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ACCA Paper F5

Performance

Management

Class Notes

June 2014

FREE ACCA KAPLAN EXAM KIT 2017-2018 Click for Download


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© Interactive World Wide Ltd, January 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,

or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior written permission of Interactive World Wide Ltd.

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Contents

PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: COST ACCOUNTING AND NEW DEVELOPMENTS 9

CHAPTER 2: DECISION MAKING AND LINEAR PROGRAMMING 31

CHAPTER 3: PRICING 57

CHAPTER 4: DECISION MAKING UNDER UNCERTAINTY 71

CHAPTER 5: BUDGETING TYPES 85

CHAPTER 6: BUDGETARY CONTROL 93

CHAPTER 7: QUANTITATIVE AIDS TO BUDGETING 103

CHAPTER 8: STANDARD COSTING AND VARIANCE ANALYSIS 113

CHAPTER 9: ADVANCED VARIANCE ANALYSIS 125

CHAPTER 10: PERFORMANCE EVALUATION 135

CHAPTER 11: TRANSFER PRICING 159

SOLUTIONS TO EXERCISES AND EXAMPLES 167

ACCA STUDY GUIDE AND INDEX 215

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Introduction to the

paper




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INTRODUCTION TO THE PAPER

AIM OF THE PAPER

To develop knowledge and skills in the application of management accounting techniques to

quantitative and qualitative information for planning, decision-making, performance evaluation

and control.

OUTLINE OF THE SYLLABUS

1. Cost accounting techniques.

2. Decision-making techniques including risk and uncertainty.

3. Budgeting techniques and methods.

4. Standard costing systems.

5. Performance appraisal including financial and non-financial measures.

FORMAT OF THE EXAM PAPER

The syllabus is assessed by a three hour paper-based examination.

The examination consists of 5 questions of 20 marks each. All questions are compulsory.

FAQs

What is the skills set that a student must bring to the paper?

As a student approaching this paper the basic requirement is an ability to understand and

compute the differing techniques and methods in the syllabus. In addition there is a need to

understand the scenario and critically be able to write in relation to the scenario and whatever

the numbers you have already calculated.

What is an average mix of discursive and numerical elements in the exam?

There is no strict guideline as to how many marks would be allocated to discursive parts and

number crunching questions. However, on average around 35% - 40% is the general average

covering discussions based on scenarios provided in the questions, and some on general

concepts.




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Formulae provided in

the examination paper




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FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER

FORMULAE SHEET

Learning curve

Y axb

Where: y = cumulative average time per unit to produce x units

a = the time taken for the first unit of output x = the

cumulative number of units produced b = the index

of learning (log LR/log 2)

LR = the learning rate as a decimal

Demand curve

P a − bQ

b change in price

change in quantity

a price when Q 0

MR = a – 2bQ




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Chapter 1

Cost accounting and

new developments

SYLLABUS CONTENT (as set by ACCA‟s study guide)

A Specialist cost and management accounting techniques

1. Activity based costing

a) Identify appropriate cost drivers under ABC.

b) Calculate costs per driver and per unit using ABC.

c) Compare ABC and traditional methods of overhead absorption based on production units,

labour hours or machine hours.

2. Target costing

a) Derive a target cost in manufacturing and service industries.

b) Explain the difficulties of using target costing in service industries. c) Suggest

how a target cost gap might be closed.

3. Life-cycle costing

a) Identify the costs involved at different stages of the life-cycle.

b) Derive a life cycle cost in manufacturing and service industries.

c) Identify the benefits of life cycle costing.




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CHAPTER 1 – COST ACCOUNTING AND NEW DEVELOPMENTS

4. Throughput accounting

a) Calculate and interpret a throughput accounting ratio (TPAR).

b) Suggest how a TPAR could be improved.

c) Apply throughput accounting to a multi-product decision-making problem.

5. Environmental accounting

a) Discuss the issues business face in the management of environmental costs.

b) Describe the different methods a business may use to account for its environmental costs.




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CHAPTER CONTENT DIAGRAM

Costing methods

Absorption Activity based

Other

costing

costing

costing

● Full cost per unit ● Accurate product ● Life cycle costing

● Issue: Arbitrary costs

● Target costing

cost allocation ● Swap cost units

● Solution: Activity with cost pools

based costing ● SwapOARs with

cost driver rates

Throughput Environmental accounting Accounting

● Return per factory hour ● Costing methods

● Cost per factory hour ● Reasons for use

● Throughput accounting

ratio (TPAR)

● Decision making




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CHAPTER CONTENTS

ABSORPTION COSTING ------------------------------------------------- 13

ABSORPTION COSTING – A REMINDER 13

TRADITIONAL OVERHEAD ANALYSIS 13

STEPS USING ABSORPTION COSTING 13

CRITICISMS OF ABSORPTION COSTING: 14

RECENT CHANGES IN MANUFACTURING 14

A REVISED ANALYSIS – ABC 15

STEPS USING ABC 15

CONDITIONS UNDER WHICH ABC IS MOST APPROPRIATE 17

BENEFITS AND LIMITATIONS 17

ACTIVITY BASED BUDGETING (ABB) ---------------------------------- 18

THROUGHPUT ACCOUNTING ------------------------------------------- 19

BASICS 19

RATIONALE 19

KEY TERMINOLOGY 19

CONCEPTS UNDERPINNING THROUGHPUT ACCOUNTING 20

FACTORS AFFECTING THE VALUE OF THROUGHACCOUNTING PUT 20

STEPS IN THROUGHPUT ACCOUNTING 20

LIMITATIONS OF THROUGHPUT ACCOUNTING 21

TARGET COSTING -------------------------------------------------------- 22

TRADITIONAL COSTING SYSTEMS 22

TARGET COSTING STEPS 22

CLOSING A TARGET COST GAP 23

IMPLICATIONS OF USING TARGET COSTING 24

LIFE CYCLE COSTING ---------------------------------------------------- 25

COMPARISON OF LIFE CYCLE COSTING AND TRADITIONAL MANAGEMENT ACCOUNTING 25

ENVIRONMENTAL ACCOUNTING --------------------------------------- 28

INTRODUCTION 28

TYPES OF ENVIRONMENTAL COSTS 28

MANAGING ENVIRONMENTAL COSTS 29

ENVIRONMENTAL COSTS STRATEGIES 29

METHODS FOR ACCOUNTING OF ENVIRONMENTAL COSTS 29




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ABSORPTION COSTING

Absorption costing – a reminder

The linking of all production costs to the cost unit to prepare a full cost per unit.

Uses

1. Stock Valuation

2. Pricing decisions

3. Budgeting

Traditional overhead analysis

Overhead Cost Cost

cost item Centre Units

Steps using absorption costing

The steps using absorption costing are:

1 Overhead costs are collected in various cost centres

Allocation: Specific overhead costs directly relating to individual cost centres, for

example, supervision, indirect materials.

Apportionment: General or common overhead costs like rent, heating, electricity are

incurred as a whole item by the company and therefore have to be distributed to cost

centres on some sharing bases like floor area, machine hours, number of staff etc

2 Overhead absorption is achieved by means of a predetermined Overhead Absorption

Rate.

a. Overhead Absorption Rate = Budgeted Overheads

Budgeted Level of Activity *

* Activity levels generally used by examiners are number of units, labour

hours or machine hours, which means overheads are charged to units on

these bases.

Number of Units: Single product environment

Labour Hours: Manual manufacturing operations

Machine Hours: Mechanical manufacturing operations

b. Absorbed overheads = OAR x Actual Activity




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Criticisms of absorption costing

Criticisms of absorption costing are:

● A big amount of guess work in relating overhead costs to the products.

● Inappropriate bases to link overheads to products

● Can only work in single product and simple manufacturing environments

Recent changes in manufacturing

The reason for the increasing inaccuracy of absorption costing is due to two basic issues:

1. Increased production complexity.

2. Increased proportion of overhead costs.

Production complexity

A wide variety of production processes have become more complex in recent years in a number

of ways:

1. Flexible manufacturing systems allow for a number of widely differing products to be

produced on the same machinery. Absorbing overhead on a simple volume base is

unlikely to reflect the differing overhead costs incurred by each product.

2. Fast product development may mean that a number of differing iterations of the same

product may be produced in quick order. With such products having differing production

volumes again a volume base is unlikely to work.

3. Wider product ranges lead to a more complex cost analysis.

Increased proportion of overhead costs

Overheads have increased in importance as a percentage of total costs due to both the

substitution of direct labour with indirect labour as companies mechanise to a greater degree.

Also the increased production complexity outlined above has given rise to increased costs for

such disciplines as production planning and logistics.

Increased proportion of support services‟ costs

Activity based costing also introduces the important aspect that cost are incurred in selling and

distributing a product and the cost of servicing customers are often more important than

production therefore an accurate cause effect relationship should be established as to what

generates the cost and what is the real impact of this cost on the volume of units sold.




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A revised analysis – ABC

Overhead Cost Cost

Cost Item Pool Unit

Steps using ABC

The steps involved in ABC are:

1. Identify an organisation‟s activities.

2. Collect the cost of each activity into what is called cost pool (equivalent to cost centre

under traditional costing).

3. Identify the factors which determine the size of the costs of an activity. These are called

cost drivers.

Activity Possible Cost Drivers Ordering number of orders

Material handling number of production run Production scheduling number of production run

Despatching number of despatches

4. Assign the cost of activities to products according to the product‟s demand for activities.

Cost Pool is an activity that consumes resources and for which overhead costs are identified

and allocated. For each cost pool there should be a cost driver.

Cost Driver is any factor which causes a change in the cost of an activity.

Steps to remember in ABC calculations:

1. Record direct costs (direct materials and direct labour) for each product in separate

columns.

2. Calculate cost driver rates, and apply them into each product as follows, we assume

product A only in this case as an instance.

Set up cost driver rate = set up overhead cost

total cost drivers (no. of set ups or runs)

3. above cost driver rate total number of set ups for product A for all units

number of units of the individual product A

Let‟s take another example, of quality related overhead cost

Quality related overheads driver rate = quality control costs

number of quality inspections

cost driver rate number of quality inspections for product A for all units number

of units of product A

This will be the relevant overhead cost share of set up or quality related overheads for product

A.




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Example 1 Hensau Ltd Hensau Ltd has a single production process for which the following costs have been estimated

for the period ending 31 December 2010:

$

Material receipt and inspection costs 15,600 Power costs 19,500 Material handling costs 13,650

Three products - X, Y, and Z are produced by workers who perform a number of operations on

material blanks using hand held electrically powered drills. The workers are paid $4 per hour.

The following budgeted information has been obtained for the period ending 31 December

2009: Product X Product Y Product Z

Production quantity (units) 2,000 1,500 800 Batches of Material 10 5 16 Data per product unit:

Direct material (square metres) 4 6 3 Direct material cost ($) 5 3 6 Direct labour (minutes) 24 40 60 No. of power drill operations 6 3 2

Overhead costs for material receipt and inspection, process power and material handling are

presently each absorbed by product units using rates per direct labour hour.

An activity based costing investigation has revealed that the cost drivers for the overhead costs

are as follows: Material receipt and inspection: Number of batches of material Process power: Number of power drill operations Material handling: Quantity of material (square metres)

handled Required (a) Prepare a summary which shows the budgeted product cost per unit for each product of

X, Y, and Z for the period ending 31 December 2010 detailing the unit costs for each

cost element using:

(i) the existing method for the absorption of overhead costs and

(ii) an approach which recognises the cost drivers revealed in the activity based costing investigation. (13 marks)

(b) Explain the relevance of cost drivers in activity based costing,and how activity based

costing can help in modern and complex manufacturing environments. (7 marks) (20 marks)




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Conditions under which ABC is most appropriate

The usefulness of ABC techniques will depend on the characteristics of the organisation, in

particular the following:

(1) Cost structure

(2) Product mix or diversity

(3) Information

(4) Environment.

Benefits and limitations

Benefits

1. More accurate product costing.

2. Is flexible enough to analyse costs by activity providing more useful costing data.

3. Provides a reliable indication of long-run variable product cost.

4. Helps understanding of cost.

5. Provides a more logical basis for costing of overhead.

Limitations

1. Cost vs benefit.

2. ABC information is historic and internally.

3. Difficult to apply in practice.

4. Focuses on the allocation of cost rather than minimizing the cost incurred.




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ACTIVITY BASED BUDGETING (ABB)

● Activity based budgeting extends the use of ABC from individual product costing, for

pricing and output decisions, to the overall planning and control systems of the business.

● The basic principle of ABB is that the work of each department for which a budget is to be

prepared is analysed by its major activities, for which cost drivers may be identified. The

budgeted cost of resources used by each activity is determined (from recent historical

data) and, where appropriate, cost per unit of activity is calculated.

● Future cost can then be budgeted by deciding on future activity levels and working back

to the required resource input.




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THROUGHPUT ACCOUNTING

Basics

Throughput accounting is a method of accounting that focuses on throughput, and relates costs

of production to throughput. Throughput accounting applies the theory of constraints as

advocated by Goldratt and Cox.

Rationale

Profitability of a product is determined by the rate at which it contributes money and the rate at

which the factory spends money. To increase profitability, Goldratt and Cox advocated that

managers should aim to increase throughput while simultaneously reducing inventory and

operational expenses. However, the scope of reducing operational expenses is limited as they

are to be maintained at some minimum level for production to take place.

Throughput is calculated as the difference between sales and material cost.

Throughput (contribution) = sale – material cost.

Key terminology

(Please note the similarity to marginal costing terminology that you already know)

Marginal costing Throughput accounting

Variable Cost = Direct Material Cost

Fixed Cost = Total Factory Cost

(Including labour cost)

Contribution = Throughput

(Sales – Variable Cost) (Sales – Direct Material Cost)




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Concepts underpinning throughput accounting

Throughputaccounting is based on following concepts:

1. Cost Behaviour

In the short-term all manufacturing cost with the exception of material cost are fixed.

2. Inventory

Holding and producing stocks do not add to the value of products (no value addition). The

longer it takes to output, the lower the profitability. Throughput is created when the

finished output is sold. If items are produced and put into finished goods stock, no

throughput is created. Therefore managers should aim to increase throughput whilst

simultaneously reducing inventory and operational expenses.

Factors affecting the value of throughputaccounting

● The selling price of the item sold

● The purchase cost of direct materials

● Efficiency in the usage of direct materials

● The volume of the throughput.

Bottleneck is any limitation or restraint in the production process which limits the production

managers to fully utilise some of their resources.

● Machine capacities

● Human resources

● Materials in scarcity.

In order to maximise throughput, managers should focus attention on any bottlenecks and

remove them. If this is not possible they should ensure that the bottlenecks are fully utilised at

all times.

Steps in throughput accounting

1. Identify the system bottlenecks. These are the constraints that restrict output from being

increased

2. Concentrate on each bottleneck in turn to ensure that they are being fully and efficiently

utilised.

3. Scale down the throughput of non-bottleneck activities to match what can be dealt with by

the bottleneck.

4. Remove the bottlenecks if possible.

5. Since throughput accounting is a continues improvement process, return to step 1 and re-

evaluate the system now that bottlenecks have been removed.




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Formula to remember:

Throughput Accounting Ratio (TPAR) = Throughput Return per bottleneck hour *

Factory Cost per bottleneck hour *

* total factory cost includes direct labour and production overheads.

Throughput Return = Selling price – direct material cost

** total factory hours in bottleneck resource or process.

Example 2 3P3M Ltd

3P3M Ltd produces three products using three different machines. The

following information is available for a product for a period:

Product X Y Z Sales ($) 20 15 10 Direct materials ($) 8 5 4 Direct labour ($) 5 3 2 Overheads ($) 2 1 1 Estimated sale demand (unit) 200 200 200

Machine hours required per unit: Machine 1 6 2 1 Machine 2 9 3 1.5 Machine 3 3 1 0.5

Machine capacity is limited to 1,600 hours for each machine.

Required:

(a) Identify the bottleneck process and explain why it is called as a bottleneck resource. (4 marks)

(b) Calculate the throughput accounting ratio for the three products and

rank the products. (10 marks)

(c) Produce an optimal production plan and maximum profit. (6 marks)

(20 marks)

Limitations of throughput accounting

● Selling price could be uncompetitive

● Material suppliers may not be reliable

● Product quality is low

● Need to deliver on time

● Very little attention is paid to overhead costs. www.studyinteractive .org 21



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TARGET COSTING

Traditional costing systems

Traditional costing systems:

1. Calculate unit cost.

2. Add profit margin.

3. Equals Selling price.

Problems:

● No consideration of market. ●

Costs are not challenged.

Target costing steps

Target costing steps:

1. Determinepossible selling price – with reference to the market/customer and taking into

consideration the specification of the product.

2. Establish the required profit margin – this is based upon the overall required return of the

business and the level of perceived risk of the product.

3. Calculate the target cost – ie the cost that the company must produce at in order to be able

to achieve the required profit level (Selling price – profit margin).

4. Close the gap – reduce the cost from the original expected cost to the target cost.




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Example 3 Fantata Ltd

Fantata Ltd makes and sells a product H which is manufactured through two consecutive

processes; assembly and finishing. Raw material is input at the commencement of the

assembly process. An activity-based costing approach is used in the absorption of product

specific conversion cost.

The following estimated information is available for the period.

Product H Production/ sales units 12,000 Selling price per unit $75 Direct material cost per unit $20 ABC variable conversion cost per unit:

Assembly $20 Finishing $12

Product specific fixed costs $170,000

Company fixed costs $50,000

The management wishes to achieve an overall net profit margin of 12% on sales in this period

in order to meet return on capital target.

Required:

(a) Calculate target cost.

(b) Calculate the cost gap.

(c) Suggest specific areas of investigation.

Closing a target cost gap

The designed specification for each product and the production methods should be examined

for potential areas of cost reduction that will not compromise the quality of the products.

For example:

1. Reduced component count

● Reducing the number of components

● Using standard components wherever possible

● Using different materials.

2. Reduce production complexity

● Acquiring new, more efficient technology

● Cutting out non-value added activities.

3. Revise production process

4. Revise specification

Note: Remember that these above points should not be implemented if they would compromise

quality.




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Implications of using target costing

Target costing requires managers to change the way they think about the relationship between

cost, price and profit.

Key advantages:

● Cost reduction and control

Possible elimination of non value added elements and activities in production process.

● Market based costing

Selling price considers what customer might want to pay for the product.

● Customers

Customer requirements for quality, cost, and time are incorporated into product and

process decisions. The value of product features to the customers must be greater than

the cost of providing them.

● Design

Cost control is emphasised at the design stage so any engineering changes must happen

before production starts.




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LIFE CYCLE COSTING

Cradle to grave

The term life-cycle costing is used to describe a system that tracks and accumulates the actual

costs and revenues attributable to each product from inception to abandonment.

In life-cycle costing the profitability of each product can therefore be determined right from

design stage through development to market launch, production and sales, and finally to its

eventual withdrawal from the market.

Life cost per unit = Total life costs for product

Total expected life volumes

The component elements of a product‟s cost over its life cycle could therefore include the

following:

1. Research and development costs

● Design

● Testing

● Production process and equipment.

2. The cost of purchasing and any technical data required.

3. Training costs (including initial operator training and skills updating).

4. Manufacturing or production costs.

5. Marketing costs

● Customer service

● Field maintenance

● Brand promotion.

6. Distribution cost (including transportation and handling costs).

Comparison of life cycle costing and traditional management accounting

● Traditional MA merely report on a periodic basis, and product profits are not monitored

over their life cycle. Such a practice does not, therefore, assess a product‟s profitability

over the entire life but rather on a periodic basis. Costs tend to be accumulated according

to function; research, design, development and customer service costs incurred on all

products during a period are totalled and recorded as period expense.

● LCC involves tracing costs and revenues on product-by-product basis over several

calendar periods throughout their entire life cycle. Costs and revenue can be analysed by

time periods, but the emphasis is on costs and revenue accumulation over the entire life

cycle for each product.

● Recognition of the commitment needed over the entire life cycle of a product will

generally lead to more effective resource allocation than the traditional annual budgeting

system.




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Key issues: ● Failure to trace all costs to products over their life cycles hinders management‟s

understanding of product line profitability, because a product‟s actual life-cycle profit is

unknown. ● Inadequate feedback information is available on the company‟s success or failure in

developing new products. ● The control function of life cycle costing lies in the comparison of actual and budgeted life

cycle costs for a product. The application of life cycle costing will ensure that cost control and cost

reduction will be carried out at the early stages, as well as during the production

stages.




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Example 4 Aeon plc Aeon Plc is designing a new, high-tech consumer product currently known as Product 801. The

research and development, design and management accounting teams have estimated that the

Product 801 could be developed and manufactured in one of two ways. Approach 1 is the

simpler option. Approach 2 requires more development and additional machinery to

manufacture the product in a more efficient way. Market research shows that Product 801 should sell for $50 per unit. Approach 1 Development costs = $1,250,000 Variable manufacturing cost per unit = $25

Selling price per unit = $50 Repairs and warranty costs = $50/unit needing repairs, and 1% of sales will incur these costs Clean-up and machinery dismantling costs at end of production $50,000 Approach 2 Development costs = $2,350,000 Variable manufacturing cost per unit = $20

Selling price per unit = $50 Repairs and warranty costs = $30/unit needing repairs, and 0.5% of sales will incur these costs Additional fixed cost per year to run new manufacturing machinery = $20,000 Clean-up

and machinery dismantling costs at end of production = $30,000 The life of Product 801 if developed and manufactured using Approach 1 should be 5 years and 50,000 units per year should be sold. Because of the higher level of research used in Approach 2, the product‟s life will be increased to 6 years. Required: (a) Using a life-cycle costing, which of Approach 1 or Approach 2 is

expected to give the higher total profit? (8 marks) (b) If the target gross profit for any product sold by the company is 40%,

what is the target cost of Product 801 and calculate whether the life-time costs per unit of

Approach 1 and Approach 2 would give costs less than the target cost. Explain, using

calculations where possible, how any cost gaps could be closed in this case. (7 marks)

(c) Explain why life-cycle costing is particularly important in high-

technology mass production industries. (5 marks)

(20 marks)




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ENVIRONMENTAL ACCOUNTING

Introduction

Due to rapid growth in world population and mass scale consumption of global resources, the

amount of wasteful and hazardous output has increased tremendously. It has become such an

important issue that business and political leaders have come to talk of the greener and safer

environment. Many organisations worldwide like Greenpeace, Environmental Protection

Agency, Kyoto Protocol are seeking to reduce emissions of greenhouse gases which are

believed to be causing global warming.

In order to comply with different local and global requirements, businesses and governments

spend huge amounts of money protecting environment in the name of environmental costs, eg

improving production process to reduce or eliminate pollutants and cleaning up contaminations

in soil and water resources.

Types of environmental costs

1. Public sector costs (social sector costs)

● Costs borne by taxpayers.

● Include staffing costs of the public sector organisations involved, reduce or eliminate

pollution from society, natural resources.

● Health and Medicare costs caused due to pollutants.

2. Private sector costs

● Business investments in environment related costs.

● Incurred to comply with local and global environmental requirements.

● Include, for example: costs of cleaning water resources due to pollutants such as toxic

wastes from production and chemical processes; compensation on a social level such as

investing in parks, public gardens, schools, forestry; and Medicare projects.

Identifiable and non-identifiable costs

Some of the above costs are clearly identified and known as attached to environment

protection, such as environmental organisations‟ staffing costs, costs of cleaning up a polluted

lake or a river etc.

Some environment costs are hidden as they are not directly tied to environment but are caused

by environmental issues. Such costs are borne by individuals, insurance companies, or even

governments, examples include medicare costs (due to cancer or other illnesses caused by

environmental pollutants).




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Managing environmental costs

Private sector focus

1. Monitoring costs.

2. Prevention costs.

3. Clean-up costs:

● On-site costs.

● Off-site costs.

Environmental costs strategies

1. End-of-pipe strategy

This strategy focuses on cleaning up pollutant and toxic waste before it is released into

environment.

2. Process improvement strategy

The focus is on products and process modification to reduce or eliminate pollutants.

3. Prevention strategy

The focus is to design the production process in such a way which does not create any pollutant

in the first place.

Methods of accounting for environmental costs

The following methods are generally in practice to deal with reporting of environmental costs.

1. Input / output method

This method records material inflows, and balances these with outflows on the same basis. The

simple idea is that what comes in should go out.

2. Material flow cost accounting

Under this method the material inflows are divided into three categories based on physical

quantities involved, their costs and value:

● Material

● System and delivery

● Disposal.

The values and costs of each of these three flows are then calculated.




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3. Activity based costing (ABC) ABC clearly distinguishes between environment related costs which can be charged to joint cost

centres and environment driven costs hidden in general overheads. It provides an allocation of

internal costs to cost centres and cost drivers on the basis of activities that give rise to the

costs. 4. Life cycle costing This method focuses on adding environment related costs, such as cost of waste disposal,

energy emissions etc into total cost of products over entire life cycle. The main aim is to reduce

total cost with environment friendly options in all stages of the cycle. 30 www.studyinteractive .org



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Chapter 2

Decision making and

linear programming


B Decision-making techniques

1. Relevant cost analysis

a) Explain the concept of relevant costing.

b) Identify and calculate relevant costs for a specific decision situations from given data.

c) Explain and apply the concept of opportunity costs.

2. Cost volume profit analysis

a) Explain the nature of CVP analysis.

b) Calculate and interpret breakeven point and margin of safety.

c) Calculate the contribution to sales ratio, in single and multi-product situations, and

demonstrate an understanding of its use.

d) Calculate target profit or revenue in single and multi-product situations, and demonstrate

an understanding of its use.

e) Prepare breakeven charts and profit volume charts and interpret the information

contained within each, including multi-product situations.

f) Discuss the limitations of CVP analysis for planning and decision making.




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CHAPTER 2 – DECISION MAKING AND LINEAR PROGRAMMING

3. Limiting factors a) Identify limiting factors in a scarce resource situation and select an appropriate technique.

b) Determine the optimal production plan where an organisation is restricted by a single

limiting factor, including within the context of „make‟ or „buy‟ decisions.

c) Formulate and solve multiple scarce resource problem both graphically and using

simultaneous equations as appropriate. d) Explain and calculate shadow prices (dual prices) and discuss their implications on

decision-making and performance management. e) Calculate slack and explain the implications of the existence of slack for decision-making

and performance management. (Excluding simplex and sensitivity to changes in objective

functions.)

5. Make-or-buy and other short-term decisions a) Explain the issues surrounding make vs. buy and outsourcing decisions. b) Calculate and compare „make‟ costs with „buy-in‟ costs. c) Compare in-house costs and outsource costs of completing tasks and consider other

issues surrounding this decision. d) Apply relevant costing principles in situations involving shut down, one-off contracts and

the further processing of joint products.




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CHAPTER CONTENT DIAGRAM

DECISION MAKING

Contribution CVP Relevant cost Sensitivity analysis analysis analysis analysis

Limitations & constraints

LINEAR PROGRAMMING




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CHAPTER CONTENTS

INTRODUCTION TO DECISION MAKING ------------------------------- 35

CONTRIBUTION ANALYSIS --------------------------------------------- 36

MAKE OR BUY DECISION 36

SHUTDOWN (DISCONTINUANCE) DECISIONS 37

LIMITING FACTOR DECISION 38

FURTHER PROCESSING DECISIONS 40

CVP ANALYSIS (BREAKEVEN ANALYSIS) ----------------------------- 42

WHAT IS CVP (BREAK-EVEN) ANALYSIS? 42

HOW IS THE BREAK-EVEN POINT CALCULATED? 42

LIMITATIONS OF BREAK-EVEN ANALYSIS 44

MARGIN OF SAFETY 45

CONTRIBUTION / SALES RATIO 45

RELEVANT COST ANALYSIS --------------------------------------------- 47

OPPORTUNITY COST 47

AVOIDABLE COSTS 47

VARIABLE COSTS 47

INCREMENTAL COSTS 47

ACCEPTING OR REJECTING ORDERS ---------------------------------- 48

LINEAR PROGRAMMING – MULTI LIMITING FACTORS -------------- 52

SENSITIVITY ANALYSIS ------------------------------------------------ 55

ASSUMPTIONS AND LIMITATIONS OF LINEAR PROGRAMMING 56




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INTRODUCTION TO DECISION MAKING

The choice between two or more alternatives, decision making normally considers only the

short term consideration of maximising profitability. We base our decisions on relevant costs

and revenues.




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CONTRIBUTION ANALYSIS

One aspect of decision making is closely linked to the impact of a change in the level of activity.

In these situations the decision is based upon the variable costs or contributions generated.

Fixed costs are not affected by activity and hence can be ignored.

Make or buy decision

The decision to make a component or product „in-house‟ or to buy from an outside supplier. The

underlying assumption of this decision is that all fixed costs of manufacture are general to the

organisation as a whole and hence only the marginal cost of making the component is relevant.

Decision criteria: Compare marginal cost of making to the purchase price (the marginal cost of

buying).

Example 1 Central Ltd

Central Ltd makes four components, W, X, Y and Z, for which costs in the coming year are

expected to be as follows:

W X Y Z Production units 1,000 2,000 4,000 3,000 Unit marginal costs $ $ $ $ Direct materials 4 5 2 4 Direct labour 8 9 4 6 Variable production overheads 2 3 1 2 14 17 7 12

Direct attributable fixed costs per annum and committed fixed costs are:

$

incurred as a direct consequence of making W 1,000 incurred as a direct consequence of making X 5,000 incurred as a direct consequence of making Y 6,000 incurred as a direct consequence of making Z 8,000 other fixed costs (committed) 30,000 50,000

A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10, and $14

respectively.

Required:

Should the company make or buy the component? 36 www.studyinteractive .org



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Other important factors to consider

1. If the components are sub-contracted, the company will have spare capacity. How should

that spare capacity be profitably used, that is, are there hidden benefits to be obtained

from sub-contracting?

2. Would the sub-contractor be reliable with supply and delivery time?

3. Would the sub-contractor supply the same or improved quality components as the one

produced internally?

4. Does the company wish to be flexible and maintain better control over operations by

making everything itself?

5. The going concern of the sub-contractor should also be considered.

Shutdown (discontinuance) decisions

The decision whether to shut down a part or segment of a business. The focus of the question is

the impact of the shutdown on the cost base. Revenue will be foregone but which costs will be

affected.

The avoidable costs include variable costs and specific fixed costs. Specific fixed costs are

those costs specific to the part or segment of the business to be shutdown. General fixed costs

will not be relevant.

The simplest way to consider such a problem is to re-draft any information in the form of a

marginal costing profit statement.

Any product that produces a positive contribution is worth undertaking as it will contribute to

profit, unless

● The company can use the capacity used by this product to produce another new product

with a higher contribution than that of this first product.

● The capacity used by this product can be used to produce more of the other existing

product with higher contribution.




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Example 2 Jones Ltd

Jones Ltd operates three divisions within a larger company. The CEO has been shown the

latest profit statements and is concerned that division C is losing money.

You are required to advise her whether or not to close down division C.

Division A B C ($000s) ($000s) ($000s) Sales 100 80 40 Variable costs 60 50 30 Fixed costs 20 20 20 Profit/(loss) 20 10 (10)

You are also informed that 40% of the fixed cost is division specific, the remainder being

allocated arbitrarily to the divisions from head office.

Required:

Should division C be shut down?

Example 3 Fantum Ltd

FantumLtd has three operating divisions. The expected financial results of each division next

year are as follows:

Division A Division B Division C $ $ $ Sales 50,000 30,000 40,000 Variable costs (30,000) (18,000 (20,000) Specific fixed cost (12,000) (10,000) (10,000) Apportioned head office costs (5,000) (4000) (5000) Profit or loss 3,000 (2000) 5000

Required:

Taking only the financial results next year into consideration, recommend whether or not

division B should be closed down.

Limiting factor decision

Where there is a factor of production that is limited in some way by:

1. Scarce raw materials.

2. Shortage of skilled labour.

3. Limited machine capacity.




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CHAPTER 2 – DECISION MAKING AND LINEAR PROGRAMMING Aim: Maximise the contribution per unit of limiting factor Steps: 1. Contribution per unit of sale.

2. Contribution per unit of scarce resource.

3. Rank in order of 2 - highest first.

4. Use up the resource in order of the ranking. Assumption: ● Fixed cost is assumed to be the same whatever the production mix is selected, so that the

only relevant cost is the variable cost. ● The unit variable cost is constant at all levels of production and sales ● The estimates of sales demand for each product are known with certainty

Example 4 (a) Neal Ltd Neal Ltd produces two products using the same machinery. The hours available on this

machine are limited to 5000. Information regarding the two products is detailed below:

Products (per unit data) M N Selling price ($) 40 30 Variable cost ($) 16 15 Fixed cost ($) 10 8 Profit ($) 14 7

Machine hours 8 3

Budgeted sales (units) 600 500

Required: Calculate the maximum profit that may be earned.

Example 4 (b) Neal Ltd Using the previous example, Neal Ltd is now able to buy in the products at the following costs

Products (per unit data) M N Purchase price($) 24 21 Required: What is the revised production schedule and the maximum profit earned?




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Example 5 WXYZ Ltd

WXYZ Ltd makes four products W, X, Y and Z for which costs and sales in the next year are

expected to be as follows:

W X Y Z Sales units 2,000 4,000 3,000 1,000 $ $ $ $ Direct materials 10 5 7.5 12.5 Direct labour 7 2 4.5 6.5 17 7 12 19 Sales price 29 11 18 39 Contribution 12 4 6 20

The company is having difficulty of obtaining the materials. Each product uses the same

material, and only one type of material is used in manufacture. The expected available

materials next year are 11,000 kilos. The material cost $5 per kilo.

An overseas manufacturer is willing to supply the items to the company at the following costs

per unit including delivery.

W X Y Z Cost to buy $20.00 $11.00 $15.75 $21.50

Required:

Which items should the company make internally, and which should it buy from the external

manufacturer?

Further processing decisions

A further processing decision may arise in a manufacturing company that produces an item in a

process or a sequence of processes. The output from a process might have a market value,

and a selling price. However, there might also be an opportunity to further process the output to

produce a finished item with a higher selling price.

The decision is whether to sell the item in its part-finished form, or whether to process it further

and sell the finished item.

The relevant cash flows are:

● The extra revenue obtained by further processing the item (incremental revenues), and

● The incremental costs of further processing.

The financial decision should be to further process the item if the extra revenue exceeds the

incremental costs.

Note: Any common/joint processing costs sgould be ignored as these do not have any impact

on the decision made.




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Example 6 CF Ltd CF Ltd manufactures two cleaning fluids, X and Y. The two fluids are manufactured in a joint

process. Every 8,000 litres of materials input to the joint process produces 4,000 litre of X and

3,200 of Y. The costs of processing are as follows: $ Direct material 1,600 Direct labour 200 Variable production overheads 300 Fixed production overheads 2,000 Product X sells for $1.10 per litre and product Y for $0.75 per litre. CF Ltd could put product X through another production process, where there is spare

production capacity. The further processing would produce another cleaning product, Zplus.

Every one litre of input to the further process will produce 0.90 litres of Zplus.

The costs of further processing would be: Product X: 4,000 litres $ Additional materials 400 Direct labour 40 Variable overheads 80 Apportioned fixed overheads 400

Total 920 Zplus would sell for $1.40 per litre Required: Using financial reasons only to justify the decision, should the company sell product X or

should it further process the product to make Zplus? Assume for the purpose of the analysis

that direct labour is a variable cost.




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CVP ANALYSIS (BREAKEVEN ANALYSIS)

What is CVP (break-even) analysis?

An understanding of the relationship between the level of activity and costs and revenues.

CVP analysis is a technique which uses cost behaviour to identify the level of activity at which

we have no profit or loss (break-even point).

It can also be used to predict the profits or losses to be earned at varying activity levels (using

the assumed linearity of costs and revenues).

CVP analysis assumes that selling prices and variable costs are constant per unit regardless of

the level of activity and that fixed costs are just that – fixed.

In order to calculate these levels we need to consider the contribution provided by each unit of

production. Contribution is the term given to the difference between the selling price and the

variable costs which contributes first towards paying the fixed costs and then towards providing

profit.

How is the break-even point calculated?

If we are to calculate the break-even point let us first imagine that the fixed costs are a large

hole in the ground. What we need to find out is how many contributions it takes to fill that hole.

Similarly the profit we require is the pile on top of the hole. How many contributions does it take

to reach the required height?

Formulae required (not given in exam): 1 Unit contribution 2 Total contribution

3 Break-even point (units)

4 Contribution target 5 Volume target

= Selling price per unit – Variable cost per unit

= Unit contribution x volume

= Fixed costs

Unit contribution

= Fixed costs + Target profit

= Contribtion target

Unit contribution

We can use these formulae to calculate our break-even point. Alternatively we can use either a

traditional break-even chart or a profit/volume chart.




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Break-even chart Costs and Sales revenue revenues

Margin of safety

Break-even point

Total costs Fixed costs

Sales activity




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Profit/volume chart

A break-even chart shows the costs and revenues at a number of activity levels. It does not

however, show the amount of profit or loss at these levels. This is shown on the profit/volume

chart.

Profit Total profit

Break-even point

Loss

Fixed costs (total loss)

From this chart we can read off the amount of profit or loss for any level of activity.

1. The x axis represents sales (units or values)

2. The y axis shows profits above the x axis and losses below.

3. When sales = zero, the net loss is equal to the fixed costs.

4. If variable cost per unit and total fixed costs are constant throughout the relevant range,

the profit/volume chart is shown as a straight line.

5. If there are\changes in either of these costs at various levels of activity, it will be

necessary to calculate the profit or loss at each point where the cost structure alters

before plotting the points onto the chart.

Limitations of break-even analysis

● Once costs and revenues have been determined, it is usually assumed that they will have

a linear relationship.

● Fixed costs will be constant over the relevant range

● Variable costs will vary in direct proportion to volume

● Selling price will remain unchanged

● The efficiency and productivity of the workforce remain constant. 44 www.studyinteractive .org



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The analysis covers either a single product or a mix of products at which it is assumed that the

proportion of each product will remain the same as volume increases or decreases.

In constructing a break-even chart, the sales and costs are likely to be valid only in a particular

range of activity. This is referred to as THE RELEVANT RANGE. Outside this range the same

cost and revenue relationships are unlikely to exist. E.g.An alteration in volume could affect the

level of fixed costs (stepped) or the rate of variable costs or selling prices (economies of scale).

Margin of safety

The margin of safety is the area between the break-even point and the maximum sales. This is

the area that the company can operate in and be certain of making a profit. It is usually classed

as the amount of sales that a company can afford to lose before it gets into a loss making

situation.

It is usually expressed as a percentage (%) of sales. It can

be calculated as:

Margin of safety = Maximum sales - break-even point 100% Maximum sales

Note: Maximum sales are alternatively described as budgeted sales revenues.

Contribution / sales ratio

The above calculations are useful in calculating the break-even point of one unit of production. If

a company makes more than one product it may be better to calculate the C/S ratio.

Weighted average C/S ratio

C/S ratio = Unit contribution

or Total contribution

Unit sales price Total sales

Example 7 Beauty Co

Beauty Co makes two products, nail polish and lipsticks.

Nail polish sales make up 30% of total sales and their variable costs are 45% as a percentage

of sales value.

Lipsticks sales are 70% of the total sales and their variable costs are 40% as a percentage of

sales value.

Total fixed costs are $400,000 for the company.

Required:

What is break-even level of sales revenues for the company?




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Example 8 CVP Ltd CVP Ltd is investigating the risks attached to sales plans and profit levels. The management of

the company feels that they are always struggling to create a realistic sales plan which should

add to the value of CVP and its shareholders. Recently there have been production problems

reported by the production director in plant utilisation which have alerted the board. Now they

are not sure whether to allocate resources to all their products equally which they have done in

the past, or to produce and sell the products in preference to each other.

Following are the extracts from last year‟s budgeted results relating to three products.

PINS NUMBS NEEDLES

$ $ $

Selling price per unit 12 14 9

Variable cost per unit 4 8 2

Fixed cost per unit 2 3 6

Profit per unit 6 3 1

Budgeted sales volume 3,000 2,000 1,000

Required:

(a) Calculate the budgeted profit. (2 marks)

(b) Determine the break even revenue and margin of safety if the company sells all the

products as per their original sales plans.(6 marks) (c) Advise the company of an alternative plan if the management wishes

to produce and sell products in preference to each other. (4 marks) (d) Using the same graph:

(i) Plot a P/V chart when all the products are produced and sold together in their

original ratio.

(ii) Plot a P/V chart when products are made and sold using an alternative plan determined in part (c) above. (8 marks)

(20 marks)

NOTE: YOUR GRAPH SHOULD BE CLEARLY DRAWN WITH ALL POINTS SHOWN AND

LABELLED.




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RELEVANT COST ANALYSIS

There are 3 components to a relevant cost:

1. Future

2. Cash flow

3. Arising as a direct result of the decision

Relevant costs Non-relevant costs

Opportunity cost Sunk cost

Incremental cost Committed cost

Variable cost Fixed O/H absorbed

Avoidable cost Depreciation (non cash flows)

Opportunity cost

The benefit foregone by choosing one alternative in preference to the next best alternative.

Avoidable costs

Costs attached to a part or segment of a business which could be avoided if that part or

segment ceased to exist. Variable costs are normally considered avoidable, fixed costs normally

not. Fixed costs may be considered avoidable if arise within the single part or segment of the

business that is relevant. They are particularly applicable in shutdown decisions.

Variable costs

Those costs which vary proportionately with the level of activity. As seen above the variable

nature of the cost often makes it more likely to be relevant. We should already know that the

variable cost is useful for break-even analysis or any other form of contribution analysis.

Incremental costs

Those additional costs (or revenues) which arise as a result of the decision. This classification is

particularly useful for further processing decisions, but may be used as a basis for tackling any

relevant cost analysis. www.studyinteractive .org 47



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ACCEPTING OR REJECTING ORDERS

Another type of decision is a decision whether or not to accept an order. The comparison here

should be between:

● The relevant costs of the order, including any opportunity cost of other opportunities

forgone as a consequence; and

● The incremental revenue from the order.

Other factors to consider

● Is there an alternative more profitable way of utilising spare capacity?

● Will fixed cost be unchanged if the order is accepted?

● Will accepting one order at below normal selling price lead other customers to ask for

price cuts?

Material costs flow chart

Is the material

YES in stock?

NO

Next question Purchase price is

relevant

Is the material in

constant use?

YES NO

Replacement cost is Next question

relevant

Is the material

scarce?

YES NO

Opportunity cost is Nil value with

relevant possible disposal

cost




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CHAPTER 2 – DECISION MAKING AND LINEAR PROGRAMMING Labour costs flow chart

Is the labour in

permanent

YES employment? NO

Next question Hourly rate is

relevant

Is the labour fully

YES utilised?

NO

Next question Nil value

Overtime possible?

YES NO

Overtime rate is Opportunity cost is

relevant relevant




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Example 9 Tricks You are the management accountant of Tricks, an organisation which has been asked to quote for the production of a pamphlet for an event. The work could be carried out in addition to the normal work of the company. Due to existing commitments, some overtime working would be required to complete the printing of the pamphlet. A trainee has produced the following cost estimate based upon the resources required as specified by the operations manager:

$

Direct materials:

- paper (book value) 4,000 - inks (purchase price 2,400

Direct labour: - highly skilled 250 hours @ $4.00 1,000 - semi-skilled 100 hours @ $3.50 350

Variable overhead 350 hours @ $4.00 1,400 Printing press depreciation 200 hours @ $2.50 500 Fixed production costs 350 hours @ $6.00 2,100 Estimating department costs 400

______ 12,150 You are aware that considerable publicity could be obtained for the company if you are able to win this order and the price quoted must be very competitive.

The following notes are relevant to the cost estimate above:

(1) The paper to be used is currently in stock at a value of $5,000. It is of an unusual

specification (texture and weight) and has not been used for some time. The replacement

price of the paper is $9,000, whilst the scrap value of that in stock is $2,500. The stores

manager does not foresee any alternative use for the paper if it is not used on the

pamphlet. (2) The inks required are presently not held in stock. They would have to be purchased in

bulk at a cost of $3,000. 80% of the ink purchased would be used in producing the

pamphlet. There is no foreseeable alternative use for the remaining unused ink.

(3) Highly skilled direct labour is in short supply, and the factory labour is already being

utilised at full capacity, therefore, to accommodate the production of the pamphlet, 50% of

the time required would be worked at weekends for which a premium of 25% above the

normal hourly rate is paid. The normal hourly rate is $4.00 per hour.

(4) Semi-skilled labour is presently under-utilised, and 200 hours per week are currently

recorded as idle time. If the printing work is carried out, 25 unskilled hours would have to

occur during the weekend, but the employees concerned would be given two hours time

off during the week in lieu of each hour worked at the weekend.

(5) Variable overhead represents the cost of operating the printing press and binding

machines. (6) When not being used by the company, the printing press is hired to outside companies for

$6.00 per hour. This earns a contribution of $3.00 per hour. There is unlimited demand for

this facility.




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(7) Fixed production costs are those incurred by and absorbed into production, using an

hourly rate based on budgeted activity. (8) The cost of the estimating department represents time spent in discussions with the

organisation concerning the printing of its pamphlet.

Required: Prepare a revised cost estimate using the opportunity cost approach, showing clearly the

minimum price that the company should accept for the order. Give reasons for each resource

valuation in your cost estimate.

(20 marks)




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LINEAR PROGRAMMING – MULTI LIMITING FACTORS

The aim of decision making is to maximise profit, assuming that the fixed cost does not change,

this would mean that we must maximise contribution. Alternatively the aim may be minimise

cost to subsequently maximise profit.

Linear programming involves the construction of a mathematical model to represent the decision

problem where the activities of the problem constitute variables.

Steps

1. Define the problem (unknowns or variables)

2. Objective function

3. Constraints

4. Graph

5. Optimal solution

6. Shadow prices

Example 10

A company makes two products (R and S), within three departments (X, Y and Z). Production

times per unit, contribution per unit and the hours available in each department are shown

below:

Product R Product S Capacity (hours) Contribution/unit $ 4 $8

Hours/unit Hours/unit Department X 8 10 11,000 Department Y 4 10 9,000 Department Z 12 6 12,000

Required:

What is the optimum production plan in order to maximise contribution?

1. Define the problem

Let x = number of units of R produced

Let y = number of units of S produced

2. Objective Function – maximise contribution = Z

Z = 4x + 8y 52 www.studyinteractive .org



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CHAPTER 2 – DECISION MAKING AND LINEAR PROGRAMMING 3. Subject to – constraints (Dept A hrs) 8x + 10y ≤ 11000

(Dept B hrs) 4x + 10y ≤ 9000

(Dept C hrs) 12x + 6y ≤ 12000 (non-negativity) x, y ≥0 4. Plotting the graph If we know the constraints we are able to plot the limitations on a graph identifying feasible and

non-feasible regions. The linearity of the problem means that we need only identify two points

on each constraint boundary or line. The easiest to identify will be the intersections with the x

and y-axes. For example:

Dept A hrs – equating the formula 8x + 10y = 11,000

If x = 0 then y = -1,100 Co-ordinates (0, 11,00)

If y = 0 then x = 1,375 (1,375, 0)

And hence:

Dept B hrs – 4x + 10y = 9,000 (0, 900) (2,250, 0)

Dept C hrs – 12x + 6y = 12,000 (0, 2,000) (1,000, 0) By plotting the individual constraints we build up an area of what is possible within all the

constraints ie the FEASIBLE REGION. 5. Identifying the optimal solution 1. The Iso-contribution (IC line) line is plotted identifying points of equal contribution. The

linear nature of the problem means that this line will be a straight line identifying an

inverse relationship between the two products.

The IC line is of importance because the relationship of the contribution earned by each

product is constant (ie$4 for R against $8 for S). This means that the gradient of the line

will remain constant as the total contribution figure gets larger or smaller.

If we „push out‟ the IC line to the point where it leaves the feasible region, that point will

be the point of maximum contribution.

Steps

(i) Choose an arbitrary contribution figure (preferably one that can be easily plotted on

the graph just drawn).

Example contribution = Z = $3,200

(ii) What are the objective function values? 4x +

8y = 3,200

(iii) Translate those values into co-ordinates for plotting on the graph Co-

ordinates (0, 400) and (800, 0)




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2. The optimal solution can now be found by interrogating the point at which the IC line

leaves the feasible region to identify the co-ordinates and hence the product mix and

maximum contribution.

The intersection or VERTEX identified is where two constraints meet, those constraints

can be solved simultaneously to identify the product mix.

a 8x + 10y = 11,000

b 4x + 10y = 9,000

(a – b)4x = 2,000

x = 500

y = 700 Therefore the optimal product mix is to make and sell 500 units of X and 700 units of Y. The

maximum contribution is (500 x 4 + 700 x 8) = $7,600. This can be checked by seeing how much of the constraints are used up:

Dept hours used hours available

A 500 x 8 + 700 x 10 = 11,000 hours 11,000 hours

B 500 x 4 + 700 x 10 = 9,000 hours 9,000 hours

B 500 x 12 + 700 x 6 = 10,200 hours 12,000 hours Slack and surplus Departments A and B are fully utilised or what are termed binding constraints (ie they bind the

decision or output). Department C has 1,800 hours un-utilised and is not binding on the

decision, it is called a slack constraint. 54 www.studyinteractive .org



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SENSITIVITY ANALYSIS – SHADOW PRICE

An investigation to identify how the optimum solution will change with changes to individual

variables.

The SHADOW PRICE or dual price is the amount by which the total optimal contribution would

rise if an additional unit of input (hour) was made available.

Department X – shadow price of one hour

If one more hour was available (ie 11,001 hours now), the constraint of department A will relax

outward slightly which should improve the overall optimum solution.

Solve the new constraint equations:

Dept X 8x + 10y = 11,001

Dept Y 4x + 10y = 9,000

Revised solution

Revised contribution

Shadow price

Effects – as A increases by 1:

1. x

2. y

3. Contribution

4. Dept Z

Department Y – shadow price of one hour

If one more hour was available (ie 9,001 hours now), the constraint of department B will relax

outward slightly which should improve the overall optimum solution.

Solve the new constraint equations:

Dept X 8x + 10y = 11,000

Dept Y 4x + 10y = 9,001

4x + 0 = 1,999

Revised solution x = 499.75, y = 700.2

Revised contribution 499.75 x 4 + 700.2 x 8 = $7600.6

Shadow price $7,600.6 - $7,600.0 =$0.6/hour of dept Y on top of the normal rate.

Effects – As Y increases by 1:

1 x decreases by 0.25

2 y increases by 0.2

3 Contribution increases by $0.6

Dept Z slack actually increases by 1.8 hours. www.studyinteractive .org 55



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Department Z – shadow price of one hour

Department Z already has spare capacity, extra hours would not increase the contribution

generated by the optimum solution (they would not change the solution). They have no shadow

price.

Assumptions and limitations of linear programming

● Linear programming may be used when relationships are assumed to be linear and

where an optimum solution does in fact exist.

● Assumes contribution per unit for each product is constant irrespective of the total

quantities produced and sold

● Assumes utilisation of resource per unit for each product is constant irrespective of the

total quantities produced and sold

● Assumes that units produced and resources allocated are infinitely divisible.

● When there are a number of variables, it becomes too complex to solve manually and a

computer is required.

Example 11 Cantata

Cantata operates a small machine shop. Next month he plans to manufacture two products, A

and B upon which the unit contribution is estimated to be $50 and $70 respectively.

For their manufacture both products require inputs of machine processing time, raw materials

and labour. Each unit of product A requires 3 hours of machine processing time, 16 units of raw

materials and 6 hours of labour. The corresponding per unit requirements for product B are 10,

4 and 6 respectively.Cantata forecasts that next month he can make available 330 hours of

machine processing time, 400 units of raw materials and 240 labour hours. The technology of

the manufacturing process is such that at least 12 units of product B must be made in any given

time.

Sales department of Cantata has forecast to sell 50 units of each product next month.

Required:

How many units of product A and B should be produced in order to maximise contribution?




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Chapter 3

Pricing



4. Pricing decision

a) Explain the factors that influence the pricing of a product or service.

b) Explain the price elasticity of demand.

c) Derive and manipulate a straight line demand equation. Derive an equation for the total

cost function (including volume-based discounts).

d) Calculate the optimum selling price and quantity for an organisation, equating marginal

cost and marginal revenue.

e) Evaluate a decision to increase production and sales levels, considering incremental

costs, incremental revenues and other factors.

f) Determine prices and output levels for profit maximisation using the demand based

approach to pricing (both tabular and algebraic methods).

g) Explain different price strategies, including:

i) All forms of cost-plus

ii) Skimming

iii) Penetration

iv) Complementary product

v) Product-line




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CHAPTER 3 – PRICING

vi) Volume discounting

vii) Discrimination

viii) Relevant cost

h) Calculate a price from a given strategy using cost-plus and relevant cost. 58 www.studyinteractive .org



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CHAPTER CONTENTS

INTRODUCTION TO PRICING ------------------------------------------- 60

FACTORS AFFECTING PRICING DECISIONS 60

WAYS OF CALCULATING THE PRICE 60

COST-PLUS PRICING ---------------------------------------------------- 61

1. FULL COST-PLUS PRICING 61

2. MARGINAL COST-PLUS PRICING 62

MARKETING APPROACHES ---------------------------------------------- 63

PRODUCT LIFE CYCLE 63

PRICING STRATEGIES 64

FOR NEW MARKETS – MONOPOLY POSITION 64

EXISTING MARKET – NO MONOPOLY POSITION 65

DEMAND BASED PRICING----------------------------------------------- 67

DERIVING THE DEMAND CURVE 67

FACTORS INFLUENCING DEMAND 67

PRICE ELASTICITY OF DEMAND 68

PROFIT MAXIMISING PRICE AND QUANTITY------------------------- 70




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INTRODUCTION TO PRICING

The pricing of products or services is one of the more difficult and more important decisions for

the organisation. The prices adopted by a company will have an immediate effect on the

profitability of an organisation and longer term implications on the marketing of the product.

Factors affecting pricing decisions

Factors underlying pricing decisions

There are several factors underlying all pricing decisions, including the following:

1. Organizational goals

2. Price and demand relationship

3. Competitors

4. Cost

5. Product mix

6. Quality

7. Inflation

8. Product life cycle

Ways of calculating the price

There are three ways to calculate the price of a product:

1. Cost-plus pricing– marginal cost or full cost as a base.

2. Marketing based pricing– the aim to generate profit maximisation in the longer term.

3. Demand based pricing– the application of economic theory to maximise profit in the short-

term.




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COST-PLUS PRICING

The simplest form of pricing, it is still widely used particularly in the retail industry and in

specific/job order situations. The price is based on the cost plus a margin.

Cost-plus pricing may be based on:

1. full cost (calculated using absorption costing) or

2. marginal / variable cost.

The rationale behind this method is that if the price is greater than the cost then a profit must be

made (providing that the expected volumes are achieved).

1. Full cost-plus pricing

Advantages of full cost-plus pricing strategy:

● Easy to use.

● Ensures that all costs are covered.

● Ensures that firm can generate profits and survive in the future.

● Avoids costs of collecting market information on demand and competitor activity.

● It is believed to establish stable prices.

Disadvantages of full cost-plus pricing strategy:

● It does not consider the demand pattern of the product.

● The absorption of overheads is a guess work therefore the strategy will produce different

selling prices using different bases.

● Takes no account of market conditions since its focus is entirely internal.

● By using a fixed mark up it does not permit the company to respond to the pricing

decisions of its competitors.

● It is not appropriate for making special decisions involving use of spare capacity.




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An example of typical total cost plus price calculation is as follows

$ $ Direct materials 10 Direct labour 15 Prime cost 25 Factory overheads:

Fixed 10

Variable 5 15 Total manufacturing cost 40 Non manufacturing costs:

Fixed 10

Variable 0 10 Total cost 50 Add profit (20% x 50) 10 Selling price 60

Manufacturing Cost-Plus Method

Total manufacturing cost 40 Add profit (50% x 40) 20 Selling price 60

2. Marginal cost-plus pricing

Pricing strategy in which a profit margin is added to the budgeted marginal or variable cost of

the product.

Advantages

● This strategy ensures that fixed costs are covered.

● The size of the mark up can be adjusted to reflect demand.

● Maximum capacity utilisation.

● Efficient and most economic use of scarce resources.

Disadvantages

● Ignore profit maximisation.

● Ignores fixed overheads. The price may not be high enough to ensure that a profit is

made after fixed overheads are covered.

● Lack of consideration of overall market and customers.




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MARKETING APPROACHES

The aim is to maximise the profit over the length of the product‟s life.

Product life cycle

Level of

Growth Decline

activity Maturity

Introduction

Time

Example 1

What are the implications on profitability, cash flow and strategy of each stage in the product life

cycle?

Phase Introduction Growth Maturity Decline

Profitability

Cash flow

Strategy




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Pricing strategies

For new markets – monopoly position

Market skimming

The price is set at a high level to generate maximum return per unit in the early units. The aim is

to sell to only that small part of the market which is not price sensitive. For market skimming to

be effective the company must have a barrier to entry in the form of a patent, brand,

technological innovation or other.

Features

1 Low volume, high price

2 Low initial investment in production capacity

3 Low risk, if strategy fails price can be dropped.

Limitations of market skimming strategy

● It is only effective when the firm is facing an inelastic demand curve (market is not price

sensitive).

● Price changes by any one firm will be matched by other firms resulting in a rapid growth

in industry volume.

● Skimming encourages the entry of competitors.

● Skimming results in a slow rate of diffusion and adaptation. This results in a high level of

untapped demand. This gives competitors time to either imitate the product or leap frog it

with a new innovation.

Market penetration pricing

The price is set at a level which should generate demand from the whole market and by so

doing encourage an acceleration of the life cycle quickly into growth and maturity phases.

Necessary if the market skimming approach is not possible because of a lack of barriers to

entry or high initial development costs.

Features

1 Low price, mass market.

2 Substantial investment required.

3 High risk, the low price is used to deter other competitors.

Penetration pricing strategy is appropriate when:

● Product demand is highly price elastic so that demand responds to price changes.

● Substantial economies of scale are available.

● The product is suitable for a mass market and there is sufficient demand.

● The product will face competition soon after introduction.




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Existing market – no monopoly position

Penetration pricing - see above

May also be used in an existing market.

Going rate pricing or average pricing

Where the product is a leading brand (in market share terms) and any change in price made

that company will lead to a change by other competitors. Competition will continue in other

forms.

Example 2

Identify three industries/companies which use going rate pricing.

Intel, Unilever, and Procter and Gamble.

Premium pricing

The product is able to command a premium due to specific and identifiable features of the

product. The premium may be payable for a number of differing reasons such as:

1. Prestige

2. Reliability

3. Longevity

4. Technology

5. Style.

Example 3

Identify the car manufacturers which use each feature to command a premium for their product.

Discount pricing (loss leaders)

The product is sold at a discount to encourage higher sales. This often has the effect of

reducing the image of the product because customers equate price with quality.

Example 4

Identify three industries/companies that use discount pricing. www.studyinteractive .org 65



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Complementary product pricing Complementary products are products that are goods that tend to be bought and used

together.For example: computers and software. If sales of one increase, demand for the other

will also increase. Also referred to as joint demand. Captive product pricing Where products have complements, companies will charge a premium price where the

consumer is captured (family of brands). Product line pricing A product line is a group of products that are related to each other. Product line pricing strategies include setting prices that are proportional to full or marginal cost

with the same profit margin for all products in the product line. Alternatively, prices can be set to

reflect demand relationships between products in the line so that an overall return is achieved.

Volume discounting A volume discount is a reduction in price given for purchases of large volume. The objective is

to increase sales from large customers. The discount differentiates between wholesale and

retail customers. The reduced cost of a large order will compensate for the loss of revenues

from offering the discount. Price discrimination This is the practice of selling the same product at different prices to different customers.

Examples: off peak travel bargains; theatre tickets sold at different prices based on location so

that customers pay different prices for the same performance.




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DEMAND BASED PRICING

The preparation of a price in relation to the demand for a product.

This technique considers the demand for a product at a given price by developing a demand

curve.

Deriving the demand curve

Formula sheet extract

Demand curve

P a − bQ

b change in price change in quantity

a price when Q 0

Example 5 Biscan

A product sells 500 units at a price of $25 and 700 units at a price of $20.

Required:

Assuming a unitary demand curve, what is the formula for the demand curve?

Example 6 Mellor

A company presently sells 20,000 units at $12.50 each. The managing director believes that

they will be more profitable if they sell 20% more unit at a price of $11 each.

Required:

(a) Derive the demand curve.

(b) Calculate the total revenue in each circumstance.

Is the managing director necessarily correct in her assumption?

Factors influencing demand

The demand for a particular company‟s goods will be influenced by 3 main factors:

1. The Product Life Cycle (PLC). If life cycle is short, a high price strategy is adopted.

2. Quality of the product. High quality of product can support a high price.

3. Marketing (Price is one of the 4 P‟s). Can capture a higher market share by adopting a

particular pricing strategy.




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Price elasticity of demand

Price elasticity of demand is the measure of the extent of change in market demand for a good

in response to a change in its price. When a small change in price results in more than a

proportionate change in demand, the product is said to be elastic, where a change in price

results in less than proportionate change in demand, we have price inelastic (e.g. salt).

However, where a change in price results in an equal change in demand, we have unitary

elastic demand. Elasticity of demand (PED) = Price elasticity of demand =

% change in demand of good X

% change in price of good X

Q2 − Q1 Q1

P2 − P1 P1 If the PEDis greater than one, the good is price elastic. Demand is responsive to a change in

price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price

elasticity = 2.0. If the PEDis less than one, the good is inelastic. Demand is not very responsive to changes in

price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price

elasticity = 0.25. If the PED is equal to one, the good has unit elasticity. The percentage change in quantity

demanded is equal to the percentage change in price. Demand changes proportionately to a

price change. If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no

influence on quantity demanded. The demand curve for such a product will be vertical.

If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity

demanded fall to zero. This demand curve is associated with firms operating in perfectly

competitive markets. Other factors affecting elasticity ● Availability of substitutes. ● Complementary products. ● Disposable income. ● Necessities. ● Tastes and fashions. ● Advertising and Marketing. ● Price. ● Local laws.




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Example 7 The price of a good is $1.20 per unit and the annual demand is 800,000 units. Market research

indicates that an increase in price of 10cents per unit will result in a fall in annual demand of

75,000 units. Required: What is the price elasticity of demand?

Advantages of demand based pricing 1. A consideration of the market. 2. It considers only incremental costs. 3. Relationship between Price and Demand.

Limitations of demand based pricing 1. Degree of accuracy to determine price and demand relationship. 2. Accuracy to determine true variable / marginal cost. 3. Many companies aim to achieve a target profit, rather than the theoretical maximum

profit. 4. Less focus on other factors such as quality, advertising, packaging, credit facilities and

after sales services also affect the quantity demanded of a product, not just the Price.




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PROFIT MAXIMISING PRICE AND QUANTITY

It is important to understand cost behaviour in many business decisions. The rate of increase in

total cost as a consequence of increase in volume may increase or decline due to price

changes, inflation, and discount factors etc.

The same principle applies to the rate of increase in revenues as a result of increase in volume.

Profit maximising price and quantity can be determined by using the idea of marginal revenue

and marginal cost.

It can be determined by plotting marginal revenue and marginal cost curves and equating them

on the graph paper, the point of intersection shows the profit maximising price and quantity.

Hence, the profit maximising price and quantity will be at a point where: Marginal

revenue (MR) = marginal cost (MC)

Marginal cost is the variable cost of product or service.

Marginal revenue function can be derived from the demand curve, and marginal revenue

gradient is twice the gradient of demand curve, therefore;

Demand function = P = a – bQ

and therefore:

Marginal revenue (MR) = a – 2bQ

Example 8:

A company sells 1,000 units at $10 per unit and 1,500 units $8 per unit. Variable costs are $5

per unit.

Required:

(a) Derive the demand function for this company, and explain its usefulness.

(b) Equate Marginal Revenue and Marginal Cost to determine the optimal quantity and

optimal price.




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Chapter 4

Decision making under

uncertainty



6. Dealing with risk and uncertainty in decision-making

a) Suggest research techniques to reduce uncertainty eg Focus groups, market research.

b) Explain the use of simulation, expected values and sensitivity.

c) Apply expected values and sensitivity to decision-making problems.

d) Apply the techniques of maximax, maximin, and minimax regret to decision-making

problems including the production of profit tables.

e) Draw a decision tree and use it to solve a multi-stage decision problem.

f) Calculate the value of perfect and imperfect information.




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CHAPTER 4 – DECISION MAKING UNDER UNCERTAINTY

CHAPTER CONTENTS

INTRODUCTION ---------------------------------------------------------- 73

WHAT IS RISK AND UNCERTAINTY? ----------------------------------- 74

UNCERTAINTY 74

RISK 74

WORST, MOST LIKELY, AND BEST OUTCOME ESTIMATES 74

DECISION CRITERIA 75

EXPECTED VALUE -------------------------------------------------------- 76

PROBABILITY 76

EXPECTED VALUES 76

SENSITIVITY ANALYSIS ------------------------------------------------ 79

INTRODUCTION 79

IMPLEMENTING SENSITIVITY ANALYSIS 79

SIMULATION ------------------------------------------------------------- 81

VALUE OF PERFECT INFORMATION (VPI) ----------------------------- 82

MARKET RESEARCH ------------------------------------------------------ 83

DECISION TREE ANALYSIS --------------------------------------------- 84 72 www.studyinteractive .org



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INTRODUCTION

Decision making, particularly long-term decisions, has to be taken under the conditions of risk

and uncertainty. www.studyinteractive .org 73



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WHAT IS RISK AND UNCERTAINTY?

Uncertainty

Uncertaintysimply reflects that there is more than one possible outcome for a given event but there

is little previous statistical evidence to enable the possible outcomes to be predicted.

Risk

Risk is where that uncertainty can be quantified in some way.

It is normal to quantify the risk in terms of a probability distribution, generally derived from

statistical data in the past.

Risk attitudes

Risk preference describes the attitude of a decision-maker toward risk – as there is a

relationship between risk and reward.

● Risk averse – a risk averse decision-maker considers risk in making decision, and will not

select a course of action that is more risky unless the expected return is higher and so justifies

the extra risk.

● Risk seeker – a risk seeker decision-maker also considers risk in making a decision.

A risk seeker, unlike a risk averse decision-maker, will take extra risks in the hope of

earning a higher return.

● Risk neutral – a risk neutral decision-maker ignores risk in making a decision.

A risk neutral decision-maker will select the course of action with the highest expected

return, regardless of risk

Worst, most likely, and best outcome estimates

The choice between two or more alternative courses of action might be based on the worst,

most likely or best expected outcomes from each course of action.

This choice will show the full range of possible outcomes from a decision, and might help

managers to reject certain alternatives because the worst possible outcome might involve an

unacceptable amount of loss.

This requires the presentation of a pay-off table.

Pay-off table (or matrix)

The pay-off matrix is a tabular layout specifying the result (pay-off) of each combination of

decision and the state of the world over which the decision maker has no control.




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Example 1 Won Ltd

Won Ltd is trying to decide the selling price for a product. Three prices are under consideration

and expected sales volume and costs are as follows:

Price per unit $4 $4.30 $4.40 Expected sale volume (unit)

Best possible 16,000 14,000 12,500 Most likely 14,000 12,500 12,000 Worst possible 10,000 8,000 6,000

Fixed costs are $20,000 and variable cost is $2 per unit.

Required:

Create a pay off table showing all possible profits.

Decision criteria

Choosing between mutually exclusive courses of action on the basis of worst, most likely or

best possible outcome can be stated as decision rules.

The choice may be based on a maximax, maximin, or a minimax regret decision rule, and

expected value.

Maximax

The decision maker will select the course of action with the highest possible payoff (the best of

the best).

The maximax decision rule is the decision rule for the risk seeker.

Maximin decision rule

The decision maker will select the course of action with the highest expected return under the

worst possible conditions. This decision rule might be associated with a risk averse decision

maker.

Minimax regret decision rule

The decision maker selects the course of action with the lowest possible regret. It aims at

minimising the regret from making the wrong decision.

Regret is the opportunity cost of having made the wrong decision, giving the actual conditions

that apply in the future. www.studyinteractive .org 75



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EXPECTED VALUE

The expected value ignores the degree of risk and focuses solely on the average return of the

event given repetition of the event.

Probability

The measurement of the outcomes in terms of their estimated likelihood of occurring.

Overall probability of an event must sum to 1.0 (or if you wish 100%). For example, if you toss a

coin there is a 0.5 (50%) probability of a head or a tail. Adding both outcomes total 1.0 (100%).

Expected values

A weighted average value of all the possible outcomes.It does not reflect the degree of risk, but

simply what the average outcome would be if the event were repeated a number of times.

A decision rule is to select the course of action with the highest expected value of profit or the lowest expected value of cost.

Expected value formula

EV = Σpx

P = probability of an outcome

x = value of an outcome

Example 2 3D Ltd

3D Ltd expects the following monthly profits:

Monthly profit Probability $50,000 0.6 $35,000 0.4

Required:

Calculate the expected value of monthly profit.




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Example 3 For Ltd Consider the following sales and probabilities.

Sale probabilities $ %

20,000 25 25,000 40 30,000 15 35,000 20

Required:

What will be the expected value?

Advantages of expected values 1. EV considers all the different possible outcomes and the probability that each will occur.

2. It recognises risk in decision, based on the probabilities of different possible results or

outcomes. 3. It expresses risk as a single figure.

Limitations of expected values 1. The EV shows a long term average, so that the EV will not be reached in the short term

and is therefore not very suitable for one-off decisions. 2. The accuracy of the results depends on the accuracy of the probability distribution used.

3. EV takes no account of the risk associated with a decision.




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Example 4 Mr Fyvestall Mr Fyvestallruns a market stall selling vegetables and fruit. He buys a product for $20 per case.

He can sell the product for $40 per case on his stall. The product is perishable and it is not

possible to store it, instead any cases unsold at the end of the day can be sold off as scrap for

$2 per case. Purchase orders must be made before the number of sales is known. He has kept records of

demand over the last 150 days.

Demand / day Number of days 10 45 20 75 30 30

Required:

(a) Prepare a summary of possible net daily margins using a payoff table.

(b) Advise Mr Fyvestall:

(i) How many cases to purchase if he uses expected values.

(ii) How many cases to purchase if he uses maximin / maximax.

(iii) How many cases to purchase if he uses minimax regret.

(c) Mr Fyvestall has been approached by a research associate to provide him more reliable

estimate of his future demand, advise Mr Fyvestall what maximum price he should pay to

gain this reliable information.




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SENSITIVITY ANALYSIS

Introduction

Sensitivity analysis is a method of risk or uncertainty analysis in which the effect on the

expected outcome of the change in values of key variables or key factors is tested. For

example, in budget planning, the effect on budgeted profit might be tested for changes in the

budgeted sales volume, or the budgeted sale price, material and labour costs, and so on.

There are several ways of using sensitivity analysis including:

● To estimate by how much costs and revenues would need to differ from their estimated

values before the decision would change.

● To estimate whether a decision would change if estimated sales were A% lower than

estimated, or estimated costs were B% higher than estimated. This is called „what if‟

analysis. For example: what if the sales volume is 5% less than the expected volume?

Implementing sensitivity analysis

The starting point of sensitivity analysis is the original plan or estimate, giving an expected profit

or value.

Key variables that determine the profit or value are identified. Such variables include: sale price,

sales volume, completion time, material and labour costs, and so on.

The values of these key variables are altered to determine how much they would differ from

their estimated values before the decision would change.

In this way, the sensitivity of a decision or plan to changes in the value of the key variables can

be measured.

Example 5 VI Ltd

VI Ltd has estimated the following sales and profit for a product which it may launch onto the

market.

$ $

Sales (2,000 units) 4,000

Variable costs:

Materials 2,000

Labour 1,000 3,000

Contribution 1,000

Incremental fixed costs 800

Profit 200

Required:

(a) Analyse the sensitivity of the product.

(b) Determine which of the variables is the product most sensitive. www.studyinteractive .org 79



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Advantages 1. It is not a complicated theory to understand 2. It forces managers to identify the underlying variables, indicate where additional

information would be most useful, and helps to expose confused and inappropriate

forecasts 3. An indication is provided of those variables to which profitability or value is most sensitive.

And the extent to which those variables may change before the investment break-even.

4. It provides an indication of why a project might fail. Once these critical variables have

been identified, management should review them to assess whether or not there is a

strong possibility of events occurring which will lead to a negative NPV.

5. It serves as an aid in the preparation of contingency plans, should key parameters show

unfavourable variations ex-post.

Disadvantages 1. The method requires that changes in each key variable are isolated. But management is

more interested in the combination of the effects of changes in two or more variables.

Looking at factors in isolation is unrealistic since they are often inter-dependent.

2. It does not examine the probability that any particular variation in cost or revenue might

occur. 3. It is not in itself a decision rule. Management must weigh the information provided by the

analysis in deciding whether the investment is worthwhile.




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SIMULATION

Simulation is a quantitative technique that uses IT based computerised packages with built in

mathematical models for decision making under conditions of uncertainty. It evaluates various

courses of action based upon facts and assumptions.

Monte Carlo is a widely used method of simulation, where complex problem is solved by

simulating the original data with random number generators.

Usefulness of simulation:

● Medical diagnosis

● Gambling

● Air force trainings

● Traffic scheduling. www.studyinteractive .org 81



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VALUE OF PERFECT INFORMATION (VPI)

If perfect information about the future were available, it would be very easy to make a decision

as the uncertainty and risk associated with it would be minimum. Therefore knowledge about

cost of obtaining the perfect information is very important for management point of view.

The price that one would be willing to pay in order to gain access to perfect information of an

uncertain outcome in decision making is known as Value of Perfect Information.

Mathematically VPI is the difference between the payoff under certainty and the payoff under

risk.

Please refer to Example 4, Mr Fyvestall, to understand how value of perfect information is

calculated.




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MARKET RESEARCH

Market research is a process of systematically and objectively gathering, recording and

analysing information. This information may relate to:

● customers;

● general trends in the market;

● competitors;

● government regulations;

● economic trends;

● technological advancements; and

● any other factors that constitute the business environment. www.studyinteractive .org 83



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DECISION TREE ANALYSIS

A decision tree is a diagram showing several possible courses of action and possible events

and the potential outcomes for each course of action.

Each alternative course of action is represented by a branch, which leads to subsidiary

branches for further course of action or possible events.

Decision tree analysis is designed to illustrate the full range of alternatives that can occur, under

all possible given conditions.

Example 6 Seven Trees Ltd

The following information relates to Seven Trees Ltd, a company which is considering whether

to develop and market a product.

Development Probability

Being successful 0.75

Being unsuccessful 0.25

Estimated development costs would be $180,000

If successful, the product will be marketed with following probabilities:

Probability Profits / (Loss) Being very successful 0.4 $540,000 Being moderately successful 0.3 $100,000 Being failure 0.3 ($400,000)

The above profits / losses figures include the effect of the development costs.

Required:

Draw a decision tree to illustrate the above problem, and recommend the best course of action.




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Chapter 5

Budgeting types


C Budgeting

1. Budgetary systems

a) Explain how budgetary systems fit within the performance hierarchy.

b) Select and explain appropriate budgetary systems for an organisation, including top-

down, bottom-up, rolling, zero-base, activity-base, incremental and feed-forward control.

c) Describe the information used in budget systems and the sources of the information

needed.

d) Explain the difficulties of changing a budgetary system.

e) Explain how budget systems can deal with uncertainty in the environment.

2. Types of budget

a) Prepare rolling budgets and activity based budgets.

b) Indicate the usefulness and problems with different budget types (including fixed, flexible,

zero-based, activity- based, incremental, rolling, top-down, bottom up, master, functional).

c) Explain the difficulties of changing the type of budget used.




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CHAPTER 5 – BUDGETING TYPES

CHAPTER CONTENTS

WHAT IS A BUDGET? ---------------------------------------------------- 87

FUNCTIONS OF BUDGETING 87

BUDGET PERIOD 87

ADMINISTRATION OF A BUDGET 88

BUDGET PREPARATION ------------------------------------------------- 89

TYPES OF BUDGET ------------------------------------------------------- 90

1. ZERO BASED BUDGETING 90

2. CONTINUOUSBUDGETING 91

3. NON-PARTICIPATORYBUDGETING 92

4. ACTIVITY BASED BUDGETING 92




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WHAT IS A BUDGET?

A quantitative plan prepared for specific time period. It is normally expressed in financial terms

and prepared for one year.

Functions of budgeting (PCCCEMA)

We can identify the aims of a budget in seven ways:

1. Planning

2. Control

3. Communication

4. Co-ordination

5. Evaluation

6. Motivation

7. Authorisation & Delegation

Budget period

The budget period is the period of time for which the budget is prepared and over which the

control aspect takes place. Except for capital expenditure budgets, the budget period is usually

the accounting year, sub divided into 12 or 13 control periods.




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Administration of a budget

It is important that suitable administration procedures are introduced to ensure that the budget

process works efficiently.

(a) Budget Committee

The budget committee should consist of high-level executives who represent the major

segments of the business. It typically includes the chief executive, the corporate or

management accountant (acting as budget officer) and functional heads. Their main task is to

ensure that budgets are realistically established and that they are coordinated satisfactory.

The functions of the committee are:

● agree policy with regards to budgets

● coordinate budgets

● suggest amendments to budgets, example, because they are not adequate

● approve budgets after amendments, as necessary

● examine comparison of actual and budget and recommend corrective actions.

The accountant and his team will normally assist managers in the preparation of their budgets.

They will circulate and advise on the instructions about budget preparation, provide past

information that may be useful for preparing the present budget, and ensure that managers

submit their budgets on time. The accounting staff does not determine the content of the various

budgets, but they do provide valuable advisory and clerical services for the line managers.

(b) Budget Manual

A budget manual describes the objectives and procedures involved in the budgeting process

and will provide a useful reference source for managers responsible for the budget preparation.

In addition, the manual may include a timetable specifying the order in which the budgets

should be prepared and the dates when they should be presented to the budget committee. The

manual should be circulated to all those who are responsible for preparing budgets.




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BUDGET PREPARATION

Steps

1. Budget aims

Strategic aims.

Key assumptions.

2. Identify the principal budget factor

1. Sales demand for production environment.

2. Cash resource for non profit making organisation.

3. Prepare the sales budget

Start with the principal budget factor:

1. Marketing department function.

2. Price/volume relationship.

4. Prepare all other functional budgets

Prepare each functional budget separately.

Participatory process

1. Local knowledge.

2. Promotes ownership.

5. Negotiation

Meeting between junior management and senior managers to ensure that the budget is a

realistic target. In particular the aim is to eliminate budgetary slack.

6. Review

Bring all individual functional budgets together to form a master budget, an overall budget for

the whole organization.

Budget assessed for:

1. Feasibility

2. Acceptability

Once completed budgeted financial statements and cash flow statements can be prepared.

7. Acceptance

Acceptance means that the budget becomes a formal authorisation for all levels of management

to take action for and on behalf of the company. www.studyinteractive .org 89



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TYPES OF BUDGET

When looking at differing types of budgeting we are concerned with the benefits or otherwise to

the more traditional budget techniques. We would normally expect a budget to be:

1. Incremental

2. Periodic 3. Participatory

(Bottom – Up)

In comparison to this we will look at four alternative budgeting types:

1. Zero based budgeting (ZBB)

2. Continuous (or rolling) budgets

3. Non-participatory budgets

4. Activity based budgeting

1. Zero based budgeting

A simple idea of preparing a budget from a „zero base‟ each time,ie as though there is no

expectation of current activities to continue from one period to the next. ZBB is normally found in

service industries where costs are more likely to be discretionary. A form of ZBB is used in local

government. There are four basic steps to follow:

1. Prepare decision packages

Identify all possible services (and levels of service) that may be provided and then cost each

service or level of service, these are known individually as decision packages.

2. Rank

Rank the decision packages in order of importance, starting with the mandatory requirements of

a department. This forces the management to consider carefully what their aims are for the

coming year.

3. Funding

Identify the level of funding that will be allocated to the department.

4. Utilise

Use up the funds in order of the ranking until exhausted.




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Advantages (as opposed to incremental budgeting)

1. Emphasis on future need not past actions.

2. Eliminates past errors that may be perpetuated in an incremental analysis.

3. A positive disincentive for management to introduce slack into their budget.

4. A considered allocation of resources.

5. Encourages cost reduction.

Disadvantages

1. Can be costly and time consuming.

2. May lead to increased stress for management.

3. Only really applicable to a service environment.

4. May „re-invent‟ the wheel each year.

5. May lead to lost continuity of action and short term planning.

2. Continuous budgeting

In a periodic budgeting system the budget is normally prepared for one year, a totally separate

budget will then be prepared for the following year. In continuous budgeting the budget from

one period is „rolled on‟ from one year to the next.

Typically the budget is prepared for one year, only the first quarter in detail, the remainder in

outline. After the first quarter is revised for the following three quarters based on the actual

results and a further quarter is budgeted for.

This means that the budget will again be prepared for 12 months in advance. This process is

repeated each quarter (or month or half year).

Advantages (as opposed to periodic budgeting)

1. The budgeting process should be more accurate.

2. Much better information upon which to appraise the performance of management.

3. The budget will be much more „relevant‟ by the end of the traditional budgeting period.

4. It forces management to take the budgeting process more seriously.

Disadvantages

1. More costly and time consuming.

2. An increase in budgeting work may lead to less control of the actual results.




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3. Non-participatory budgeting (top-down budgets)

Some organisations do not require junior management to participate in the budgetary process.

This may be because of security or more likely due to centralised nature of the company.

Advantages

1. Saves time and money.

2. Individual wishes of senior management will not be diluted by others‟ plans.

3. Reduces the likelihood of information „leaking‟ from the company.

4. Activity based budgeting

Use of activity based costing principles to provide better overhead cost data for budgeting

purposes. The advantages of using such a technique accrue from better cost allocation.

Exam questions will be closely related to the ABC questions we looked at earlier on in the

course.

Applicability of ABB

Used in an environment with the following criteria:

1. Complex manufacturing environment.

2. Wide range of products.

3. High proportion of overhead costs.

4. Competitive market.

Benefits of ABB

1. Better understanding of overhead costs.

2. Identifies the accurate relationship between product and activity.

3. Each activity more accurately describes where costs are incurred.

Each and every benefit allows for better control of costs together with the opportunity to reduce

the costs using other management accounting techniques.

Key point

Whenever discussing ABB in an exam context a balance must be drawn between the better

information that is provided against the high cost of implementation and maintaining an ABB

system. 92 www.studyinteractive .org



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Chapter 6

Budgetary control


C Budgeting

2. Types of budget

b) Indicate the usefulness and problems with different budget types (flexible).

3. Behavioural aspects of budgeting

a) Identify the factors which influence behaviour.

b) Discuss the issues surrounding setting the difficulty level for a budget.

c) Explain the benefits and difficulties of the participation of employees in the negotiation of

targets.




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CHAPTER 6 – BUDGETARY CONTROL

CHAPTER CONTENTS

INTRODUCTION ---------------------------------------------------------- 95

FIXED BUDGET ----------------------------------------------------------- 96

FLEXIBLE BUDGET ------------------------------------------------------- 97

STEPS IN FLEXIBLE BUDGETING 97

SEPARATING FIXED AND VARIABLE COST 97

INTRODUCTION TO BUDGETARY CONTROL --------------------------- 98

PLANNING AND CONTROL CYCLE -------------------------------------- 99

PLANNING PROCESS: 99

BUDGETING PROCESS: 100

FEEDBACK AND FEED-FORWARD CONTROL 100




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INTRODUCTION

The use of budgeted data for control purposes. The budget is used as the comparator against

which the actual results may be compared. Any differences can then be investigated and

appropriate action taken. Budgetary control may also be called responsibility accounting because

it gives individual managers the responsibility to achieve results.

Receive actual

Compare to

budget

Analyse the

differences

Revise the Revise the

budget actual

Take action

Example 1 Ogrisovic

Ogrisovicplc has the following budgeted and actual information:

Units Cost

Budget 1,000 $20,000

Actual 1,200 $22,500

Required:

Has the company done better or worse than expected?

If we are now told that $10,000 of budgeted costs are variable, the remainder being fixed: are

we able to tell whether the company has done better or worse than expected?




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FIXED BUDGET

A budget prepared at a single (budgeted) level of activity.

The term fixed budget means the following

1. that, the budget is prepared on the basis of an estimated volume of production and

sales, but no plans are made for the event that actual volume of production and

sales may differ from budgeted volume

2. when actual volume of production and sales during a control period are achieved, a

fixed budget is not adjusted to the new levels of activity.

Advantage:

A fixed budget is likely to be useful in circumstances where the organisational environment is

relatively stable and can be predicted with a reasonable degree of certainty. 96 www.studyinteractive .org



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FLEXIBLE BUDGET

A budget prepared with the costs classified as either fixed or variable. The budget may be

prepared at any activity level and can be „flexed‟ or changed to the actual level of activity for

budgetary control purposes.

Flexible budget recognises the difference in behaviour between fixed and variable cost in

relation to fluctuations in output, turnover or other variable factors and is designed to change

appropriately with such fluctuations.

Steps in flexible budgeting

1. A fixed budget is set at the beginning of the period based on estimated production. This is

the original budget.

2. This is then flexed to correspond with actual level of activity.

3. The result is compared with actual cost and differences (variances) are reported to the

managers responsible.

Separating fixed and variable cost

One problem normally faced in examinations is how to divide cost into its fixed and variable

elements. One possible way of separating fixed and variable cost is through the use of high-low

method.

Example 2 ABC Ltd

ABC Ltd expects production and sales during the next year to be 90% of the company‟s output

capacity, which is 9000 units of a single product. Cost estimates will be made using the high/low

technique and the historic records of cost were provided.

Units of output/sales cost of sale

9,800 $44,400 7,700 $38,100

The sales price per unit has been fixed at $5.

Required:

The company‟s management is not certain that the estimate of sales is correct, and has asked

for flexible budget to be prepared at output and sales levels of 8,000 and 10,000 units.




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INTRODUCTION TO BUDGETARY CONTROL

Budgetary control involves

1. setting targets or performance standards for individuals (budget holders)

2. comparing actual performance against the budget (variances)

3. expecting the budget holder to use this information to take action where necessary to

make sure that the budget is achieved

4. where necessary, changing the budget targets or performance standards. 98 www.studyinteractive .org



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PLANNING AND CONTROL CYCLE

The key stages in the planning process that links long-term objectives and budgetary control

can be divided between long-term planning and the budgeting process.

Long-term planning involves:

1. Identifying objectives;

2. Identifying, evaluating and selecting alternative courses of action.

Budgeting Process involves:

1. Implementing the long-term plan in the annual budget;

2. Monitoring actual results;

3. Responding to divergences from plan.

Planning process:

Identifying objectives

The planning process cannot take place unless organisational objectives are identified, since

these determine what the organisation is seeking to accomplish through its operations and

activities. These objectives will be long-term or strategic in nature and will give direction to the

organisation‟s operational activities.

Identifying alternative courses of action

Once organisational objectives have been identified, alternative courses of action that may lead

to achieving those objectives can be identified.

Strategic analysis of the organisation and its environment can indicate potential courses of

action. For example, a company may look at its existing products and markets, its potential

markets, the threat posed by its competitors, the impact of changes in technology on its

products and production processes, and so on, and decide that a key objective is the

development of new products to replace existing products in existing markets that are reaching

the end of their product life cycle.

Evaluating alternative courses of action

At this stage the various alternative courses of action are considered from the point of view of

suitability, feasibility and acceptability. In order for this to be done, detailed information about

each alternative course of action needs to be gathered and analysed.

Selecting alternative courses of action

Once the most appropriate alternative courses of action have been selected, long-term plans to

implement them are formulated. Because these plans are long-term in nature, they will of

necessity be less detailed than short-term plans, and will need to allow a degree of flexibility in

responding to the changing organisational environment.




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Budgeting process:

Preparing and implementing the budget

A budget is a short-term plan formulated in financial terms and will show in detail the short-term

actions the organisation will take in working towards its long-term objectives. Once the budget

has been formulated, finalised and agreed it can be implemented.

Monitoring actual results

In order to achieve the long-term objectives that are reflected in the budget, the organisation

must ensure that actual performance is proceeding according to plan. It will therefore need to

monitor actual performance and results.

Responding to divergences from plan

Divergences from planned activity, as measured by variances from budget, can lead to action if

they are deemed to be significant. This action may be corrective in nature, in order to bring

actual activity back into line with planned activity, or may entail revision of the budget if one of

its underlying assumptions is seen as being in error.

Feedback and feed-forward control

Feedback control

Feedback control is defined as the measurement of differences between planned outputs and

actual outputs achieved, and the modification of subsequent action and/or plans to achieve

future required results. (CIMA).

Control through feedback is where actual result (output) are compared with those which were

planned for the budget period. Likewise, the input (cost) are compared with the budget, taking

account of the actual level of outputs. This comparison of actual with plan takes place after the

event. The intention is to learn for the future so that future deviations of actuals and plans are

avoided or minimised. Feedback is a reactive process.

Budgetary control systems are feedback control systems.

Feed-forward control

Feed-forward control is an alternative approach to control using feedback.

Feed-forward control is defined as the forecasting of differences between the actual and

planned outcomes and the implementation of actions before the event, to prevent such

differences. (CIMA).

Control through feed-forward is where prediction is made of what output and inputs are

expected for some budget period. If these predictions are different from what was planned, then

control actions are taken which attempts to minimise the differences. The aim is for control to

occur before the deviation is reported hence feed-forward control is more proactive. Budget

generation is a form of fed-forward in that various outcomes are considered before one is

selected.




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Example 3 You have been provided with the following operating statement, which represents an attempt to

compare the actual performance for the quarter that has just ended with the budget.

Budget Actual Variance

Number of units sold (000) 640 720 80

Cost of sales (all variable) $000 $000 $000

Materials 168 144 24

Labour 240 288 (48)

Overheads 32 36 (4)

440 468 (28)

Fixed Labour cost 100 94 6

Selling and distribution costs

Fixed 72 83 (11)

Variable 144 153 (9)

Administration costs

Fixed 184 176 8

Variable 48 54 (6)

548 560 (12)

Total Costs 988 1,028 (40)

Sales 1,024 1,071 47

Net Profit 36 43 7

Required: (a) Using a flexible budgeting approach, redraft the operating statement so as to provide a

more realistic indication of the variances, and comment briefly on the possible reasons (other than inflation) why they have occurred.

(10 marks) (b) Explain why the original operating statement was of little use to

management. (2 marks) (c) (i) Discuss the problems associated with the forecasting of figures

which are to be used in flexible budgeting. (4 marks)

(ii) Further analysis has indicated that the 'variable' overheads for cost of sales are, in

fact, only semi-variable. Whilst the budgeted overheads for 640,000 units is

indicated to be $32,000, it is felt that the budget for 760,000 units would be

$37,000. Included in this later cost is $1,000 incurred when the activity reached

750,000 units due to extra hiring capacity.

Produce a revised flexed budget for the overheads contained in

cost of sales for an activity level of 720,000 units. (4 marks)

(20 marks)




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Chapter 7

Quantitative aids to

budgeting


C Budgeting

3. Quantitative analysis in budgeting chapter 7

a) Analyse fixed and variable cost elements from total cost data using high/low methods.

b) Estimate the learning effect and apply the learning curve to a budgetary problem,

including calculations on steady states.

c) Discuss the reservations with the learning curve.

d) Apply expected values and explain the problems and benefits.

e) Explain the benefits and dangers inherent in using spreadsheets in budgeting.




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CHAPTER 7 – QUANTITATIVE AIDS TO BUDGETING

CHAPTER CONTENTS DIAGRAM

Quantitative Aids to Budgeting

High Low Learning method curve




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CHAPTER CONTENTS

INTRODUCTION --------------------------------------------------------- 106

HIGH LOW ANALYSIS -------------------------------------------------- 107

LEARNING CURVE ------------------------------------------------------ 108

MATHEMATICAL ILLUSTRATION 108

USING THE FORMULA 108

GENERAL USE OF LEARNING CURVE 111




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INTRODUCTION

Budgeting requires the prediction, or forecasting, of the volume of output and sales, sales

revenue and costs. Forecasts in budgeting process are to establish realistic assumptions for

planning.

Forecasts might be prepared using a number of forecasting models, methods or techniques.

The two main areas of consideration are the prediction of costs, mainly based upon the

assumption of a linear relationship between costs and activity level, and time series analysis,

commonly used for forecasting sales. 106 www.studyinteractive .org



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HIGH LOW ANALYSIS

High Low analysis can be used to make forecast or estimate wherever a linear relation is

assumed between two variables, and historical data is available for the analysis.

One problem normally faced in examinations is how to divide cost into its fixed and variable

elements. One possible way of separating fixed and variable cost is through the use of high-low

method.

Example 1

A company has recorded expenditure on advertising and resulting sales for 6 months as

follows:

Month Marketing spend Sales

($000) ($000)

x y

July 40 680

August 80 960

September 100 1,040

October 120 1,200

November 60 880

December 80 1,000

Required:

Forecast sales using High Low method when advertising expenditure is:

(i) $100,000

(ii) $250,000 www.studyinteractive .org 107



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LEARNING CURVE

A statistical relationship establishes this fact that labour time per unit falls as a complex task is

repeated. As workers become more familiar with the production of a new product or task,

average time (and average cost) will decline and exhibit a statistical relationship. It can be

stated as follows:

“As cumulative production doubles from the first unit, the cumulative average time per

unit falls by a constant percentage”

Mathematical illustration

Example 2

If the first unit requires 100 hours and the learning curve rate is 80%, calculate the following

cumulative and incremental data.

Cumulative Average Cum Incremental Incremental Incremental units time per total units total time Average

unit time time per unit

1 unit

2 units

4 units

8 units

As cumulative output doubles, the cumulative average time per unit falls to a fixed percentage of

the previous average time.

Using the formula

The geometric formula can be used to establish the average time (or average cost) per unit.

y = axb

where:

y = average time (or average cost) per unit

a = time (or cost) for first unit

b = slope = log r

(r = rate of learning)

log 2

x = cumulative output




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Example 3 Required: Using the above example calculate the incremental time taken by the 2nd, 3rd and 4th units. Applying the learning curve theory The application of the learning curve is important and can be found in questions involving:

● pricing ● budgeting ● standard costing ● decision making. The following illustration shows its use in the preparation of budgets. www.studyinteractive .org 109



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Example 4 Limitation plc Limitation plc commenced the manufacture and sale of a new product in the fourth quarter of

1991. In order to facilitate the budgeting process for quarters 1 and 2 of 1992, the following

information has been collected. (a) Forecast production/sales (batches of product) is as follows:

Quarter 4, 1991 30 batches Quarter 1, 1992 45 batches Quarter 2, 1992 45 batches

(b) It is estimated that direct labour is subject to a learning curve effect of 90%. The labour

cost of batch 1 of quarter 4, 1991 was £600 (at $5 per hour). The labour output rates from

the commencement of production of the product, after adjusting for learning effects, are

as follows:

Total batchesproduced Overall averagetime per batch

Batches Hours 15 79.51 30 71.56 45 67.28 60 64.40 75 62.25 90 60.55 105 59.15 120 57.96

Labour hours worked and paid for will be adjusted to eliminate spare capacity during each quarter. All time will be paid for at $5 per hour.

(c) Variable overhead is estimated at 150% of direct labour cost during 1992.

(d) All units produced will be sold in the quarter of production at $1,200 per batch.

Required:

(a) Calculate the labour hours requirement for the second batch and the sum of the labour

hours for the third and fourth batches produced in quarter 4, 1991. (3 marks)

(b) Prepare a budget for each of quarters 1 and 2, 1992 showing the contribution earned

from the product. Show all relevant workings. (12 marks)

(c) Limitation plc wishes to prepare a quotation for 12 batches of the product to be produced

at the start of quarter 3, 1992.

Calculate the cost of the labour and labour related costs incurred as a result of the additional batches produced. (5 marks)

(20 marks)




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General use of learning curve

Learning curve provides useful information to management accountant since it helps with:

● setting realistic labour standards

● planning manpower needs

● formulating budgets

● interpretation of variances

● calculation of incentive rates in bonus wages

● setting delivery date

● pricing for successive units, where prices are established, or quotations are made, on a

cost plus basis.

Limitations of learning curve

● It is only applicable in labour intensive operations which are repetitive and reasonably

skilled.

● It assumes that employees are motivated to learn.

● It assumes that there is a stable labour mix with a negligible turnover.

● Difficulty in determining the learning curve effect accurately.

● Difficulty in determining the level of production where the curve will be flat and no further

learning takes place.

● Breaks between production runs must be short or learning will be forgotten.

Example 5 BG

BG has recently developed a new product. The nature of their work is repetitive, and it is usual

for there to be 80% learning curve effect when a new product is developed. The time taken for

the first unit was 22 minutes. Assuming that an 80% learning effect applies:

Required:

What is the time to be taken for the fourth unit?

Example 6 Martina Ltd

Martina Ltd has received an order to make 8 units of product sampa. The time to produce the

first unit is estimated to be 80 hours and an 80% learning curve is expected. The rate of pay is

$7.50 for each hour.

The direct material cost for each unit is $4,000 and fixed costs associated with the order are

$6,400.

Required:

Calculate the average cost for each unit for this order.




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Chapter 8

Standard costing and

variance analysis


D Standard costing and variances analysis

1. Budgeting and standard costing

a) Explain the use of standard costs.

b) Outline the methods used to derive standard costs and discuss the different types of cost

possible.

c) Explain the importance of flexing budgets in performance management.

d) Explain and apply the principle of controllability in the performance management system.




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CHAPTER 8 – STANDARD COSTING AND VARIANCE ANALYSIS


Standard Costing

Basic Variances

Material Labour Sales Overheads cost cost cost cost

variances variances variances variances




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CHAPTER CONTENTS

STANDARD COSTING --------------------------------------------------- 116 TYPES OF STANDARDS 116

PREPARATION OF STANDARD COSTS 117

USES OF STANDARD COSTS 117

PROBLEMS IN SETTING STANDARDS 117

VARIANCE ANALYSIS -------------------------------------------------- 118

MATERIAL VARIANCES 119

LABOUR VARIANCES 120

VARIABLE OVERHEAD VARIANCES 120

FIXED OVERHEAD VARIANCES ---------------------------------------- 121

ABSORPTION COSTING PRINCIPLES 121

SALES VARIANCES ------------------------------------------------------ 123 www.studyinteractive .org 115



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STANDARD COSTING

● A standard is „a benchmark measurement of resource usage, set in defined conditions‟.

● Standard costing is a system of accounting based on pre-determined costs and revenue

per unit, which are used as a benchmark to compare actual performance, and therefore

provide useful feedback information to management.

● Variance analysis is performed by comparing the actual cost and the standard cost to

ascertain the difference.

● Standard costs can be prepared using either absorption costing or marginal costing.

Types of standards

Ideal standard

● A standard that assumes perfect working conditions and does not make allowance for

any losses, waste and machine breakdown.

● It can be used as a long-term organisational goal and is particularly applicable in total

quality management environments.

● The variances can only be adverse and it may have an adverse motivational impact.

Attainable standard

● It is based upon efficient (but not perfect) levels of operation but will include allowances

for normal material losses, realistic allowances for fatigue, machine breakdowns, etc.

● Attainable standards must be based on a tough but realistic performance level so that its

achievement is possible, but has to be worked for.

● They are used for budgeting and budgetary control.

Basic standard

● These are long-term standards which remain unchanged over a period of years. Their

sole use is to show trends over time for such items as material prices, labour rates and

efficiency and the effect of changing methods.

● They cannot be used to highlight current efficiency because they are out-of-date.




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Preparation of standard costs

Standard costing is directly linked to the budgeting process. Individual standards are prepared

for each component of cost. From these a standard cost may be prepared for each product

produced (or service provided). Material Usage x Price Labour Hours x Rate Var. O/H Hours x rate

Build the variable costs up to the

unit cost

Standard cost

per unit

Break the total fixed costs down using the

budgeted level of activity

Fixed O/H

Budgeted fixed

cost ÷

Budgeted number

of units

Uses of standard costs

● Preparation of budgets

● Stock valuation

● Budgetary control and variance analysis

Decision making (pricing)

Performance monitoring and evaluation

Problems in setting standards

1. Deciding how to incorporate inflation into planned unit costs.

2. The cost of setting up and maintaining a system of establishing standards.

3. Possible behavioural problems.

4. Deciding on the quality of materials and grade of labour to be used.




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VARIANCE ANALYSIS

The main application of standard costing is for budgetary control purposes. The standard is

compared to the actual result the difference being the variance. The analysis provides the

following information:

1. Cost control.

2. Reconciliation between Budgeted and Actual Profit (or Contribution or cost).

3. Variances may quantify the value of a known difference.

4. Performance Appraisal.

Example 1 Owen Ltd

Owen Ltd uses a standard costing system. The standard cost card for one product is shown

below:

$ Direct Material 4 kg at $5 per kg 20 Direct Labour 2 hours at $8 per hour 16 Variable Overhead 2 hours at $3.5 per hour 7 Total Variable Cost 43 Fixed Overhead 2 hours at $7 per hour 14 Total Product Cost 57 Standard Selling Price 70 Standard Profit Margin 13

The budgeted output and sales was 1,000 units. Actual output for the period was 1,300 units

and actual sales for the period was 1,250 units.

Actual cost and revenue were as follows:

$ Direct Material 5,000 kg, costing 22,700 Direct Labour 2,850 hours, costing 21,500 Variable Overhead 7,800 Fixed Overhead 14,600 Sales Revenue 1,250 units at $68 per unit 85,000

Required:

Calculate all possible variances.




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Material variances

Standard Cost

Direct Material 4 kg at $5 per kg

Actual Results

Actual output 1,300 units Materials Purchased and used 5,000 Kg, costing $22,700

Key pro forma

SQSP

Usage

AQSP

Price

AQAP www.studyinteractive .org 119



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Labour variances

Standard Cost

Direct Labour 2 hours at $8 per hour

Actual Results

Actual output 1,300 units Hours paid and worked 2,850 Labour Cost $21,500

Key pro forma

SHSR

Efficiency

AHSR

Rate

AHAR

Variable overhead variances

Standard Cost

Variable overhead 2 hours at $3.5 per hour

Actual Results

Actual output 1,300 units Hours worked (from above) 2,850 Variable overhead Cost $7,800

Key pro forma

SHSR

Efficiency

AHSR

Expenditure

AHAR 120 www.studyinteractive .org



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FIXED OVERHEAD VARIANCES

Fixed costs are a constant in total terms, hence total cost is our starting point. The analysis of

variances will be dependent on the costing methodology. Do we use absorption costing or

marginal costing? Either is potentially applicable.

Absorption costing principles

Using absorption costing the fixed cost is charged or absorbed to the cost unit or product. The

total fixed overhead variance will be similar to the under/ over absorption of overhead.

The total variance may be sub-analysed into two:

1. Volume variance – if the company produces more or less units and hence absorb more or

less overhead than budgeted.

2. Expenditure variance – if the company spends more or less fixed overhead than budgeted.

Question extract

Standard and Budgeted Cost

The fixed cost is($7/hour for 2 hours) $14per unit The budgeted number of units is 1,000 Budgeted fixed overheads is therefore $14,000

Actual Results

Actual output 1,300 units Hours worked (from above) 2,850 Fixed overhead Cost $14,600

Key pro forma

Std fixed OH cost (of actual output)

Volume variance

Budgeted fixed OH cost

Expenditure variance

Actual fixed OH cost




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Further analysis of fixed overheads It is also possible to further analyse fixed overheads by considering actual hours in relation to

the actual and budgeted units produced. To be comparable the output measures must be

measures in terms of standard hours. Key pro forma SHSR

Efficiency

AHSR

Capacity

BHSR

Expenditure

AHAR 122 www.studyinteractive .org



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SALES VARIANCES

The sales variances identify any change between the selling price and the standard cost.

Key formulae

Volume variance

(AS - BS) x SPM

Price variance

(AP - SP) x AS www.studyinteractive .org 123



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Chapter 9

Advanced variance

analysis



3. Material mix and yield variances

a) Calculate, identify the cause of, and explain material mix and yield variances.

b) Explain the wider issues involved in changing material eg cost, quality and performance

measurement issues.

c) Identify and explain the relationship of the material price variance with the material mix

and yield variances.

d) Suggest and justify alternative methods of controlling production processes.

4. Sales mix and quantity variances

a) Calculate, identify the cause of, and explain sales mix and quantity variances.

b) Identify and explain the relationship of the sales volume variances with the sales mix and

quantity variances.

5. Planning and operational variances

a) Calculate a revised budget.

b) Identify and explain those factors that could and could not be allowed to revise an original

budget.




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CHAPTER 9 – ADVANCED VARIANCE ANALYSIS

c) Calculate planning and operational variances for sales, including market size and market

share, materials and labour. d) Explain and discuss the manipulation issues involved in revising budgets.

6. Behavioural aspects of standard costing a) Describe the dysfunctional nature of some variances in the modern environment of JIT

and TQM. b) Discuss the behavioural problems resulting from using standard costs in rapidly changing

environments. c) Discuss the effect that variances have on staff motivation and action.




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CHAPTER CONTENTS

INTRODUCTION --------------------------------------------------------- 128

ADVANCED VARIANCES ------------------------------------------------ 129

PLANNING AND OPERATIONAL VARIANCES 129

MIX AND YIELD VARIANCES 131

INVESTIGATION AND INTERPRETATION ---------------------------- 133

SALES MIX VARIANCE 133

SALES QUANTITY VARIANCE 133

MARKET SIZE AND MARKET SHARE VARIANCES 134




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INTRODUCTION

Variance analysis is used to separate costs and revenues into controllable elements (eg

material, labour etc) in order that we can compare expected (standard) performance with actual

results. Advanced areas simply increase the degree to which the variances may be sub-

analysed into

1. Planning and operational variances.

2. Excess idle time variances.

3. Investigation and interpretation of variances. 128 www.studyinteractive .org



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ADVANCED VARIANCES

Planning and operational variances

Traditionally, when comparing standards to actual results the comparison has suffered from the

time delay between setting the standard and the incurrence of actual results.

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

relates, this means that the difference between standard and actual may arise solely due to an

unrealistic budget and not due to operational factors.

Normal

analysis

Original Revised Actual

Standard Standard result

Planning Operational

variance variance

Planning error Operational

Changes over

factors

time Management

action

Reconciling item Controllable

Uncontrollable

Example 1 Liddell

A company expects to use 4kg per unit at a standard price of $5/kg. During the period it used

4,000 kilos at a total cost of $25,000.

After closer consideration of the market for the raw material it has been found that the general

market price of the material has risen by 50% due to exchange rate movements.

Required:

(a) Based on normal variance analysis, has the purchasing manager done a good or bad

job?

(b) Is your conclusion changed as a result of sub-analysing the variance into planning and

operational elements?




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Pro Forma (using materials variances)

Basic pro forma Planning Operational

(substitute actual with (substitute standard with

revised standard) revised standard)

SQSP SQSP RSQRSP

Usage

AQSP RSQSP AQRSP

Price

AQAP RSQRSP AQAP

Advantages

● Variances are more relevant, especially in an unpredictable environment.

● The operational variances give fair reflection of the actual results achieved in the actual

conditions that existed.

● Managers are more likely to accept and be motivated by the variances reported which

provide a better measure of their performance.

● It emphasises the importance of planning and the relationship between planning and

control and a better guide for cost control.

Disadvantages

● The establishment of the revised standard is very difficult

● There is a considerable amount of administrative work

● It may become too easy to justify all variances as being due to bad planning, so no

operational variances will be highlighted.

Example 2

Standards

3kg/unit for $5/kg

Actual

Output 12,500 units

Usage 38,000 kg

Cost $195,500

Required:

Prepare the variances using basic variance analysis and assess whether the purchasing

manager and production manager individually have done a good or bad job.




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Example 2 (cont)

After further consideration the standards have been revised to reflect changes that have

occurred over time. The standard usage is now expected to be 3.1kg due to a poor harvest

leading poorer quality material inputs. In addition due to adverse movements in the exchange

rate the material costs have changed. It is now expected that each kg will cost $5.15.

Required:

Prepare an analysis of variances into both planning and operational elements and assess the

performance of the purchasing manager and the production manager individually.

Mix and yield variances

A sub-analysis of the material usage variance into a mix and a yield component.

Applicable in a manufacturing environment where:

1. 2 or material inputs go into to making the product (a mix)

2. The material inputs are inter-changeable to some degree (process costing environment).

Key pro forma

SQSP

Yield

AQ(SM)SP

Mix

AQSP

Price

AQAP




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CHAPTER 9 – ADVANCED VARIANCE ANALYSIS Example 3 Dalglish

Dalglish manufactures a fertiliser by mixing three chemicals, A, B and C, and the following standards apply:

Standard proportions Standard cost per tonne % $ A 70 20 B 20 30 C 10 50

During the process of mixing, a process loss of 10% is regarded as the standard.

In a week, 855 tonnes of the fertiliser were produced and inputs were as follows:

Actual inputs Actual prices Actual cost tonnes $ per tonne $ A 660 21 13,860 B 210 32 6,720 C 130 47 6,110

_____ ______

1,000 26,690 _____ ______

Required:

Calculate the material price, mix and yield variances.




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SALES MIX AND QUANTITY VARIANCES

Sales mix variance

Sales mix variance refers to the proportion of different products in total sales.

It is the difference between planned mix of various products and actual mix or proportion of

those products.

Also called as margin variance, it determines the impact of change in the mix on profits.

Sales Mix Variance =

budgeted contribution per unit x (actual sales at actual mix – actual sales at budgeted mix)

Sales quantity variance

It determines the effect on profit of selling a different total quantity from the budgeted total

quantity.

Sales Quantity Variance =

budgeted contribution margin per unit x (actual sales at budgeted mix – standard sales at

budgeted mix)

Example 4

A B

Budgeted Sales 800 1,200

Actual Sales 500 1,500

Budgeted contribution per unit $5 $8

Required:

Calculate Sales mix variance.

Example 5

ABC company budgeted sales of 10,000 units and the budgeted sales mix was 2:3 for products

X and Y respectively. The actual sales of X and Y were 3,000 units and 10,000 units

respectively. Sales prices were $5 and $9 respectively. The variable costs are 50% of the sales

prices.

Required:

Calculate Sales Quantity variance. www.studyinteractive .org 133



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Market size and market share variances

The sales quantity variances can further be analysed into a component due to changes in

market size and a component due to changes in market share, provided published industry

sales statistics are readily available.

Market size variance:

Budgeted market share % x (budgeted industry sales volume – actual industry sales volume) x

budgeted contribution per unit

Market share variance:

(Budgeted market share % - actual market share %) x (actual industry sales volume x budgeted

average contribution margin per unit)

Alternatively applying the planning and operational variance analysis idea, following Performa

can be used to calculate market size and market share variances.

Original Sales Volume x standard contribution per unit

= Market Size variance

Revised sales volume x standard contribution per unit

= Market Share variance

Actual sales volume x standard contribution per unit

Example 6

A company producing caffeinated drinks has noticed a slump in the market due to public being

more health conscious lately. In the past the company has always had a market share of around

5% in the local market. The total market volumes recorded by the department of trade and

industry last year were 5 million units, which has recently shown a slump of nearly 10%.

The following are extracts from financial records relating to its product.

Budgeted volume 250,000 Budgeted selling price $10 per unit Budgeted variable cost $4 per unit Actual volume 240,000 Actual selling price $9 per unit

Required:

Calculate the following variances:

1. Sales price and sales volume.

2. Market size and market share. 134 www.studyinteractive .org



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Chapter 10

Performance

evaluation


E Performance measurement information systems

1. The scope of performance measurement

a) Identify the accounting information requirements and describe the different types of

information systems used for strategic planning, management control and operational

control and decision-making.

b) Define and identify the main characteristics of transaction processing systems;

management information systems; executive information systems; and enterprise

resource planning systems.

c) Define and discuss the merits of, and potential problems with, open and closed systems

with regard to the needs of performance management.

2. Sources of management information

a) Identify the principal internal and external sources of management accounting

information.

b) Demonstrate how these principal sources of management information might be used for

control purposes.

c) Identify and discuss the direct data capture and process costs of management accounting

information.

d) Identify and discuss the indirect costs of producing information.

e) Discuss the limitations of using externally generated information.




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CHAPTER 10 – PERFORMANCE EVALUATION

3. Management reports

a) Discuss the principal controls required in generating and distributing internal information.

b) Discuss the procedures that may be necessary to ensure security of highly confidential information that is not for external consumption.

4. The scope of performance measurement

a) Describe, calculate and interpret financial performance indicators (FPIs) for profitability,

liquidity and risk in both manufacturing and service businesses. Suggest methods to

improve these measures.

b) Describe, calculate and interpret non-financial performance indicators (NFPIs) and

suggest method to improve the performance indicated.

c) Explain the causes and problems created by short-termism and financial manipulation of

results and suggest methods to encourage a long term view.

d) Explain and interpret the Balanced Scorecard, and the Building Block model proposed by

Fitzgerald and Moon.

e) Discuss the difficulties of target setting in qualitative areas.

6. Performance analysis in not for profit organisations and the public

sector

a) Comment on the problems of having non-quantifiable objectives in performance

management.

b) Explain how performance could be measured in this sector.

c) Comment on the problems of having multiple objectives in this sector.

d) Outline Value for Money (VFM) as a public sector objective.

7. External considerations and behavioural aspects

a) Explain the need to allow for external considerations in performance management,

including stakeholders, market conditions and allowance for competitors.

b) Suggest ways in which external considerations could be allowed for in performance

management.

c) Interpret performance in the light of external considerations.

d) Identify and explain the behaviour aspects of performance management. 136 www.studyinteractive .org



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PERFORMANCE EVALUATION

Responsibility Performance

Accounting Measurement

Cost Profit Investmen Financial Non-

financial

centres centres t centres analysis

analysis




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CHAPTER CONTENTS

RESPONSIBILITY ACCOUNTING -------------------------------------- 140 RESPONSIBILITY CENTRES 140

DIVISIONALISATION (DECENTRALISATION) 140

REPORTING RESPONSIBILITY CENTRE RESULTS ------------------- 142

COST CENTRE REPORTING 142

PROFIT CENTRE REPORTING 143

PERFORMANCE EVALUATION MEASURES ---------------------------- 144

RETURN ON CAPITAL EMPLOYED (ROCE) OR (ROI) 144

RESIDUAL INCOME (RI) 145

KEY ISSUES ------------------------------------------------------------- 146

GOAL CONGRUENT DECISION MAKING 146

SHORT-TERMISM AND DEPRECIATION OF ASSETS 147

MANAGEMENT FRAUD 147

TRANSFER PRICING 147

RATIO ANALYSIS ------------------------------------------------------- 148

PROFITABILITY RATIOS 148

LIQUIDITY RATIOS 148

EFFICIENCY RATIOS 148

GEARING RATIO 148

PERFORMANCE EVALUATION –NON FINANCIAL MEASURES ------- 149

THE BALANCED SCORECARD------------------------------------------- 150

CUSTOMER PERSPECTIVE 150

INTERNAL BUSINESS PERSPECTIVE 150

INNOVATION AND LEARNING PERSPECTIVE 151

FINANCIAL PERSPECTIVE 151

SERVICE INDUSTRIES 151

THE BUILDING BLOCK MODEL ----------------------------------------- 152

1. STANDARDS 152

2. REWARDS 152

3. DIMENSIONS 153

PERFORMANCE MEASUREMENT IN A NOT FOR PROFIT

ORGANISATION AND THE PUBLIC SECTOR -------------------- 154




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OBJECTIVES OF A NOT FOR PROFIT ENTITY 154

PROBLEMS OF PERFORMANCE MEASUREMENTOF A NOT FOR PROFIT ENTITY 154

PERFORMANCE MEASUREMENT 155 VALUE FOR MONEY (VFM) --------------------------------------------- 156

THE KEY TO VFM 156




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RESPONSIBILITY ACCOUNTING

Responsibility accounting segregates revenue and cost information into areas of personal

responsibility to assess the performance achieved by relevant persons to whom authority has

been designated.

This system recognise various decision centres throughout the organisation and trace costs,

revenue, assets and liabilities, to the individual managers who are primarily responsible for

making decisions about the costs, revenue, etc in question.

Responsibility centres

Cost centre

● a unit of a business where the manager is made accountable for all the cost.

Revenue centre

● a unit of an organisation where the manager is accountable for the sales earned in the

unit.

Profit centre

● where the manager is responsible for the profitability of the unit.

Investment centre

● where the manger is responsible for both the profitability and the capital investment of the

unit.

Note that variance analysis alone will not work particularly well in the last two situations.

Divisionalisation (decentralisation)

Decentralisation refers to delegating responsibilities to divisional managers or unit heads.

Advantages

● It increases motivation of the divisional managers as they feel involved in the decision

making of the organisation.

● It is a form of training for the divisional managers and it easy for them to rise through the

ranks to strategic positions.

● It should promote goal congruence (see later), as all decisions been taken are all geared

towards achieving the objectives of the whole organisation.

● It drastically reduces the time taken to make decisions.




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CHAPTER 10 – PERFORMANCE EVALUATION Disadvantages ● Divisional managers may make dysfunctional decisions (decisions that are not in the best

interests of the organisation). ● There is a need for a performance appraisal system to assess the performance of

individual managers. ● Top management may lose control by delegating decision making to divisional managers,

since they are not aware of what is going on in the whole organisation.

● Lack of economies of scale. For example, efficient cash management can be achieved

much more effectively if all cash balances are centrally controlled.




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REPORTING RESPONSIBILITY CENTRE RESULTS

Cost centre reporting

Performance and control reporting for cost centre focus on the costs of the centre, by comparing

actual costs with the expected costs for a given level of activity. Performance reporting should

recognise both variability of costs and controllability of costs.

Variability of costs – cost should be analysed into their fixed and variable cost elements, and the

expected costs for the period should be based on a flexed budget.

Controllability of costs - Responsibility accounting is based on the principle that it is appropriate to

charge to an area of responsibility only those costs that are significantly influenced by the manager

of that responsible centre.

Controllable costs are costs which can be directly influenced by a given manager within a given

time span.

As a general rule, controllable costs are both variable costs and some or all of the fixed costs

that are directly attributable to the centre.

Cost centre report

Expected (flexed budget) actual variance

$ $ $

Variable costs

Material cost

Labour cost

Other variable cost

Controllable fixed cost

Labour

Others

Uncontrollable fixed cost

Apportioned central cost

Total costs 142 www.studyinteractive .org



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Profit centre reporting

The profitability of profit and investment centres should be prepared on the basis of marginal

costing, that is, to identify the contribution to profit from the centre in each reporting period.

Controllable fixed cost is then deducted to get the controllable profit for the centre. The

uncontrollable fixed cost is then deducted to obtain the net profit.

Profit and investment centre report

Expected (flexed budget) actual variance

$ $ $

Sales

Variable costs

Material cost

Labour cost

Other variable cost

Contribution

Controllable fixed cost

Labour

Others

Controllable profit

Uncontrollable fixed cost

Apportioned central cost

Net profit




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PERFORMANCE EVALUATION – FINANCIAL MEASURES

The basic measure of performance is profit. The measure of profit that is used is normally

related to operating profit or PBIT this being the measure that is within the control of operational

management.

When assessing performance of a manager it is important to only assess the manager on a

profit measure that is within the control of the manager. This means that any costs or revenues

that are outside the control of the manager should be excluded.

In practice the obvious uncontrollable cost for a division would be apportioned head office costs

on the basis that the incurrence of cost is controllable by head office and is charged in an

arbitrary manner to the division.

When looking at an investment centre the manager is able to control the amount of investment

in the division. It is normal to assess the performance of profit in relation to investment made by

head office in the division using either return on investment (ROI) or residual income (RI)

Return on capital employed (ROCE) or (ROI)

ROCE = profit before interest and tax 100 capital employed

Advantages of ROCE

1. It is easy to understand and easy to calculate.

2. ROCE is still the commonest way in which business unit performance is measured and

evaluated, and is certainly the most visible to shareholders.

3. Managers may be happy in expressing project attractiveness in the same terms in which

their performance will be reported to shareholders, and according to which they will be

evaluated and rewarded.

4. The continuing use of the ROCE method can be explained largely by its utilisation of

balance sheet and income statement magnitudes familiar to managers, namely profit and

capital employed.

Criticisms of ROCE

1. It fails to take account of the project life or the timing of cash flows and time value of

money within that life.

2. When assets are valued at net book value, reported performance improves with time as

the assets get old. In this case there is a disincentive to invest in new assets.

3. It uses accounting profit and capital employed, hence subject to manipulation due to

various accounting conventions.

4. Performance measurement based on ROCE encourages short-termism in decision

making. Failure to invest in new assets could be harmful to the long-term interest of the

division and the organisation as a whole.




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5. It is difficult to assess the significance of ROI. There is no definite investment signal. The

decision to invest or not remains subjective in view of the lack of objectively set target

ROI

6. ROI is sometime confused with internal rate of return (IRR)

Residual income (RI)

RI = profit – (capital employed x the cost of capital)

Advantages of residual income

Residual income overcomes many of the problems of ROI:

● It encourage investment centre managers to undertake new investments if they add to

residual income.

● As a consequence it is more consistent with the objective of maximising the total

profitability of the company.

● It is possible to use different rates of interest for different types of asset.

Disadvantages of residual income

● Like ROI, residual income is also based on accounting profit and capital employed which

can be manipulated.

● It encourage investment centres managers to think in the short-term about how to

increase next year‟s residual income for the centre, hence does not encourage decision

making for long-term.

● Residual income is not as widely used as the ROI despite overcoming some of the

problems in ROI.

Example 1 Tata

Tata is a division of Tatan group. Its manager has the authority to invest in new capital

expenditure, within limit set by head office. The senior management team of the division is

considering an investment of $4.2 million. This would have a residual value of zero after four

years. Net cash flows from the investment would be $1.4 million for each of the next four years.

The cost of capital for the Tata division is 10%. It is the group‟s policy to use straight-line

depreciation when measuring divisional profit.

For measuring purpose and reporting purposes, capital is defined as the opening net book

value at the start of each year.

Required:

(a) Calculate residual income each year.

(b) Calculate the return on investment each year. www.studyinteractive .org 145



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KEY ISSUES

● Goal congruent decision making

● Short-termism

● Management fraud

● Transfer pricing

Goal congruent decision making

In decision making, managers should not use measures like ROI and RI. However, generally

the aforementioned measures are used in performance measurement; therefore managers tend

to include these in their assessments of new projects.

Example 2

There are two divisions with the following performance for the current year

Division X y

Investment ($m) 10 30

Controllable Profit 2 3

Required rate of return 15%

Required:

Calculate the performance of each division based using:

(a) ROI

(b) RI

Which division has superior performance?

Example 3

Continuing from the previous example each division has the opportunity to invest in a new

project.

Division X y Investment ($000s) 500 1,000 Controllable Profit 80 120

Required rate of return is 15%.

Required:

Using the measures of performance above assess the decisions that would be made by:

(a) the divisional managers;

(b) head office;

(c) whether the decisions are congruent with each other.




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Short-termism and depreciation of assets

However the performance is appraised, it is normal to appraise divisional managers over one

year. When using ROI and RI the investment will fall in value over time as a result of

depreciation. This has the impact of increasing the reported performance for each year that

investment is not made within the division.

A cynical manager could improve their perceived performance simply as a result of deferring

investment and using increasingly outdated assets. This could well have adverse consequences

to the business including:

1. Poorer quality output due to worn out machines

2. Higher risk of machine breakdown

3. using outdated technology.

Management fraud

Having a single profit measure or relatively few related measures of performance appraisal

allows managers to manipulate the figures underpinning these measures. In simple terms the

manager only needs to overstated profits in a period or understate the investment.

Simple ways to overstate of profits

1. Phasing of apportioned costs to charge fewer costs during the period.

2. Revenue recognition of sales in previous periods or future periods.

3. Ignoring part of the cost base.

4. Incorporate sales from other divisions.

5. Double count sales.

To reduce the opportunity for fraud a range of performance measures should be used that are

inter-linked. They will make it more difficult for managers to manipulate the figures for personal

gain.

Transfer pricing

The sale of goods between one division and another within the same organisation. The setting

of the transfer price will have no direct impact on the overall performance of the company but a

very real impact on individual divisional performance.

The setting of transfer prices will therefore be highly political. The manager can improve his own

reported performance more easily by arguing for a better transfer price than in any other way. www.studyinteractive .org 147



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RATIO ANALYSIS

Any financial ratios could be required by the examiner. Please note that it is unlikely that a wide

range of ratios will be required in a single question, instead the focus will be on 3 or 4 ratios at

most normally focussing in profit measures.

Profitability ratios

Return on Capital Employed = net profit

capital employed

Net Profit margin * = net profit

sales

Asset Turnover = sales

capital employed

*alternatively you can use gross profit to calculate gross profit margin

Liquidity ratios

Current ratio = current assets

current liabilities

Quick (acid test) ratio = current assets − inventory

current liabilities

Efficiency ratios

Inventory days = inventory 365

cost of sales

Receivable days = receivables 365

revenue

Payable days = payables 365

cost of sales

Gearing ratio

Gearing = equity

debt equity




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PERFORMANCE EVALUATION –NON FINANCIAL MEASURES

Non-financial measure of performance should focus on critical success factors of a non-financial

nature. The measures include market share, capacity utilisation, labour turnover, etc.

Below are some examples of non-financial measures:

AREA POSSIBLE CRITERIA

COMPETITIVENESS ● sale growth by product or service ● measures of customer base

● relative market share and position

ACTIVITY ● sales units ● labour hours

● machine hours

● number of material requisitions serviced

● number of accounts reconciled

PRODUCTIVITY ● efficiency measurements of resources planned against those consumed

● production per person

● production per hour

● production per shift

QUALITY OF SERVICE/PRODUCT ● number of customer complaints ● rejections as a percentage of production or sales

● number of account lost or gained

QUALITY OF WORKING LIFE ● days absence ● labour turnover

● overtime

● measures of job satisfaction

INNOVATION ● proportion of new products and services to old ones

● new product or service sales level

CUSTOMER SATISFACTION ● speed of response to customer need

● informal listening by calling a certain number of customers each week

● number of customer visit to the factory or workplace

● number of managers visit to customers




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THE BALANCED SCORECARD

The balanced scorecard forces managers to look at the business from four important

perspectives.

It links performance measures by requiring firms to address four basic questions:

1. How do customers see us? – Customer perspective.

2. What must we excel at? – Internal perspective.

3. Can we continue to improve and create value? – Innovation & learning perspective.

4. How do we look to shareholders? – Financial perspective.

The justifications of balanced scorecard over the traditional measures are that:

● accounting figures are easily manipulated and as such unreliable

● changes in the business and market environment do not show in the financial results of a

company until much later. Factors other than financial performance must therefore be

targeted.

Customer perspective

● How do customers perceive the firm?

● This focuses on the analysis of different types of customers, their degree of satisfaction

and the processes used to deliver products and services to customers.

● Particular areas of focus would include: o

Customer service.

o New products. o

New markets.

o Customer retention. o

Customer satisfaction.

Internal business perspective

● How well the business is performing.

● Whether the products and services offered meet customer expectations.

● Activities in which the firm excels?

● And in what must it excel in the future?

● Quality performance.

● Quality.

● Motivated workforce. 150 www.studyinteractive .org



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Innovation and learning perspective

● Can we continue to improve and create value?

● In which areas must the organisation improve?

● Product diversification.

● % sales from new products.

● Amount of training.

● Number of employee suggestions.

● Extent of employee empowerment.

Financial perspective

● This is concerned with the shareholders view of performance.

● Shareholders are concerned with many aspects of financial performance.

● Amongst the measures of success are: o

Market share.

o Profit ratio.

o Return on investment. o

Economic value added.

o Return on capital employed. o

Cash flow.

o Share price.

Service industries

In general services differ from manufacturing since they are:

● Intangible.

● Simultaneous.

● Perishable.

● Heterogeneous.




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THE BUILDING BLOCK MODEL

This model is particularly suited to service industries.

Fitzgerald and Moon divide performance measurement into three areas:

1. Standards.

2. Rewards.

3. Dimensions.

Dimensions

● Financial

performance

● Competitiveness ● Quality ● Flexibility ● Resource utilisation ● Innovation

Standards Rewards

● Ownership ● Clarity ● Achievability ● Motivation

● Equity ● Controllabilit

1. Standards

This refers to the targets that are set within the organisation. These should be:

● High enough to motivate.

● Be owned by the employees (through participation in target-setting).

● Be seen to be equitable.

2. Rewards

This refers to what the organisation (and the employee) is trying to achieve.

● The organisation‟s objectives should be clearly understood.

● Employees should be motivated to work towards these objectives.

● Employees should be able to control areas over which they will be held responsible.




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3. Dimensions

This refers to how performance will be measured. The areas are:

● Financial

● Competitive performance

● Quality of service

● Flexibility

● Resource Utilisation

● Innovation.




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PERFORMANCE MEASUREMENT IN A NOT FOR PROFIT

ORGANISATION AND THE PUBLIC SECTOR

In simple terms the basic objective of a not for profit is to provide a service without making a

loss, a profit or surplus simply being either a timing issue or a means to an end.

The wider issue is that the organisation is providing a service of social or moral worth. We can

attempt to measure this service.

Objectives of a not for profit entity

The objective for such an organisation will differ widely from one organisation to another. They

may include one or more of the following:

● Client satisfaction

● Employee satisfaction (particularly when volunteers are a substantial part of the

workforce)

● Maximisation of surplus (perhaps to assist in growth or protect against loss of future

funding)

● Growth

● Usage of facilities (for example library services)

● Maintenance of capability (for example a fire service or army).

The key to remember in the exam is that for every not for profit organisation there will be

multiple objectives that have to be addressed as opposed to a profit making organisation where

profit is the key aim in relation to satisfying the owners or shareholders.

Problems of performance measurementof a not for profit entity

1. Multiple objectives

As seen above most organisations will have competing objectives. The difficulty arises

when attempting to identify the relative importance of the objectives.

2. Measurement of services provided

The nature of many services is that they are more qualitative than quantitative. When

measuring such outputs it is often very difficult to get meaningful aggregate measures of

performance.

3. No profit motive

Measures such as ROI and RI cannot be used to gain an overall measure of

performance.

4. Identification of cost unit

The cost unit is likely to be relatively complex and there is likely to be more than one cost

unit. For example what is a cost unit for a hospital/ there are likely to be multiple such

cost units being used by a single patient.




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5. Key constraint

For most organisations the key constraint is the level of finance available. A charity is

limited to its donations and a government department is limited to its allocation from the

finance department. This constraint is separate in most organisations to their end

objective.

6. Political intervention

Unlike commercial entities not for profit entities are far more likely to be affected by

political influence, either directly in the form of elected official or indirectly by public

sentiment.

7. Legal considerations

It is likely that adherence to restrictive legal rules are going to impact on a not for profit

entity because of the nature of the organisation or the links to government at a local or

national level.

Performance measurement

In order to establish meaningful measures within such an environment we can employ the

following solutions:

1. Input measurement

In the absence of easily measured output then more consideration can be put into the

costs and resourcing of an organisation.

2. Independent scrutiny and target setting

There is need for fine judgement when setting qualitative targets. By use of independent

experts then measures can be set that reflect performance levels appropriate without

introducing bias.

3. External comparison

A powerful assessment of the performance of an organisation is to benchmark that

performance in relation to similar organisations. This allows for both historical results to

be used but also best practice measures to be developed.




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VALUE FOR MONEY (VFM)

Value for money is a framework by which not for profit organisations can be measured. It

separates the performance of the business into three areas – the three Es:

1. Effectiveness

2. Efficiency

3. Economy

1. Effectiveness (an output measure)

This may be described as how well the organisation meets its objectives. Perhaps an easier

way of understanding it would be to see how well the output of services match the client need.

2. Efficiency (the relationship between input and output)

This describes how well resources are utilised; it measures the output of services for a given

level of resource or input.

3. Economy (an input measure)

This considers the cost of sourcing the input resources. The aim being to minimise the costs of

the input for a given standard and level of resource.

The key to VFM

The key to VFM is to understand that performing in a single area is not sufficient, instead the

organisation must achieve in relation to all three aspects in order to provide value for money.




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CHAPTER 10 – PERFORMANCE EVALUATION Management Information Systems (MIS)

A MIS converts data from internal sources into information to aid managers make decisions.

Information from these systems tends to be used by tactical managers. It maybe manual or

automated, but mostly it is automated to timely process the data to be used in decision making. Transaction Processing Systems (TPS)

A TPS captures, stores, batch processes and summarises routine transactions and other

accounting data. It is mainly used at operational level of management. Inventory and Ledger

records are good examples of routine TPS.

A TPS has mainly four functions.

COLLECTION STORAGE MODIFICATION RETRIEVAL

Using source input the data and processing, real future use of documents keep it time or batch further processing

The transactions may be batch processed or real time processed.

Executive Information Systems (EIS)

An EIS aids strategic decision making by providing internal and external information which is

relevant to the critical success factors of the organisation.




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Enterprise Resource Planning Systems (ERPS) An ERP system is a computer system that pulls together information from all parts of the

organization and provides more integration between different parts of the company.

Involves the planning of: ● manufacturing

o planning for production

o planned purchasing of materials o

quality management and control

● sales and distribution

o management of sales orders and customers o

transportation and shipping

● accounting o accounts receivables and payables

o budgeting

o standard costing

● human resources

o training

o recruitment

o employee development.




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Chapter 11

Transfer pricing



5. Divisional performance and transfer pricing

a) Explain and illustrate the basis for setting a transfer price using variable cost, full cost and

the principles behind allowing for intermediate markets.

b) Explain how transfer prices can distort the performance assessment of divisions and

decisions made.

c) Explain the meaning of, and calculate, Return on Investment (ROI) and Residual Income

(RI), and discuss their shortcomings.

d) Compare divisional performance and recognise the problems of doing so.




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CHAPTER 11 – TRANSFER PRICING


TRANSFER PRICING

Dimensions of Transfer pricing

transfer pricing methods

Cost Market Other

based based approaches




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CHAPTER CONTENTS

INTRODUCTION --------------------------------------------------------- 162 OBJECTIVES 162

SUBSIDIARY OBJECTIVES 163

DECISION-MAKING 163

PERFORMANCE MEASUREMENT 163

DIVISIONAL AUTONOMY 163

BASES FOR SETTING TRANSFER PRICES ----------------------------- 164

1. COST BASED TRANSFER PRICE 164

2. MARKET-BASED TRANSFER PRICE 165

3. NEGOTIATED TRANSFER PRICE 166




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INTRODUCTION

Supplying Buying

Division

Division

When an organization is structured into profit centres or investment centres, authority is

delegated to the profit or investment centre managers. The performance of these managers will

be assessed and rewarded, on the basis of the results of their centres. Profit centre managers

will therefore be motivated to optimise the result of their own division, regardless of other profit

centres and regardless of the organization as a whole.

Transfer pricing is used when divisions of an organization need to charge other divisions of the

same organization for goods or services they provide to them.

Objectives

Goal congruent decision making

Any decision by the management to improve the performance of either of the divisions must

also improve the performance of the company as a whole.

“Fair” performance measurement

The transfer price used will normally have a substantial effect on the distribution of profit

between divisions, it is important that this distribution is seen to be equitable to all parties.

Maintaining divisional autonomy

A key purpose of decentralisation is to provide greater autonomy at divisional level, there is little

point in granting autonomy and then imposing transfer prices that will materially affect the

profitability of those supposedly autonomous divisions. 162 www.studyinteractive .org



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Subsidiary objectives

Minimising global tax liability

If transactions occur within one tax regime little can be gained by manipulating transfer prices. A

multinational organisation can and will use transfer pricing to move profits “round the world”

either to a low tax regime or alternatively to the country of the holding company.

Recording the movement of goods and services

An important function of transfer pricing is simply to record movement of goods and services in

financial terms.

Decision-making

In order to promote goal congruence we must ensure that the transfer price encourages the

divisions to trade with each other only when it is appropriate for the larger organisation. In order

for this to take place we follow a simple rule:

GENERAL RULE - All goods and services should be transferred at opportunity cost.

Performance measurement

The aim is to set a transfer price that will give a “fair” measure of performance in each division,

ie profit. There is no formula for ensuring this and the result will always be an arbitrary allocation

between the divisions involved. We will see however that in some circumstances this will give a

“better” result than others. How do the transfer prices we have already calculated measure up?

Divisional autonomy

Should the transfer prices be imposed on the divisions by Head Office, or should the divisions

negotiate the transfer price between themselves? The negotiation route seems more consistent

with divisional autonomy. There are however significant disadvantages:

1. Negotiation is time-consuming.

2. It leads to conflict between divisions.

3. Negotiated transfer prices are unlikely to reflect rational factors.

4. They will reflect Personality/Skill/Status/Training.

5. Senior management will need to spend substantial time overseeing the process.




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BASES FOR SETTING TRANSFER PRICES

There are three main bases for setting transfer price:

1. Cost-based prices.

2. Market-based prices.

3. Negotiated prices.

1. Cost based transfer price

Non-existent market

Where there is no external market for the transferred product, the ideal transfer price should be

based on cost.

A cost based transfer price could take the following forms:

● transfer at full cost to the selling division of producing the product or services with or

without profit mark-up

● transfer at marginal cost to the selling division of producing the product or services with or

without profit mark-up.

Example 1

The following relates to two divisions of a company:

Division A Division B Selling price ($) - 20 Variable production cost per unit($) 5 3 Fixed cost ($) 40,000 80,000

The budgeted unit for division B are 20,000 units transferred from division A.

There is no external market for the product from division A. The products of division A are required to produce product of division B.

Required:

Determine the ideal transfer price. 164 www.studyinteractive .org



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Example 2

The following relates to a selling division:

External market price ($) 30 Variable cost of production ($) 15

Total capacity of the division is 20,000 units.

The market demand for this product is 15,000.

A buying division requires 2000 unit of this product.

Required:

Determine the ideal transfer price.

2. Market-based transfer price

Market-base transfer price might be used when there is an intermediate market for transferred

goods or services. An intermediate market is the external market for the goods or services of

the selling division.

The market based transfer price could take the following forms:

● the transfer price is the price of the item in the external market, or

● the transfer price is at a discount to the external market price to allow for a saving in

selling cost by selling internally.

Example 3

Division A of a company produces sigma which is needed as a component by division B of the

same company. Division B converts the sigma to form alpha which is sold externally.

The following is relevant:

Division A Division B Selling price ($) 30 50 Marginal cost of production ($) 20 - Further marginal cost ($) 25 Fixed costs ($) 300,000 400,000

Required:

Determine the ideal transfer price, if there is a perfect market for sigma.

Example 4

Assuming the same facts as in example above and that division A can sell in the external

market at a marginal selling cost of $4 per unit.

Required:

What will be the ideal transfer price? www.studyinteractive .org 165



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3. Negotiated transfer price

In some cases transfer price might be negotiated. If divisional managers are allowed to

negotiate transfer prices with each other, the agreed transfer price may be finalized from a

combination of accounting arithmetic, negotiation and compromise.

The difficulties encountered in establishing a sound system of transfer pricing have led to

suggestions that negotiated transfer prices should be used. Negotiated transfer prices are most

appropriate in situations where some market imperfections exist for the transfer product,

particularly when there are different selling costs for internal and external sales, or where there

exist different market prices.

In order to solve these problems other negotiating transfer price techniques can be used. These

are the dual transfer price and the two-part tariff arrangement.

Dual transfer price

Dual transfer price is applied where the buying division pays one transfer price for unit

purchased from the selling division and the selling division receives a different, higher transfer

price for each unit that it transfers to the receiving division. The difference in the two transfer

prices (the buying price and the selling price) is subsidized by the head office, which charges

the loss to head office costs.

The advantage for having dual prices should be to motivate the divisional managers to produce

and sell the quantities that will maximize the profit of the company.

One major problem with dual price is that it removes the decision-making authority from the

profit centres, since the head office decides what the transfer prices should be as they have to

absorb the loss.

Two-part tariff arrangement

Two-part tariff arrangement is where the receiving division pays the selling division a fixed price

per unit transferred which is equal to the variable cost of the selling division and a fixed fee as a

lump sum payment to the selling division, representing an allowance for the fixed cost of the

selling division.

The advantage of this approach is that the transfers will be made at the variable or marginal

cost of the selling division, and both divisions should be able to report profit from inter-divisional

trading. This approach ensures that the selling division would not make loss, and would make

profit if its actual costs are less than the agreed transfer fixed fee and unit rate.

Also the receiving division is made aware of the full cost of obtaining products from other

divisions.

The problems of this approach are that:

● the measurement of performance of the selling division would not be fair

● it does not provide motivation to the selling division manager, since it earns no profit on

the transaction made during the period if actual is equal to the agreed figures.




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Solutions to exercises

and examples




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SOLUTIONS TO EXERCISES AND EXAMPLES

CHAPTER 1

Example 1 Hensau Ltd

(a) (i) Cost per Unit ($)

X Y Z Direct materials 5 3 6 Direct labour 1.6 2.7 4 ------ ----- ------ 6.6 5.7 10 Production Overheads 7.5 12.5 18.75 ------ ------- -------- Total Cost per unit 14.1 18.2 28.75

(a) (ii)

Cost Drivers Calculation:

Number of batches X 10 Y 5 Z 16

Total 31

Number of drill operations: X 2,000 x 6 = 12,000 Y 1,500 x 3 = 4,500 Z 800 x 2 = 1,600 Total 18,100

Quantity of materials: X 2,000 x 4 = 8,000 Y 1,500 x 6 = 9,000 Z 800 x 3 = 2,400 Total 19,400

Cost Driver rate Calculation:

Material receipts and inspections $15,600 / 31 $503.23 / batch Power $19500 / 18100 $1.08 / drill ops Material Handling $13,650 / 19400 $0.70 / sq. Meter

Cost Per Unit ($)

X Y Z Prime Costs 6.6 5.7 10 Overheads:

Material receipts 2.52 1.68 10.06 Power 6.48 3.24 2.16 Material Handling 2.8 4.20 2.10 ------- ------- -------- Cost per unit 18.4 14.82 24.32 168 www.studyinteractive .org



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SOLUTIONS TO EXERCISES AND EXAMPLES OR

Drivers

Drivers X Y Z TOTAL

Batches of material 10 5 16 31

Drill operations (2000 x 6) (1,500 x 3) (800 x 2) 12,000 4,500 1,600 18,100

Material Handing (2,000 x 4) (1,500 x 6) (800 x 3) 8,000 9,000 2,400 19,400

Cost Pool X Y Z TOTAL

Material receipts and (10/31 x 15,600)

inspections 5,032 2,516 8,052

$15,600

Power (12,000/18,100 x

19,500)

12,928 4,848 1,724 $19,500

Material handling (8,000/19,400 x

13,560)

5,592 6,290 1,678 $13,560

Total 23,552 13,654 11,454

Divide by units (23,552/2,000) (13,654/1,500) (11454/800) 48,750

11.78 9.10 14.32

Cost Per Unit ($)

X Y Z

Prime Costs 6.6 5.7 10

Overheads 11.78 9.10 14.32

------- ------- --------

Cost per unit 18.38 14.80 24.32

(b)

Relevance of cost drivers in ABC environment:

The basic principle in developing an ABC model is to establish a relationship between the

manufacturing activities and the cost generation. This is best described as “cause and effect”

relationship. It is only possible and fruitful exercise if the production process is divided into clear

sub activities, where the cost effect can be fairly linked. Linking the right activity with the true

cost driver makes the cost allocation fairer, and hence, better product costing and pricing.

Overhead costs are so complex in reality that finding a true relationship between every single

overhead cost to the relevant activity maybe difficult enough, and therefore, for many general

overhead costs, we still apply absorption costing principles adopting labour or machine hours to

charge overheads to the products.

ABC in modern manufacturing environment:

Production has become fairly a more complex model as compared to simple manufacturing

environments many years ago. This has been due to following changes over period of time:

1. Improvement in science and technology, bringing better and efficient production methods,

saving time and money.




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2. Reduced reliance on the manual techniques, using automated manufacturing support and

even robotics in manufacturing process. 3. Volume of products has increased many times 4. Number of product lines has increased many folds. 5. Proportion of overhead costs as compared to direct costs has increased considerably.

Due to all above issues, simple absorption costing finds it difficult to truly relate overhead costs

to various products relying only on the number of machine or labour hours etc. ABC has helped

businesses to create a cause and effect relationship, so that overhead costs can be fairly linked

to various product lines.

Example 2 3P3M Ltd

(a)

Total machine hours required for each product

X Y Z

Sales demand 200 200 200

Required machine hours:

Machine 1 (6, 2, 1) 1,200 + 400 + 200 = 1,800 Machine 2 (9, 3, 1.5) 1,800 + 600 + 300 = 2,700 Machine 3 (3, 1, 0.5) 600 + 200 + 100 = 900

Required hours as a percentage of hours available

Machine 1 1800/1600 = 112% Machine 2 2700/1600 = 169%

Machine 3 900/1600 = 56% Machine 2 represents the bottleneck activity because it has the highest machine utilization.

(b) Calculation of return per factory hour

Sales - direct material cost Usage in hours of bottleneck resource X Y Z Sales 20 15 10 Direct materials 8 5 4 Throughput 12 10 6 Usage in hours of bottleneck 9 3 1.5 Return per factory hour 1.333 3.333 4 Cost per factory hour

Total factory cost bottleneck resource hours available




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Total factory cost (labour and overheads)

X Y Z Factory cost per unit (5+2), (3+1),(2+1) = 7 4 3 Units 200 200 200 Total factory cost 1,400 800 600 = 2,800 Cost per factory hour 1.75 1.75 1.75

Cost per factory hour = $2,800/ 1600 = $1.75

Throughput accounting ratio

Return per factory hour

Cost per factory hour

X Y Z Return per factory hour 1.33 3.33 4.00

Cost per factory hour 1.75 1.75 1.75

Throughput accounting ratio 0.76 1.90 2.29

Ranking 3 2 1 (c) The allocation of the 1,600hours of the bottleneck activity is: Production Machine hours balance of hours available 200 units of Z 300 1,300 200 units of Y 600 700 77 units of X 700 - The maximum profits to be generated from the above production plan would be as follows;

Throughput Return: $

200 units of Z x $6 1,200 200 units of Y x $10 2,000 77 units of Xx $12 924

Total Throughput 4,124

Less: Total factory cost 2,800 ($14 x 200 units)

Net profit $1,324 www.studyinteractive .org 171



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Example 3 Fantata Ltd

(a) Target Cost Target selling price 75 Target profit margin @ 12% (9) Target Cost 66

(b)

Expected current cost per unit: $

Direct materials 20 ABC conversion cost

Assembly 20 Finishing 12 Product specific fixed cost 14.17 Company fixed cost 4.17

Total expected current cost per unit 70.34

Cost Gap (70.34 – 66) 4.34 (c) The company is falling considerably short of its 12% net profit margin target. If sales quantities

and prices are to remain unchanged, costs must be reduced if the required return is to be

reached. Cost reduction methods exercise must be concentrated particularly on this product if its

production is to continue to be seen to be worthwhile. The designed specification for each product and the production methods should be examined

for potential areas of cost reduction that will not compromise the quality of the products. For

example: ● Can any materials be eliminated, eg cut down on packing materials? ● Can a cheaper material be substituted without affecting quality? ● Can part assembled components be bought in to save on assembly time? ● Can the incidence of the cost drivers be reduced, in particular for product Y? ● Is there some degree of overlap between the product-related fixed costs that could be

eliminated by combining service departments or resources?




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SOLUTIONS TO EXERCISES AND EXAMPLES Example 4 Aeonplc

(a)

Approach 1

Life-time costs are:

Approach 1 $

Development costs 1,250,000 Clean-up costs 50,000

Variable manufacturing costs 6,250,000 5 x 25 x 50,000

Repairs and warranty costs 125,000

5 x 50,000 x 1% x 50

Total costs 7,675,000

Approach 2 $

Development costs 2,350,000 Clean-up costs 30,000

Variable manufacturing costs 6,000,000 6 x 20 x 50,000

Repairs and warranty costs 45,000

6 x 50,000 x 0.5% x 30

Additional fixed costs 120,000

20,000 x 6

Total costs 8,545,000

Approach 1

Total revenue = 5 x 50,000 x $50 = 12,500,000 Total costs = 7,675,000 Total profit = 4,825,000

Approach 2

Total revenue = 6 x 50,000 x $50 = 15,000,000 Total costs = 8,545,000 Total profit = 6,455,000

Therefore, Approach 2 is preferable as it yields the higher total profits.

(b)

Target cost = 60% x $50 = $30

Approach 1 cost per unit = 7,675,000/(5 x 50,000) = $30.70 Approach

2 cost per unit = 8,545,000/(6 x 50,000) = $28.48

Approach 2 produces product below the target cost, but with Approach 1 there is a cost gap of

$0.70/unit.

This cost gaps could potentially be closed by:

● Reducing the development costs – though there might be adverse knock-on effects in the

variable cost of production or in repair/warranty costs. Development costs would have to

reduce by 0.7 x 5 x 50,000 = $175,000, which is 14% of estimated costs.




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● Reducing the clean up costs – though completely eliminating those would save only

$50,000/(5 x 50,000) = $0.20 per unit. ● Increasing the production run length. The variable costs relate to variable manufacturing

and warranty costs, and these amount to 6,375,000 over 250,000 units = $25.50 per unit.

This leaves a maximum cost of $4.50 per unit for the development costs and clean-up

costs. Therefore, the required production would be: 1,300,000/4.50 = 288,889 units.

If production stayed at 50,000 per year, then a production run of 5.78 years would

achieve the required target cost. ● Reducing the variable production costs per unit by $0.70. For example, by negotiating a

better deal with suppliers or attempting to use less labour on each item.

(c) Life-cycle costing is particularly important in high-technology mass production industries

because: ● Development costs are likely to be substantial – new products are complex. Therefore,

these must not be ignored. ● Once a product is designed then the company will be committed to many future costs and

it is too late to make substantial savings at the production stage. If a product is badly

designed so that it is overly complex and difficult to make, efficient production can do little

to reduce costs. ● The machinery used to make the product is likely to be specialist and so its cost must also

be included. ● High-tech products often have short lives, so it is important to estimate if all costs can be

covered by revenue and to see how a product‟s life might be extended.

Complex production technology can often produce toxic by-products and the disposal of these

must be taken into account.




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CHAPTER 2

Example 1 Central Ltd

The relevant costs are the differential costs between making and buying, and they consist of

differences in unit variable costs plus the differences in directly attributable fixed costs. Sub-

contracting will result in some fixed cost savings.

W X Y Z $ $ $ $ Unit variable cost of making 14 17 7 12 Annual required units 1,000 2,000 4,000 3,000 Total variable cost 14,000 34,000 28,000 36,000 Direct attributable fixed cost 1,000 5,000 6,000 8,000 Relevant cost of making 15,000 39,000 34,000 44,000

W X Y Z Unit Variable cost of buying 12 21 10 14 Annual required units 1,000 2,000 4,000 3,000 Total variable cost of buying 12,000 42,000 40,000 42,000 Attributable Fixed cost of 0 0 0 0 buying

Relevant cost of buying 12,000 42,000 40,000 42,000

Differences in relevant cost 3,000 (3,000) (6,000) 2,000

The company would save $3,000 and $2,000 per annum for buying components W and Z

respectively. Therefore component W and Z should be purchased from the subcontractor and

components X and Y should be produced internally.

Example 2 Jones Ltd

If Division C is shut down as per the CEO‟s concerns, the following would be the financial

impact on the company.

Loss of Sale from closure (40,000) Savings in variable cost 30,000 Fall in contribution (10,000) Saving in Division specific fixed cost 8,000

Fall in divisional / company profits (2,000)

Decision: Division C should not be closed down. www.studyinteractive .org 175



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Example 3 Fantum Ltd Loss of sale from closure (30,000) Saving in variable costs 18,000 Fall in contribution from closure (12,000) Savings in specific fixed cost 10,000 Net loss from closure (2,000) On the basis of this information, Division Y should remain open as it will make a net additional

to profit next year of $2,000. This assumes that the specific fixed costs will be saved if the division closes but there will be no

savings in head office costs – this being a general fixed cost.

Example 4 (a) Neal Ltd Step 1: Calculate the extent of Limiting factor (shortage) Product M 600 units x 8 hours/unit = 4,800 hours Product N 500 units x 3 hours/unit = 1,500 hours Total hours required = 6,300 Hours available = 5,000 Shortage = 1,300 hours That explains that hours at present are not sufficient to fulfil demand for both products so we will

have to develop the optimal production plan using 5,000 hours which maximises the profit.

Step 2: Calculate contribution per unit M N

24 15

Step 3: Calculate contribution per hour 3/hour 5/hour

Ranking 2 1 Step 4: Develop optimal (most profitable) production plan using 5,000 hours Product 1 (N) 500 units x 3 hours per unit = 1,500 hours

Leaving 3,500 remaining hours to be allocated to product 2 (M)

3,500 hours / 8 per unit = 437 units

Step 5: Total contribution from M and N

M 437 unit x 24 per unit 10,488

N 500 units x 15 per unit 7,500

Total contribution 17,988

Less fixed cost 10,000*

Total profit 7,988

*Fixed cost (M =10 x 600 + N = 8 x 500) 176 www.studyinteractive .org



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Example 4 (b) Neal Ltd M N

Variable cost to make 16 15

External purchase price 24 21

Make Make Based on the above comparison both products should be made internally, but due to limited

plant capacity only 437 units can be produced as per 6 (a), therefore in order to fulfil the

demand of M, remaining 163 units will have to be bought in. Revised Contribution

M on first 437 units x 24 per unit 10,488 on the purchased units(163 units x 16 per unit) 2,608

N (as per 6(a)) 7,500 Total contribution 20,596 Less: fixed cost 10,000

Revised Profit 10,596 www.studyinteractive .org 177



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Example 5 WXYZ Ltd Are the materials a limiting factor? W X Y Z

Units 2,000 4,000 3,000 1,000

Materials (kilos) per unit 2 1 1.5 2.5

4,000 4,000 4,500 2,500 = 15,000 Available = 11,000 Shortage = 4,000

Therefore materials are a limiting factor.

W X Y Z $ $ $ $ Variable cost per unit to make 17 7 12 19 Cost of buying 20 11 15.75 21.5 Savings if made internally 3 4 3.75 2.5

Materials per unit 2 1 1.5 2.5 Savings per kilo 1.5 4 2.5 1

Ranking 3rd 1st 2nd 4th The make or buy decision should be as follows, to maximise contribution and profit.

Products Units Materials(Kilos) Contribution/unit Total

contribution

Make $ $

X 4,000 4,000 4 16,000

Y 3,000 4,500 6 18,000

W(balance) 1,250 2,500 12 15,000

11,000 49,000

Buy

W(balance) 750 9 6,750

Z 1,000 9 17,500

Total 73,250

contribution




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Example 6 CF Ltd The joint processing costs are irrelevant to the decision. They will be incurred whether product X

is sold for $1.10 per litre or is processed further to make Zplus. The analysis of relevant cash

flow is as follows: Every 4,000 litres of product X can be further processed to make 3,600 litres of Zplus.

$ $

Revenue from sale of 3,600 litres of Zplus @ $1.4 5,040

Revenue from sale of 4,000 litres of X @ $1.1 4,400

Incremental revenue from further processing 640

Incremental cost of further processing

Added materials 400

Direct labour 40

Variable production overheads 80 520

Incremental gain from further processing 120

This analysis assumes that there would be no additional fixed costs from further processing,

and that no capital expenditure would be required to make further processing possible.

Example7 Beauty Co The formula needed for a multi product break-even point is:

Break-even point = Total fixed costs

Weighted average C/S ratio

Weighted average C/S ratio in this case: Nail polish C/S ratio is 55% and proportion of its sales is 30%, therefore proportionate C/S ratio

would be 55% x 30% =16.5% Lipstick C/S ratio is 60% and proportion of its sales is 70%, therefore proportionate C/S ratio

would be 60% x 70% =42% The combined weighted average C/S ratio, therefore will be: 16.5% + 42%=58.5% Break-even sales = $400,000

------------ 58.5%

$683,761 (to the nearest dollar)




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Example8 CVP Ltd

(a) Budgeted profit: $

Pins 3,000 units x $6/unit = 18,000

Numbs 2,000 units x $3/unit = 6,000

Needles 1,000 units x $1/unit = 1,000

25,000

(b)

Breakeven revenue = Total fixed costs

Weighted average c/s ratio

Total fixed costs = ($2 x 3,000) + ($3 x 2,000) + ($6 x 1,000) = $18,000

Weighted average c/s ratio = $8 3,000 $6 2,000 $7 1,000

$12 3,000 $14 2,000 $9 1,000

= $43,000 / $73,000 = 0.589 or 58.9%

Break even revenue = $18,000 / 58.9%

= $30,560 (rounded)

Margin of safety = Budgeted sales - break even revenue 100

Budgeted sales

= $73,000 - $30,560 / $73,000

= 58.14%

(c) C/S ratios for each product: Pins Numbs Needles $8/$12 $6/$14 $7/$9 66.67% 42.86% 77.78% From the above c/s ratios, Needles has the highest c/s ratio, Pins has the second highest

whereas Numbs with the lowest one. Therefore, the products should be produced in the above

preference to maximise profits and to reach at the break even point more quicker. (d) Workings: Breakeven point with priority production plan:

Total fixed costs: $18,000 Contribution from Needles $7,000 Contribution from Pins required to break even $11,000 Therefore total contribution required to break even using above plan will be calculated as

follows: Revenue from Needles = $9,000

Revenue required from Pins = $11,000/$8 x $12 $16,500 $25,500 180 www.studyinteractive .org



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SOLUTIONS TO EXERCISES AND EXAMPLES Graph:

A




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Example 9 Tricks

Revised estimate: $

Direct materials- paper (opportunity cost) 2,500 Inks(full purchase value) 3,000

Direct Labour: Highly skilled (125 x 4 + 125 x 5) 1,125 Semi skilled (idle capacity) 0

Variable overheads (as per original 1,400 Printing press(200 hours x 3.00) 600 Fixed production costs (not relevant) 0 Estimating department costs (not relevant) 0

Total relevant cost (minimum price) 8,625

Example 10 The optimum productionplan is to make and sell 500 units of X and 700 units of Y. The

maximum contribution is (500 x 4 + 700 x 8) = $7,600. Please see page52 for step-by-step answer.

Example 11 Cantata 1. Define the unknowns:

X = units of product A Y = units of product B

2. Constraints

Machine hours 3x + 10y ≤ 330 Materials 16x + 4y ≤ 400 Labour 6x + 6y ≤ 240 Units of Product B Y ≥ 12

3. Objective function

Maximise Contribution Z = Total contribution Z = 50x + 70y




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SOLUTIONS TO EXERCISES AND EXAMPLES 4. Graph the constraints 5. Optimal production plan is the point where the labour constraint line meets the machine

hours constraint line.

Machine hours 3x + 10y = 330 (multiply by 2)

6x + 20y = 660 Eq1

Labour 6x + 6y = 240 Eq2

So Deducting Eq 2 from Eq 1 we get;

14Y = 420

And y = 420 / 14

Y = 30

By substituting Y into Eq 2 we get

6x + 6 x 30 = 240

And 6x = 240 – 180

X = 60/6

X = 10

Maximum contribution:

50 x 10 + 70 x 30 = 2,600




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CHAPTER 3

Example 1

Phase Introduction Growth Maturity Decline

Profitability Low but will Steady and Profits begin Profits falling

depend on rising profit to fall, and may fall

pricing levels boosted by faster if

strategy. product decommissioning

relaunched of product

with necessary

variations on

the original eg

different

colours

Cashflow Steadily Accelerating Cash „cow‟ Cashflow falling

increasing to max point accelerated by

need to cover

fixed costs until

they step as

product sales

fall.

Strategy Price Launch to Product Deliberate

Skimming – different relaunch replacement of

profit level geographic market drive product

occurs faster. areas, variety to hold sales

Price

of sizes levels

versions to

Penetration –

boost sales

if successful

volumes

causes profit

faster

Example 2

Intel, Unilever, and Procter and Gamble.

Example 3

BMW, Bentleys.

Example 4

Supermarket economy range, Lidl, 99p shops.




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Example 5 Biscan 25 = a – (b x 500)

b = 5/200 = 0.025

25 = a – (0.025 x 500)

A = 37.50

So: P = 37.50 – 025Q

Example 6 Mellor

(a) 12.50 = a – (b x 20,000)

b = 1.50/(20,000 x 20%) = 0.000375

12.50 = a – (0.000375 x 20000)

a = 20

So:

P = 20 – 0.000375Q (b) P x Q =

If price = $12.50

12.50 x 20,000 = $250,000 If

price = $11

11.00x(20,000 x 1.2) = $264,000

Based on the revenue figures price of $11 is better than $12.50.

Example 7 % change Q % change P

Annual demand at $1.20 = 800,000 units Annual demand at $1.30=725,000 units 75,000

100

800,000

Elasticity of demand = -1.125

0.10 100

1.20

Ignoring the negative sign, the elasticity of demand is 1.125. The demand will therefore be elastic, because the price elasticity of demand is greater than 1.




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Example 8 (a) Demand Curve (function)

P = a – bQ (given in formulae sheet)

First we need to calculate b = change in price / change in quantity 10-8 /

1,000 – 1,500

= 2/500 = 0.004

Now substitute any price and demand pair given in the question

$10 = a – 0.004 x 1,000

a = 20

So P = 20 – 0.004Q

(b) Now we equate MC = MR (MR = a – 2bQ) given in formulae sheet

5 = 20 – 2 x 0.004 Q

Q= 1,875

Substituting Q in demand function above

P = a – bQ P = 20 – 0.004 x 1,875

And P = 12.50




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CHAPTER 4

Example 1 Won Ltd

TABLE IN $ DECIDE $4 $4.30 $4.40

To price

OUTCOME

Sales volume

Best *1 32,000 *3 32,200 30,000

Most likely *2 28,000 28,750 28,800

Worst 20,000 18,400 14,400

Fixed costs ignored and can make decision on contribution. Alternatively decision can be made

based on the revenue figures, but in most exams, the requirement is based on a payoff table

with possible profit or contribution values.

$4 $4.30 $4.40

Contribution 2 2.30 2.40 per unit if VC

$2

*1 – 16,000 x 2 =32,000

*2 – 14,000 x 2 = 28,000

*3 – 14,000 x 2.30 = 32,200

Example 2 3D Ltd

Monthly profit x Probability p EV = px

50,000 0.6 30,000

35,000 0.4 14,000

∑44,000

EV monthly profit is £44,000 www.studyinteractive .org 187



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Example 3 For Ltd

Sale (x) Prob (p) EV = (px)

20,000 0.25 5,000

25,000 0.4 10,000

30,000 .15 4,500

35,000 .2 7,000

∑26,500

EVof sales is £26,500.




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SOLUTIONS TO EXERCISES AND EXAMPLES Example 4 MrFyvestall

(a) Payoff Table

Workings – Probability of demand

Number of Days Probability

45 45/150 = 0.3

75 75/150 = 0.5

30 30/150 = 0.2

Total 150

TABLE IN $ DECIDE 10 20 30

To Buy

PROBABLE COLUMN FOR

OUTCOME PROBABILITY

Demand

10 *1 200 *420 (160)

20 *2 200 *5 400 220

30 *3 200 *6 400 600

*1 - Buy 10 sell 10,

10 x (40-20) = 100

*2,*3 - only bought 10 so maximum

*4– Buy 20 only sell 10 and scrap 10

Income (10 x $40) + (10 x $2) = 420 Costs (20 x $20) (400)

£20

*5, *6

Income (20 x $40) = 800 Costs (20 x $20) = (400)

$400 www.studyinteractive .org 189



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Add probability:


To Buy

PROBABLE COLUMN FOR

OUTCOME PROBABILITY

Demand

10 0.3 200 20 (160)

20 0.5 200 400 220

30 0.2 200 400 600

Expected 200 286 182

Values

(b) (i)

0.3 x 200 200

0,5 x 200 200

0.2 x 200 200

∑200

0.3 x 20 6

0,5 x 400 600

0.2 x 200 80

∑286

0.3 x (160) (48)

0,5 x 220 110

0.2 x 600 120

∑182

(c)

EV = $286per day so buy 20

(b) (ii)

Maximin buy 10,Maximax buy 30




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(b) (iii) Minimax Regret


To Buy

PROBABLE

OUTCOME

Demand

10 0 180 360

20 200 0 180

30 400 200 0

Max 400 200 360

Minimax regret buy 20

Value of perfect information:

With perfect information gained from the research associate, following decisions will be made:

To buy 10 and sell 10, expected value = $200 x 0.3 = 60



Total expected value with information = $380

Without perfect information, expected value = $286

Value of perfect information = $94

Example5 VI Ltd

(a) Sales fall by 200/4,000 x 100

Costs rise by 200/3,800 x 100

(b) Materials rise by 200/2,000 x 100

Labour rise by 200/1,000 x 100

Fixed costs rise by 200/800 x 100 Sales need to fall by least % so is most sensitive.

= 5% = 5.3% = 10% = 20% = 25%




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Example 6 Seven Trees Ltd Step 1: Draw the tree from left to right showing appropriate decisions and events/outcomes.

Symbols to use:

A square is used to represent a Decision point. At a decision point the

decision maker has a choice of which course of action he wishes to

undertake.

A circle is used at a chance Outcome point. The branches from here

are always subject to probabilities.

Label the tree and relevant cash inflows/outflows (discounted to present values)

and probabilities associated with outcomes. Step 2: Evaluate the tree from right to left carrying out these two actions:

1. Calculate an EV at each Outcome Point.

2. Choose the best option at each Decision Point. Step

3: Recommend a course of action to management.

3 (0.4)

4 (0.3)

2 (0.75)

1 5 (0.3)

6 (0.25)

7

1. Develop product 2. Development succeeds 3. Very successful 4. Moderately successful 5. Failure 6. Development fails 7. Do not develop the product




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Calculation of EV of each outcome:

Decision Outcome Outcome Profits EV

Develop successful very successful

product

0.75x 0.4=0.3 x $540,000 = $162,000

Develop successful moderately succ profits EV

product

0.75x 0.3=0.225 x $100,000 = $22,500

Develop successful Failure loss EV

product

0.75x 0.3= 0.225 x ($400,000) = ($90,000)

Develop Development loss EV

product fails

0.25 ($180,000) ($45,000)

Overall result $49,500

Do not Develop product EV 0

Thus, based on expected values developed from the decision tree, the company should develop

the product as it is giving a positive sum of profits.




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CHAPTER 6

Example 1 Ogrisovic

Based on traditional analysis, the company has overspent $2,500 (difference between budgeted

cost and actual cost), whereas we will have to use flexible budgeting style to analyse

information further into variable and fixed components for a fair conclusion.

Flexed variable cost for 1,200 units ($10 per unit x 1,200 units) $12,000

Flexed fixed cost for 1,200 units $10,000

Total flexed costs $22,000

Actual costs for the period $22,500

There is still an adverse variance of $500 but it is better than original analysis where results

were $2,500 adverse and it could have led to a de-motivational situation for the concerned

managers.

Example 2 ABC Ltd

Total cost Unit produced

44,400 9,800

38,100 7,700

Difference 6,300 2,100

Variable cost per unit 6,300

= $3

2,100

The fixed and flexible budget can be prepared as:

Fixed budget Flexible budget Flexible budget 9,000 unit 8,000 unit 10,000 unit

sales ($5) 45,000 40,000 50,000 variable cost ($3) 27,000 24,000 30,000 Contribution 18,000 16,000 20,000 fixed cost 15,000 5,000 15,000 Profit 3,000 1,000 5,000 194 www.studyinteractive .org



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Example 3

(a) Flexible budget Operating statement flexed at actual units of 720,000 Flexed Budget Actual Variance $000 $000 $000

Cost of sales: (all variable) Materials 189 144 45 F Labour 270 288 18 A Overheads 36 36 0

Variable S&D costs 162 153 9 F Variable admin costs 54 54 0

Total variable costs 711 675 36 F

Fixed costs: Labour 100 94 6 F Selling & Distribution 72 83 11 A Administration 184 176 8 F

Total fixed costs 356 353 3 F

Sales 1,152 1,071 81 A Contribution 441 396 45 A Net Profit 85 43 42 A (b) The original operating statement was prepared on the basis of fixed budgeting basis, and is of

little use to management due to following reasons: 1. Out of date budgeted figures were compared with actual results – which were a year

later. 2. Market fluctuations were not considered and updated into the original budget in order to

give better ideas to management, thus providing less meaningful variance analysis.

3. The original budgeted statement was produced on the basis of original budgeted output,

whereas actual results were drafted on actual output achieved – which was significantly

different from the budget. 4. Variable costs should have been flexed on the basis of actual output to provide

reasonable comparison. For example,the material costs original budget was produced on

the basis of 640,000 units whereas 720,000 units were actually produced: therefore the

flexed costs for materials should have been calculated to compare with actual material

costs – thus providing more meaningful variance.

5. The original statement was misleading in terms of providing more meaningful feedback

for various operations. It therefore might de-motivate some managers since their

performance would be monitored on wrong basis.




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(c) (i) The following are the main problems associated with forecasting of figures used in flexible

budgeting: 1. Accurate identification of different cost behaviours, in their variable and fixed

components, may be complicated in complex manufacturing environments. 2. Determination of linear relationship of variable costs based on their activity levels such as

output. Some costs may directly depend on volume of units and some costs may depend

on other factors like labour hours, machine hours. 3. Accurate understanding of activity levels (cost drivers) affecting various costs may be

difficult to determine. 4. Use of different forecasting models may produce different results which may create a

misleading effect. 5. Cost bases used in original budgets may be different as to the flexible budgets due to

change in cost behaviours and market patterns. Furthermore, they maybe significantly

different from actual spending patterns. 6. Currency fluctuations and inflation adjustment can be complicated to be incorporated on

exact and accurate basis.

(c) (ii)

Using High Low method

Variable cost per unit $4,000 / 120,000 units = $0.0333 per unit

Fixed cost will be = $10,667

Flexed budget for 720,000 units (720,000 x $.0333) + $10,667 = $34,667




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CHAPTER 7

Example 1

First of all we need to apply High-Low method to separate variable and fixed elements in the

total sales, to see how much of revenue depends on marketing spend and how much is

independent.

Step 1: Pick up Highest and Lowest pairs of data:

Marketing Spend ($000) Sales ($000)

High 120 1,200

Low 40 680

Difference 80 520

Step2: Establish variable sales dependent on the marketing spend: $520 $80

= 6.5 (it means that every $ spent on marketing generates $6.50 of sales)

Step 3: Calculate fixed (independent) sales by Substituting 6.5 into either of high or low

activities:

Fixed sales = $1,200 – (6.5 x 120)

= $420 or $420,000

(i) When marketing spend is $100,00, total sales expected to be generated:

= $420,000 + (6.5 x 100,000)

= $1,070,000

(ii) When marketing spend is $250,000, total sales to be generated:

= $420,000 + (6.5 x 250,000)

= $2,045,000

Example 2

Cumulative

Average Cum Incremental

Incremental

time per

total

units

units total time

unit

time

1 unit 100 100 1 100

2 units 80 160 2nd 60

4 units 64 256 3rd

and 4th

96

8 units 51.2 409.6 5th to 8th 153.60




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SOLUTIONS TO EXERCISES AND EXAMPLES Example 3

2nd

= 60 hours 3

rd and 4

th – can‟t do using this as you can get time of next 2 so 2 take 96 hours but not actual

time of 3rd

and 4th




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SOLUTIONS TO EXERCISES AND EXAMPLES Example 4 Limitationplc (a) Time for second batch, sum of third and fourth together

Cumulative Average Cum

Incremental

Incremental

time per

total

units

units total time

unit

time

1 unit 120 120 1 120

2 units 108 216 2nd 96

4 units 97.2 388.8 3rd

and 4th

172.8

(b)

Quarter 1 Quarter2

$ $

Sales ($1,200 per batch) 54,000 54,000

Variable costs:

Material

Labour *1 12,610 11,432

Variable Overheads (150% labour) 18,915 17,148

Total variable costs 31,525 28,580

CONTRIBUTION 22,475 25,420

*1 Cumulative total to end Q1 = 75 batches

75 batches – first 30 batches in Q4 = Q1 45 batches For 75 in total (y = ax

b) x 75 = (120 (75

-0.152)) x 75 = 62.25 x 75 =

4,668.75hours (note 62.25 hours was given too) For first 30 in total = (120 (30

-0.152)) x 30 = 71.56 x 30 = 2,146.8hours (note 71.56

hours was given too)

4,668.75hours (2,146.8hours) 2,521.95 hours @$5 = £12,610

Cumulative total to end Q2 = 120 batches 120 batches – first 70 batches in Q4 and Q1 For 120 in total = (120 (120

-0.152)) x 120 = 57.96 x 120 = 6,955.2hours

(note 57.96 hours was given too) For 75 in total (y = ax

b) x 75 = (120 (75

-0.15 )) x 75 = 62.25 x 75 =

4,668.75hours (note 62.25 hours was given too)

6,955.2hours (4,668.75hours) 2,286.45 hours @$5 = £11,432.25




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(c)

Cumulative total to end Q3 = 132 batches 132 batches – first 120 batches in Q4, Q1and Q2 For 132 in total (y = ax

b) x 132 = (120 (132

-0.152)) x 132 = 57.13x 132 =

7,541hours For 120 in total = (120 (120

-0.152)) x 120 = 57.96 x 120 = 6,955.2hours (note 57.96

hours was given too)

7,541.16 hours

(6,955.2hours) @$5 = $2,929.80 are the labour costs

585.96 hours

And variable overhead would be = $4,394.70

Example 5 BG b = log 0.8/log 2 = -0.3219

Total time of 4

(22 (4-0.3219

)) x 4 = 14.08 x 4 = 56.32 minutes

Total time of 3

(22 (3-0.3219

)) x 3 = 15.45 x 3 = 46.34 minutes

Time of 4th

9.98 minutes Example 6 Martina Ltd

Direct Material ($4,000 x 8) $32,000 Direct Labour average *1 $2,458 Fixed cost $6,400 Total for 8 $40,858 Average per unit $40,858/8 = $5,107 *1 b

= log 0.8/log 2 = -0.3219 Time to make 8 = (80 x (8

-0.3219)) x 8 = 40.96 hours x 8 = 327.7 hours x $7.50 = $2,458




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CHAPTER 8

Example 1 Owen Ltd

Direct Materials:

Total Variance = Standard material cost for actual output – actual material cost

($20 x 1,300) – $22,700 = $3,300 F

Price Variance = (SP – AP) x AQ

($5 – 4.54) x 5,000 = 2,300 F

Usage Variance = (SQ – AQ) x SP

(5,200kg – 5,000kg) x $5 = $1,000 F

Direct Labour Variances:

Total Variance = Standard labour cost for actual output - actual labour

cost

($16 x 1300) - $21,500 = $700 A

Rate variance = (SR – AR) x AH paid for

(£8 - $7.543) x 2850 = $1,300 F

Efficiency variance = (SH – AH) x SR

(2,600 – 2,850) x $8 = $2,000 A

Variable overheads variances:

Total variance = Standard variable overheads cost for actual output -

actual cost

($7 x 1,300) - $7,800 =$1,300 F

Expenditure variance = (SR – AR) x AH

($3.50 - $2.736) x 2850 = $2,175 F

Efficiency Variance = (SH – AH) x SR

(2,600 – 2,850) x $3.50 =$875 A

Fixed Overheads variances:

Total variance = Standard fixed overheads cost for actual output - actual cost

($14 x 1,300) – $14,600 = $3,600 F

Expenditure Variance = Budgeted fixed cost – actual fixed cost

($14 x 1,000) – $14,600 = $600 A

Volume Variance = (BV – AV) x OAR

(1,000 – 1,300) x $14 = $4,200 F www.studyinteractive .org 201



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Sales variances:

Price variance = (SP – AP) actual units sold

($70 x 1,250) – 85,000 = $2,500 A

Volume Variance = (SV – AV) x Standard profit per unit

(1,000 – 1,250) x $13 = $3,250 F 202 www.studyinteractive .org



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CHAPTER 9

Example 1 Liddell

(a)

Material Price $

Should pay 20,000

(4,000kg x 5)

Did pay 25,000

5,000

Adv

Purchasing manager has done a bad job as it is adverse.

(b)

Planning $

Initial standards 20,000

(4,000kg x 5)

Revised standards 30,000

4,000 x ($5 +50%)

10,000

Adv

Standards were incorrect.




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Operations $

Revised standards 30,000

4,000 x ($5 +50%)

Did Pay 25,000

5,000

Fav

Purchasing manager did a good job.

Example 2

Material Price $

Should pay 190,000

(38,000kg x 5)

Did pay 195,500

$5,500

Adv

Purchasing manager has done a bad job as it is adverse

Material Use Kg $

Should use 37,500

(12,500 x 3)

Did use 38,000

500

x $5 2,500

Adv

Production manager has done a bad job.




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Example 2 (contd)

Planning $

Initial budget flexed 187,500

(12,500 x 3 x 5)

Revised budget flexed 199,562.50

(12,500 x 3.1 x 5.15)

12,062.50

Adv

Standards were incorrect.

Planning - use kg $

Initial budget flexed 37,500

Should use

(12,500 x 3)

Revised budget flexed 38,750

Now will use

(12,500 x 3.1)

1,250

X $5 6,250

Adv

Standards were incorrect for use.




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SOLUTIONS TO EXERCISES AND EXAMPLES Planning - price Initial budget flexed

Should pay (12,500 x

3.1 x 5) Revised budget flexed

Now will pay (12,500 x 3.1 x 5.15)

Standards were incorrect for price.

$

193,750 199,562.50

5,812.50

Adv

Operations $

Material Price

Should pay Revised 195,700

standards

38,000 x 5.15

Did Pay 195,500

200

Fav

Purchasing manager did a good job.




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Operations $

Material Use Kg

Should use Revised 38,750

standards

(12,500 x 3.1)

Did use 38,000

750

x $5.15 3,862.50

Adv

Production manager has done a good job. www.studyinteractive .org 207



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Example 3 Dalglish

PRICE

SHOULD PAY DID PAY VARIANCE

$

A 13,200 13,860 660 ADV

B 6,300 6,720 420 ADV

C 6,500 6,110 390 ADV

26,000 26,690 690 ADV

MIX

SHOULD MIX DID MIX DIFFERENCE STANDARD VARIANCE

KG KG KG COST $ $

A 700 660 40 20 800 FAV 70

%

B 200 210 (10) 30 300 ADV 20

%

C 100 130 (30) 50 1,500 ADV 10

%

1,000 1,000 0 1,000 ADV




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YIELD – IN TOTAL

UNITS

ACTUAL INPUT SHOULD YIELD 900

(1,000 X 90%)

DID YIELD 855

45

X STANDARD COST INCLUDING LOSS

GROSSED UP

20 X 70% = 14

30 X 20% = 6

50 X 10% = 5

25/0.9 = $27.77 $1,250 ADV

Example 4

Sales mix variance:

Budgeted contribution per unit x (actual sales at actual mix – actual sales at budgeted

mix)

Budgeted sales mix = 800 units + 1,200 units = 2,000 units

= 2:3

Therefore budgeted mix for actual sales of A should be: = (500

+ 1,500) x 2/5 = 800 units;

and budgeted mix for actual sales of B should be: = (500

+ 1,500) x 3/5 = 1,200 units;

but actual sales were 500 units of A and 1,500 units of B;

so the sales mix variance will be:

A $5 x (800 – 500) = $1,500 A

B $8 x (1,500 – 1,200) = $2,400 F

Total sales mix variance = $900 F www.studyinteractive .org 209



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Example 5 Sales Quantity variance:

Budgeted contribution per unit x (Standard sales at budgeted mix – Actual sales at

budgeted mix) Budgeted sales 10,000 units, so the standard mix of these budgeted sales will be: A 10,000 x 2/5 = 4,000 units

B 10,000 x 3/5 = 6,000 units.

Actual sales 13,000 units, the actual sales at budgeted mix will be:

A 13,000 x 2/5 = 5,200 units

B 13,000 x 3/5 = 7,800 units. Sales quantity variance:

A $2.50 x (4,000 – 5,200) = $3,000 F

B $4.50 x (6,000 – 7,800) = $8,100 F

Total sales quantity variance = $11,100 F

Example 6

Sales price variance: ($9 - $10) x 240,000 units = $240,000 adverse

Sales volume: (240,000 – 250,000) x $6 = $60,000 adverse

Original budgeted volume 250,000 units x $6 = $1,500,000

Market size variance $150,000 adverse

Revised budgeted volume 225,000 x $6 = $1,350,000

Market share variance $90,000 favourable

Actual sales volume 240,000 x $6 = $1,440,000 210 www.studyinteractive .org



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CHAPTER 10

Example 1 Tata

(a)

YEAR 1 2 3 4

Profit 0.35 0.35 0.35 0.35

(1.4-1.05)

Asset 3.15 2.1 1.05 0

Cost-

accumulated

depreciation

ROI 11.11% 16.67% 33.33% ∞

(b)

YEAR 1 2 3 4

Profit 0.35 0.35 0.35 0.35

(1.4-1.05)

Imputed 0.315 0.21 0.105 0 interest

Cost-

accumulated

depreciation x

cost of capital

RI 0.035 0.14 0.245 0.35

Example 2

(a)

ROI

X = $2 m / $10 m = 20% Y = $3m / $30m = 10%

(b)

RI = NOPAT – internal cost of capital

X $2m - $1.5m = $0.5m

Y $3m - $4.5m = -$1.5m

Hence division A has performed better currently on both yardsticks.




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SOLUTIONS TO EXERCISES AND EXAMPLES Example 3 X ROI = $80,000/$500,000 = 16% RI = $80,000 - $75,000 = $5,000

Y ROI = $120,000/$1,000,000 = 12% RI = $120,000 - $150,000 = -$30,000 (a) X would accept the project on the basis of both measures. Y can accept the project on

the basis of ROI as it is higher than current one, but overall they would resist as it still not

meeting the requirements of the head office. (b) Head office should go for both projects. Clearly X is acceptable. But Y can also be

accepted on the basis of ROI as it will improve the results, and may motivate the

managers of Y in the long run.




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CHAPTER 11

Example 1

Variable cost $5

Fixed costs ($40,000 / 20,000 units) $2

Total cost per unit for Division A $7

As there is no external market price, therefore the ideal transfer price should be based on cost

based approach ($7) with or without any profit margins depending upon policy of the division /

organisation.

Example 2

We have to see here that the division has extra capacity to produce and sell 2,000 units to the

buying division, therefore the selling division will not have to incur any additional fixed costs for

this manufacture, but also have to note a point that the division has an external market for this

product.

So the ideal transfer may range from the variable costs per unit to the external selling price.

Transfer price ranges $15 ------ $30

Example 3

There is a perfect external market for the product Sigma, therefore external market price ($30)

should be an ideal price for the selling division to maximise its profitability and hence its

performance.

Example 4

In this situation selling division can deduct selling cost from the external selling price to revise its

internal transfer price for the buying division and it could be reduced to $26. But as the buying

division cannot afford to pay more than $25, therefore it might be restricted to $25.




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ACCA STUDY GUIDE

and INDEX




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ACCA STUDY GUIDE AND INDEX

ACCA STUDY GUIDE

Can I rely on these Class Notes to cover the syllabus?

The answer is YES!

Each chapter begins with ACCA‟s STUDY GUIDE.

To quote ACCA:

This is the main document that students, tuition providers and publishers should

use as the basis of their studies, instruction and materials. Examinations will be

based on the detail of the study guide which comprehensively identifies what could

be examined in any examination sitting. The study guide is a precise reflection and

breakdown of the syllabus.

Below I have set out ACCA‟s Study Guide in detail for you. To help you even more, I have also

cross-referenced the individual items to the relevant chapters in your Notes.

A Specialist cost and management accounting techniques

1. Activity based costing chapter 1

a) Identify appropriate cost drivers under ABC.

b) Calculate costs per driver and per unit using ABC.

c) Compare ABC and traditional methods of overhead absorption based on production units,

labour hours or machine hours.

2. Target costing chapter 1

a) Derive a target cost in manufacturing and service industries.

b) Explain the difficulties of using target costing in service industries.

c) Suggest how a target cost gap might be closed.

3. Life-cycle costing chapter 1

a) Identify the costs involved at different stages of the life-cycle.

b) Derive a life cycle cost in manufacturing and service industries.

c) Identify the benefits of life cycle costing.

4. Throughput accounting chapter 1

a) Calculate and interpret a throughput accounting ratio (TPAR).

b) Suggest how a TPAR could be improved.

c) Apply throughput accounting to a multi-product decision-making problem.




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5. Environmental accounting chapter 1

a) Discuss the issues business face in the management of environmental costs.

b) Describe the different methods a business may use to account for its environmental costs.


1. Relevant cost analysis chapter 2

a) Explain the concept of relevant costing.

b) Identify and calculate relevant costs for a specific decision situations from given data.

c) Explain and apply the concept of opportunity costs.

2. Cost volume profit analysis chapter 2

a) Explain the nature of CVP analysis.

b) Calculate and interpret breakeven point and margin of safety.

c) Calculate the contribution to sales ratio, in single and multi-product situations, and

demonstrate an understanding of its use.

d) Calculate target profit or revenue in single and multi-product situations, and demonstrate

an understanding of its use.

e) Prepare breakeven charts and profit volume charts and interpret the information

contained within each, including multi-product situations.

f) Discuss the limitations of CVP analysis for planning and decision making.

3. Limiting factors chapter 2

a) Identify limiting factors in a scarce resource situation and select an appropriate technique.

b) Determine the optimal production plan where an organisation is restricted by a single

limiting factor, including within the context of „make‟ or „buy‟ decisions.

c) Formulate and solve multiple scarce resource problem both graphically and using

simultaneous equations as appropriate.

d) Explain and calculate shadow prices (dual prices) and discuss their implications on

decision-making and performance management.

e) Calculate slack and explain the implications of the existence of slack for decision-making

and performance management. (Excluding simplex and sensitivity to changes in objective

functions.)

4. Pricing decision chapter 3

a) Explain the factors that influence the pricing of a product or service.

b) Explain the price elasticity of demand.

c) Derive and manipulate a straight line demand equation. Derive an equation for the total

cost function (including volume-based discounts).




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d) Calculate the optimum selling price and quantity for an organisation, equating marginal

cost and marginal revenue. e) Evaluate a decision to increase production and sales levels, considering incremental

costs, incremental revenues and other factors. f) Determine prices and output levels for profit maximisation using the demand based

approach to pricing (both tabular and algebraic methods). g) Explain different price strategies, including:

i) All forms of cost-plus

ii) Skimming

iii) Penetration

iv) Complementary product

v) Product-line

vi) Volume discounting

vii) Discrimination

viii) Relevant cost h) Calculate a price from a given strategy using cost-plus and relevant cost.

5. Make-or-buy and other short-term decisions chapter 2 a) Explain the issues surrounding make vs. buy and outsourcing decisions. b) Calculate and compare „make‟ costs with „buy-in‟ costs. c) Compare in-house costs and outsource costs of completing tasks and consider other

issues surrounding this decision. d) Apply relevant costing principles in situations involving shut down, one-off contracts and

the further processing of joint products.

6. Dealing with risk and uncertainty in decision-making

chapter 4 a) Suggest research techniques to reduce uncertainty eg Focus groups, market research.

b) Explain the use of simulation, expected values and sensitivity. c) Apply expected values and sensitivity to decision-making problems. d) Apply the techniques of maximax, maximin, and minimax regret to decision-making

problems including the production of profit tables. e) Draw a decision tree and use it to solve a multi-stage decision problem. f) Calculate the value of perfect and imperfect information.




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C Budgeting

1. Budgetary systems chapter 5

a) Explain how budgetary systems fit within the performance hierarchy.

b) Select and explain appropriate budgetary systems for an organisation, including top-

down, bottom-up, rolling, zero-base, activity-base, incremental and feed-forward control.

c) Describe the information used in budget systems and the sources of the information

needed.

d) Explain the difficulties of changing a budgetary system.

e) Explain how budget systems can deal with uncertainty in the environment.

2. Types of budget chapters 5& 6

a) Prepare rolling budgets and activity based budgets.

b) Indicate the usefulness and problems with different budget types (including fixed, flexible,

zero-based, activity- based, incremental, rolling, top-down, bottom up, master, functional).

c) Explain the difficulties of changing the type of budget used.

3. Quantitative analysis in budgeting chapter 7

a) Analyse fixed and variable cost elements from total cost data using high/low methods.

b) Estimate the learning effect and apply the learning curve to a budgetary problem,

including calculations on steady states.

c) Discuss the reservations with the learning curve.

d) Apply expected values and explain the problems and benefits.

e) Explain the benefits and dangers inherent in using spreadsheets in budgeting.

4. Behavioural aspects of budgeting chapter 6

a) Identify the factors which influence behaviour.

b) Discuss the issues surrounding setting the difficulty level for a budget.

c) Explain the benefits and difficulties of the participation of employees in the negotiation of

targets.




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1. Budgeting and standard costing chapter 8

a) Explain the use of standard costs.

b) Outline the methods used to derive standard costs and discuss the different types of cost

possible.

c) Explain the importance of flexing budgets in performance management.

d) Explain and apply the principle of controllability in the performance management system.

2. Material mix and yield variances chapter 9

a) Calculate, identify the cause of, and explain material mix and yield variances.

b) Explain the wider issues involved in changing material eg cost, quality and performance

measurement issues.

c) Identify and explain the relationship of the material price variance with the material mix

and yield variances.

d) Suggest and justify alternative methods of controlling production processes.

3. Sales mix and quantity variances chapter 9

a) Calculate, identify the cause of, and explain sales mix and quantity variances.

b) Identify and explain the relationship of the sales volume variances with the sales mix and

quantity variances.

4. Planning and operational variances chapter 9

a) Calculate a revised budget.

b) Identify and explain those factors that could and could not be allowed to revise an original

budget.

c) Calculate planning and operational variances for sales, including market size and market

share, materials and labour.

d) Explain and discuss the manipulation issues involved in revising budgets.

5. Behavioural aspects of standard costing chapter 9

a) Describe the dysfunctional nature of some variances in the modern environment of JIT

and TQM.

b) Discuss the behavioural problems resulting from using standard costs in rapidly changing

environments.

c) Discuss the effect that variances have on staff motivation and action.




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1. The scope of performance measurement chapter 10

a) Identify the accounting informationrequirements and describe the different types of

information systems used for strategic planning, management control and operational

control and decision-making.

b) Define and identify the main characteristics of transaction processing systems;

management information systems; executive information systems; and enterprise

resource planning systems.

c) Define and discuss the merits of, and potential problems with, open and closed systems

with regard to the needs of performance management.

2. Sources of management information chapter 10

a) Identify the principal internal and external sources of management accounting

information.

b) Demonstrate how these principal sources of management information might be used for

control purposes.

c) Identify and discuss the direct data capture and process costs of management accounting

information.

d) Identify and discuss the indirect costs of producing information.

e) Discuss the limitations of using externally generated information.

3. Management reports chapter 10

a) Discuss the principal controls required in generating and distributing internal information.

b) Discuss the procedures that may be necessary to ensure security of highly confidential

information that is not for external consumption.

4. The scope of performance measurement chapter 10

a) Describe, calculate and interpret financial performance indicators (FPIs) for profitability,

liquidity and risk in both manufacturing and service businesses. Suggest methods to

improve these measures.

b) Describe, calculate and interpret non-financial performance indicators (NFPIs) and

suggest method to improve the performance indicated.

c) Explain the causes and problems created by short-termism and financial manipulation of

results and suggest methods to encourage a long term view.

d) Explain and interpret the Balanced Scorecard, and the Building Block model proposed by

Fitzgerald and Moon.

e) Discuss the difficulties of target setting in qualitative areas. www.studyinteractive .org 221



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5. Divisional performance and transfer pricing chapter 11 a) Explain and illustrate the basis for setting a transfer price using variable cost, full cost and

the principles behind allowing for intermediate markets. b) Explain how transfer prices can distort the performance assessment of divisions and

decisions made. c) Explain the meaning of, and calculate, Return on Investment (ROI) and Residual Income

(RI), and discuss their shortcomings. d) Compare divisional performance and recognise the problems of doing so.

6. Performance analysis in not for profit organisations and the public sector chapter 10

a) Comment on the problems of having non-quantifiable objectives in performance

management. b) Explain how performance could be measured in this sector. c) Comment on the problems of having multiple objectives in this sector. d) Outline Value for Money (VFM) as a public sector objective.

7. External considerations and behavioural aspects chapter 10 a) Explain the need to allow for external considerations in performance management,

including stakeholders, market conditions and allowance for competitors.

b) Suggest ways in which external considerations could be allowed for in performance

management. c) Interpret performance in the light of external considerations. d) Identify and explain the behaviour aspects of performance management.




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