ABSORPTION COSTING

Note the process of allocating, apportioning and reapportioning indirect

costs to cost centres and ultimately production centres.

Under-/over-absorbed overhead occurs when overheads incurred do not equal

overheads absorbed.

The rate of overhead absorption is based on estimates (of both numerator and
denominator) and it is quite likely that either one or both of the estimates will
not agree with what actually occurs.
 Over absorption means that the overheads charged to the cost of sales are
greater than the overheads actually incurred.
 Under absorption means that insufficient overheads have been included in the
cost of sales.

The reasons for under-/over-absorbed overhead

The overhead absorption rate is predetermined from budget estimates of
overhead cost and activity level.
Under or over recovery of overhead will occur in the following circumstances.
 Actual overhead costs are different from budgeted overheads.
 The actual activity level is different from the budgeted activity level.
 Actual overhead costs and actual activity level differ from those budgeted.
4.3.2 Accounting for under-/over absorbed overheads
If overheads are under-absorbed, the cost of units sold will have been
understated and therefore the under-absorption is charged to the income
statement for the period. It is not usually considered necessary to adjust
individual unit costs and therefore inventory values are not altered. Any over-
absorption is credited to the income statement for the period.

4.3.3 The problems caused by under-/over-absorption of overheads

If under-absorption occurs, product prices may have been set too low as
managers have been working with unit rates for overheads that are too low. This
could have a significant impact on profit levels. If overhead rates have been
unnecessarily high (over-absorption), it is likely that prices have been set too
high which could significantly reduce sales of the product.

Two Costing Systems

Absorption costing
$$
Sales X
Opening inventory (at full cost) X
Full production cost X
Less closing inventory (at full cost) X
Cost of sales X
Under-/over-absorbed overhead X
Total cost X
Gross profit X
Less non-manufacturing costs X
Net profit X

Marginal costing
$$
Sales X
Opening inventory (at variable cost) X
Production cost (variable costs) X
Less closing inventory (at variable cost) X
Cost of sales X
Contribution X
Less fixed production costs X
Gross profit X
Less non-manufacturing fixed costs X
Net profit

ANALYZING AND MANAGING COSTS

1.2 Cost analysis in the modern business environment

Most costs can be analysed between the following.
(a) Short-term variable costs, that vary with the volume of production
(b) Long-term variable costs, that are fixed in the short term and do not vary
with the volume of
production, but that do vary with a different measure of activity
It has been suggested that long-term variable costs are related to the complexity
and diversity of
production rather than to simple volume of output. For example, costs for
support services such as setups,
handling of inventory, expediting (progress chasing) and scheduling do not
increase with the volume of output. They are fixed in the shorter term but they
vary in the longer term according to the range and complexity of product items
manufactured.

The problem of producing a small number of products in volume against

producing a large variety of products in small runs is known as volume versus
variety and can be expressed graphically.

Activity based costing (ABC)

Activity based costing (ABC) has been developed as an alternative costing

system to traditional overhead absorption costing.

ACTIVITY BASED COSTING (ABC) is 'An approach to the costing and monitoring of
activities which involves tracing resource consumption and costing final outputs.
Resources are assigned to activities and activities to cost objects based on
consumption estimates. The latter use cost drivers to attach activity costs to
outputs'.

ABC traces the appropriate amount of input to each product. However, it is

important to realise that although ABC should be a more accurate way of relating
overheads to products, it is not a perfect system and product costs could still be
inaccurate, as ABC is based on a number of assumptions.

The merits and criticisms of activity based costing

(a) ABC recognises the increased complexity of modern businesses with its
multiple cost drivers, many of which are transaction based rather than
volume based.

(b) ABC is concerned with all overhead costs, including such 'non-factory floor'
costs as quality control and customer service, and so it takes cost
accounting beyond its 'traditional' factory floor boundaries.

(c) ABC gives a meaningful analysis of costs which should provide a suitable
basis for decisions about pricing, product mix, design and production.

(d) ABC helps with cost reduction because it provides an insight into causal
activities and allows organisations to consider the possibility of
outsourcing particular activities, or even of moving to different areas in
the industry value chain. This is discussed later in the chapter, under
activity based management.

Criticisms

(a) The cost of obtaining and interpreting the new information may be
considerable. ABC should not be introduced unless it can provide additional
information for management to use in planning or control decisions.
(b) Some arbitrary cost apportionment may still be required at the cost pooling
stage for items like rent, rates and building depreciation. If an ABC system has
many cost pools, the amount of apportionment needed may be greater than
ever.
(c) Many overheads relate neither to volume nor to complexity. The ability of a
single cost driver to fully explain the cost behaviour of all items in its associated
pool is questionable.
(d) There will have to be a trade-off between accuracy, the number of cost
drivers and complexity.
(e) ABC tends to burden low-volume (new) products with a punitive level of
overhead costs and hence threatens opportunities for successful innovation if it
is used without due care.
(f) Some people have questioned the fundamental assumption that activities
cause cost; they suggest that decisions cause cost or the passage of time causes
cost – or that there may be no clear cause of cost.

Wider uses of ABC

Planning
Before an ABC system can be implemented, management must analyse the
organisation's activities, determine the extent of their occurrence, and establish
the relationship between activities, products/services and their cost. This can be
used as a basis for forward planning and budgeting.

Control
Knowledge of activities also provides an insight into the way in which costs are
structured and incurred in service and support departments. Traditionally, it has
been difficult to control the costs of such departments because of the lack of
relationship between departmental output levels and departmental cost. With
ABC, however, it is possible to control or manage the costs by managing the
activities that underlie them using a number of key performance measures which
must be monitored if costs and the business generally are to be controlled.

Decision making
Many of ABC's supporters claim that it can assist with decision making because it
provides accurate and reliable cost information. This is a contentious issue
among accountants. Many 'purists' consider that marginal costing alone provides
the correct information on which to make short-term decisions such as the
following.
(a) Pricing
(b) Make or buy decisions
(c) Promoting or discontinuing products or parts of the business
(d) Developing and designing changed products

The pricing implications of activity based costing

Many modern companies produce and sell large volumes of a standard product
and a number of variants of the basic product that sell in low volumes at a higher
price. Such companies absorb fixed overheads on a conventional basis, such as
direct labour hours, and price their products by adding a mark-up to full cost.
Activity based management (ABM)

OPERATIONAL ABM - Actions based on activity driver analysis, that increase

efficiency, lower costs and improve asset utilisation.
STRATEGIC ABM - Actions based on activity based cost analysis, that aim to
change the demand for activities so as to improve profitability.

Cost reduction and process improvement

ABM analyses costs on the basis of cross-departmental activities and thus
provides management with information on why costs are incurred and on the
output of the activity in terms of cost drivers. By controlling or reducing the
incid-ence of the cost driver, the associated cost can also be controlled or
reduced.

Value-added and non-value-added activities

The processing time of an organisation is made up of four types.

(a) Production or performance time is the actual time that it takes to

perform the functions necessary to manufacture the product or perform
the service.

(b) Performing quality control results in inspection time.

(c) Moving products or components from one place to another is transfer

time.

(d) Storage time and time spent waiting at the production operation for
processing are idle time.

The application of ABC therefore offers the possibility of turning costs that were
deemed to be fixed into variable costs: variability is a function of managers'
decisions about levels of expenditure and the speed at which the supply of
resources should be changed as requirements change.

Whereas absorption costing aims to recover costs, ABC aims to highlight

inefficiencies, and so cost drivers should be based on the possible level of
activity rather than the expected level of activity. If the cost driver rate is $100
per order and 50 orders are handled in a month, the cost assigned is $5,000. If
budgeted expenditure is $6,000, the cost of unused capacity is $1,000. ABC
therefore enables management to identify resources that are not being
fully utilised.

Design decisions
In many organisations today, roughly 80% of a product's costs are committed at
the product design stage, well before production begins. By providing product
designers with cost driver information, they can be encouraged to design low
cost products that still meet customer requirements.
The identification of appropriate cost drivers and tracing costs to products on the
basis of these cost drivers has the potential to influence behaviour to support the
cost management strategies of the organisation.
A product that is designed so that it uses fewer components will be cheaper to
produce. A product using standard components will also be cheaper to produce.
Management can influence the action of designers through overhead absorption
rates if overheads are related to products on the basis of the number of
component parts they contain. Hitachi's refrigeration plant uses this method to
influence the behaviour of their product designers and ultimately the cost of
manufacture.

Performance evaluation
ABM encourages and rewards employees for developing new skills, accepting
greater responsibilities and making suggestions for improvements in plant
layout, product design and staff utilisation. Each of these improvements reduces
non-value-added time and cost. In addition, by focusing on activities and costs,
ABM is better able to provide more appropriate measures of performance than
are found in more traditional systems.
(a) Activity volume measures provide an indication of the throughput and
capacity utilisation of activities.

(b) To increase customer satisfaction, organisations must provide a speedy

response to customer requests and reduce the time taken to develop and
bring a new product to the market.

(c) A focus on value chain analysis is a means of enhancing customer

satisfaction. The value chain is the linked set of activities from basic raw
material acquisition all the way through to the end-use product or service
delivered to the customer.

(d) Cost driver rates (such as cost per set-up) can be communicated in a
format that easily understood by all staff and can be used to motivate
managers to reduce the cost of performing activities (given that cost
driver rate  activity level = cost of activity)

CGMA COST TRANSFORMATION MODEL

1. Engendering a cost conscious culture
2. Managing risks that come from a cost conscious culture
3. Connecting products with profitability
4. Generating maximum value through new products
5. Incorporating sustainability to optimise profits
6. Understanding cost drivers

ABC Benefits and Limitations

1. Provides more accurate product line costings particularly where non-

volume related overheads are significant and a diverse product line is
manufactured.
ABC and Decision making

Activity-Based Costing has a role in longer-term decision making.

ABC Systems are designed to furnish management with cost information relating
to organisational products.

ACTIVITY-BASED MANAGEMENT
“System of management which uses ABC Information for a variety of purposes
including cost reduction, cost modelling and customer profitability analysis”

ABM seeks to classify each activity within a process as a value added or non
value added,

DIRECT PRODUCT PROFITABILITY

Used primarily in the retail sector DPP involves the attribution of both the
purchase price and other indirect costs( distribution, warehousing, retailing) to
each product line. Thus a net profit as opposed to a gross profit can be identified
to each product.

Example
Direct Product Profit for Product A

Selling Price 1.50

Less: Bought-In-Price (0.80)

Gross Margin 0.70

Less: Direct Product Costs
WareHouse Costs 0.16
Transport Costs 0.18
Store Costs 0.22

(0.56)
Direct Product Profit 0.14

The Benefits of DPP

- Better cost analysis
- Better pricing decisions
- Better management of store and warehouse space
- Rationalisation of product ranges
- Better merchandising decisions

CUSTOMER PROFITIBILITY ANALYSIS

CPA – Is the analysis of revenue streams and service costs associated with
specific customers or customer groups

CUSTOMER PROFITABILITY CURVE

 Profit

CUSTOMERS

- Some customers provide 80% of the profit for a company

- Small volume customers are unprofitable because of high production costs

15. PARETO ANALYSIS

Is based on the 80:20 rule

The pareto phenomenon often shows itself in relation to profitability. Often
around 80% of an organisations contribution is generated by 20% of the revenue

80%

20% Sales Revenue

Products that generate the largest portion of the contribution need to be looked
after. One reason for their profitability may be a high degree of branding which
increases contribution per unit.

Another use for Pareto analysis is in inventory control where it may be found that
only a few of the goods in inventory make up most of the value.
- Alternatively it may be found that a few items take up most of the storage
space and therefore storage costs are unduly high so it may be possible to
move towards a just in time system for these items only
 - Another study might relate to activity based costing and overheads. It may
show that 20% of an organisations cost drivers are responsible for 80% of
the total cost

PARETO PROCEDURE
1. Rank the data in descending order
2. Find each figure as a percentage of the total
3. Turn this into a cumulative percentage
4. Draw to illustrate

16 DISTRIBUTION CHANNEL PROFITABILITY

Distribution channels are in simple terms the means of transacting with

customers. The channel is the point of purchase. Companies may transact with
their customers through direct channels e.g sales teams, shops, internet or
indirect channels e.g retailers, wholesalers, resellers. A company should not only
aim to satisfy the needs of the customer but must also ensure the products they
providing are profitable. The method of channel distribution can account for a
significant proportion of total cost

Example Crale & CO

Retail $40
Costs $10
Contribution = $30

Commerce – Website 1’000’000 Retail distributors 1’000’000

$30million $30million

Overheads Overheads
1’110’000 Discount 1’500’000

Lost Sales
20000 x 30
=600000 Processing $620000

Packaging
800000

Shipping
600000

Key aspects that the company needs to consider in relation to their distribution
channels include; access to the customer base, brand awareness,
competitiveness, achieving sales and market targets, speed payments, customer
retentions rates and profitability.
Costing Channels

In companies, it is just as important to cost channels as it is to cost products and

customers. Different channels will differ in profitability.

ABC makes this possible because it creates pools for [Link] makes
channel profitability analysis possible and allows companies to build up
distribution channel profitability profiles. So it becomes possible to identify costly
distribution channels for low margin products or services supplied through direct
channels which should be supplied through indirect channels instead.

Practice Questions

Smartphone Type 1 – Option 3

Smartphone Type 2 – Option 1
Smartphone Type 3 – Option 2

Objective Test Q2
IV)

Objective Test Q3
B)

Data Set Question

Net Profit Per Kitchen Roll TR

Retail price $1.00

Bought-In ($0.60)
Gross Profit =0.40
Warehouse $0.0375
Supermarket$0.08
Transport $0.05
Total $0.2325
Workings

Warehouse Cost 75000 / 10000 = 7.50m3

Supermarket Cost 40000 / 5000 = 8.00m3
Transportation 400 / 40 = 10.00m3

KR TS T

Items per Case 10 25 40

Cases per m3 20 30 20
Area Occupied = 200 750 800
7.50/200
=0.0375 x 1week
Area Occupied = 200
8/200 x 2 weeks
=0.08

Transport = 10m3 / 20 cases per m3 / 10 items per case = 0.05 per item

The Modern Business Environment

Characteristics of the modern business environment

Global Environment
- Companies operate in a world economy
- Customers and competitors come from all over the world
- Products made from global components
- Firms have to be world class
- Internal regulations

Flexibility
Production processes will be designed differently to accommodate flexibility of
production rather than just throughput.

Employee Empowerment
Management accounting systems are moving from providing information to
managers to monitor employees to providing information to employees to
empower them to focus on continuous improvement

World Class Manufacturing

The world class manufacturing approach to quality is quite different from the
traditional approach because the primary emphasis is placed on the resolution of
the problems that cause poor quality, rather than merely defecting it.

Just in time

A system whose objective is to produce or procure products or components as

they are required by a customer or for use rather than for inventory. A JIT system
is a pull system that responds to demand.

JIT Production is defined as

A system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next
stage.

JIT Purchasing.
A system in which material purchases are contracted so that the receipt and
usage of material to the maximum extent possible.

JIT Requires the following

1 – The labour force must be versatile
2 – Grouped by product line.
3 – Infallible information system
4 – Get it right first time
5- Strong supplier relationships.
TOTAL QUALITY MANAGEMENT
Programmes which seek to ensure that goods are produced and services
supplied of the highest quality.
1- Get it right first time
2- Continuous improvement

The costs of quality

Divided into CONFORMANCE and NON-CONFORMANCE costs

Prevention Costs – Are the costs of ensuring that defects do not occur
in the first place.
1- Routine prevent
2- Quality training for operatives
3- Building quality into the design

Non-Conformance Costs internal failure

1 – Costs of scrap
2 – Reworking costs
3 – Manufacturing and process engineering required to correct the
failed process.

External failure
1- Marketing costs associated with failed products
2- Manufacturing or process engineering costs
3- Units returned
4- Repair costs
5- Liability claims

Example 1.

Prevention costs – 2000

praisal costs – 9500
Non – Conformance – 17700

Investment in prevention inevitably results in a saving on total quality

costs

Successful implementation of TQM

Plan to do all jobs right first time
Recognize achievements
Make quality a way of life

Management Accounting Reports

Can help organisations achieve their quality goals by including both
financial and non financial information traditional systems focused on
output not quality

Non-financial information includes

Throughput accounting and theory of constraints

Throughput = Sales revenue less direct material cost
Mangers should aim to increase throughput while simultaneously reducing
inventory and operational expense

“Factors that prevent throughput being higher = bottleneck”

The process of identifying and taking steps to remove the constraints that
restrict output as the theory of constraints (TOC)

Throughput accounting measures

Throughput – Sales revenues less direct material costs
- The only costs that is deemed to related to volume of output is the direct
material cost. All other costs(including labour costs) are deemed to be
fixed. These fixed costs may be called total factory costs. (TFC)

Performance measures to help measure throughput:

Return per factory hour = Throughput per unit

Product time on the Bottleneck resource

Cost per factory hour = Total factory costs

Total time on the bottleneck resource

Throughput Accounting ratio = Return per factory hour

Cost per Factory hour

Example 3

a) Throughput = 85 – 42.50 =42.50

42.50 / 1.50 = 28.33 Return per factory hour.

Cost per Factory Hour = 8000/400

= 20
Throughput Accounting Ratio = 28.33/20 = 1.4165

6) Kaizen Costing
Kaizen costing is a planning method used during the manufacturing cycle that
emphasises reducing variable costs of a period below the cost level in the base
period.
Kaizen is a philosophy of customer-driven improvement. Its aim is to create a
culture of continuous quality, cost and delivery.

Kaizen Activity
Standardise an operation or activity
Measure the operation
Compare measurements
Innovate to meet requirements and increase productivity
Standardise the new improved operation.

Implement kaizen activity Actions to take:

Make kaizen a strategy
Provide a budget for kaizen
Measure effectiveness of kaizens
Celebrate small improvements

7. Business Process Re-Engineering

BPR – BRP is concerned with making far-reaching one-off changes to improve

operations or processes.
“The fundamental rethinking and radical redesign of business processes to
achieve dramatic improvements in critical contemporary measures of
performance such as cost, quality, service and speed. In other words BRP
focuses on amending existing processes, streamlining processes that are already
in place.

Value added Analysis

This BPR pattern looks at the process from a customers perspective. A process is
said to add value if it increases the worth of a product for the customer, value
added when

1. Customer is willing to pay for the output

2. Activity physically changes output in someway
3. Activity is performed correctly first attempt

Non-Value adding activities

1. Preparation and set-up

2. Control and inspection
3. Simply moving a product without physically changing it
4. Activities that result from delays or failures of any kind.

Supply Chain Management

A supply chain is the network of customers and suppliers that a business deals
with
Purchasing
Inventories
Customer Ordering
Delivery and Logistics.

Outsourcing
Outsourcing involves the buying in of components, sub-assemblies, finished
products and services from outside suppliers rather than supplying them
internally. Regarded as a management strategy by which an organisation
delegates major non-core functions to specialised providers.

Practice Questions
D)

A - Appraisal
B – Internal Failure
C – Prevention Costs
D – External failure costs

QUESTION 3 TQM

Buffer Inventory, delays, customer goodwill

TQM, Quality, Output, Production Problems, Quality

QUESTION 4
2,4,5

DATA SET QUESTION

PRODUCT X PRODUCT Y PRODUCT Z

$12 - $3 $16 - $10 $14 - $7
=$9 / 3 = $6 / 1.5 =$7 / 7
=3 =4 =1

$100000 / 80000 $100000 / 80000 $100000 / 80000

=1.25 = 1.25 = 1.25

=1.36 =2.4 =1.4

240000 + 60000
300000 – 100000
=200000

Costing Techniques

Target Costing

Target costing is a pro-active cost control system. The target cost is calculated
by deducting the target profit from a pre-determined selling price based on
customers views. Functional analysis, value analysis and value engineering are
used to change production methods and/or reduce expected costs so the target
is met.

- The target profit requirement should be driven by strategic profit

planning rather standard mark-up.
 - Therefore the procedures used to derive the target profit must be
scientific, rational and agreed by all staff responsible for achieving it.

Using target cost in the concept and design stages

With the target-cost approach, the new product team, consisting of product
designers, purchasing specialist, and manufacturing and process people, works
together jointly to determine product and process characteristics that permit the
target cost to be achieved.

Pre-production stages
1 – Planning “This includes fixing the product concept and primary specifications
for performance and design”

$52 * 5000 = 260000

TC = SP – GP
Return required on an investment of $1000000* 12% = 120000 Targeted profit
Sales $52 * 5000 = 260000
Cost Allowed = 140000

Concept Design

Basic product is now designed.

Target cost divided into smaller parts reflecting manufacturing process.

TOTAL TARGET COST

Development Manufacturing Target

Cost
Costs Equipment Per Unit

Manufacturing Cost Per Unit Distribution

Per Unit

Functional Product Functional Product Functional Product

Area Cost Area Cost Area Cost

Basic Design
The components are designed in detail so they do not exceed the functional
target costs.
Value engineering is used to get the costs down to the target. If one function
cannot meet its target the targets for the others must be reduced

Example 2

Selling Price 56
Profit (56 *25/125) 11.20
Target Cost 44.80
Material Cost (16 * 10/8) 20
Labour – 2 hrs 24.80
Labour rate per hour = 24.80/2 $12.4

Cost GAP - refers to the difference between the current cost of producing a
product or providing a service and the target cost that the company aims to
achieve in the future

Target costing for existing products

Target costing is typically associated with new product development, but it can
also be applied to existing products. When used for existing products, the goal is
to reduce costs to meet market-driven price expectations or improve profitability
while maintaining product quality and features.

Applying Costing to existing products

1- Set a Target Price - The company identifies the maximum price

customers are willing to pay for the product
 2- Determine the Target Profit Margin - Based on business goals, desired
profitability levels, and the competitive landscape, the target profit margin
is set.

3- Calculate the Target Cost - Target Cost=Target Price−Target Profit

4- Compare with Current Cost: - Evaluate the current production cost of the
product. If the current cost exceeds the target cost, the company
identifies a cost gap that must be closed.

5- Close the Cost Gap - To reduce costs, a company can use several
strategies, such as:
Process improvements - Streamlining production processes to reduce
waste, defects, or inefficiencies.
Material substitution - Switching to lower-cost materials without
sacrificing quality.
Supplier negotiations - Renegotiating terms with suppliers for better
pricing.
Product redesign - Simplifying the product design to reduce
manufacturing complexity.
Economies of scale - Increasing production volumes to lower unit costs.

The impact of technology to reduce costs

Differences Between Target and Standard Costs:

1. Purpose:
o Target Costing: A strategic approach where the cost is derived from
the market price and desired profit margin. It is market-driven and
focuses on reducing costs to meet a price point that ensures
competitiveness.
o Standard Costing: An operational approach where the cost is
determined based on internal efficiency expectations, historical
data, or industry standards. It is more internally driven.
2. Development Basis:
o Target Cost: Starts with the market price and works backward to
determine the allowable cost. The focus is on what the customer is
willing to pay.
o Standard Cost: Starts with analysing production processes and
setting cost benchmarks based on efficient production, often
without explicit market input.
3. Timing:
o Target Cost: Determined before production or design, heavily
influencing product development and decisions on features.
o Standard Cost: Determined after the production process is planned
but before actual production begins.
4. Scope:
o Target Costing: Involves cross-functional teams including
marketing, design, and engineering to ensure product viability at
the desired cost.
o Standard Costing: Primarily focused on accounting and production
teams to control and monitor manufacturing costs.
5. Variance Treatment:
o Target Costing: Encourages innovation and design modifications to
close the gap between allowable cost and actual cost.
 o Standard Costing: Focuses on identifying and analysing variances
between standard and actual costs to highlight inefficiencies or
issues.

DIFFERENCES BETWEEN KAIZEN AND TARGET COSTING

1. Purpose and Focus:

 Kaizen Costing - Focuses on continuous improvement and cost reduction
after the product is in production. It aims to achieve small, incremental
cost savings during manufacturing by enhancing processes and efficiency.
 Target Costing: - Focuses on cost planning and control before production
begins. The goal is to design products at a price that meets customer
expectations while ensuring profitability

Kaizen Costing and Target Costing are both cost management

techniques, but they serve different purposes and are used at different
stages of a product's lifecycle. Here are the key differences:

1. Purpose and Focus:

 Kaizen Costing: Focuses on continuous improvement and cost reduction
after the product is in production. It aims to achieve small, incremental
cost savings during manufacturing by enhancing processes and efficiency.
 Target Costing: Focuses on cost planning and control before production
begins. The goal is to design products at a price that meets customer
expectations while ensuring profitability.
2. Stage of Product Lifecycle:
 Kaizen Costing: Applied during the production phase, focusing on reducing
costs through process improvements, efficiency gains, and waste
reduction.
 Target Costing: Applied in the design and development phase,
determining the target cost based on market-driven pricing, and then
designing the product to meet that cost.

3. Cost Reduction Approach:

 Kaizen Costing: Achieves cost reduction through continuous

improvements. The emphasis is on maintaining current levels of
quality and functionality while finding ways to reduce manufacturing
and operational costs.
 Target Costing: Achieves cost reduction by setting a target cost
early in the design process and ensuring that the product is
designed to meet that cost without sacrificing customer
requirements or profitability

Value analysis/Value Engineering

Value analysis helps to design products that meet customer needs at a

lower cost, while assuming the required standard of quality and reliability.
Value analysis relates to existing products. Value engineering relates to
products that have not yet been produced.

Types of Value

Cost value : Cost incurred by producing the product

Exchange value : Money Consumers willing to pay
Use value : Related to function
Esteem value : Status regarded with ownership.
FUNCTIONAL ANALYSIS

It focuses on identifying and evaluating the functions of a product or service to

ensure that the value delivered is optimized in relation to its cost. The goal is to
deliver the required functionality at the lowest cost without compromising quality
or performance.

6. The value chain

Primary Activities

These activities involve the physical movement of raw material and finished
goods to outputs of a BU

1. Inbound Logistics, Operations, Outbound Logistics, Marketing n Sales,

Service.

Support Activities
Procurement, Technology development, HR, Firm infrastructure.

Organisations develop sustainable competitive advantage

1. Low Cost Strategy
2. Differentiation Strategy

Life-Cycle Costing

The accumulation of costs for activities that occur over the entire life cycle of a
product from inception to abandonment. The goal of life cycle costing is to
provide a comprehensive view of the total cost of ownership over the entire life
span of a product, project, or asset

Life cycle costing typically involves five key stages:

1. Pre-production costs: Research, design, and development costs.
2. Production costs: Direct costs of manufacturing or creating the product.
3. Post-production costs: Distribution, marketing, and servicing costs.
4. Operation and maintenance costs: Costs incurred during the product's use.
5. Disposal costs: Costs associated with decommissioning or recycling the
product.
Asset Life Cycle Costing (LCC) is a method of financial analysis that assesses
the total cost of owning and operating an asset over its entire life span. This
approach provides a comprehensive view of the costs associated with an asset
from its acquisition through to its disposal. The goal is to help organizations
make more informed decisions about purchasing, maintaining, and retiring
assets

Actions to take
- Encourage a whole-life product profitability mindset among
multidisciplinary teams
- Customer perspective
- Think about social impact of product development

Practice Questions
Q1 – Required Return is 15% * $250000 = $37500
Sales 250 * 500 = $125000
Target Cost = $87500 / 500 = 175
Data Required for decision making

Capital investment decisions normally represent the most important decisions an

organisation makes.

RELEVANT CASH FLOWS

Relevant costs are those which will be affected by the decision being taken. A
relevant cash flow is a future, incremental cash flow

Investment decisions should be analysed in terms of cash flows that can be

attributable to them.

“Only future cash flows that occur as a result of the decision should be
considered”

“Sunk Costs irrelevant already occurred in the past”

“Incremental, only cash flows that occur as a result of the decision should be
considered” – Fixed costs should be ignored unless there is an incremental fixed
cost as a result of the decision – Opportunity costs should be included when we
are aware of the next best alternative use of a resource.

- Cash Flows only cash items are relevant to the decision.

Example 1

Example 2

a) Yes
b) Yes
c) No
d) No
Opportunity Costs

The foregone potential benefit from the best rejected course of action

Notional costs and opportunity costs

Notional Rent could be the rental that the company is forgoing by occupying the
premises itself. “It is only a true opportunity cost if the company can actually
identify a forgone opportunity to rent the premises.

4- Avoidable costs

“The specific costs of an activity or sector of a business which would be avoided

if that activity or sector did not exist”
“Costs such as apportioned head office costs that would not be saved as a result
of the shutdown are unavoidable costs”

Differential / Incremental Costs

A differential / incremental cost as a the difference in total cost between
alternatives.

Non Relevant costs

If a cost remains unaltered regardless of the decision being taken then its called
a non-relevant cost.

A) Sunk or past costs.

B) Absorbed fixed overheads that will not increase or decrease as a result of
the decision being taken.
C) Expenditure that will be incurred in the future but as a result of decisions
taken in the past that cannot now be charged.
D) Historical cost depreciation
E) Notional costs such as notional rent and notional interest.”Only relevant if
they represent an identified lost opportunity cost”

5) Incremental Revenues

Incremental revenues are the differences in revenues between the alternatives.

Cash flows to include

Cash flow if project accepted – Cash flow if project rejected = Relevant Cash flow

Qualitative Factors

Quantitative Costs
- Purchase price of the machine
- Installation and training costs

Quantitative Benefits
- Lower direct labour costs
 - Lower scrap costs and items requiring rework
- Lower stock costs

Qualitative Costs
- Increased noise levels
- Lower morale if existing staff have to be made redundant

Qualitative Benefits
- Reduction in product development time
- Improved product quality and service
- Increase in manufacturing flexibility

Sources of management information

Types of information External information

- Accounting Records - Competitor information

- Personnel and payroll information - Customer info
- Timesheets - Supplier
- Production information

8 Collecting analysing and presenting high quality data

Management information must relate financial to non-financial data and not just
report past performance, but also monitor the current operations.

Benefits of collecting analysing and presenting high quality data

- Collaborative working
- Customer insight
- Risk Management
- Governance

Costs
- Software licenses costs
- Software maintenance costs
- IT Training costs
- User training costs
- Integration costs

10 Business Intelligence systems

The term is used to describe the technical architecture of systems that extract,
assemble, store, and access data to provide reports and analysis. BI is about
company wide recognition that a companies data is an important strategic asset
that can yield valuable management information and implement change so that
this information is used to improve decision making

BI systems can provide more forward looking analysis based on a combination

of both financial and non-financial information.

11 Data analytics and data mining

Data analytics is the complex analysis, data mining and predictive modelling
enabled by BI applications which can access both financial and non-financial data
from the businesses data

Data analytics is the process of collecting, organising and analysing large sets of
data to generate trends and other info to aid decision making.

Data mining is the process of sorting through data to identify patterns and
relationships within a data set between different items, usually with the use of
statistical algorithms

Structured Data – Data that is contained within a field in a data record or file
(databases, data warehouses and spreadsheets) in a data warehouse everything
is archived and ordered in a defined way.

Unstructured Data – Data that is not easily contained within structured data
fields, such as pictures, videos, webpages, PDF files. “Data lake” contains data in
its rawest form – unadulterated by processing or analysis.

12 Business intelligence and new business opportunities

BI can be used for new reports and analysis which should lead to increased
profitability through improved operating performance and better strategic focus
on profitable products and segments.

13 Business intelligence and reducing costs

The investment decision-making process

Capital rationing a key decision making approach then applies when investment
funds are limited and not all profitable projects can be undertaken.

The Capital investment process

1. Identify Objectives
2. Search for investment opportunities
3. Identify states of nature
4. List possible outcomes
5. Measure payoffs
6. Select investment projects
7. Obtain authorisation and implement projects.
8. Review capital investment decisions

In capital investment appraisal we initially assume that:

1 – All cash inflows and outflows are known with certainty

2 – Sufficient funds are available to undertake all profitable investments
3 – There is zero inflation
4 – There is zero taxation

3 Time Value of Money

Discounted cash flow techniques take account of this time value of money when
appraising investments.

Three main reasons:

Consumptions preferences
Impact of inflation – Purchasing power lost overtime
Risk – The earlier cashflows are due to be received the more certain they are

4 Compound Interest

Formula for compounding

FV = X(1+r)^n

5 Discounting
Performs the opposite function to compounding.

Formula for discounting

DF = 1/(1+r)^n or (1+r)^-n

The cost of capital

NPV is the difference between the sum of the projected discounted cash inflows
and outflows attributable to a capital investment or other long-term project.

NPV Represents the surplus funds after funding the investment earned on a
project

Any project with a positive NPV is viable

Projects with a negative NPV are not viable
Faced with mutually-exclusive projects choose the project with highest NPV

NPV is considered superior than most other methods because

- Considers time value of money

- Absolute mean of return
- Based on cashflows not profits
- Considers whole life of the project
- Maximisation of shareholders wealth

7 Internal Rate of Return

Is the rate of return which the project has a NPV of zero

If the IRR is greater than the cost of capital the project should be accepted – The
IRR method of analysis is to calculate the exact rate of return that the project is
expected to achieve.

Calculating the IRR (Using linear interpolation)

1. Calculate two NPV’s for the project at two different costs of capital
2. IRR = L + NL / NL – NH * (H-L)
 L = Lower rate of interest H = Higher rate of interest
NL = NPV at Lower Rate of interest NH = NPV at higher interest
rate

Calculating the IRR of a project with even cash flows

If project cash flows are annuities where it equals annual cash flows

1 – Find the cumulative discount factor, Initial investment + Annual inflow

2 – Find the life of the project, n
3 – Look along the n year row of the cumulative discount factor

IRR of a perpetuity = Annual inflow / Initial Investment * 100

Advantages of IRR
- IRR Considers the time value of money.
- IRR is a percentage and easily understood.
- IRR uses cashflows not profit

Disadvanatges

- Not a measure of absolute profitability

- Interpolation only provides an estimate
NPV versus IRR

IRR Tells us the cost of capital at which the project will break even.
IRR Tells us how far the cost of capital could increase before the project would
not be worth accepting
General rule is where mutually exclusive projects are being considered the one
with the highest NPV is preferred.

The modified IRR

MIRR measures the economic yield of the investment under the assumption that
any cash surpluses are reinvested at the firms current cost of capital.

MRR = [(Terminal value of inflows/Present Value of outflows)^1/n]-1

MIRR tells us the return on a project assuming realistic reinvestment and

financing rates, making it a more accurate and reliable metric, especially for
comparing different projects. It avoids the overly optimistic assumptions of IRR
and handles unconventional cash flows better.

When we say cash flows are reinvested, we mean that any positive cash flows
(profits or returns) generated by a project are assumed to be put back into the
business or into another investment. Essentially, the assumption is that
these intermediate cash flows don’t just sit idle—they are used to generate
additional returns during the project's life
 The cost of capital is the minimum rate of return a company must earn to
satisfy its investors (both debt and equity holders). It reflects the return the
company needs to generate to break even, considering its risk and financing
structure.
 When reinvesting cash flows, using the cost of capital assumes that any new
investments made by the company would at least need to generate returns at
this rate to justify the risk and use of funds. It’s a conservative and realistic
assumption about how the company might reinvest those intermediate cash
inflows.

NPV and IRR with equal cash flows

Annuity factor = Discounting Factor

PV = Annual cash flow * AF

Advanced perpetuities

T0 + Disounted T1 etc etc Simply add 1 to the AF to find the PV of these

perpetuities

Changing discount rates

We have to calculate the discount rate for each year this is done by (1+Cost of
Capital) / Previous year discount factor

Dealing with non annual periods

We need to pro-rate the discount rate to match the period of the cash flows.
Formula = (1+i)^1/4 -1

Capital Rationing

Capital rationing occurs when insufficient funds are available to undertake all
beneficial projects

Soft rationing – Used to refer to situations where for various reasons the firm
internally imposes a budget ceiling on the capital expenditure.

Hard rationing – Capital is restricted because of external constraints such as

inability to obtain funds from financial markets

The objective of all rationing exercises is the maximisation of the total NPV of the
chosen projects

Profitability index = NPV of Project / Initial cash outflows

Optimal investment plan is determined by

1 – Calculate PI for each project
2 – Rank projects according to their PI
3 – Allocate funds according to the project rankings
Interpretation:
PI > 1: The project is considered profitable, as the present value of future cash
flows exceeds the initial investment.
PI = 1: The project breaks even, with no gain or loss.
PI < 1: The project is not profitable, as the present value of future cash flows is
less than the initial investment.

Discounted Payback Profitability index (DPBI)

DPBI = Present value of net cash inflows / Initial cash outlay

Discounted Payback Period: This is the time it takes for the project’s
discounted cash flows to repay the initial investment. Unlike the regular payback
period, which doesn’t consider the time value of money, the discounted payback
period discounts the cash flows at a specified rate (usually the cost of capital).

PI = 0.3 NPV = 15000

PI = 0.3 NPV = 15000
PI = 0.6 NPV = 30000
PI = 1.08 NPV = 54000
PI = 0.96 NPV = 48000

Identifying real options in investment appraisal

- Flexibility adds value to an investment

Real options theory attempts to classify and value flexibility in general by taking
ideas of financial options pricing and developing them.

OPTIONS TO DELAY OR DEFER

The key here is to be able to delay the investment without losing the opportunity
creating a call option on the future investment

OPTIONS TO SWITCH/REDEPLOY

It may be possible to switch the use of assets should market conditions change.

OPTIONS TO EXPAND/CONTRACT

It may be possible to adjust the scale of an investment depending on the market

conditions

OPTIONS TO ABANDON

If a project has clearly identifiable stages such that investment can be staggered
management must decide to abandon or continue

The following considerations must be taken into account in deciding whether to

continue or abandon a project.

Future cash outflows associated with the project

Future cash inflows associated with the project
Revenues/Costs that would arise if the project were abandoned.

NPV and Real Options:

Traditional NPV Analysis: In standard NPV analysis, future cash flows are
discounted back to their present value, assuming a set strategy without
considering flexibility.
NPV with Real Options: When integrating real options into NPV analysis, the
value of the options is added to the traditional NPV. This provides a more
comprehensive view of an investment's potential by recognizing the value of
management's strategic choices in the face of uncertainty.

Abandoning the project is only necessary when the net discounted expected
future cashflow of the project is negative.

Post Completion Audit

Benefits of post-completion audit

It might identify weaknesses in the forecasting techniques and the estimating

techniques used. Quality of forecasting can be improved.

Managers motivated to achieve forecast results if they are aware of a pending

post-completion appraisal.

Working Capital

Treated as an investment at the start of the project, like any other investment.
Only the change in working capital is treated as a cash flow.

At the end of an investment or project, working capital is treated as an inflow

because any capital that was tied up in day-to-day operations (such as inventory,
accounts receivable, and accounts payable) is typically liquidated or reduced.
Here's why:
1. Inventory Reduction: As a project or investment concludes, the business
may sell off its remaining inventory. The cash from these sales is
considered an inflow.
2. Receivables Collection: Any outstanding accounts receivable (money
owed by customers) is usually collected by the end of the investment. This
cash collection is treated as an inflow.
3. Payables Decrease: If the business has accounts payable (money it
owes to suppliers), it would ideally be paid off before the end of the
project. In cases where payables decrease, the reduction in liabilities is not
a cash outflow, but rather, the working capital (cash) tied up in these
liabilities becomes free.
4. Recovering Cash Tied in Operations: As the project wraps up, all cash
that was needed to sustain operations is no longer required, and this
released capital (previously tied in working capital) is considered an
inflow.

The impact of inflation on cash flows

Cashflows that have not been increased for expected inflation they are known as
current cash flows, or real cash flows.

- Where cash flows have been increased to take account of expected

inflation they are known as money cash flows

Methods of dealing with inflation

Real Method
Money Nominal Method

Real rate of Return (1+r) = (1+m)/(1+i)

R = Real rate of return
M = Money cost of capital
I = Rate o finflation

7) Specific and general inflation rates

Two types

Specific Inflation Rate (Each cashflow is affected by a specific rate)

General Rate of inflation (Impacts the investors overall required rate of return)

The money Method.

Inflate the cash flows at their specific inflation rates
Discounting using the money rate.

Deflation
How deflation may affect business decisions making in several ways:

It May be difficult to reduce some costs – especially in wages in line with

deflation
Consumers may defer purchasing decisions in anticipation that prices may fall

Questions with both tax and inflation are best tackled using the money method.
- Inflate costs and revenues where necessary
- Ensure that the cost and disposal values have been inflated
- Always calculated Working capital on these inflated figures.
- Use post tax money discount rate.

Capital Asset replacement decisions

Two decisions to consider

1. Considering mutually-exclusive options with unequal lives
2. Calculating an optimum replacement cycle

Under option 1
We calculate an equivalent annual cost = PV of Cost / Annuity factor for year N

Steps to Calculate the Optimum Replacement Cycle

1. Gather Data:
 o Initial Cost: The purchase cost of the asset.
o Maintenance Costs: Projected annual maintenance costs as the
asset ages.
o Operating Costs: Costs that increase with asset wear (e.g., fuel,
energy consumption).
o Resale Value: Estimated resale value or salvage value of the asset
over time.
o Economic Life: The number of years the asset can operate
efficiently.
2. Set Up a Table: Create a table to track costs and resale values over the
asset's life. For each year:
o Maintenance costs.
o Operating costs.
o Total costs (sum of maintenance and operating costs).
o Cumulative costs (total costs plus the depreciated purchase cost).
o Resale value.
3. Calculate Equivalent Annual Cost (EAC): Use EAC to compare costs
over different timeframes:
EAC= Total Costs – Resale Value / Number of years

This formula spreads the costs over the years of asset life and allows
comparison.
4. Determine the Optimum Point:
o Identify the year with the lowest EAC. This year represents the
optimal replacement cycle.
o Beyond this point, costs usually increase due to higher maintenance
and reduced efficiency.
5. Account for Inflation or Discount Rates (if applicable): For long-term
projects, adjust costs and values to account for the time value of money
using a discount rate:
Present Value (PV)=Future Value (FV)(1+r)n / (1+r)^n
Where r is the discount rate, and n is the number of years.

Example
Suppose a machine costs $50,000 with a useful life of 10 years. Maintenance and
operating costs rise, and the resale value drops yearly:
Yea Maintenance Operating Resale Value Total Cost
r ($) ($) ($) ($)
1 1,000 5,000 40,000 16,000
2 1,200 5,500 35,000 16,700
3 1,400 6,000 30,000 18,400
4 1,800 7,000 25,000 22,300
Calculate EAC for each year and determine the lowest cost year to replace the
machine.

How It Works:
The formula takes the present value of costs and distributes them evenly over
the asset's life by using the concept of an annuity factor:
Annuity Factor = 1/r – 1/ r(1+r)^n

 The annuity factor calculates how much of the PV needs to be allocated

to each year so that the sum of these annual payments, when discounted
back to present value, equals the original PV.
  This distribution accounts for the time value of money

Factors in replacement decisions

Capital cost of new equipment

Operating costs
Resale value
Inflation
Taxation and incentives

The Pricing Decision

Price Elasticity of Demand

Volume – Cost – Price = Profit

Price Elasticity of Demand = Change in Quantity Demanded as a percentage of

demand / Change in price as a percentage of the price.

= 8 / 20 = 40%

Elastic Demand (Very responsive to changes in price)

If the percentage change in demand exceeds the change in price then price
elasticity will be greater than 1

Inelastic Demand
If the changes are lower than price elasticity will be less than 1

Demand is inelastic when not responsive to changes in price.

Revenue decrease when price is reduced

Revenue increase when price is increased

Price increase are recommended but price cuts are not

Price Elastic Demand

Demand

Elasticity of Demand = -% Change in quanity demanded / % Change in price

Different products in the same industry have different price elasticity because
they are sold in slightly different markets due to product differentiation.

Factors affecting price elasticity

1. Scope of the market

2. Information within the market
3. Avalibility of substitutes
4. Complementary products
5. Disposable income
6. Necessities
7. Habit

Different types of market structures

In a perfectly competitive market every buyer or seller is a price taker and no

participant influences the price of the product it buys or sells.

Characteristics of perfectly competitive markets include

- Zero Entry/ Exit Barriers – Relatively easy to enter or exit as a business
- Perfect information – Prices and quality of products are assumed to be
known
- Companies aim to maximise profits
- Homogenous products – Characteristics of any given market good or
service do not vary across suppliers

Imperfect competition –
 Monopoly – There is only one seller
Oligopoly – Few companies dominate the market and are interdependent
Monopolistic Competition – products are similar but not identical. There
are many producers “Price setters” and many consumers in a given market
no one has control over market price.

The profit maximisation model

The model is based on the economic theory that profit is maximised at the
output level where marginal cost is equal to marginal revenue

(Marginal revenue exceeds marginal cost).

A firm should therefore produce units up to the point where the marginal
revenue equals the marginal cost MR = MC

p = a + bx

p = price
x = quantity demanded

a and b are constants, where b is the slope

Marginal revenue equation can be found by MR = a + 2bx

Marginal revenue additional revenue from selling and extra unit

7 Procedure for establishing the optimum price of a product

1. Establish the linear relationship between price (P) and quantity demanded
(Q)
P = a +Bq
Where a is the intercept and b is the gradient of the line. As the price of a
product increases, the quantity demanded will decrease. Equation of a straight
line P = a + Bq can be used to show the demand for a product at a given price.

Price

P = a +Bq

The price equation is a concept that links MR and the elasticity of demand
Total revenue is TR = P * Q

Example 2

P = a + b.Q

9 Limitations of the profit maximisation model

1) It is unlikely that organisations will be able to determine the demand

function for their products.
2) Majority organisations aim to achieve target profit rather than theoretical
maximum profit
3) Determine an accurate and reliable figure for marginal or variable cost.

10 Pricing strategies based on cost : Total cost-plus pricing

Involves adding a mark-up to the total cost of the product, in order to arrive at
the selling price
Profit mark-up needs to be based on some assumption. Normally it is fixed so
that the company makes a specific return on capital based on a particular
capacity utilization.

Advantages are claimed for cost-plus pricing

Required profit will be made if budgeted sales volumes are achieved.

Useful in contract costing industries such as building
Cost-Plus pricing can be useful in justifying selling prices to customers.

Problems with cost-plus pricing

There will always be problems associated with selection of a suitable basis on

which to charge fixed costs because which fixed costs are we adding to the
product costs.

Marginal Cost-Plus Pricing

Some of the reasons for using it in preference to total costs are as follows:

It is just as accurate as total cost-plus pricing. A larger mark-up percentage is

added because both fixed costs and profit must be covered

Knowledge of MC gives management the option of pricing below TC when times

are bad to fill capacity.

12 Criticism of marginal cost-plus pricing

Lowering of prices until one company is forced out.

13 Marketing-based pricing strategies

Premium pricing (Price inelastic)

Premium pricing is pricing above competition on a permanent basis. This can
only be done if the product appears different and superior to competition.

Marketing Skimming
Technique where a high price is set for the product initially so that those who are
desperately keen on the product will buy it.

Penetration pricing
Occurs when the company sets a very low price for the new product initially
below total cost. The aim is to establish a large marketshare quickly

Price differentiation

If the market can be split into different segments each quite separate from the
others with its own demand function.

Loss leader pricing

When a product range consists of one of more main products and a series of
related optional extras which the customer can add on to the main product the
supplier can set a relatively low price for the main product and high one the
extras.

Discount Pricing
Based on low cost, high volume and low margins.

Controlled pricing

When an industry is regulated on selling price elasticity is zero

Product Bundling

The product life cycle

Sales Revenue

Profit

Introductory Phase
Growth
Maturity
Decline

Responsibility Centres

Decentralisation – Also known as divisionalisation, seeks to overcome the

problem of managing a large organisation by creating a structure based on
several autonomous decision-making units.

Objectives of decentralisation can be listed as

Ensure goal congruence

Increase motivation of management
Reduce head office bureaucracy

2 Cost, revenue, profit and investment centres.

In responsibility accounting, a specific manager takes responsibility for a

particular aspect of the budget.
The area of operations for which a manager is responsible is called a
responsibility centre.

If a manager is responsible for a particular aspect of operating costs, the

responsibility centre is a cost centre. A production or service function, activity or
item of equipment for which costs are accumulated.

If a manager is responsible for revenue, the responsibility is a revenue centre the

division is only responsible for the generation of revenue.

If manager is responsible for revenue as well as costs, the responsibility centre is

a profit centre.

If a manager is responsible for investment decisions as well as for revenues and

costs the responsibility centre is an investment centre.

3 Responsibility accounting and controllability of costs

A controllable cost is a cost which can be influenced by its budget holder.
Controllable costs are generally assumed to be variable costs and directly
attributable fixed costs. These are fixed costs that can be allocated in full as a
cost of the centre.

An item that is uncontrollable for one manager could be controllable by another.

At senior management level control should be exercised over long-term costs

Advantages are
: Profit centre managers are made aware that they need to earn sufficient profit
to cover costs
:Profit centre managers are made aware of the signigicane

Disadvantages:
:PCM are made accountable for a share of other overhead costs but they can do
nothing to control them

Committed fixed costs – Costs that are uncontrollable in the short term, but are
controllable over the longer term
Discretionary fixed costs – which are costs treated as fixed cost items that can
nevertheless be controlled in the short term. Because its subject to management
discretion.

An argument could therefore be made that profit centre managers should be

made accountable for a share of overhead costs that are not under their control,
and share of these costs should be charged to the profit centres.

4 Pros and Cons

The advantages of this approach to responsibility accounting are:

Profit centre managers are made aware of the significance of other overhead
costs

Disadvantages of this approach are:

Profit centre managers are made accountable for a share of other overhead
costs, but they can do nothing to control them.

5 Key performance indicators

An organisation and its divisions should have certain targets for achievement.
Targets can be expressed in terms of key metrics.

A budget should not be approved be senior management unless budgeted

performance is satisfactory as measured by the key metrics. Actual performance
should be then assessed in comparison with the targets.

Key areas of financial performance

- Profitability
- Liquidity
- Asset Turnover

Profitability
A key metric for profitability might be the profit/sales ratio or the
contribution/sales ratio

ROCE return on capital employed Return on capital employed the asset turnover
and profit/sales percentage.

Profit/Turnover * Turnover/Capital Employed = Profit/ Capital Employed

Profit Margin * Asset Turnover = ROCE

Capital employed = equity + long term finance

Liquidity

Liquid assets are therefore cash and short-term investments that can be readily
sold if the need arises.
Liquidity is improved through efficient cash management and an important cash
management is control over inventory, trade receivable and trade payable.

On the other hand a business can have excessive liquidity with too much capital
tied up in working capital.

6 Divisional performance measurement

Cost Centre Division incurs cost no revenue stream

CPU, Cost Variances
Revenue Centre Responsible for generating revenue TR
and RPU

7 Return on Investment

ROI/ROCE = Divisional controllable profit before interest and tax / Capital

Employed * 100%

- Controllable profit is usually taken after depreciation but before tax.

- Capital employed is total assets less current liabilities or total equity plus
long term debt. Use net assets if capital employed is not given.

Non-current assets might be valued at cost, net replacement cost or net book
value.

ROI Calculation

ROI = 28000 / 108000 = 28%

Evaluation of ROI as a measure of performance

ROI is a popular measure for divisional performance.

Advantages – Widely accepted, inline with ROCE

ROI – Enables comparisons between divisions or companies of different sizes

a) Division A will accept the project as its current ROI is sufficient the cost of
capital of 15%

Residual Income

RI = Controllable profit – Notional interest on capital

Controllable profit (i.e controllable profit at divisional level)

Notional interest on capital is the capital employed in the division, multiplied by
a notional cost of capital interest rate.

Economic Value Added

EVA is a measure of performance similar to residual income, except the profit
figure used is
The economic profit and the capital employed figure used is the economic capital
employed.

Calculation is
1. NOPAT
2. Deduct the eva of the capital employed * cost of capital

 The calculation should be based on opening capital employed. We assume

that the capital employed at the start of the year was used to generate
profits for the year

NOPAT is calculated from PAT

Add back items that are non-cash
Accounting depreciation
Provision for doubtful debts
Non-cash expenses
Interest paid
Add back items that add value
Good will amortised
Development costs
Operating leases

Take off
Economic depreciation
Any impairment in the value of goodwill

=NOPAT

Focus on Operations: NOPAT only considers the company's core business

activities, ignoring interest expenses or income, which makes it useful for
evaluating performance regardless of how a company is financed.
Used in Free Cash Flow Calculations: NOPAT is often used in the calculation
of Free Cash Flow (FCF) and Economic Value Added (EVA), making it an essential
metric in assessing a company's profitability and value creation
Tax Impact: By multiplying by (1 - Tax Rate), NOPAT reflects the operating
income available after taxes, giving a more accurate picture of profitability on a
comparable after-tax basis.

2) Deduct the charge for the cost of capital

Opening capital employed

Cost of Capital Charge=Opening Capital Employed×Cost of Capital (WACC)
Capital Invested=Opening Capital Employed+Adjustments for Net Replacement Cost of Non-Current
Assets

Net Replacement Cost: This refers to the current market cost to replace
tangible non-current assets (like property, plant, and equipment) with similar
assets at today’s prices. Using replacement cost instead of historical cost
provides a more accurate reflection of the current capital invested in the
company, as it considers inflation and changes in asset values over time.
Adjustments: To calculate the true Capital Invested, you need to adjust the
balance sheet to reflect the net replacement cost of tangible non-current
assets, rather than historical book value. This adjustment ensures that the
capital base accurately represents the economic value of the assets deployed in
the business.

Economic depreciation
Considered to be a measure of the economic use of assets during a year involves
a process of valuation. It is the period by period change in the market value of an
asset.

Advantages of EVA
Performance measure that puts a figure to the increase or decrease that should
have arisen a period from the opearations of a company

Can be measured for each financial reporting period

Based on economic profit and economic values not accounting profits.

EVA is the residual wealth generated by the business after accounting for the
cost of all capital employed.

EVA = Net Operating Profit After taxed (NOPAT) – (Capital Employed * WACC)

Where:
 NOPAT: Net Operating Profit After Taxes
 Capital Employed: Total funds employed in the business (equity + debt).
 WACC: Weighted Average Cost of Capital (the cost of equity and debt)

 Value Creation:
EVA indicates value creation when it is positive. A positive EVA means the
business earns returns greater than the WACC.
 Cost of Capital:
EVA explicitly considers the cost of capital, distinguishing it from traditional
accounting profit.
 Economic Performance:
EVA aligns with shareholder wealth maximization, as it measures true economic
profit

Adjustments for Accurate EVA Calculation

To ensure EVA reflects economic reality, several adjustments are made:
 Capitalization of Intangible Assets: Capitalize R&D, advertising, and
employee training costs.
 Depreciation: Adjust depreciation to reflect the economic value of assets.
 Operating Leases: Treat lease obligations as capital to recognize their
financing impact.
 Provisions: Exclude non-operating provisions like restructuring costs.
 Taxes: Use cash taxes instead of accrual taxes to better reflect economic
cost.

Capitalization of Intangible Investments

 Why Adjust?
Intangible investments such as research and development (R&D),
 advertising, and employee training are treated as expenses under
traditional accounting. However, these expenditures often create long-
term value and should be treated as assets.
 Adjustment Process:
o Capitalize these costs by adding them back to the operating profit.
o Amortize them over their estimated useful life to reflect their
gradual consumption.
 Example:
A company incurs R5 million in R&D. Instead of expensing the entire
amount in one year, the R&D cost is treated as an asset and amortized
over five years. This increases both the operating profit and capital
employed

Depreciation Adjustments
 Why Adjust?
Depreciation in accounting is based on arbitrary rules and may not reflect
the economic wear and tear of assets. EVA requires economic
depreciation.
 Adjustment Process:
o Replace accounting depreciation with a more realistic economic
depreciation estimate.
o Adjust operating profit and capital employed to reflect these
changes.
 Example:
If a machine costing R100,000 is expected to generate value evenly over
10 years, annual economic depreciation is R10,000. If accounting
depreciation is higher (say R15,000), the extra R5,000 is added back to
the operating profit.

Operating Leases
 Why Adjust?
Under traditional accounting, operating leases are treated as off-balance-
sheet items, but they represent long-term financial obligations.
 Adjustment Process:
o Treat the present value of future lease payments as a liability,
effectively capitalizing the lease.
o Add back the lease expense to operating profit and include the
capitalized lease value in capital employed.
 Example:
If a company pays R1 million annually for a 5-year lease, the present value
of these payments is calculated and added to capital employed.

Tax Adjustments
 Why Adjust?
EVA uses actual cash taxes paid, not the tax expense shown in the income
statement, because cash taxes better reflect the economic cost.
 Adjustment Process:
o Replace accounting tax expense with actual cash tax payments.
o If deferred taxes are significant, include them in the calculation.
 Example:
If the income statement shows a tax expense of R300,000 but the cash
flow statement indicates actual tax payments of R250,000, use R250,000
for NOPAT calculation.
Provisions and Restructuring Costs
 Why Adjust?
Accounting often includes one-off or non-operating provisions like
restructuring or litigation costs. These may distort true operating
performance.
 Adjustment Process:
o Exclude one-off, non-operating provisions from NOPAT.
o Exclude any associated liabilities from capital employed.
 Example:
A company incurs a one-time restructuring cost of R2 million. This amount
is added back to operating profit since it is non-recurring

Goodwill
 Why Adjust?
Goodwill amortization or impairment under accounting rules may not
reflect the actual economic value of the goodwill.
 Adjustment Process:
o Add back goodwill impairment or amortization to NOPAT.
o Treat goodwill as part of capital employed if it represents real
economic value.
 Example:
If a company writes off R1 million in goodwill, add it back to NOPAT, unless
the goodwill is determined to have no economic value.

So in NOPAT we add back non cash items because they do not reflect economic
profit
Add back items that add value

We deduct cost of capital multiplied by WACC (Weighted Average Cost of Capital)

from NOPAT (Net Operating Profit After Taxes) because this reflects the
fundamental principle of Economic Profit (or EVA): a business must generate
returns that exceed its cost of capital to create value for its shareholders.

 Accounting Depreciation:
 Based on accounting standards, it typically allocates the cost of a tangible
asset over its useful life.
 It may not always reflect the actual economic consumption of the asset's
value.
 Economic Depreciation:
 Represents the actual decline in the economic value of the asset during a
period.
 It factors in the asset's market conditions, technological obsolescence, and
other external economic factors.

Alternative Measures of Performance

Budgetary Control :Flexing budgets to measure performance

A fixed budget will remain the same no matter the volume of sales or production.
A fixed budget is not particulary useful for control;
A Flexible budget is one which by recognising cost behaviour patterns is
designed to change as volume of activity changes. A flexible budget should
represent what the costs and revenues were expected to be at different levels of
activity.

Key Points
A fixed budget is set at the beginning of the period based on estimated
production. This is the original budget at the same time a flexible budget may be
produced at a range of activity levels.

Budgetary Control and responsibility accounting are linked.

Planning and operational vaiances

TRADITIONAL VARIANCE
Compares actual results with the Original Budget

Planning Variance Operational

Budget
Compares the revised budget Compares actual results with
revised
and the original flexed budget

Benefits of planning and operational variances

- In volatile and changing environments, standard costing and variances
analysis are more useful using this approach
- Operational variances provide up to date info about current levels of
efficiency

3 Shortcomings of financial indicators

1. They only tell what has happened over a limited period
2. Give no indication of the future
3. Vulnerable to manipulation

4 Non-Financial performance indicators

To obtain a fuller evaluation of performance we have to turn to a range of

financial performance indicators.

Non-financial performance indicators are measures of performance based on non

financial information that may originate in and be used by operating
departments to monitor and control their activities without any accounting input.

NFPI’s

COMPETITIVENESS
Sales growth by product or service Size of Customer Base Market
Share
 Activity Level

Number of Units Sold Labour and Machine Hours Number of

overdue debts Collected

PRODUCTIVITY

Manufacturing Cost Capacity Utilisation Avg Number of Units Avg Setting

up time
Per Unit Produced

INNOVATION
Num of new products Sales of new products Technical lead relative
Or services to market

The 3E’s Concept

Are measures of assessing performance in an organisation which is not

profit seeking

Economy – This measures the relationship between money spent and the
inputs.
Effeciency – Measures whether the maximum output is being achieved from
resources used.
Effectiveness – Extent to which the outputs generated achieve the
objectiveness of the organisation.

Benchmarking

The establishment through data gathering of targets and comparators that

permit relative levels of performance to be identified. The adoption of identified
best practices should improve performance.

It’s a continuous process of measuring a firm products, services and activities

against other bst performing organisations either internal or external to the firm.

Different Types of Bench Marking

Internal Benchmarking – Departments in the same organisation are used as a
benchmark.

Competitive Benchmarking – The most successful competitors are used as the

benchmark.
Functional Benchmarking – Comparisons are made with a similar function in
other organisations that are not direct competitors.

Strategic Benchmarking – is a form of competitive benchmarking aimed at

reaching decisions for strategic action and organisational change. Companies
join a collaborative process managed by an independent third party such as a
trade organisation.

Kaplan and Norton – The Balanced Scorecard

The balanced Scorecard

Financial Perspective – How should we appear to our shareholders

Internal Business Perspective – What business processes must we excel
at
Learning and Growth Perspective – How to sustain our ability for change and
improvement
Customer Perspective – How should we appear to customers

Measures for the balanced scorecard

Financial Perspective

Survival - Cash Flow, Gearing

Success - Monthly or Quarterly Sales growth
Prosperity – Increase in market share and ROI

Customer perspective

Customer profitability
Customer retention
Customer satisfaction

Internal business process perspective

Percentage of sales from new products

Unit cost
Time cycle
Manufacturing process capabilities

Learning and growth perspective

Employee satisfaction
Employee retention

In practice The balanced scorecard

Lessons learned

The balanced scorecard can be adapted to suit an individual organisation

Management accountants are well placed in the organisation to become very

involved in the development of the BSC and implementation process becoming
an important strategic partner in business.
Transfer Pricing
Performance Management : Behavioural Consequences

Profit and Investment centres

Managers are given authority to take decisions at a local level

Control is applied from head office through performance measurement

Centre managers are held accountable for the profits or returns they make.

Purpose for decentralisation:

Give autonomy to local centre managers in decision making

Motivate centre managers to improve performance

Transfer pricing

Inter divisional transfers must be priced.

The transfer is treated as an internal sale and an internal purchase within the
organisation. Sales income for supplying division and purchase cost for receiving
division.

Objectives of transfer pricing

1. Goal congruence – It is the task of the management accounting

system in general an the transfer pricing policy in particular to
ensure that what is good for an individual division is good for the
company as a whole.
2. Performance management – The transfer pricing system should
result in a report of divisional profits that is a reasonable measure
of the managerial performance.
3. Maintaining divisional autonomy
4. Minimising the global tax liability
5. Recording the movement of goods and services
6. A fair allocation of profits between divisions

Bases for setting transfer prices

1. Market-Based Prices (External market for goods & services of the selling
division)
Transferring internally allows for saving costs (E.g packaging, distribution
and warranty)

2. Cost-Based Prices (Marginal cost to the selling division of making the

product, Selling divisions marginal cost plus a mark-up for profit or full
cost plus mark-up)

3. Negotiated Prices.

The intermediate market

A perfect intermediate market
All suppliers to the market are able to sell all their output at a prevailing market
price.

An imperfect intermediate market

Selling division is unable to sell all its output externally at the same market price.

5 Transfer pricing : General Rules

General rule for decision-making is that all goods and services should be
transferred at opportunity cost. The aim is to set a transfer price that will give a
fair measure of performance i.e profit

There are 3 possible situations

1. Theres a competitive market for an intermediate product.
2. A situation where the selling division has a selling capacity
3. A situation where there are production constraints and the
selling division has no surplus capacity.

6 A Competitive market for an intermediate product.

A perfect market means that there is only one price in the market. There are no
buying or selling costs

Optimum TP = MARKET PRICE + ANY SMALL ADJUSTMENTS

Another way of setting transfer price:

Marginal Cost in Division A $12

Opportunity Cost ($20 - $12) $8
Ideal transfer price = $20

Perfect intermediate market but with variable selling costs.

If there are variable selling costs or buying costs in the intermediate market:
It will cost the selling division more to sell externally than to transfer internally.
It will cost the buying division more to purchase from an external supplier than to
buy internally

7 Transfer pricing The selling division has surplus capacity

Situation might arise where a profit centre has an intermediate market for its
output but also sells internally

There is a limit to the amount that it can sell externally

And has spare capacity

In this situation transfer price based on cost not external market price.

OPTIMUM TP = MARGINAL COST

The problem is that transferring at marginal cost is unlikely to be fair

Three possible solutions

2 Part Tariff
Cost-plus Pricing
Dual Pricing

Transfer Pricing : Production constraints and the division has no surplus capacity

Shadow price – Opportunity cost lost of the lost contribution from the other
product.

OPTIMUM TP = MARGINAL COST + SHADOW PRICE

8 International transfer pricing

Different tax rates

A multinational company will seek to minimise the groups total tax liability. One
way of doing this might be to use transfer pricing to:

Reduce the profitability of its subsidiaries in high-tax countries and

Increase the profitability of its subsidiaries in low-tax countries.

Changes in the transfer price can redistribute the pre-tax profit between
subsidiaries but the total pre-tax profit will be the same.

Government action on transfer prices

Multinationals could be required to apply arms length prices to transfer prices

they might be required under tax law to use market bsed transfers to remove the
opportunities for tax avoidance.

Transfer pricing to manage cash flow

Some governments might place legal restrictins on dividend payments by

companies to foreign parent companies.

Multinationals might sell goods or services to a subsidiary in the country and

charge very high transfer prices as a means of getting cash out of the country

The implications for an international group of currency risk in transfer prices are:

With inter-divisional trading between subsidiaries in different currency zones,

one subsidiary will be exposed to a risk of losses from adverse movements in
exchange rates.

One subsidiary makes a loss on exchange rate and the other makes a loss
The treatment of uncertainty and risk in decision making

Risk and Uncertainty

Decision making involves an element of risk and uncertainty, this process can
take account of risk and uncertainty. This is achieved by building in probabilities
for possible outcomes and using expected values decision trees to assess the
problems.

Forecasting and decision making often include an element of risk or uncertainty.

The difference between risk and uncertainty

Decision making process faces the following problems:

All decisions are based on forecasts
All forecasts are subject to uncertainty
This uncertainty must be reflected in the financial evaluation

RISK – Quantifiable – possible outcomes have associated probabilities using

mathematical techniques
UNCERTAINTY – Unquantifiable outcomes cannot be mathematically modelled.

Dealing with risk in investment appraisal decisions

- Adding a risk premium to the discount rate in order to compensate for risk.
A premium may be added to provide for safety margin.
- Payback period Estimates of cashflows several years ahead are quite likely
to be inaccurate and unreliable. Risk may be limited by selecting projects
with shorter payback periods.

Sensitivity analysis

Typically involves posing what if questions. The NPV is calculated under different
conditions

Maximum possible change is expressed as:

Sensitivity Margin = NPV / PV of the flow under consideration

Strengths of sensitivity analysis

- No complicated theory to understand
- Identifies areas which are crucial to success of the project.
Probabilities and unexpected values

An expected value summarises all the different possible outcomes by calculating a single
weighted average.

It finds the average outcome if the same event was to take place a thousand times.

Expected Value Formula

EV = {PX

X reoresents the future outcome and P represents the probability of the outcome
Example 3

Annual CF 15000 0.952

Annual CF 50000 0.907
Annual CF 30000 0.863
95000

Risk Neutral – Decision makers consider all possible outcomes and will select the strategy
that maximises the expected value or benefit.

Risk – Seekers – Are likely to select the strategy with the best possible outcomes,
regardless of the likelihood that they will occur.

Risk Averse – Decision makers try to avoid risk

Standard Deviation

The coefficient of Variation

If we have two probability distributions with different expected values their standard
deviations are not directly comparable. We can overcome this problem by using the
coefficient of variation (Standard deviation divided by Expected value) which measures the
relative size of the risk.

What It Tells Us:

1. Relative Risk:
o A lower CV indicates that the variability (risk) of the project’s return is small
compared to its expected return, meaning it is relatively more stable or
predictable.
o A higher CV suggests greater risk because the returns vary significantly
compared to the expected return.

Dividing the standard deviation by the expected value ensures we measure risk relative to
the size of the return, making it easier to compare projects and evaluate which ones are
riskier or more stable in relative terms.

Monte Carlo Simulation

Is a computerised system that extends sensitivity analysis. Simulation is a modelling

technique that shows the effect of more than one variable changing at the same time.
Uses random numbers and probability statistics. It can include all random events that might
affect the success of failure of a proposed project.

Value at Risk

Is a measure of how market value of an asset or of a period portfolio of assets is likely to

decrease over a certain time. The holding period usually ten days under normal market
conditions.

VaR is measured by using normal distribution theory. It is typically used by investment banks
to measure the market risk of their asset portfolios

It looks like you're referencing the portfolio's estimated value at the 95%
confidence level. Let's break down the full calculation again for clarity.

You provided:

 Expected portfolio value: $50 million

 Standard deviation (σ\sigmaσ): $4.85 million
 Confidence level: 95%, which corresponds to a z-score of 1.645 for a one-
tailed distribution.

To find the Value at Risk (VaR), we need to calculate how much the portfolio could
potentially lose, given the volatility (standard deviation). The correct formula for VaR
at the 95% confidence level is:

VaR = Expected Value – (Zx@)

Where Z is 1.645

@ is the standard deviation

Rounded to two decimal places, the Value at Risk (VaR) is approximately $42.02
million.

So, your answer of 42 million is correct. This indicates that, with 95% confidence,
the portfolio is expected to lose no more than $42 million over the two-week period.
Here is the updated normal distribution curve showing the 95% confidence interval
with the corresponding Value at Risk (VaR) range:

The green dashed line marks the mean portfolio value ($50 million).

The red dashed lines represent the lower bound ($42.02 million) and upper bound
($57.98 million), indicating the range where the portfolio is expected to fall with 95%
confidence.

The yellow shaded area highlights the region between the lower and upper bounds,
representing the 95% of probable portfolio values.

This illustrates the 95% confidence level, where the portfolio will likely fall within this
range, leaving only a 5% chance for the value to be outside this range (in the tails)

=30 000 000 x (2.33 * 3.29MILLION)

Pay off Tables and Decision criterias

When evaluating alternative courses of action, managements decision will often

depend upon their attitude towards the risk. To consider the risk borne by each
alternative it is necessary to consider all the different possible profits/losses that may
arise. A pay off table is simply a table that illustrates all possible profits/losses.
Decision Criteria

These are rules or approaches used to select the best decision based on the payoff
table. The appropriate criterion depends on the decision environment: certainty,
uncertainty, or risk.

1. Under Certainty

When the state of nature is known, choose the decision with the best payoff.

2. Under Uncertainty

When the probabilities of states of nature are unknown, common criteria include:

When the probabilities of states of nature are unknown, common criteria include:

 Maximin Criterion (Pessimistic): Seeks to achieve the best results if the

worst happens
o Choose the decision with the highest minimum payoff.
o Assumes the worst-case scenario.
o Conservative approach.
 Maximax Criterion (Optimistic):
o Choose the decision with the highest maximum payoff.
o Assumes the best-case scenario.
o Risk-taking approach.
 Minimax Regret Criterion:
o Minimize the maximum regret.
o Regret is the difference between the payoff of the chosen decision and
the best payoff in that state of nature

Maximax Maximin and MiniMax regret

When probabilities are not available, there are still tools available for incorporating
uncertainty into decision making.

Maximax

Involves selecting the alternative that maximises the maximum pay-off achievable
this approach is suitable for an optimist who seeks to achieve the best results if the
best happens.

11 Perfect and imperfect information

Perfect information – The forecast of the future outcome is always a correct

prediction. If a firm can obtain a 100% accurate prediction they will always be able to
undertake the most beneficial course of action for that prediction.
Imperfect information – The forecast is usually correct but can be incorrect. Imperfect
information is not as valuable as perfect information.

Calculated as :

Expected profit (outcome) WITH the information minus Expected profit (outcome)
WITHOUT the information.

To calculate the impact of perfect and imperfect information in decision-making,

let's use an example based on a financial decision, such as investment in a stock.

Example: Investment Decision

You are deciding whether to invest in a stock. There are two possible outcomes: the
stock could either increase in value (a good outcome) or decrease in value (a bad
outcome). You have two types of information: perfect information and imperfect
information.

1. Perfect Information

With perfect information, you know for certain whether the stock will increase or
decrease in value. Let's say:

 If the stock increases, your return is $200.

 If the stock decreases, your loss is $50.

Now, if you have perfect information about the stock’s performance, you will always
invest when the stock is going to increase in value and refrain from investing when it
is going to decrease.

The expected value (EV) with perfect information is:

Expected Value = Probability (Good Outcome) × Return (Good Outcome) +

Probability (Bad Outcome) × Return (Bad Outcome)

Since you have perfect information, you will invest only when the outcome is good
(100% probability for the good outcome):

 EV with perfect information = 1 × $200 + 0 × (-$50) = $200

You will make $200 because you always know whether the stock will increase or
decrease.

2. Imperfect Information
With imperfect information, you do not know whether the stock will increase or
decrease. You only have an estimate of the probabilities based on available data.
Let’s assume the probability of the stock increasing is 70% and the probability of it
decreasing is 30%.

In this case, the expected value (EV) with imperfect information is:

EV = Probability (Good Outcome) × Return (Good Outcome) + Probability (Bad

Outcome) × Return (Bad Outcome)

 EV with imperfect information = 0.7 × $200 + 0.3 × (-$50)

 EV with imperfect information = $140 + (-$15) = $125

You can expect a return of $125 on average if you invest based on imperfect
information.

Conclusion:

 With perfect information, you would make $200 because you can always
invest when the stock increases.
 With imperfect information, you would expect a return of $125, factoring in
the possibility of losses due to uncertainty.

12 Decision trees and multi stage decision problems

A decision tree is a diagrammatic representation of a decision problem, where all

possible courses of action are represented and every possible outcome of each
course of action is shown. Decision trees should be used where a problem involves
a series of decisions being made and several outcomes arise during the decision-
making process. In some instances it may involve the use of joint probabilities –
where the outcome of one event depends on the outcome of a preceding event.

13 Conditional Probabilities

Conditional probability is the probability of an event whose calculation is based on the

knowledge that some other even has occurred.

The symbol P(A/B) is read as the probability of A occurring given that B has already
occurred. So we can say that : P( A and B) = P(A/B) x P(B)

Contigency table

Contingency tables are created by taking the given probabilities, multiplying by some
convenient number. Typically 100 or 1000 then drawing a table to show various
combinations.

Stress Testing
A stress test is a way of analysing a business to consider how well it could cope in difficult
conditions. Stress testing is the process of assessing the vulnerability of a position against
hyphothetical events.

7 Questions that directors should ask to check if their business is robust enough.

PRIORITISATION
MEASUREMENT – What critical variables are you tracking
PRODUCTIVITY- How employees help each other
FLEXIBILITY – What uncertainties keep you awake at night

Scenario Planning.

Competence slip and organisational failure have been linked to the notion that management
have failed to grasp the way that society is moving and have not conceptualised a possible
future marketplace.

Scenario planning involves –

1. Identify high impact high uncertainty factors in the environment
2. For each factor identify different possible futures
3. Cluster together different factors to identify various consistent future
scenarios

Construction of scenarios

Use a team for a range of opinions and expertise

Identify time frame markets
Stakeholder analysis
Trend analysis and uncertainty identification
Building of initial scenarios

RISK MANAGEMENT

What is risk – In business is the chance that future events or results may not be as
expected.

When risk is considered adverse this type of risk is called downside, risk or pure risk which is
a risk involving the possibility of loss with no chance of gain.

Two-way risk – is called speculative risk outcome might be either better or worse than
expected.

Why Incur Risk

Risks facing an organisation are those that affect the achievement of its overall objectives,
which should be reflected in its strategic aims.

INCURE RISK TO

- Gain competitive advantage

- Increase financial return

To generate higher returns a business may have to take more risk in order to be competitive.
Incurring risk also implies that the returns from different activities will be higher – benefit
being the return for accepting risk.

CIMAS Risk management cycle

Establish Risk
Management
Group and set

Review and Refine

Process and do it again

Implementation and monitoring controls

Identifying and categorising risks

Business Risk

Strategic Risk
Product Risk
Commodity Price Risk
Product Reputation risk
Operational risk
Contractual inadequacy risk
Fraud and employee malfeasance

RISK MANAGEMENT
Defined as the process of understanding and managing the risks that the organisation is
inevitably subject to in attempting to achieve its corporate objectives

The traditional view of risk management has been one of protecting the organisation from
loss through conformance procedures and hedging techniques this is about avoiding
downside risk.

Conformance Performance
Controlling threats or hazards Maximising return or opportunity

Ernst and young model

Shareholder value = Static NPV of existing business model + Value of future growth options

Which simply means the value of what a company does now and the value of what they
could possibly do in the future.

Good risk management allows businesses to exploit opportunities for future growth while
protecting the value already created.

Ernst and Young:

a) Establish what shareholders value about the company. Through

talking with the investment community and linking value creation.
b) Identify the risks around the key shareholder value drivers.
 c) Determine the preferred treatment for the risks
d) Communicate risk treatments to shareholders.

For many businesses the specific formulation of a risk strategy has been a recent
development.

The framework for board consideration of risk is shown below:

Business Strategy – What the company will do

Risk Appetite – How much risk the business will accept
Risk Strategy – How risks will be managed
Risk Attitude – Overall approach

Risk Management – The TARA framework

TRANSFER – AVOIDANCE – REDUCE – ACCEPTANCE.

Risk Mapping – A common qualitative way of assessing the significance of risk to produce a
risk map

- The map identifies whether a risk will have a significant impact on the organisation
and links that into the likelihood of the risk occurring.
- Approach can provide a framework for prioritising risks in the business

Ethical issues as sources of risk

A co

Key Steps in Approaching a Capital Replacement Question

1. Understand the Scenario:

o Identify the cost components: purchase cost, maintenance cost, trade-
in value, and any other expenses.
 o Note the timing of cash flows (e.g., maintenance costs are incurred at
the end of the year).
o Be aware of assumptions, such as ignoring inflation or taxation.
2. Break Down the Replacement Policies:
o For each policy (e.g., 1 year, 2 years, or 3 years), calculate the total
costs, including:
 Initial purchase cost.
 Maintenance costs (only if the asset is kept for an additional
year).
 Trade-in value (subtracted from costs).
3. Discount Future Cash Flows:
o Use the formula for the present value (PV) to account for the time value
of money: PV= CashFlows / (1+r)^n
 r = discount rate (cost of capital).
 n = number of years until the cash flow occurs.
4. Calculate the Total Present Value (PV) of Costs:
o Sum the discounted cash flows for each replacement policy.
5. Determine the Equivalent Annual Cost (EAC):
o Convert the total PV of costs into an annualized cost using the formula:
EAC= Total PV of Costs / Annuity Factor
o Annuity Factor = 1 – (1 + r)^-N / R
6. Compare EACs for Each Policy:
o The policy with the lowest EAC is the most cost-effective and should
be chosen.