 units (rounded) of the raw material per day. If the lead time
is five days, it means that Brezie will have to place its next order for 500 units when inventory
levels hit 5 x 63 = 315 units. If instead, Brezie waits until the 500 units are all used up before the
next order is placed, it will be too late, as Brezie will only receive the next batch of 500 units five
days later. The inventory level (315 units in this example) that is available at the point in time
when you have to place the next order, is called the "re-order point".
At an order size of 500 units, Brezie will have to place 22 500 ÷ 500 = 45 orders per year. This
means that an order will have to be placed every 360 ÷ 45 = 8 days.
Let us now have a look at how this explanation fits in with some of the formulas you need to study
and be able to apply.
Average usage per day

= Annual usage ÷ (Assumed) number of days in a year
= 22 500 ÷ 360
= 63 (rounded up)
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A question usually states or implies the number of days you need to use, for example, “240
operating days”, “360 days”, “the company operates for five days a week and 52 weeks in a year,
except for on 10 public holidays that fall within the work week”. Only if the question does not
specify this, one will use 365 days. The average usage rate can also be expressed per week, per
month, etcetera.
• Average usage during lead time
= Lead time x Average usage per day
= 5 days x 63 units per day
= 315 units
Note that you also need to know how to calculate the number of orders for the year as well as the
order interval:
• Number of orders placed per year
= Annual usage ÷ EOQ
= 22 500 ÷ 500
= 45 orders
Brezie will thus have to place 45 orders during the year if its annual usage is
22 500 units and its EOQ is 500 units.
• Order interval
= Number of days in a year ÷ Number of orders placed per year
= 360 ÷ 45
= 8 days
The “order interval” is the time lapse between orders.
In this question, our lead time is measured in days, so we need to determine the daily usage
requirements of the inventory item. If the lead time was measured in weeks, one would have
calculated the average usage per week, order interval in weeks, etcetera.
How to determine exactly when (on which dates) to place an order

Let's say Brezie receives its first order of 500 units today. The entity will use up these 500 units
in a period of eight days (500 units ÷ 63 units), so eight days from now, Brezie will need another
500 units to be delivered. To receive these units in time, Brezie will have to place the second
order already in three days from now, as it takes five days before any order is delivered. Order
number three will have to be placed in 3 + 8 = 11 days from now; order number four in 11 + 8
= 19 days from now, and so forth until the final order for the inventory used in the current year
is placed 8 + 5 = 13 days before year-end, i.e., on day 360 – 13 = 347.
We can thus say:

Number of days into the year that the second order needs to be placed
= Order interval less lead time
= 8 days – 5 days
= 3 days
The second order will then be placed eight days after the first order.
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The current example also assumes that no uncertainty exists in terms of any of the information
regarding the inventory (Drury 2015:660). What now if some uncertainty exists about how many
units of the raw material Brezie will actually use during the year, how long the supplier will take
before it delivers, etcetera?
Example 2C: The re-order point if some safety stock is kept

If Brezie is worried that the supplier may not keep to the five-day lead time or that the daily usage
may exceed 63 units on some days, Brezie may also want to keep some additional units as a
backup in order to reduce the risk of running out of raw materials. We call this “backup” inventory
that is kept to reduce the probability of stock shortages due to uncertain factors to an acceptable
level “safety stock” (Korponai, Tóth & Illés 2017:336-338).
In calculating Brezie’s re-order point, one will also have to take into account the safety stock level
that is required. In other words, should Brezie decide to keep a backup of, say 25 units of raw
materials inventory, Brezie will have to place its orders even earlier (at a higher inventory level
than the 315 units in example 2B). Use the following formula to calculate the re-order point:
Formula: Re-order point = Daily* requirement x Lead time in days* + Safety Stock4
As soon as an inventory level of 340 units (315 + 25) is reached, Brezie will have to place its next
order. Brezie’s re-order point is thus 340 units in the current scenario.
“Re-order point” principles as applied to production runs

The re-order point principles can also be adapted to calculate “the point (in units) at which a
production run should be started” (Berry & Raath 2019:9). The lead time will now be the time
gap between setting up production and completing it.
14.9 Calculating elementary safety stock levels

To try and hedge itself against uncertainties such as those mentioned in section 1.6, Brezie may
want to keep some safety stock as already explained. During the lead time of five days, Brezie
would, under conditions of certainty, require 5 x 63 = 315 units (that is average usage during lead
time) as discussed. But if the conditions were uncertain, how could Brezie potentially go about in
determining how many additional units to keep "for in case"?
Example 2D: Safety stock

Let's assume that Brezie is unsure if the 63 units per day will be sufficient under all circumstances
and/or whether the supplier will be able to always keep to a lead time of only five days. However,
Brezie feels comfortable that its demand for the raw material will never exceed 70 units per day
and trusts its supplier to never take longer than seven days to deliver. Brezie may therefore want
to revise its re-order point to incorporate this uncertainty by effectively using the “maximum usage
during maximum lead time” instead of the average usage during lead time. Therefore, instead of
4 * Can replace “daily” and “days” with other time period, e.g. “monthly” and “months”, as applicable. Consistency is,
however, required – do not mix time periods, such as days and months. We can also refer to the “Daily requirement
x Lead time in days” (or “Weekly requirement x Lead time in weeks”, etc.) as the “average usage during lead time”.
76
MAC3701/103/3/2024
using 5 x 63 = 315 units as its re-order point as before, Brezie will now use 7 x 70 = 490 units as
its re-order point.
Our safety stock can be calculated as the difference between our re-order point under conditions
of uncertainty (490 units) and our re-order point under conditions of certainty (315 units), which
amounts to 175 units.
Brezie may also choose not to work with the worst-case scenario (maximum usage and maximum
lead time) as illustrated above but to only keep some safety stock, taking the risk that it might not
be enough and it may result in an opportunity cost. However, the scenario will guide you in terms
of which scenario is applicable.
In other words, safety stock (if not given) can be calculated as:
Re-order point under conditions of uncertainty less re-order point under conditions of
certainty
As mentioned, the calculation will depend on whether the company is willing to take risk, and if
so, how much risk:
1. No risk: Worst-case scenario:

490 - 315 = 175 units
Or
2. Taking risk: Assume Brezie keeps safety stock to accommodate demand of up to 65 units
per day and a waiting period of up to six days in terms of delivery:
(6 x 65) - 315
= 390 - 315
= 75 units
If we now assume that the example stated that Brezie keeps safety stock of 175 units, we would
have been able to calculate the re-order point as follows:
Re-order point = Average usage during lead time + Safety stock
= 315 units + 175 units
= 490 units
We would still refer to the 63 units as the average usage rate and the five days (not the seven
days) as our lead time.
14.10 Just-in-time (JIT) purchasing

The final part of this document brings in a short overview of just-in-time, or "JIT", purchasing. One
of the important developments in the field of Management Accounting is the JIT approach. You
have learned more about this in Learning unit 13: Other ancillary topics of this course (Williams
et al 2020:548-551). However, it is necessary for us to refer to certain aspects of JIT, as JIT
affects the planning and control of inventory.
77
JIT purchasing involves, amongst other aims, the following (Drury 2015:664-665; Berry & Raath
2019:9; Williams et al 2020:548-551):
• Keeping as little inventory as possible – for this to realise, suppliers need to be reliable in
delivering inventories just before the entity needs them. If they deliver late, the entity
may have stock-out costs (Drury 2015:661) and not be able to meet demand (we discussed
the transaction motive and precautionary motive for holding inventory earlier on in this
document).
• Minimising the number of suppliers – this could possibly be done by channelling business
to those suppliers that are the most reliable in terms of timeous delivery and that are the
most willing to ensure that the goods delivered are of impeccable quality so that they can be
used immediately and without any further checking. In the process, longstanding
relationships with suppliers may be created.
JIT purchasing could have advantages like the following (Drury 2015:664-667; Berry & Raath
2019:9; Williams et al 2020:549-551):
• A reduction in inventory holding costs.
• Better relationships with suppliers over the long-term.
• A reduction in ordering costs, possibly due to better relationships with suppliers leading to
more bargaining power for the entity, or automation.
Similarly, JIT principles may be applied to the manufacturing process to reduce, for example, set-
up times and costs, as well as batch sizes due to more frequent production runs (Drury 2015:665-
666).
Techniques similar to those used in “Step 2” of Example 2A: Deciding about a quantity discount
above may also be used to determine the net relevant saving or cost associated with
implementing JIT purchasing or manufacturing.

4.11.1 Review the inventory management video that can be found on myModules.
78
MAC3701/103/3/2024
BIBLIOGRAPHY
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Breytenbach, J & De Villiers, C. 2012. Supply elasticity within the South African ICT labour market.
[Online.] Available at: https://pdfs.semanticscholar.org/2627/1de6cde5e017b0386c40fa6f11502
a0592f9. pdf [Accessed 3 February 2020].
Coetzee, WJ, Jordaan, AH, Sithole, SKM & Verster, JM. 2012a. Principles of management
accounting: Study Guide 1 for MAC2601. Pretoria: University of South Africa.
Coetzee, WJ, Ntuli, SB & Verster, JM. 2012b. Principles of management accounting: Study Guide
2 for MAC2601. Pretoria: University of South Africa.
Drury, C. 2015. Management and cost accounting. 9th edition. Hampshire: Cengage Learning.
Drury, C & EL-Shishini, H. 2005. Divisional performance measurement: an examination of the

potential explanatory factors (CIMA research report). [Online.] Available at:
http://www.cimaglobal.com/ Documents/Thought_leadership_docs/tech_resrep_divisional_perfo
rmance_measurement_2005.pdf [Accessed 30 January 2020].
Els, G, Van der Walt, R & De Wet, SR. 2017. Fundamentals of cost and management accounting.
8th edition. Johannesburg: LexisNexis.
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https://www.google.co.za/search?ei=7zA3XIH4Jbed1fAP0IyQ0A0&q=inventory+definition&oq=i
nventory+defi&gs_l=psyab.3.0.0l10.13513.15320..16300...0.0..0.362.3514.2-12j2......0....1..gws-
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standards/list-of-standards/ias-2-inventories/ [Accessed 12 October. 2023].
Inglesi-Lotz, R & Blignaut, JN. 2011. Estimating the price elasticity of demand for electricity by
sector in South Africa. [Online.] South African Journal of Economic and Management Sciences
14(4). Available at: http://www.scielo.org.za/scielo.php?script=sci_arttext&pid =S2222-
34362011000400007&lng=en&nrm=iso [Accessed 3 February 2020].
Kaplan Publishing, 2020. Official study text. Management Accounting. Operational level. P1.
Berkshire. United Kingdom. Kaplan Publishing.
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Kaplan Publishing, 2020. Official study text. Advanced Management Accounting. Management
level. P2. Berkshire. United Kingdom. Kaplan Publishing.
Korponai, J., Tóth, A.B. and Illés, B. 2017. Effect of the safety stock on the probability of
occurrence of the stock shortage. 7th International Conference on Engineering, Project, and
Production Management. Procedia Engineering, 182, 335-341. [Online.] Available at:
https://reader.elsevier.com/reader/sd/pii/S1877705817312420?token=0B28F52237FD78C0825
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B89B79C [Accessed 12 October. 2023].
Li, Z., Fei, W., Zhou, E., Gajpal, Y. and Chen, X. 2019. The impact of lead time uncertainty on
supply chain performance considering carbon cost. Sustainability, 11, 6457 (article number: 6457.
https://doi.org/10.3390/su11226457). [Online.] Available at: https://www.mdpi.com/2071-
1050/11/22/6457 [Accessed 12 October. 2023].
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MAC3701. Pretoria: University of South Africa.
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Oxford University Press Southern Africa.
© UNISA 2024
All rights reserved. No part of this document may be reproduced or transmitted in any form or by any means without
prior written permission of Unisa.
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MAC3701/103/3/2024

Tutorial Letter 103/3/2024

Department of Management Accounting

This tutorial letter contains important information

10.4 Using data and technology in linear programming ...................................................................... 37

PURPOSE OF THE MODULE

PREREQUISITE AND PRIOR KNOWLEDGE

Tutorial letter (TL) 101

QB001 QUESTION BANK

Final written examination

STRUCTURE OF THE TUTORIAL LETTERS FOR THE MODULE

SERIES CONTENT OVERVIEW

LECTURERS’ CONTACT DETAILS

STRUCTURE OF THIS TUTORIAL LETTER

This tutorial letter consists of the following seven learning units:

LEARNING UNIT TITLE

STUDY MATERIAL REFERENCE

ASSESSMENTS AND SCOPE

LEARNING UNIT 8: PROCESS COSTING

8.2 Learning outcomes

Assumed prior knowledge

Term used in MAC2601 Term used in Principles of

Study the following sections in chapter 8 of the prescribed textbook:

8.4 Losses identified at the inspection point

8.5 Accounting for the proceeds and costs of normal scrap

8.6 The short-cut method for allocating normal losses

Self-practice exercise 8.6.1: longer method vs short-cut method

Self-practice exercise 8.6.1: suggested solution

(b) Statement of profit or loss and other comprehensive income

Conversion Units Calculations R

W3. Allocation statement

(c) Determining if the short-cut method is applicable

The quantity statement, using the short-cut method, will be as follows:

Physical units Equivalent units

Net profit before taxation 481 670

Calculation of the rand value of the normal loss

Allocation of the rand value of the normal loss

W4. Allocation statement

Self-practice exercise 8.6.2

8.7 The suitability of process costing in a service organisation

But can process costing also be applicable in a service organisation?

8.8 Batch or operation costing

PROCESS COSTING STATEMENTS

Quantity Production cost Cost allocation Income

8.10 Self-review exercises

9.2 Learning outcomes

Assumed prior knowledge

9.3 Topic outline

9.4 Sales volume variances: levels to use in MAC3701

9.5 Further illustration of idle time and labour efficiency variances

9.5.1 Selected key terms within labour variances

Key terms Explanation

9.5.2 Idle time variance and labour efficiency variance formulae

9.5.3 Idle time variance and labour efficiency variance example

(a) Idle time variance

*From example 13.6 in the prescribed textbook

9.6 Fixed manufacturing overheads variances