Management Informa-on Systems And Data Analy-cs

MANAGEMENT INFORMATION SYSTEMS AND DATA ANALYTICS

Information Systems

Information systems, consisting of hardware, software, and communication networks, are essential
for managing an organization. IT is widespread in modern systems, supporting all management
levels.

Benefits Of Information Systems

• Provides strategic management with comprehensive business overview.
• Allows for customized information extraction, saving time and reducing clerical expenses.
• Enhances efficiency by simplifying data use and presentation in various formats.
• Real-time information can drive improvements, such as meeting customer needs.

Costs Of Information Systems

• Initial set-up costs including hardware, software licensing, and installation.
• Data conversion of historical information.
• Staff and user training
• Modifications and system upgrades.
• Communication charges for internet access.

Network Technology
• A computing network is a group of devices connected through physical or wireless
connections.

• Networking technologies include Local Area Networks (LAN), Wide Area Networks (WAN),
Storage-Area Networks (SAN), and Virtual Private Networks (VPN).

o LAN – a group of computers connected across short distances

o WAN – for example, the Internet, connects computers worldwide.

o SAN – network that connects shared pools of storage devices to several servers.

o VPN – users access a private network across the internet.

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 Management Informa-on Systems And Data Analy-cs
Internet

Internet is the global network of computers and devices connected with an Internet Protocol (IP)
address.

Intranet Extra Net?

Intranets are private networks within an organization that only authorized users can access. They
facilitate collaboration and document sharing, enabling remote working.

Wireless Technology

• Wireless technology transmits data without a physical connection using radio frequency,
infrared, and satellite technologies.

o It allows devices like tablets, laptops, printers, and smartphones to communicate

with the internet.

o Mobile phone networks allow long-distance communication.

o Bluetooth exchanges data over short distances.

o RFID tags store data, useful in industry for inventory management, asset tracking,
and restricted access control.

Principal Controls For The Distribution Of Internal Information

• Controls and procedures should be in place to ensure that reports are prepared when the
benefits outweigh the cost, sent to relevant managers to prevent "information overload,",
preventing duplicates and ensuring only relevant information is included in the report.

• Internal reports are subject to strict distribution controls, including a pre-determined format
and provision of distribution lists for all reports.

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 Management Informa-on Systems And Data Analy-cs

Confidential Information

• Information security safeguards users and information systems from harm from hacking,
operational errors, and sabotage.
o Security – protection of the system from harm.
o Privacy – restriction of knowledge to authorised persons.

• Hacking is the deliberate unauthorised access to a system and its data.

• Hacking usually takes one of two forms:

o Authorisation attack – password cracking using computer programs.

o Trapdoor/backdoor attacks – utilising existing weaknesses within the program code

of the system.

Control Measures for Confidential data:

General Security Controls

Staff Management

• Segregating duties, such as restricting code changes to programmers or viewing sensitive

data without authorization.

• Thorough screening of job applicants before employment.

• Applying procedures for cleansing of security access for terminated staff.

• Conducting risk analysis on sensitive staff to identify low morale, poor motivation, and
potential "grudge" bearers.

Physical Access Controls

• Prevent unauthorised people from accessing computer systems include:

o Security guards and cameras
o Time controls
o Electronic door locks

Limits data theft

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Logical Access Controls

• Protects data or software from unauthorised access.

• Includes system passwords and usage logs.
• Call-back (dial-back) security authenticates remote system access.
o Example: System calls user back on pre-agreed phone number after a user enters a
name and password. like OTP

Passwords

• Passwords are sequences of characters known only to the user, allowing access to a
system.
• Characters should be alpha, numeric, upper and lower case
• Passwords should never be readable from the screen.
• Limit the number of password attempts for high-risk systems.

Encryption

• Encryption is a method that makes data unreadable, preventing unauthorized access.

• It involves an algorithm and a secret code.

• The data must be decrypted using a matching key to be read.

Software Audit Trail

• It is a record of crucial transaction data, including user, transaction type, quantities, and
values.

• This is used by third parties like internal auditors and system analysts for inspection and
verification.

Testing Systems Security

• External organizations offer "attack and penetration" services, attempting to access

computer systems physically and logically.
• In-house staff may test systems, but they may have a vested interest.

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 Management Informa-on Systems And Data Analy-cs
Principal Sources Information Principle sources of information:

Internal Sources

• Accounting system
• Inventory system
• Payroll system
• Qualitative information systems (e.g. Customer satisfaction)

External Sources

• Government statistics;
• Business directories of detailed information about the activities of other organisations;
• Trade magazines or other similar publications

Dividing Management into 3:

Accounting Information Requirements
1. Top level managers --> strategic level
Strategic Planning [Link] level managers ---> tactical level
3. Junior level managers ---> operational level
• Strategic planning, typically carried out by the board of directors.
• Strategic planning addresses high-level objectives.

• Incorporates extensive external information.

• Includes forecasts covering a longer time horizon.

• Strategic control information includes business segment profits, external factors influencing
the organization, market studies, and investment appraisal.

Tactical Management
• Tactical management involves middle management implementing strategic plans, ensuring
resource utilization, preparing annual budgets, and recruiting staff.

• Mainly internal information.

• Regularly provided, like monthly revenue analysis and variance analysis.

• Includes forecasts for up to 12 months.

• Key tactical control measures include sales analysis, inventory levels, and cash flow
projections.

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Operational Management

• Operational management involves day-to-day business operations

• Requires transaction-based data.

• Internal and short-term
• Control measures include customer complaints, output records and payroll details etc

Information Systems for 3 levels of management

Transactions Processing Systems (TPS)

• TPS are operational staff tools used to capture and process data, improving information
accuracy and timeliness.
• They collect and store transaction data
o Examples : withdrawing cash, receiving inventory.
• Two approaches to process the data:
o Batch processing – individual transactions of the same type are collected and stored
for later (periodic) input to the computer.
o Real-time systems processing – transactions are processed immediately as they
occur.

Management Information Systems (MIS)

• MIS convert data from internal and external sources into information for management at all
levels and functions.

• They are used for planning, controlling, and decision-making.

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Decision Support Systems (DSS)

• DSS are computer-based systems that aid managers in decision-making, often using
analytical modelling techniques.
• These systems analyse large data sets and provide information on likely outcomes based
on rules and assumptions.

Executive Information System (EIS)

• EIS is a decision support system that aids senior management in making strategic
decisions by providing summarised information from internal and external sources.
• It provides high-level performance data, often accompanied by charts, tables, and graphical
tools.

Enterprise Resource Planning Systems (ERP) Connects all other functions of the company

• An ERP system is a software that integrates business processes into a unified approach,
allowing for seamless information flow across an organization.
• It typically includes modules like accounting, financial, inventory control, and customer
relationship management.

Customer Relationship Management Systems (CRM)

• CRM is a strategic approach to manage customer interactions and data, improving

customer service, retention, and sales growth.
• CRM software consolidates customer information for easy access and management.
• Key features include easy data import, user-friendly interface, adaptability, improved
customer satisfaction, and easy reporting and tracking features.

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 Management Informa-on Systems And Data Analy-cs
Big Data
used for decision making based on customer interest
• Big data is the vast data sets that may be analysed to reveal patterns, trends and
associations, especially relating to human behaviour and interactions.
o Structured data – data stored within defined fields within a defined record, along with
similar data, according to the specifications laid down in a data model.
o Unstructured data – information gathered in various forms and ways, not in
accordance with any data model, and thus may be difficult to store or analyse.

Characteristics V/S Normal data stored by the company

• Volume: Large amounts of data, not easily handled by a single computer.

5 V's
• Variety: Non-uniform data from internal and external sources, some structured but primarily
unstructured.
• Velocity: Fast and continuous data that needs quick processing for useful results.
• Veracity: Assesses the reliability of the data and the source.
• Value: Big data analysis can be costly, the organization must consider the potential value of
big data analysis.

Data Analytics

• The processing of big data is generally known as data analytics and includes the following:

o Data testing: testing models or hypotheses on existing data. based on assumptions

o Data mining: analysing data to identify patterns, relationships and [Link]

o Predictive analytics: a type of data mining which aims to predict future events , very
often using statistical or machine learning techniques.

o Text analytics: scanning emails and word documents to extract useful information.

o Statistical analytics: used to identify trends, correlations and changes in behaviour.

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 Management Informa-on Systems And Data Analy-cs
The Big Data (DIKW) Pyramid

It is designed to show the stages of the transformation of the initial unstructured data obtained into
material that can be used for reliable decision-making and accurate forecasting.

Level Description

Facts and figures.

Data may be provided from a number of sources, but it is not helpful if there
are no links between different items.
Data

Identifying data relationships.

The initial analysis aims to find the meaning of the data and establish what
links and relationships there are between the data. If these are established,
the data becomes information.
Information

Understanding data relationships.

Further analysis provides more detail about the context of how and why the
links between the data might arise and what the specific connections and
patterns are. Establishing these things means that the data becomes
knowledge.
Knowledge

Improved decision-making from the understanding of data relationships.

Ensuring the knowledge can be used to make an informed decision and

correct predictions means that it becomes wisdom.
Wisdom

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 Management Informa-on Systems And Data Analy-cs
Benefits Company's perspective

• Marketing: Gaining insights about customer preferences through browsing histories and
purchases.

• Customer Service: Collecting feedback from various sources, including social media.
• Competitive Strength: Identifying and responding to customer preferences early
• Customer Loyalty: Using data to make personalized offers.
• Operational Efficiency: Improved sales volume forecasting for better inventory
management.

• Performance Measurement: Accessing diverse insights to avoid over-focusing on readily

available information.

Challenges And Risks

when using modern tech
• Cost: Establishing hardware and analytical software is costly, but costs are decreasing.

• Time and staff resource: Analysing important data can be time-consuming.

• Regulation: Some countries and cultures have laws regulating data collection, storage, and
use.

• Loss and theft of data: Companies may face civil legal action if data is stolen.

• Incorrect data (veracity): Outdated or incorrect data can lead to erroneous conclusions.

• Overfitting: Risk of finding patterns in data that cannot be used for future prediction.

Importance of Data Visualisation Data management

Data visualisation uses graphic representations like charts, graphs, and maps to present and
analyse big data, identifying trends, patterns, outliers, anomalies, and providing insights.

Tables

Tables should be user-friendly, fit on one page, and indicate if data is from a specific source.
Guidelines include having a title, headings for columns and rows, and bolding totals.

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 Management Informa-on Systems And Data Analy-cs
Bar Charts

Bar charts, with two axes, are used for comparing data series and observing trends. They must be
drawn from the origin, with zero x- and y-axes. They can take various forms and are best for
comparing data series.

Different Types:
• Simple bar chart
• Compound (“clustered”) bar chart
• Component (“stacked”) bar chart
• Percentage component bar chart

Line Charts

Line charts, with two axes, are used to observe trends over time. They are best suited for
observing the independent variable on the x-axis and the dependent variable on the y-axis.

Different Types:
• Simple Line Chart
• Multiple Line chart

To identify/compare relative size

Pie Charts

Pie charts are most suitable for showing the proportions of multiple data series at a single period
or point.

Scatter Diagram not getting a straight line

Scatter diagrams plot data points on a chart with two variables for each axis.

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Additional Notes

• Automated systems for data capture are generally more reliable than data capture requiring
input by individuals.
• Management information systems are based mainly on internal data sources rather than
sources that are external to the organisation.
• Controls are needed over internally produced information to prevent excessive amounts of
information being circulated – leading to waste of management time. Controls are also
needed to ensure that unauthorised information is not circulated. Controls may extend to
the use of emails containing 'off-the-record' comments which could, potentially, have legal
implications for the organisation.
• Structured data refers to any data that is contained within a field in a data record or file.
This includes data contained in databases and spreadsheets. Unstructured data is data that
is not easily contained within structured data fields: pictures, videos, webpages, PDF files,
emails, blogs etc.
• Data visualisation is based on the data available so it can only be as accurate as the
original data. Visualisation does not improve this accuracy.
• Many cloud services are provided by external third parties, and therefore reliance on these
suppliers will be increased.
• Using big data allow organisations to react more quickly than rivals in the marketplace
giving them a competitive edge. This can be achieved by better tracking of consumer trends
as well as the actions of competitors themselves. The actions and changes of competitors
can be accounted for by examining data on rivals such as their public announcements and
market expectations.

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 Management Informa-on Systems And Data Analy-cs
Summary

• An information system is an integrated set of components that collect, store, process and
communicate information.
• Control procedures to ensure the security of confidential data typically include physical and
logical access controls, passwords, encryption, systems logs and audit trails.
• Sources of information are:
o Internal (e.g. Transaction processing systems); and
o External, which may be primary (e.g. Market research) or secondary (e.g.
Government statistics).
• An MIS converts data from internal and external sources into information used by
management for planning, control and decision-making.
• Systems include:
o EIS – provides high-level information to senior management and typically includes
reporting tools and drill-down facilities.
o ERP – can be used by all functions within the organisation and include a central
shared database.
o CRM – used to manage customer interactions and data, improve customer service,
retain customers and drive sales growth.
• The "Vs" of big data are volume, variety, velocity, veracity and value.
• Data analytics refers to the analysis of big data to reveal patterns, trends and associations,
especially relating to human behaviour and interactions, which may help a business
improve its performance.
• Data analytics includes:
o Data testing;
o Data mining;
o Predictive analytics;
o Text analytics; and
o Statistical analytics.
• The purpose of data visualisation is to present data to users in a form that is easy to
understand and analyse, summarising big data in a way that even non-technical users may
understand.

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 Cos%ng basics
COSTING BASICS

Financial Accounting and Management Accounting

• Management accounting involves preparing and presenting accounting information to

management for business operations planning, control, and decision-making.
• Financial accounting focuses on preparing and presenting information on a business's
performance and financial position.

Costing

Costing is the process of determining the costs of products, services or activities.

Cost Classification

By Nature

• Material
• Labour
• Other expense

By Behaviour

• Variable cost: costs which change in direct proportion to the level of production.
o Example – material cost.
• Fixed cost: those costs which do not change with the level of activity.
o Example – staff salary.
• Semi variable: mixture of fixed and variable costs.
o Example – Electricity / Telephone charges.
• Step cost: constant at a certain activity level but increase or decrease when an activity
threshold is met crossed.
o Example – rent.
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 Cos%ng basics
By Traceability

• Direct cost: a cost that can be directly identifiable with a specific cost unit. Cost unit----> 1 unit

o Example – material cost

• Indirect cost: a cost that cannot be directly identifiable with a specific cost unit. ---> overheads
o Example - rent, salary.

Some Basic Terms

• Cost unit: a unit of measurement for the quantity of a product or service

• Cost centre: a location, function or item of equipment in respect of which costs may be
ascertained and related to cost units.
• Prime cost: sum of all direct costs.
o Prime cost = direct material + direct labour + direct expense
• Conversion cost: manufacturing or production costs necessary to convert raw materials into
products
o Conversion cost = direct labour + direct expense + production overheads

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Traditional Costing Techniques

Absorption Costing

• Aims to determine the full production cost per unit by considering both direct and indirect
expenses.
• Product cost includes fixed and variable elements.
• Under absorption costing, fixed production overhead costs must be allocated, apportioned
and absorbed.
o Allocation: Overhead costs are allocated to their respective cost centres, with costs
related to a single cost centre being allocated to that cost centre.
o Apportionment: Common overheads must be shared between the relevant cost
centres using an appropriate method of apportionment.
o Re-apportionment: Overheads previously allocated to service cost centres must be
re-apportioned to production cost centres.
o Absorption: overheads in each production department must now be absorbed into
the units.

Possible bases of absorption

§ a rate per direct labour hour

§ a rate per machine hour
§ a rate per unit
§ a percentage of direct materials cost
§ a percentage of direct labour cost
§ a percentage of direct prime cost

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 Cos%ng basics
Example 1

Details of a product are as follows:

Direct material cost per unit $6

Direct labour cost per unit $4

Total production overhead $2,000

Total units 1,000 units

Required

Calculate full production cost per unit.

Example 2

A company makes two products, the A and B.

A B

Labour hours per unit 2 5

Total production units 10,000 6,000

Total overhead $150,000

Total direct labour hours 50,000

Required

What is the overhead cost per unit for A and B respectively if overheads are absorbed on the basis
of labour hours?

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 Cos%ng basics
Marginal Costing

Marginal costing is an accounting technique where variable production costs are charged to units,
with fixed overheads treated as period costs.

Contribution

Contribution is the difference between sales and variable cost. Contribution is more useful for
decision-making.

Contribution = sales revenue – variable cost

Example 3

Details of a product are as follows:

Variable cost per unit $20

Selling price $60

Total fixed cost $25,000

Total sales units 12,000 units

Required:

Calculate the total profit.

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 Ac$vity-Based Cos$ng
ACTIVITY BASED COSTING

Absorption Costing
Limitation of absorption costing

Traditional costing uses a single basis to allocate overheads into cost units, under-allocating costs
to low-volume products and over-allocating costs to higher-volume products.

Activity-Based Costing Reason for cost, ie cost driver

Activity-based costing is a costing method that tracks resource consumption and outputs,
assigning resources to activities and cost objects. It uses cost drivers to attach activity costs to
outputs, identifying activities that cause overhead costs. This approach extends absorption
ABC is an extend of absorption costing
costing, considering the cost drivers that cause overhead costs. The overhead is apportioned to
bettering th process of OAR calculation
each product based on the use of activities. Fair allocation of cost

Example 1

Products A B
Production units 1,000 units 2,000 units
Total ordering cost $9,000
Number of orders 700 200

Required:

Calculate the total cost of both products using absorption costing and activity based costing

Stages in Developing Activity Based Costing System

• Group production overheads into cost pool.
• Identify cost drivers causing cost changes.
• Calculate absorption rate per cost driver for each activity.
• Charge overhead cost to products based on activity usage.
• Calculate full production cost.

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 Ac$vity-Based Cos$ng
Cost Driver

A cost driver is a factor that generates overhead costs and can cause changes in the cost of an
activity.

Cost Pool

A cost pool refers to an activity that uses resources and allocates overhead costs for each activity,
accumulating costs for each activity.

for addressing Modern manufacturing

Overhead Costs and Possible Cost Drivers – Examples complexities

Cost Pool Possible Cost Driver Nature of costs

Ordering costs Number of orders

Despatching costs Number of orders despatched
Machine operating costs Machine running costs Number of machine hours
Machine set-up costs Number of machine set-ups
setting the machine and making ready for production runs
Materials handling costs Material movements Number of production runs 1 batch of production
Production scheduling costs Number of production runs
it gets complicated when there are more production cycle ...

Note:

• Number of production runs = Number of machine set-ups

• Production volume-related costs should be linked to products using direct labour hours or
machine hours as cost drivers.

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 Ac$vity-Based Cos$ng
Example 2

TR Co manufactures four products, W, X, Y and Z. Output and cost data for the period just ended
are as follows:

Product Total Material cost Labour hours Labour cost Production Runs
units per unit ($) per unit per unit ($) in the Period
W 10 20 1 5 2 W : 1 production run = 5 units
X 10 80 3 15 2
Y 100 20 1 5 5
Z 100 80 3 15 5

Overhead costs

Set-up costs 10,920

Materials handling costs 7,700

Required:

Prepare unit costs for each product using:

a) Conventional absorption costing (overheads are absorbed using direct labour hours)
b) Activity based costing

Advantages of Activity Based Costing

• Accurate overhead costs per unit

• Fair cost calculation ; Provides accurate selling price. Insight about the reasons for
cost, ie: cost drivers.
• Easy overhead cost control : Enables informed cost reduction actions Controlling cost drivers for
reducing cost
• Recognizes modern manufacturing complexity through multiple cost drivers.
• Applicable to both production and non-production overheads.
Other than cost calculation; ABC can be used for;
ABM - Activity based management
ABB - Activity based budgeting
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 Ac$vity-Based Cos$ng
Disadvantages of Activity Based Costing

• Time consuming and expensive

Risk arises when actual amount varies, calculations may need
• ABC is based on budgeted overheads. corrections
Simply dividing based on Activity, (without
• Selection of cost drivers may be complex
any proper reason)
• ABC does not eliminate the need for cost apportionment ; arbitrary apportionment may still
Co may instead divide OH
exist. For some costs, fair Cost drivers may not exist
cost by absorption costing,
• ABC is a form of absorption costing, not a variable cost. via activity eg: Rent

• ABC benefits are limited if overhead costs are volume-related or a small proportion of
overall cost. In these cases, Absorption costing is appropriate

Comparison of ABC and Traditional Methods

Traditional Absorption Costing Activity-Based Costing

Initial allocation and apportionment of Initial allocation and apportionment of
overheads is to cost centres. overheads is to cost pools.
Absorption of overheads of each cost centre is Absorption of overheads of each cost pool is
based on volume of output (e.g. Number of based on the "driver" that causes the costs to
units or labour hours). vary.
Many different types of costs for a particular Costs for a particular activity will include only
cost centre are included in the blanket the costs of performing that activity.
overhead absorption rate of that department.
Since costs are assumed to depend on volume Identification of cost drivers allows
of output, limited information is provided to management to understand better the causes
management about ways to reduce costs. of costs and to find more appropriate ways to
control them.

Use of ABC in the Public Sector

ABC aids public sector bodies in accurately assessing service costs, but its disadvantages extend
to organizations, and critics argue that resources should be better spent on frontline services.

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 Ac$vity-Based Cos$ng
Additional Notes

• The cost driver for materials handling and despatch costs is likely to be the number of orders
handled.
• The cost driver for quality inspection costs is likely to be either the number of units produced or
the number of batches produced, depending on whether quality inspection is linked to batches
produced or total production output.
• Some costs of activities may vary with the volume of the activity, but other costs of the activity
will be fixed costs
• ABC costs should not be treated as relevant costs for the purpose of short-term decision-
making
• ABC can be used for cost-plus pricing
• ABC establishes separate cost pools for support activities
• Reapportionment of service Centre cost is not done via ABC specifically.
• ABC does not affect the prime cost of products. It will however give better details on indirect
costs which will be shared between products on a fairer basis (thus impacting on the total
production cost of each product and potentially the selling price of each product).
• A cost pool is an activity which consumes resources and for which overhead costs are
identified and allocated.
• ABC can help with determining a more accurate incremental cost, however it’s accuracy
depends on identifying appropriate cost drivers.
• It is difficult to achieve complete accuracy with ABC as it depends on the accuracy of the cost
drivers identified.
• If budgeted level of activity differs from actual level of activity, over-absorption or under-
absorption of overheads may occur under ABC just as under absorption costing. This will have
to be accounted for when reconciling the budgeted and actual profit under ABC.
• ABC can be applied to both manufacturing and service industry.
• Marginal costing takes into account only variable costs whereas ABC accounts for all costs
when computing the cost of a product. This means that ABC gives a better reflection of the true
cost of a product unlike marginal costing which computes a lower cost.

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 Ac$vity-Based Cos$ng
Summary

• Management accounting is concerned with the preparation and presentation of accounting

information to assist management to plan, control and make decisions.
• Costing involves calculating the unit cost of a product or service. Traditional methods are
absorption costing and marginal costing.
• Under absorption costing, a share of fixed production overheads is included in the unit cost.
Steps used in absorption costing are:
o Allocation and apportionment to cost centres.
o Re-apportionment of service centre costs to production cost centres.
o Absorption of the total cost of each production cost centre into the unit cost using an
appropriate basis (e.g. Labour or machine hours).
• Activity-based costing (ABC) aims to provide a more meaningful cost of a product, by
linking costs to the activities that drive them.
• Steps in ABC:
1) Identify the activities that cause costs to be incurred.
2) Allocate and apportion costs between "activity cost pools".
3) Identify the cost drivers for each activity.
4) Calculate the absorption rate per unit of driver (divide costs in (2) by quantities in
(3)).
5) Calculate the total overhead for product (multiply (4) by the number of activities for
each product).
6) Calculate the overhead cost per unit of product (divide (5) by the number of units for
each product).
• The main advantage of ABC is that it focuses on the activities which cause costs rather
than products.
• The main disadvantage is its complexity (and expense of implementing), which makes it
inappropriate for many organisations.

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 Target Cos+ng
TARGET COSTING

Target Costing

Target costing is an approach that sets a target cost by subtracting a desired profit margin from a
target selling price. This method is more effective in competitive markets where the price of a
product may be determined by the market. It aims to achieve an acceptable margin by identifying
ways to reduce production costs. Target costing is most suitable during the design phase of a
product, as it helps identify ways to close the target cost gap and produce and sell the product at
the target cost.
of an identical product

Steps in Target Costing

• Determine a product and adequate sales volume.
• Decide a target selling price.
• Estimate the required profit.
• Calculate target cost.
o Target cost = Target selling price – Target profit
• Prepare an estimated cost for the product, based on the initial design specification and
Current cost levels.
• Calculate target cost gap.
o Target cost gap = Estimated cost – Target cost
• Make efforts to close the gap.

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 Reducing cost without compromising quality Target Cos+ng
Closing a Target Cost Gap
which, Customer are not
• Reconsidering design to eliminate non-value-added elements. giving importance

• Reducing the number of components and standardizing components. where it is possible

Not so important components
• Using cheaper materials. Lower price and at par quality
• Employing a lower grade of staff.
• Investing in new technology. To reduce per unit cost, reducing running cost

• Outsourcing elements of production or support activities. Non core items

• Reducing manning levels or redesigning the workflow. To crease efficiency

Techniques for Cost Reduction

• Value analysis can be used to identify where small cost reductions can be applied to close
a cost gap once production commences.

• "Tear down analysis" (reverse engineering): Identifying possible improvements or cost

reductions.

• Value engineering: Investigating factors affecting the cost of a product or service. Value
engineering is applied to new products/services at the beginning of the development
process.

• Functional analysis: Identifying attributes/functions of a product which customers value.

Functional analysis can be used at the product design stage.

• Activity analysis identifies and describes activities in an organisation and evaluates their
impact on operations to assess where improvements can be made.

Notes

• Reducing product costs should not lead to lower quality.

• A risk with target costing is that cost reductions may affect the perceived value of the
product.
• Increasing the sales price is not a viable method of reducing the gap.

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 Target Cos+ng
Example 1

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

Required:

Find the target cost.

Target Costing in Service Industries

Target costing is suitable for manufacturing industries with standard products, but can be
challenging in service industries due to non-standard, customized products, higher indirect costs,
and potential sacrifices in customer service or quality. In manufacturing, cost savings can be
achieved by removing unvalued parts of a product.

Characteristics of Service Industries

1. Intangibility Physical presence; not physically seen or touched

2. Simultaneity Production and consumption At the same time:

3. Variability/Heterogeneity non identical , Different services

4. Perishability Cannot buy, or store in BULK at a time

5. No transfer of ownership Only have the right to use, consume
6. Higher indirect costs. Increased Commonly incurred cost (fixed costs), not specifically incurred

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 Target Cos+ng
Additional Notes

• For services with a large fixed cost base, activity-based management and increasing sales
volume can be effective cost control methods.

• Overhead costs are a significant portion of total costs, necessitating accurate sales demand
estimates to establish target costs.

• Variance analysis is not relevant to target costing as it is a feedback control tool used in the
production phase of the product life cycle.

• Although just-in-time (JIT) is often associated with cost reduction and performance
improvement, there is no prerequisite that JIT must be in operation for target costing to be
useful, as long as there is scope to reduce costs sustainably in other ways.

• Target costing can be used alongside life cycle costing and planning.

• Target costing does encourage looking at customer requirements early on so that features
valued by customers are included.

• Target costing would help to focus on the market price of similar services provided by
competitors, where this information is available.

Summary

• The business environment within which companies operate has become more competitive.
Products have shorter lifecycles and there is an emphasis on quality.
• New management accounting techniques have evolved to meet this new environment.
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 Target Cos+ng
• Target costing attempts to achieve an acceptable margin in a situation where the price of a
product or service is determined externally by the market. It can be used during the design
phase of a new product (to "design out" costs) for existing products.
• Techniques that may be used in closing a target gap include:
o Tear down analysis (“reverse engineering”);
o Value engineering; and
o Functional analysis.

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 Life-Cycle Cos-ng
LIFE CYCLE COSTING

Life-Cycle Costing

Life-cycle costing is a system that tracks and accumulates costs and revenues for a product from
development to abandonment. It aims to maximize return over the total life while minimizing costs.

Modern manufacturing often involves early costs in development, design, and set-up, while
revenues only arise during manufacturing and sale. Life-cycle costing estimates and accumulates
costs throughout a product's lifecycle, ensuring profits cover pre- and post-manufacturing costs.

Stages in Life Cycle

• Development Stage: Product design, prototype production, and creation of manufacturing
processes. Negative cash flow due to lack of revenue.
• Introduction Phase/Launch: Special pricing strategies may be used, affecting demand in
later years.
• Growth Phase: Increased competition may force lower prices due to new suppliers entering
the market.
• Maturity Phase: Most profits are made, prices may be stable.
• Decline Phase: Prices may fall with demand.

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 Life-Cycle Cos-ng
Committed Costs

Committed costs are future expenditures incurred during the planning and design phase of a
product, primarily during the manufacturing stage. These costs, which vary by industry, can reach
80% of the total costs over the product's life.

Maximising Return Over the Product’s Lifecycle

• Careful design of product (can save design and manufacturing costs). Design phase of a product
• Take the product to market as soon as possible (minimise the time to market).
• Minimize breakeven time. No profit - No loss

• Maximize the length of the life span Extend products maturity

Strategies to Extend Product Maturity

The life-cycle cost per unit can be reduced by extending the maturity of the product. The following
strategies can be used for this:

• Developing updated versions of the product with new features.

• Repackaging the product to give it a new image.
• Selling the product in new markets.

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 Life-Cycle Cos-ng
Relevance to Services Industries

Life-cycle costing is crucial for services requiring significant upfront research and development,
such as software development. It helps businesses recover costs before the software becomes
obsolete. It also applies to customers, as the costs of providing goods or services may vary over
their life.

Advantages of Lifecycle Costing

• Helps assess profitability over a product's life, aiding in decision-making on product

development or continuation. Evaluate based on a product's whole lifecycle
Clear estimations of revenue and
• Results in earlier actions to generate more revenue or lower [Link] based on lifecycle of a product
Investment costs ---> initial amount invested
• Helps balance investment costs and operating expenses. Operating expenses ---> recurring expenses
P&L only reports year end figures ( 1 year) , but lifecycle costing
• Provides a true financial cost of a product. includes revenues and costs incurred in its lifecycle (Total Costs
and revenues)
• Helps in designing out costs earlier to achieve lower costs.
In designing phase

Limitations:

1 Time consuming
2 Expensive
3 Future estimates may not be reliable

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 Life-Cycle Cos-ng
Additional Notes

• LCC looks at the entire life of a product or service and therefore considers the long term.
• The main disadvantages of LCC are that it is costly and time consuming to operate.
• Although life-cycle costing tracks the actual costs and revenues attributable to each product
from ‘cradle to grave’ it does not give a better understanding of the actual causes of
overhead costs.

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 Life-Cycle Cos-ng
Summary
• Life-cycle costing involves tracking the cumulative costs and revenues through the states of
a product from development to abandonment. It encourages management to plan the
pricing strategy for a product over its life rather than the short term.

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 Throughput Accoun-ng
THROUGHPUT ACCOUNTING

Just in Time (JIT) Environment

• It originally referred to the production of goods to meet customer demand exactly, in time,
quality and quantity. Products should not be made unless there is a customer for them.
both raw materials and finished goods, inventory
• In a JIT environment, inventory is not desired. Ideally, inventory would be zero.
ideally= perfectly, not real, theoretical

If a company is running/operating perfect situation, inventory

levels would be zero levels
Throughput Accounting

• Throughput accounting is an approach to production management which aims to maximise

throughput, while reducing inventory and operational expenses. reducing factory costs
• Throughput is the rate at which the system generates money through [Link] throughput
contribution
• In short-term, ONLY material cost is variable. ALL other factory costs are fixed (both direct
labour costs and overhead costs are assumed to be 'fixed' costs).
• Operational expenses, also known as factory expenses, are all the other costs of operations.
• Work-in-progress should be valued at material cost only.

Throughput Contribution

Throughput contribution = sales revenue – material cost

Bottleneck Resource or Binding Constraint or limiting factors: resources that are restricting
output

• Bottleneck resource or binding constraint is an activity which has a lower capacity than other
activities. They slow down the whole production process.
• Bottleneck resources may be:
o Labour hours
o Machine hours
• Production is limited to the capacity of the bottleneck resource but this capacity must be fully
utilised. This may result in some idle time in non-bottleneck resources.

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 Throughput Accoun-ng
The Theory of Constraints

Five steps for dealing with a bottleneck activity

1. Identify : the bottleneck resource.

2. Exploit : The optimal output should be obtained from the bottleneck resource without any
delay, and a buffer inventory should be held immediately before this resource.
3. Subordinate: operations prior to the binding constraint should operate at the same speed.
4. Elevate the bottleneck: steps should be taken to increase resources or improve its efficiency.
5. Return to step 1: the removal of one bottleneck will create another elsewhere in the system.

Maximising Throughput and Multiple Products

Steps To Determine Optimum Production Plan

• Determine the bottleneck resource.

• Calculate the throughput per unit for each product.
• Calculate the bottleneck resource per unit.
• Calculate throughput per unit of bottleneck resource (Return per hour).
• Rank products
• Allocate resources to arrive at optimum production plan.

Example 1

Product A B C
Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units

Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week.

Required:

Determine the optimum production plan for WR Co and calculate the weekly profit that would arise
from the plan.
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 Throughput Accoun-ng
Throughput Accounting Ratio (TPAR)

It is the ratio of the throughput per unit of bottleneck resource to the factory cost per unit of
bottleneck resource.

Interpretation of TPAR

• If TPAR > 1, the product is profitable, as the throughput contribution exceeds the fixed
costs.
• If TPAR < 1, the product is loss-making. The throughput contribution generated does not
cover the fixed costs required to make it.
• If TPAR = 1, the product breaks even.

Criticisms of TPAR

• It concentrates on the short-term.

• It is more difficult to apply throughput accounting concepts to the longer-term, when all
costs are variable, and vary with the volume of production and sales or another cost driver.
• In the longer-term an ABC approach might be more appropriate for measuring and
controlling performance.

Example 2

Product A B C
Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units

Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week.

Required:

Calculate the Throughput Accounting Ratio for all the products.

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 Throughput Accoun-ng
Improving Throughput Accounting Ratio

• Increase the sales price.

• Reduce the material cost.
• Reduce total operating expenses, to reduce the cost per hour.
• Improve productivity, reducing the time required to make each unit of product.
• Elevate the bottleneck.

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 Throughput Accoun-ng
Additional Notes

• In throughput accounting, all inventory should be valued at the cost of their materials. They
should not include any other costs.
• Unless output capacity is greater than sales demand, there will always be a binding constraint.
• Output from a binding constraint should be used immediately, not built up as inventory,
because it is the factor that constrains output and sales. Some inventory may build up before
the binding constraint, but the general principle in throughput accounting is that any inventory
is undesirable.
• The production capacity of a bottleneck resource should determine the production schedule for
the organisation as a whole. This means inevitably that there will be idle time in other parts of
production where capacity is greater.
• Factory labour costs are always treated as a part of the factory cost/conversion cost of a
product. Throughput accounting does not make a distinction between direct and indirect costs.
It is also assumed that labour costs are a fixed cost.
• The whole aim of JIT is to hold no inventory. Thus raw material storage costs should fall.
Customer order costs will not be changed by the introduction of JIT.
• The throughput accounting approach is more suitable for short-term decision making than
limiting factor analysis.
• Throughput accounting considers that time at a bottleneck resource has value, not elsewhere.
• Reduction in rent and discounts on materials will reduce costs and will improve the TPAR.
• Giving a customer a loyalty discount will reduce sales revenue and as a result the TPAR.

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 Throughput Accoun-ng
Summary

• According to the theory of constraints there is always at least one constraint (a bottleneck)
that limits the achievement of a goal.

• Throughput accounting draws management’s attention to bottleneck processes.

o Throughput contribution means sales revenue less material cost.

o Throughput accounting aims to maximise the throughput generated per hour by

eliminating bottlenecks.

o A product breaks even if its throughput accounting ratio (TPAR) is 1.

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 Accoun'ng For Environmental And Sustainability Factors

ACCOUNTING FOR ENVIRONMENTAL AND

SUSTAINABILITY FACTORS

Environmental Issues
• Global warming due to greenhouse gas emissions.
• Depletion of global reserves of natural resources, especially energy and water.
• Pollution causing habitat loss for both nature and humans.

Importance of the Environment Accounting for Business

• Poor environmental behaviour can harm an organization's image and lead to sales loss
• Governments may impose fines on companies causing environmental harm.
• Increased environmental regulations have increased compliance costs for businesses.
• Improving environmental behaviour can reduce costs, like energy efficiency programs.
• Businesses have a moral duty to reduce environmental harm.

Environmental Accounting Benefits

• Incorporating environmental effects in capital expenditure decisions.
• Understanding hidden environmental costs in overheads.
• Reducing waste and saving energy.
• Understanding environmental effects on life-cycle costs.
• Measuring environmental performance to understand stakeholders' environmental impact.
• Involving management accountants in long-term strategic planning for environmental-
related issues.

Environmental Management Accounting

Environmental Management Accounting (EMA) involves identifying, collecting, and analysing

physical and monetary information for internal decision-making. It focuses on resource usage and
waste, as well as costs, earnings, and savings related to the environment.

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 Accoun'ng For Environmental And Sustainability Factors
Environmental Costs 1st criteria
• Conventional costs: costs having environmental relevance (e.g. Costs of buying energy
including raw material costs
and other scarce resources).
• Potentially hidden costs: those environmental costs which are recorded, but simply
included in general overheads, so management is not aware of them.
• Contingent costs: potential future costs (e.g. Costs of cleaning up damage caused by
pollution).
• Image and relationship costs: the costs of producing environmental reports and promoting
the company's environmental activities.

2nd criteria --> based on cost of quality.

An alternative categorisation of environmental costs
• Prevention costs: the costs of activities undertaken to prevent the production of waste (e.g.
Spending on redesigning processes to reduce the amount of pollution).
• Detection costs: those incurred to ensure that the organisation complies with regulations
and voluntary standards (e.g. Costs of auditing the organisation's environmental activities).
• Internal failure costs: costs incurred to clean up environmental waste and pollution before
it has been released into the environment (e.g. Costs of disposing of toxic waste).
• External failure costs: costs incurred on activities performed after discharging waste into
the environment (e.g. Costs of cleaning up).1. Prevention
2. Detection ---> Objective = reduce waste, environmental impact

[Link] failure ---> occurs after a mistake of wastage

[Link] failure ---> occurs after a mistake of wastage
EMA Techniques
(ENVIRONMENTAL MANAGEMENT ACCOUNTING)
Input-Output Analysis To calculate waste generation

The input output analysis helps management understand waste generation by comparing output of
a production process with input, ensuring that what comes in must go out, and what is not included
in output is considered waste.

For example: Process flow chart

---> wastage

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 Accoun'ng For Environmental And Sustainability Factors
Flow Cost Accounting better version of input/ output analysis

Flow cost accounting is a more detailed version of input-output analysis. It identifies waste and
calculates the costs and values of each process's output and waste, using process costing
principles. This approach ensures that input costs are accounted for and apportioned between the
output and waste.

The costs used in flow cost accounting are sometimes categorised as follows:
3 categories
• Material costs;
• System costs, which are the costs incurred within the various processes which add value to
the product
• Delivery and disposal costs, which are incurred in delivering goods to customers or
disposing of waste.

Environmental Activity-Based Costing based on cost drivers

Environmental activity-based costing uses ABC principles to accurately allocate environmental

costs to products using the incurred drivers. This method helps to address the issue of hidden
environmental costs in general overheads, ensuring product costs accurately reflect the
environmental costs associated with their production.
Applied on Environment- driven cost

Types of cost in ABC

• Environment-related costs are attributed to joint environmental cost centres such as

sewage plants or incinerators. Acts like a fixed cost
• Environment-driven costs are hidden in general overheads and do not relate directly to a
joint environmental cost centre. Such costs are allocated to environmental activities using
the key drivers of the activity. For example, the costs of monitoring emissions can be
apportioned to products based on kg of emissions produced by each product.

Considers environmental cost while calculating lifecycle cost (in every stage of
Life-Cycle Costing
the product)
Life-cycle costing is particularly relevant for environmental costs, because many environmental
costs are not incurred during the production phase. Clean-up costs may be high but are not
incurred until after the production process is finished.

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 Accoun'ng For Environmental And Sustainability Factors

Accounting for Environmental and Sustainability Factors Long term perspective

• Sustainability is the ability to meet the present's needs without compromising the ability of
future generations to meet their own needs.
• Sustainable development requires organisations to consider the long-term consequences of
their decisions.

The International Integrated Reporting <IR> Framework

<IR> Framework was first developed by the International Integrated Reporting Council (IIRC) to
provide a foundation of the future in communicating value creation.

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 Accoun'ng For Environmental And Sustainability Factors

Sustainability Strategy Perspectives factors to considers

A sustainability strategy aims to create shareholder value and contribute to a sustainable society,
requiring an integrated accounting process that considers multiple perspectives for informed
decisions.

Role of Accountants in Developing Sustainable Practices

• Identify and connect significant trends and impacts to the organization's strategy, business
model, and performance.
• Integrate natural and social capital issues into management information for strategic
planning and investment decisions.
• Assess benefits of responding to environmental and social matters, including value
creation, cost reduction, revenue generation, and reputation improvement.
• Organize systems, processes, and people to support decision-making and ensure
measurement and management.
• Drive efficiency by reducing waste and lowering costs.
• Provide credibility to data and information through effective governance and oversight.
• Facilitate transparency through stakeholder communications and disclosures supported by
appropriate reporting frameworks.

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 Accoun'ng For Environmental And Sustainability Factors
Additional Notes
• A system of environmental management accounting provides environmental information for
internal use by management, but not for external reporting. It is distinct from environmental
accounting, which is concerned with external reporting (as well as internal reporting).
• In material flow cost accounting, waste is treated as a negative product and given a cost.
• Material flow cost accounting should encourage management to focus on ways of achieving
the same amount of finished output with less material input.
• The majority of environmental costs are already captured within a typical organisation's
accounting system. The difficulty lies in identifying them.
• Environmental failure costs are costs incurred as a result of environmental issues being
created either internally or outside the company. These can be financial or societal costs.

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 Accoun'ng For Environmental And Sustainability Factors
Summary

• Environmental management accounting (EMA) aims to provide management with monetary

and non-monetary (physical) information to enable them to understand and manage the
environmental impact of the organisation's activities.

• Environmental costs include:

o Conventional costs;

o Potentially hidden costs;

o Contingent costs; and

o Image and relationship costs.

• Techniques used in EMA include input/output analysis as well as ABC and life-cycle
costing.

• Accountants must be able to link sustainability to the broader busines agenda by

highlighting elements that build resilience and develop a sustainable strategy.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions

RELEVANT COST ANALYSIS

AND

MAKE-OR-BUY AND OTHER SHORT-TERM DECISIONS

application of relevant costing

Relevant Costs
• Only those costs and revenues which will be affected by a decision are "relevant".
direct consequence of a decision
• Relevant costs are:
o Future ; historical costs and revenues are not relevant, as they have already been
incurred;
o Incremental - the amount by which costs/revenues will change as a result of the
decision
o Cash flows ;Non-cash expenses and income are not relevant.

Relevant Cost Examples

• Avoidable costs - Those which would be avoided if a particular course of action were taken
• Controllable costs
• Opportunity cost
• Variable production costs
• Incremental fixed cost
• Realisable value of an asset

Non-Relevant Costs Examples

• Sunk costs– the historical cost of or past cost

• Committed costs − although future and cash flows, they are not incremental.
• Fixed costs and apportionments of fixed costs are not relevant.
• Depreciation and carrying values are irrelevant.
• Uncontrollable costs.
• Notional costs.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Opportunity Cost

• The value of the benefit sacrificed when one course of action is chosen, in preference to an
alternative.
• The opportunity cost is represented by the foregone potential benefit from the best rejected
course of action.
• Opportunity costs only apply to the use of scarce resources; where resources are not
scarce, no sacrifice results from using them.
eg; time

Difficulties in Using Opportunity Costs

• How to estimate future costs/revenues and hence the benefit sacrificed.

• Identifying alternative uses to know what is the best alternative foregone.
• Lack of accounting for effects on accounting profit
• Also, as is true for any costing method, it ignores non-financial factors

Short term decisions

One-Off Contract

One decision-making scenario is to decide how much to tender for a one-off contract. To make the
decision, it is necessary to consider all the relevant costs of the contract to ensure that the
revenue from the contract covers them.

Minimum Price

• The minimum price for a contract is equal to the relevant cost

• At this price no profit or loss would be made on the contract.
• It's useful for price negotiations as a lower price would result in a real loss.
• Businesses may undertake contracts at relevant cost to anticipate future business.
• Under-utilization during low season may lead to additional contracts, building goodwill with
potential customers.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions

Relevant Cost Of Materials

• If the materials required have not already been acquired, it will be necessary to buy them
for the contract. The current market price is the relevant cost.
• Historical costs and book values are not relevant costs as they are sunk costs.
• If the materials have already been acquired, it is necessary to consider whether they are
used regularly in the business:
o If used regularly, materials will need to be replaced, so the replacement cost (which
is also current market price) would be the relevant cost.
o If used regularly, and replacements are not available, the relevant cost would be
the opportunity cost, which would be the contribution foregone from regular
production.
o If not used regularly the relevant cost is their opportunity cost. This is often their
scrap value.

OR alternative use

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions

Relevant Cost Of Labour

• If the organisation has spare labour time, the relevant cost is zero. This might arise, for
example, where workers are being paid a fixed weekly wage and are currently
underemployed.
• If additional labour time is required and can be obtained without taking workers away from
other activities, the direct cost of the labour is relevant. This may be paid at a higher rate if
overtime is involved.
• If there is a limit on the amount of labour available a contract may require workers to be
taken away from other profitable activities. In this case, the relevant cost of labour is
the direct cost plus the lost contribution from the other activities.

Idle capacity = spare capacity

+ Variable pay

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions

Relevant Cost Of Non-Current Assets

• If the asset is to be rented the rental costs over the period of use are relevant.
• If the asset is to be acquired for the contract, the cost of acquiring the asset would be
relevant.
• An asset such as the one that is required may already be owned.
---> the relevant cost then depends on whether that asset is already operating at full capacity on other activities
o If the asset has spare capacity, the relevant cost is the fall in realisable value that will
arise if the asset is used for the contract.
o If the asset is already operating at full capacity its relevant cost is its deprival value

Deprival Value rare adjustment

• If an asset that is required for a contract is currently fully utilised in other activities, the
relevant cost is its deprival value

• Deprival value is the lowest cost option between the "value in use" and the "replacement
cost" of the asset:

Value in use

Non-Financial Factors
A contract should proceed if revenue exceeds cost, but management should consider non-
financial factors like the contract's potential to develop knowledge, enhance reputation, or reduce
profitability if it poses a high risk of reputational damage, such as harm to the environment or
unethical activities.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Shut Down
Shutdown decisions involve deciding whether to close an operation or stop producing a product or
service. Managers should consider whether all costs assigned to a division would be saved,
especially fixed costs from the head office, and should ignore non-incremental costs in decision-
making.

Relevant Costs
• The lost contribution from the area that is being closed
• Penalties and other costs resulting from the closure, e.g., redundancy, compensation to
customers
• Reorganisation costs etc

Relevant Benefits
• Savings in specific fixed costs from closure
• Additional contribution from the alternative use for resources released etc

Example 1
A company manufactures three products, A, B and C. The present net annual income from these
is as follows:
A B C
$ $ $
Sales 50,000 40,000 60,000
Variable costs 30,000 25,000 35,000
Contribution 20,000 15,000 25,000
Fixed costs 17,000 18,000 20,000
Profit/loss 3,000 (3,000) 5,000

The company is concerned about its poor profit performance, and is considering whether or not to
cease selling B. $5,000 of the fixed costs of product B are direct fixed costs which would be saved
if production ceased. All other fixed costs, it is considered, would remain the same.

Required:
Comment on the shutdown decision.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Non-Financial Factors

• Redundancies could negatively impact employee morale.

• Permanent loss of resources and skills: Absence of future opportunities.
• Impact on demand: Closing a division may limit product range.
• Potential for profitability: Development of new products or services could revive a loss-
making division.
• Potential asset sale: Assets like buildings could be sold to raise finance or reduce debt.

Further Processing
different outputs
• Joint products and by-products occur when one product necessitates the production of
other products. Joint products have significant sales value, while by-products have small
sales value. Products are not identifiable until the split-off point (SOP), with joint costs
apportioned between them. these costs are not relevant in further processing decision

• Once the products have reached the split-off point the manufacturer may have a choice of
selling the product immediately or processing further.
• In making the further processing decision, the manufacturer needs to compare the
additional revenue that can be gained by further processing the product against the
additional costs of further processing.

Example 2
The Chemical company produces two joint products, A and B from the same process. Joint
processing costs of $150,000 are incurred up to the split-off point, when 100,000 units of A and
50,000 units of B are produced. The selling prices at the split-off point are $1.25 per unit for A and
$2.00 per unit for B.
The units of A could be processed further to produce 60,000 units of a new chemical, A plus but at
an extra fixed cost of $20,000 and variable cost of 30c per unit of input. The selling price of A plus
would be $3.25 per unit.

Required:

Should the company sell A or A plus?

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Outsourcing

Outsourcing involves buying goods or services externally, such as office cleaning, catering,
payroll, IT, and security services. It's also common in manufacturing, with component parts often
outsourced. The trend has been boosted by reduced costs of international trade, allowing
components to be made in lower-cost economies and assembly closer to markets.

Advantages of Outsourcing

• Lower cost: Outsourcing can provide goods or services at lower costs due to economies of
scale.
• Services become variable costs, allowing management to focus on core competencies.
• Improved quality: Specialist third-party services offer better quality.
• Wider expertise: Outsourcing allows access to a wider range of expertise, as providers deal
with multiple clients.

Disadvantages of Outsourcing

• Dependence on third-party supply, causing loss of control over business processes.

• Trust in third-party confidential information.
• Hidden costs due to unspecified contract costs.
• Potential loss of quality, especially with fixed contract price per unit.
• Dependence on outsourcing company linked to financial stability.
• Potential demotivation of workforce due to job losses.
• Potential negative publicity if outsourcing to another country.

Make or Buy Decisions

When deciding to outsource a component's manufacturing, organizations must consider the

financial impact. Outsourcing eliminates in-house production, potentially leading to fixed cost
savings. To determine the savings, including incremental fixed costs, companies must compare
the costs of buying the component from an external supplier with the costs of in-house production.

general outsourcing activities ---> non core activities

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Example 3
Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows:
W X Y Z

Production (units) 1,000 2,000 4,000 3,000

Unit marginal costs ($) 14 17 7 12

Directly attributable fixed costs per annum and committed fixed costs

Incurred as a direct consequence of making W 1,000

Incurred as a direct consequence of making X 5,000

Incurred as a direct consequence of making Y 6,000

Incurred as a direct consequence of making Z 8,000

Other fixed costs (committed) 30,000

Directly attributable fixed costs are all items of cash expenditure that are incurred as a direct
consequence of making the product in-house.

A subcontractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14
respectively.

Required:

Should Shellfish make or buy the components?

Decisions with a Limiting Factor

A limiting factor, such as scarce materials or skilled labour, can prevent a business from producing
all necessary quantities. To determine which components to make in-house and outsource, the
company should calculate the saving per unit of scarce resource from making the product rather
than from buying it. This helps in determining the most cost-effective production method.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Example 4

MM manufactures three components, S, A and T, using the same machines for each. The budget
for the next year calls for the production and assembly of 4,000 of each component. The variable
production cost per unit is as follows:

Product Machine hours per unit Variable cost per unit

S 3 20

A 2 36

T 4 24

Assembly cost 20

Only 24,000 hours of machine time will be available during the year, and a subcontractor has
quoted the following unit prices for supplying components:
S-$29; A-$40; T-$34.

Required:

Prepare production plan and purchase plan.

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 Relevant Cost Analysis And Make-Or-Buy And Other Short-Term Decisions
Summary

• In decision making, relevant costs and revenues are those which change as a result of the
decision. All other revenues and costs are ignored.
• An opportunity cost is a benefit foregone. Opportunity costs are relevant costs.
• Decision-making scenarios include "one-off contracts" which require the calculation of the
relevant cost of performing a contract.
• A relevant cost may be a current (replacement) cost or an opportunity cost (which may be
zero).
• The deprival value of a non-current asset is the lower of its replacement cost and value in
use. Value in use is the higher of net realisable value and economic value.
• In shut down decisions, costs of the loss-making division that will not be saved are not
relevant to the decision.
• Further processing decisions consider whether it is worthwhile processing joint- or by-
products further.
• To buy-in rather than make a product is an outsourcing decision.

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 Cost Volume Profit Analysis
COST VOLUME PROFIT ANALYSIS

Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the
financial results of a business.

Contribution

• Contribution is calculated by deducting variable costs from revenue. Excess contribution

over fixed costs is considered profit.
• Unit contribution = Selling price – Variable cost per unit
• Total contribution = Total revenue – Total variable cost
• In the short term, the fixed costs of a business do not change with output.

Single Product Analysis

Breakeven Point

• Breakeven point – the level of activity at which neither a profit nor a loss is made.
• The breakeven point is when total revenue equals total costs.
• At breakeven point contribution is equal to fixed costs as there is no profit or loss made.
• Total contribution = Total fixed costs
• The breakeven point is a measure of the lowest activity level at which the activity is viable

Example 1

Details of a product are as follows:

Selling price per unit = $15

Variable cost per unit = $12

Total fixed cost = $36,000

Required:

Calculate break-even point (units and sales)

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 Cost Volume Profit Analysis
Target Profit

Example 2

Details of a product are as follows:

Selling price per unit = $15

Variable cost per unit = $12

Total fixed cost = $36,000

Targeted Profit = $21,000

Required:

Calculate the sales volume required to achieve the target profit.

Margin of Safety

Margin of safety is the measure of sensitivity or riskiness of the budget. It is the excess of
budgeted sales over the breakeven sales.

Example 3

Details of a product are as follows:

Selling price per unit = $15

Variable cost per unit = $12

Total fixed cost = $36,000

Total budgeted units = 20,000 units

Required:

Calculate margin of safety.

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 Cost Volume Profit Analysis
Multi Product Environment

Example 4

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

Required:

Calculate the breakeven point for PL.

Graphs

Traditional Breakeven Chart

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 Cost Volume Profit Analysis
Profit Volume Chart

A "PV" chart is another way of presenting the same information as a breakeven chart but it
emphasises profits and losses at different activity levels (i.e. Sales volume or value).

To construct it requires only the following information:

• Profit/(loss) at any (i.e. Just one) level of sales; and

• Total fixed costs (i.e. total loss at zero sales volume).

Limitations/Assumptions of Cost-Volume-Profit Analysis

Assumptions = Limitations
• Total cost behaves as a linear semi-variable cost within the activity range.
• Fixed costs remain fixed with the range, while total variable costs change proportionally
with volume. may include step fixed cost Variable cost may not be constant
Practically, with increased volume, selling price may be
• Unit selling prices do not change with volume. discounted.
Assuming that there is no
• Costs and income are matched, i.e., no significant change in inventory. opening, closing inventory
• Efficiency and productivity levels do not change.
practically, sales mix may not be constant
• There is only a single product or a constant sales mix of multiple products.
• Total costs and total revenue are linear functions. practically this may not be true

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 Cost Volume Profit Analysis
Additional Notes

• If the more profitable products are sold first, this means that the company will cover its fixed
costs more quickly. Consequently, the breakeven point will be reached earlier, i.e. Fewer
sales will need to be made in order to break even. So, the breakeven point will be lower.
• The contribution to sales ratio (C/S ratio) can be used to indicate the relative profitability of
different products.

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 Cost Volume Profit Analysis
Summary

• The breakeven point is the level of activity at which a company makes neither profit nor
loss. To break even a company needs to sell enough units to cover its fixed and variable
costs.
• A breakeven chart which shows how total costs and total revenues vary with output. The
profit-volume chart shows how profit varies with output.
• In multi-product situations, a standard or per-determined product mix must be assumed to
remain constant. Breakeven revenue can then be calculated by dividing fixed costs by a
weighted average C/S ratio.
• The usefulness of CVP analysis is limited by the simplifying assumptions that have to be
made to make it work.

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 Limiting Factors
LIMITING FACTORS

Limiting Factor Scarce resources

Limiting factor is that resource which is in short supply and which limits the output of the business.
For example, output may be restricted by a shortage of Materials, Labour and Machine.

Single Limiting Factor

The following approach is used to decide which product(s) to make to maximise contribution and
therefore profit, where one of the factors of production is limited:

• Identify the limiting factor.

• Calculate contribution per unit of each product.
• Calculate limiting factor per unit for each product.
• Calculate the contribution per limiting factor (contribution generated from one unit of limiting
factor).
• Rank products on the basis of contribution per limiting factor.
• Allocate the resource in order of the ranking (optimal production plan).

Example 1

Products A B
Selling price $14 $11
Variable cost per unit $8 $7
Labour hours per unit 2 hours 1 hour
Maximum sales demand 3,000 units 5,000 units

During July the available direct labour is limited to 8,000 hours.

Total fixed costs per month are $20,000.

Required:

Determine the profit maximising production budget.

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 Limiting Factors
Limitations of Key Factor Analysis
• Assumes single objective of contribution/profit maximisation.
• Assumes constant variable cost per unit and total fixed costs.
• Deals with one scarce resource.
• Apply only to situations where short-term capacity constraints cannot be removed.

Multi Limiting Factor

Linear Programming
• A mathematical technique for problems of rationing scarce resources between products to
achieve optimum benefit.

• Objective function − quantifies the objective.

For example:

o Profit maximisation (which is always by maximising contribution);

o Cost minimisation.

• The syllabus only includes situations involving two variables this allows the equations to be
shown as straight lines on a graph. 2 products situations( can only plot 2 values on graph --->
x axis & Y axis)

The Graph

The process of graphing a linear programming model includes the following steps:

• Define variables.
• Establish constraints.
• Construct objective function.
• Draw the constraints on a graph.
• Establish the feasible region for the optimal solution.
• Determine the optimal solution.

Two methods:

o The objective function method − also referred to as the iso-contribution method.

o The simultaneous equation method.
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 Limiting Factors
Example 2

WX Co manufactures two products, A and B. Both products are produced using the same
machines and same type of labour.
The organisation's objective is to maximise contribution.

Products A B
Selling price $1.5 $2
Variable cost per unit $1.3 $1.7
Machine hours per unit 0.06 0.08
Labour hours per unit 0.04 0.12
Maximum sales demand Unlimited 13,000

Total available machine hours = 2,400 hours

Total available labour hours = 2,400 hours

Required:

Determine the optimal production plan.

Assumptions
• Contribution per unit and resource utilisation per unit are the same for any quantity
produced and are sold in the range under consideration.

• Solution may not have integer values and should not be rounded.

• Solution is dependent on the quality of the input data.

• Only one quantifiable objective can be satisfied. Non-quantifiable objectives are not
considered at all.

• Only two "products" for graphical solution.

Binding Constraint

• Resource which is fully utilised under the optimal solution.

• Maximum capacity is utilised.

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 Limiting Factors
Non-binding Constraints

Slack is the difference between maximum resources available and resources used at the optimal
point.

Implications of Slack

• Low slack indicates potential resource constraints due to increased availability of other
scarce resources.

• High slack indicates resource availability exceeds usage, potentially allowing for resource
use elsewhere or sub-contracting.

Shadow Price

• Shadow price is the additional contribution that would be generated if one more unit of the
resource were to become available.

• The shadow price represents the maximum premium over the normal price the company would
be prepared to pay for each additional unit.

• The maximum price for additional scarce resource that can be paid is the sum of the normal
price and shadow price.

More Than Two Variables

This chapter discusses linear programming methods for two variables and constraints, focusing on
graphs. Other methods of solving for more than two variables :

o The dual problem

o Simplex.

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 Limiting Factors
Additional Notes

• If the aim is to minimise costs, the solution is where the total cost line touching the feasible
area at a tangent, is as close to the origin as possible as this will allow the company to
make as little as possible given constraints.
• If the aim is to maximise profit, the solution is where the total contribution line touching the
feasible area at a tangent, is as far away from the origin as possible as this will allow the
company to make as much as possible given constraints.
• A shadow price for a scarce resource is its opportunity cost. It is the amount of contribution
that would be lost if one unit less of that resource were available. It is similarly the amount
of additional contribution that would be earned if one unit more of that resource were
available. (This is on the assumption that the scarce resource is available at its normal
variable cost.)
• The slope of the iso-contribution line will be determined by the relative contribution per unit
of each product. If it is very flat, the product on the vertical axis must have a higher
contribution than the product on the horizontal axis.
• Linear programming is only suitable when there are two products.

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 Limiting Factors
Summary

• Where factors of production are scarce, production decisions have to be made to

maximise contribution(and hence profit) given limited resources.
• Where one resource is scarce, the approach is to rank products
by contribution generated per unit of scarce resource (“key factor”).
• For make or buy decisions, the method is to rank products by saving per unit of scarce
resource.
• Where there is more than one constraint, use linear programming:
1. Define variables.
2. Define the objective function (usually to maximise contribution).
3. Formulate constraints.
4. Plot constraints on a graph and identify the feasible area.
5. Use a sample contribution line to find the point on the feasible region which
generates the highest contribution (i.e. Is furthest form the origin).
6. Solve the equation(s) for the optimal point in (5.) To specify the corresponding
values of the variables.
7. Answer the question. Maximum profit MUST be calculated as maximum
contribution less total fixed overheads never using unit profit.
• The shadow price of a resource is the amount by which contribution would be increased
if one more unit of the scarce resource were available.
• Slack arises where the company does not use all of the resource available. Slack can
be calculated as resource available less resource used.

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 Pricing Decisions
PRICING DECISIONS

Factors Influencing Price

• Cost
• Product lifecycle
• Demand
• Price elasticity
• Type of market
• Competitors
• Customers

Cost Based Pricing Approaches

Full Cost Plus Pricing

• Adds profit margin/mark-up to full cost.

• Long-term pricing strategy.
---> Ensures prices cover all variable and fixed costs

Advantages

• If the budget sales level is achieved, profit will be made.

• Appropriate where fixed costs are significant.
• Simple and cheap to operate.

Disadvantages

• The method of accounting for overheads will have a large impact.

• If actual sales are below budget, losses may occur.
• Ignores external factors (e.g. Demand/ price relationship, competitors' prices).

Marginal Cost Plus Pricing

• Adding profit margin/mark-up to marginal (variable) costs.
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 Pricing Decisions
Advantages

• Mark-up represents contribution, which is useful in short-term pricing decisions

• Treats fixed costs by their nature and not using an arbitrary allocation.

Disadvantages

• May lead to failure to recover fixed costs.

• Not appropriate for long term pricing, particularly where fixed costs are significant.

Return On Investment (ROI) Pricing

• Prices are set to achieve a target percentage return on the capital invested in production.
• ROI pricing is a long-term pricing method.

Advantages

• Links price to both short-term costs and long-term capital employed.

• Target ROI can be set to take account of risk.

Disadvantages

• Ignores external factors.

• Problems in calculating capital employed (e.g. Whether to use book values or replacement
cost).
• Subjective split of shared investment between products.

Relevant Cost Pricing

• Relevant cost pricing is a short-term strategy used to price:

o One-off projects
o Special orders
o Tenders for contracts.
• Price = Relevant costs + mark-up
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 Pricing Decisions
Lifecycle Cost Pricing

• Considers all costs over product's life.

• Total revenue should cover design, manufacture, closedown costs, and production costs.

Limitations of Cost-Based Approaches

• Ignores external factors like demand and competition.
• May result in prices different from competitors.
• May underestimate attractive product features, justifying higher prices..
ignores unique product features

Level Of Demand
Demand is the quantity of a good or service consumers want and can pay for. Factors influencing
demand include income, price of substitute goods, price of complementary goods, consumer
tastes and fashion trends, advertising, and consumer views and capacity to pay.

Price Elasticity of Demand

• Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes

in price.
• Demand for a product can be described as:
o If the PED is greater than 1 – Elastic : demand is very responsive to changes in
price. The change in the quantity demanded will be relatively greater than the
change in price.
o If the PED is less than 1 – Inelastic : a change in price will have little impact on
demand. Demand will change by a relatively small amount than the change in price.
o If the PED is equal to 1: The percentage change in quantity demanded is equal to
the percentage change in price.
o If the PED is equal to zero – Perfectly Inelastic: A change in price will have no
influence on quantity.
o If the PED is equal to infinity – Perfectly Elastic: Customers will buy an infinite
amount but only up to a particular price. Any price increase above this level will
reduce demand to zero.

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 Pricing Decisions
Example 1

The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research
indicates that an increase in prices of 10 cents per unit will result in a fall in annual demand of
75,000 units.

Required:

What is the price elasticity of demand?

Demand Based Approach

Demand Curve
• Demand means the total quantity of a product or service the buyers in a market would wish
to buy in a given period.
• Economic theory argues that the higher the price of a good, the lower will be the quantity
demanded.

Equation
The demand curve can be expressed as an equation of the form:

P = a – bQ

Where:

P = the price

Q = the quantity demanded

a = the price at which the demand would be nil

b = change in price / change in quantity

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 Pricing Decisions
Example 2

The current price of a product is $12. At this price the company sells 60 items a month. One month
the company decides to raise the price to $15, but only 45 items are sold at this price.

Required

Determine the demand equation

Maximising Profits (Algebraic Method)

• The objective of most businesses is to maximise profits.

• The economist's model is used to find the price that will meet this objective. This is
determined as follows:
• Identify the quantity of sales (Q) that would lead to maximum profits. This is the quantity at
which:

Marginal cost = Marginal revenue

Marginal Revenue

Marginal revenue is the increase in total revenue resulting from selling one additional unit.

Equation

Marginal revenue MR = a − 2bQ

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 Pricing Decisions
Marginal Cost

• Marginal cost refers to the increase in total cost from producing and selling one additional
unit of a product or service.
• Economists assume marginal cost changes with output increase, initially falling due to
economies of scale.
• Accountants and examiners assume marginal cost equals variable cost per unit.
• Marginal cost is usually constant

Example 3

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

Required:

Calculate the profit-maximising selling price for product G.

Summary of Algebraic Method

• Establish the demand function, P = a − bQ.

• Establish the equation for marginal revenue, MR = a − 2bq.
• Identify the marginal cost function. Normally marginal cost = variable cost.
• Solve the equation MC = MR. This gives the value of Q at the point of maximum profit.
• Put the value of Q into the demand function to determine the price.

Tabular Approach

The tabular approach is an alternative method for identifying the profit maximising point of output
when there is limited data, insufficient data for accurate price equations, or a non-linear
relationship between price and demand.

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 Pricing Decisions
Example 4

Total output units Selling price per unit Average cost per unit
1 504 720
2 471 402
3 439 288
4 407 231
5 377 201
6 346 189
7 317 182
8 288 180

Required:

Calculate the profit-maximising selling price.

Practical Disadvantages of the Economist's Model

• Limited accuracy in estimating demand curves for products/services.

• Ignores exogenous variables like market conditions.
• Treats demand for each product as independent of others.
• Allows companies to have strategies beyond profit maximisation.

Decision To Increase Production And Sales Levels

When deciding to increase production and sales levels, consider relevant costs such as marginal
revenue and marginal cost. However, other factors like storage space, selling price, and product
quality can complicate the decision. Additionally, increasing production may lead to customers
switching to more reliable suppliers, reduced selling prices, and reputational damage. It's crucial to
consider incremental costs and revenues

Types Of Market

Monopoly

Only one seller who dominates many buyers, so price can be set as high as possible.

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 Pricing Decisions
Perfect Competition

Describes a market with many sellers and buyers, identical products, no barriers to entry, and
perfect information.

Other Pricing Strategies

Market Skimming
• Typically used when a product is launched, setting a high price initially to generate a large
profit margin.
• Later, the price may be lowered to appeal to a larger market segment once the early
adopter segment is satisfied.
• Appropriate for new, different products, unknown or inelastic demand, liquidity issues, high
development cost or products with a short lifecycle.

Market Penetration
• Market penetration is a strategy used to launch a product into a new market, aiming to
attract new customers at a low initial price.
• Low-cost introduction is suitable when a company is trying to discourage new entrants,
where there are many existing products, wants to push a product to its growth and maturity
stage quickly, can enjoy great economies of scale, or if product demand is highly elastic.

Complementary Product Pricing

• Understanding the impact of one product's price on the demand for the other is crucial.
• The impact on demand for the complementary product may be more important than the
demand or profit of the first product.
• Pricing policies should be set for goods that are usually bought together.

Loss Leaders
A loss leader is a product sold at a loss to attract customers, often used in complementary pricing
or supermarket promotions. These low, loss-making prices encourage customers to buy other
products, thereby attracting more purchases.

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 Pricing Decisions
Price Discrimination
• Price discrimination involves setting different prices for a product or service in different
markets.
• It aims to achieve maximum price in each market.
• Barriers between markets are necessary for price discrimination to be feasible.
• Examples include selling products for unique moments in time, unique locations, software
discounts for educational users, and different service charges for commercial and
residential customers.

Going-Rate Pricing
Going-rate pricing is a strategy where businesses charge the market price, often used in
competitive markets, for homogeneous products with minimal variation, such as aluminium or
beef.

Product-Line Pricing
Product-line pricing involves setting prices for related products sold to the same customer or
outlets. Two common approaches include product bundling, where a group of products are sold
together for less than the total, and setting differentials between different products in a range, such
as a basic car with a 1.4 litre engine for all other versions.

Volume Discounting
Many organizations offer discounts to customers who buy a certain number of products, such as
"buy one, get one for 50%" in retail stores. This strategy aims to offer a more competitive price and
acknowledge the law of diminishing marginal utility, which suggests that consumers get most
satisfaction from the first unit.

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 Pricing Decisions
Additional Notes

• A price in excess of full cost per unit will not necessarily ensure that a company will cover
all its costs and make a profit. Making a profit with cost plus pricing also depends on
working at a sufficient capacity level, so that all fixed costs are covered by sales revenue.
• Cost plus pricing is an appropriate pricing strategy when there is no comparable market
price for the product or service.
• If demand is price-inelastic, a reduction in price will result in a fall in total sales revenue. At
the lower price, there will be some increase in sales demand, so total costs will increase.
With falling revenue and increasing costs, profits will fall.
• In circumstances of inelastic demand, prices should be increased because revenues will
increase and total costs will reduce (because quantities sold will reduce).
• When the price elasticity of demand is elastic, a reduction in price by x% will increase the
quantity demanded by more than x% and as a result total sales revenue will increase.
Without knowing about marginal costs, it is not possible to determine whether profits would
increase or fall.
• Algebraic model requires a consistent relationship between price (P) and demand (Q), so
that a demand equation can be established, usually in the form P = a – bQ. Similarly, there
must be a clear relationship between demand and marginal cost, usually satisfied by
constant variable cost per unit and constant fixed costs.
• The tabular method is only suitable for companies operating in a monopoly, because any
‘optimum’ price might become irrelevant if competitors charge significantly lower prices

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 Pricing Decisions
Summary

• Cost plus pricing methods involve adding a given margin to the cost of a product. The cost
may be the marginal cost, the full cost or even the relevant cost.
• Full cost plus pricing is a long-term pricing strategy. It ensures that prices cover all variable
and fixed costs.
• Opportunity cost (relevant cost) pricing is suitable for short-term pricing decisions.
• A significant weakness of cost plus methods of pricing is that they take no account of
demand.
• In the economist's model, price is a function of the quantity demanded. As the price falls,
demand increases.
• Marginal revenue is the increase in total revenues resulting from selling one more unit of a
product or service.
• For exam purposes, marginal cost is equal to variable cost per unit (at least until full
capacity is reached).
• A business maximises its profit when marginal revenue equals marginal cost.
• Pricing is a strategic decision and different pricing strategies are applied in different
circumstances (e.g. When demand for one product is linked to demand for another).
• The price elasticity of demand is a measure of the degree of sensitivity of demand for a
good to changes in the price of that good.

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 Dealing With Risk And Uncertainty In Decision-Making

DEALING WITH RISK AND UNCERTAINTY IN DECISION-MAKING

Risk and Uncertainty

• Risk is the existence of several possible outcomes, which are known in advance along with
the related probability.
• Uncertainty is when there are a number of possible outcomes but the probability of each
outcome is not known or the potential outcomes of a decision that are not known in
advance

Market Research
• Systematic gathering of information about customers, competitors, and the market.
• Helps companies make decisions about product development and marketing.
• Can be based on primary or secondary data.
o Primary data: Company collects original data, like interviews.
o Secondary data: Uses published data like statistics.

Focus Groups
• Focus groups reduce uncertainty in new product launches.
• Groups provide opinions on new products or services in an interactive environment.

Types of Decision-Makers
• Risk seekers are those who seek the maximum possible return regardless of the probability
of it occurring. As optimists, they consider the best-case scenario.
• Risk neutral are those who consider the most likely outcome.
• Risk averse are those who dislike risk and so make decisions based on the worst possible
outcome.

Profit (Payoff ) Tables

A profit table (also referred to as a payoff matrix) shows all possible “payoffs” (NPV, contribution,
profits, etc) which may result from a decision-makers chosen strategy.
pm syllabus ---> contribution, profits

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 Dealing With Risk And Uncertainty In Decision-Making
Example 1
A Company is trying to set the sales price for one of its products. Three prices are under
consideration, and expected sales volumes and costs are as follows:

Pricing choices Sales demand (units)

$4 Best possible 16,000

Most likely 14,000
Worst possible 10,000

$4.30 Best possible 14,000

Most likely 12,500
Worst possible 8,000

$4.40 Best possible 12,500

Most likely 12,000
Worst possible 6,000

Variable costs are $2 per unit.

Required:

Prepare a pay-off table for the different possible outcomes for each decision option.

Decision Rules

Maximax
• Select the alternative with the maximum possible payoff (i.e. Highest return under the best-
case scenario).

• The risk seeker's (i.e. Optimist's) rule.

Maximin
• Select the alternative with the highest return under the worst-case scenario.
• The pessimist's rule (i.e. Risk averse).
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 Dealing With Risk And Uncertainty In Decision-Making
Minimax Regret
• Select the alternative with the lowest maximum regret. Regret is defined as the opportunity
loss from having made the wrong decision.
• Minimax regret is also suited to investors that are adverse to missing out.

Expected Value (EV)

• EV is a weighted average of possible outcomes from a decision.
• EV indicates long-term outcomes if the decision can be repeated.
• EV formula: EV = Σpx
• Decision with highest EV of benefit or lowest EV of cost should be selected.
• EV users may be risk neutral, focusing on the expected return.

Advantages Of EV
• It reduces the information to one number for each choice.
• The idea of an average is easily understood.

Limitations Of EV
• Difficulty in estimating probabilities of different outcomes.
• Average may not match all possible outcomes.
• Unsuitable for "one-off" situations unless repeated.
• Average doesn't indicate spread of possible results, ignoring risk.

Value of Information
• The value of information is the difference between the expected value of profit with
information and the expected value of profit without information.
• It is the maximum amount a decision-maker would be willing to pay for advance information
to know which outcome will occur.
• Value of information = EV with information − EV without information

Value of Perfect Information

Perfect information is said to be available when a 100% accurate prediction can be made about
the future.

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 Dealing With Risk And Uncertainty In Decision-Making
Example 2
The management of Ivor Ore must choose whether to go ahead with either of two mutually
exclusive projects A and B. The expected profits are as follows:

Demand Probability Profit

Project A Project B
Strong 0.2 $4,000 $1,500
Moderate 0.3 $1,200 $1,000
Weak 0.5 ($1,000) $500

Required:
Calculate the value of perfect information about demand.

Value Of Imperfect Information

Imperfect information is not 100% accurate but provides more knowledge than no information.

Example 3
Suppose that a company want to make a decision between two mutually exclusive options, Option
A and Option B.
The profits from each option will depend on the state of the economy in the next 12 months.
Current estimates are that there is a 60% probability that the economy will be weak and a 40%
probability that the economy will be strong.
The profitability with each decision option would be as follows:

Demand Probability Profit

Project A Project B
Weak 0.6 $50,000 $20,000
Strong 0.4 $60,000 $100,000

Research could be carried out into the state of the economy in the next 12 months. It has been
estimated that if the true state of the economy will be weak, there is an 80% probability that the
research would predict this correctly. It is also estimated that if the true state of the economy will
be strong, there is a 90% probability that the research would predict this correctly.

Required:
What is the value of this imperfect information?
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Decision Trees
• A decision tree aids in visualizing and evaluating outcomes in multi-stage decision-making
processes. It provides a pictorial representation of the decisions needed at each stage,
indicating their potential outcomes and associated probabilities.
• Decision trees are usually drawn from left to right.
o Decision point − this is a point at which a decision- maker has to decide between two
or more decisions.

o Outcome point − this occurs where there are several possible outcomes. Normally,
for each decision taken, there will be two or more possible outcomes.

• The rollback analysis stage involves evaluating and recommending decisions using a
decision tree. The tree is evaluated from right to left, calculating the EV at each outcome
point and choosing the best option at each decision point.

Example 4
Beethoven Co has a new wonder product, the violin, of which it expects great things. At the
moment the company has two courses of action open to it, to test market the product or abandon
it. If the company test markets it, the cost will be $100,000 and the market response could be
positive or negative with probabilities of 0.60 and 0.40.
If the result of the test marketing is positive the company could either market if full scale or
abandon it. If it markets the violin full scale, the outcome might be low, medium or high demand,
and the respective net gains(losses) would be ($200,000), $200,000 or $1,000,000. These
outcomes have probabilities of 0.20, 0.50 and 0.30 respectively.
If the result of the test marketing is negative and the company goes ahead and markets the
product, estimated losses would be $600,000.
If, at any point, the company abandons the product, there would be a net gain of $50,000 from the
sale of scrap.

Required:

Draw a decision tree.

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Sensitivity Analysis
Sensitivity analysis measures a decision's responsiveness to changes in variables, comparing one
variable at a time and determining the percentage change before the decision changes.

Example 5
Company has estimated the following sales and profits for a new product

Sales (2,000 units) $4,000

Variable costs:
Material $2,000
Labour $1,000
Contribution $1,000
Less incremental fixed costs ($800)
Profit $200

Required:
Analyse the sensitivity of the project to changes in key variables.

Advantages
• Indicates decision's sensitivity to original estimate changes.
• Adaptable for use in spreadsheet packages.

Limitations
• Only used when one variable changes and others remain constant.

Simulation
• Simulation is a mathematical model used to represent real-life processes or situations,
allowing multiple variables to change simultaneously. It's particularly useful for complex
situations with multiple uncertain variables.
• Process:
o Specify major variables and their relationships.
o Attach probability distributions to each variable.
o Generate random numbers for simulation.
o Record outcomes of each simulation.
o Repeat simulations for probability distribution.
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Advantages
• Overcomes limitations of sensitivity analysis by examining all possible variable
combinations.
• Provides more information about outcomes and relative probabilities. applicable to real life situations
• Highlights implausible assumptions and detects bias. assess the possibilities of all outcomes

• Useful for problems not analytically solved.

Limitations simulation makes the decision-making process easier

simulations can be only used to analyze different probabilities and
• Not a decision-making technique. situations
decision should be made by decision makers with
• Time-consuming without computer.
• Expensive for computer simulation design and operation.
• Relies on reliable estimates of underlying variable probability distributions.
eg; assuming that a particular variable is connected by certain percentage

LIMITATIONS OF ALL TECHNIQUES:

reliability of data, as it will lead to correct probabilities and outputs

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Additional Notes
• A unique feature of simulation modelling using the Monte Carlo method is the use of
random numbers to determine the value of input variables to the model.
• The 'What if' refers to the type of question used in sensitivity analysis. For example, what if
the volume of sales is 10% less than expected?
• Market research is used to obtain data about customer/consumer attitudes and preferences
to products or markets, and the quantitative or qualitative information obtained from market
research can help to reduce uncertainty for some elements of decision making.
• Expected values are used to support the risk-neutral decision maker, who will ignore any
variability or extremities in the range of possible outcomes and be interested only in the
overall average expected value. By contrast, a risk-averse decision maker is likely to be
more interested in those extreme outcomes, and so an overall average will not give enough
information.
• Sensitivity analysis can be used to gain insight into which assumptions or variables in a
situation are critical. Sensitivity analysis provides information on the basis of which
decisions can be made but it does not point to the correct decision directly. Sensitivity
analysis only identifies how far a variable needs to change, it does not look at the
probability of such a change. Sensitivity analysis assumes that changes to variables can be
made independently
• Simulation models the behaviour of a system. Simulation models can be used to study
alternative solutions to a problem. A simulation model cannot prescribe what should be
done about a problem.
• The expected value does not give an indication of the dispersion of the possible outcomes;
a standard deviation would need to be calculated. The expected value is an amalgamation
of several possible outcomes and their associated probabilities so it may not correspond to
any of the actual possible outcomes
• Expected values do not take into account the variability which could occur across a range of
outcomes; a standard deviation would need to be calculated to assess that

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Summary
• The difference between risk and uncertainty is that risk is measured in terms of probability.
• Expected value is an average outcome based on probabilities. It is not suitable for one-off
decisions. It is the decision rule for anyone who is risk-neutral.
• A profit table (payoff matrix) shows all possible payoffs which may result from the strategy
chosen by the decision-maker.
• The value of perfect information is the maximum amount a business would be prepared to
pay for an accurate forecast of the uncertain variables it faces. It is defined as:
EV with perfect information (the forecast) less EV without perfect information
• Imperfect information has value if it results in a higher expected return than the expected
value without it.
• Decision trees are a technique to visualise multi-stage decisions with various potential
outcomes at each stage.
• A payoff table can be used to apply decision rules:
o Maximax selects the option with the highest potential outcome. Maximax is the decision
rule for risk seekers.
o Maximin selects the best outcome of the worst case scenarios. Maximin is a decision
rule for the risk averse.
• To apply the minimax regret rule also requires a table of regrets.
• Sensitivity analysis calculates how responsive a decision is to changes in any of the
variables used to calculate it.
• Simulation allows for more than one variable to change at a time.
• In the real world, much of the risk that commercial organisations face comes from new
products. Such risk can be reduced by focus groups or other forms of market research.

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 Budgetary Systems And Types Of Budget
BUDGETARY SYSTEMS AND TYPES OF BUDGET

Budget

A budget is a quantified plan of action for a forthcoming accounting period.

Long-Term Planning
Budgeting for long-term planning involves setting strategic objectives using a performance
hierarchy, which typically covers 12 months.

A typical hierarchy of objectives is as follows:

Mission

The mission of an organisation can be described as the reason for the organisation's existence.

The Planning And Control Cycle decision

• Identify objectives
• Identify alternative course of action (strategies) which might contribute towards achieving the
objectives planning

• Evaluate each strategy

• Choose alternative course of action
decision making
• Implement the long-term plan in the form of the annual budget
• Measure actual results and compare with the plan
• Respond to divergences from plan Control
plan/ take corrective actions

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Objectives Of Budgetary Control System

• Coordination

• Responsibility

• Resource utilisation

• Motivation

• Evaluation Performance Evaluation

• Communicate Communicate company's plan Via budgets

Ethical And Sustainability Considerations Discussed in detail in Ch: Accounting for

environmental and sustainability factors

Budgets traditionally focus on economic aspects, but with business sustainability becoming more
important, the budget-setting process needs to incorporate ethical and sustainability elements.
Sustainable budgeting is primarily focused on the public sector, but is increasingly adopted by
commercial firms. The primary focus should be on addressing sustainability and societal well-
being measures, such as climate impact, pollution, and CO2 emissions. Budgets should include
measures related to the UN's sustainable development goals and should focus on the objectives
of the budgetary process and the system, processes, and controls that identify and measure
achievement in these concerns.

Master Budget

The master budget consolidates all other budgets and is approved by the board for supervision
and strategic goals implementation. If not approved, it is returned to those responsible for
preparing it, who must decide on changes in subsidiary budgets. Issues with subsidiary budgets
can significantly affect the master budget, and even minor amendments can be complicated.

Functional Budgets

Operational managers are responsible for preparing functional budgets, including sales,
production, materials, labour, and capital. These budgets must be prepared sequentially, starting
with the principal budgeting factor, such as sales demand. Data from one budget may be input for
another, and each budget must be reviewed to ensure consistency. Adjustments may be time-
consuming.
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 Budgetary Systems And Types Of Budget
Top-Down & Bottom-Up Budgeting
• Top-down budgeting involves senior management preparing centrally, with junior managers
tasked with operating their departments within the budget.
• Bottom-up budgeting involves managers preparing their department's budget, which is then
discussed with senior managers, and changes may be made to ensure the final budget meets
the organization's objectives before approval.
• If junior managers are not allowed to participate in their budgets, they may become
demotivated and may become demotivated.
• Additionally, if managers are evaluated against the budget, the budget should be challenging
but realistic. Budgetary slack, which is the intentional underestimation of budgeted revenues or
costs, can occur if managers participate in preparing their own budgets.

Incremental Budgeting stable environament

An incremental budget is a budget based on a previous period's performance, adding incremental

amounts for the new period.

Usefulness Of Incremental Budgeting

• Appropriate for stable businesses with good cost control.

• Simple to operate and understand.

• Avoids conflicts if departments are treated similarly.

• Facilitates budget coordination.

• Quickly shows effect of change.

Problems With Incremental Budgeting

• Assumes consistent activities and work methods.
• Does not encourage new ways of working or cost reduction.
• Promotes a "spend it or lose" mentality.
• May become outdated and unrelated to current activity or work type.
• Priority for resources may have changed since budgets were set.
• Does not review or justify budgetary slack in previous budgets.
• Tendency to justify next year's budget based on current levels.

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Zero-Based Budgeting (ZBB)
To overcome cyclical budgeting issues, consider a "zero base" budgeting approach, where
resources are justified and alternatives are compared. For example, instead of considering the
current sales force, the company should develop the optimum sales strategy for a specific market,
requiring planning for implementation.

Stages Of The ZBB

1. Each manager identifies activities or programmes to undertake in the budgeted period. A
"decision package" is then prepared for each activity. This is a mini–budget that analyses
how much will need to be spent on the activity. There also may be some narrative
explaining the benefits of the package and quantifying any revenues (or cost savings) if
appropriate. cost benefit analysis, and ranking ( prioritizing) the important activities
2. A budget committee reviews all the decision packages and ranks them (in decreasing order
of benefits). Management accepts each package up to the point at which the total budgeted
expenditure is reached.
3. Resources are allocated to the activities selected in step 2. The budget is then a
consolidation of all the accepted packages.

Decision Package
A decision package is created for each activity managers plan to undertake in the following year,
including base level and incremental packages. The budget committee can decide whether to
accept the base package or provide funds for the incremental package. Decision packages can be
mutually exclusive, with one package being in-house and another outsourcing.

Benefits Of ZBB
• Forces re-evaluation of budget activities, eliminating obsolete ones.

• Links resource allocation to results and needs.

• Fosters a questioning attitude, encouraging alternative solutions.

• Promotes bottom-up approach, motivating employees.

• Prevents "budget creep" associated with other budgeting techniques.

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Drawbacks Of ZBB
• Lack of skills in departmental managers for decision package creation, requiring training.
• Large organizational activities leading to unmanageable paperwork from ZBB.
• Difficulty in ranking packages due to inability to compare activities quantitatively.
• Inability of management information systems to provide necessary information.
• Short-term goals may be prioritized over long-term ones due to annual budgeting cycle.

When ZBB Is Appropriate Dynamic environment

• ZBB is beneficial for organizations with high discretionary costs like research, development,
and advertising, as it allows them to reassess their expenditure without halting operations,
while still benefiting from reduced expenses.

• ZBB is increasingly used by public sector bodies for transparency, ranking decision
packages, and allocating limited resources. It allows taxpayers to understand where their
money is being spent, while ranking decision packages ensures that limited resources are
allocated effectively.

Rolling Budgets (Rolling Forecasts)

A rolling budget is a budgeting system where the budget is continuously updated, keeping the
horizon constant by adding another month or quarter to the end of the budgeted period.

Example 1

A company uses a system of rolling budgets. The sales budget is displayed below.

Jan – Mar Apr – Jun Jul – Sep Oct – Dec Total

Sales $78,480 $86,120 $91,800 $97,462 $353,862

Actual sales for January – march were $74,640.

The adverse variance is explained by growth being lower than anticipated and the market being
more competitive than predicted. Senior management has proposed that the revised assumption
for sales growth should be 2.5% per quarter.

Required:

Update the budget as appropriate.

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Usefulness Of Rolling Budgets Realistic / relevant / achievable budget

• They are more relevant and valid for performance comparison.

• Budgets for the next 12 months are available for cash flow planning.

• Realistic budgets motivate managers by considering external changes. by giving Achievable /

-> Budgets are regularly updated to reflect external changes realistic budget

Problems With Rolling Budgets

• Time-consuming and costly due to regular updates.
• Potential for budget changes to conceal operational inefficiencies.
blaming market conditions for not
achieving targets, and updating
budgets accordingly

Appropriateness Of Rolling Budgets

• Appropriate for dynamic industries with frequent external changes.
-> Less useful in stable industries where continuous budget updates may not yield significant benefits

Activity-Based Budgeting (ABB)

Activity-based budgeting (abb) is a more sophisticated method for determining costs of support
activities that don't necessarily depend on the number of units produced or sold, following the
principles of activity-based costing (ABC).

Preparation Of ABB
Preparing activity-based budgets is rather like performing ABC in reverse. The following steps are
used:

1. Estimate the budgeted volume of sales and production, in units.

2. For each activity estimate the number of units of driver which would be required to support
the budgeted volume of sales and production
This may require an analysis of factors such as labour time
3. Determine the cost of each unit of driver. required, labour cost per unit, etc.
4. Calculate the budgeted cost of each activity. (No. of drivers*cost per unit of driver)

Advantages Of ABB
• Focuses on activities for easier control.
• Understanding cost causes can lead to cost reduction opportunities.
• Identifies "non-value adding" activities for elimination.
eg; Activity based management ---> identifies reasons

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Disadvantages Of ABB
• Requires detailed overhead analysis and activity measurement.

• Costs may outweigh benefits in narrow product ranges.

Appropriateness Of ABB

ABB is a complex method suitable for large companies with high overheads, multiple activities,
and products with varying production times and methods.

Feedback Control
A feedback control system monitors outputs against a predetermined standard, addressing
deviations. Examples include budgetary control systems, where actual results are compared
against the budget, and if not achieved, corrective action is taken.

Closed-Loop System
A closed-loop system is any system with feedback. Reliance on feedback makes such systems
reactive rather than proactive.

• Standard: what the system is aiming for (e.g. The budget).

• Sensor: measures the output of the system (i.e. Accumulation of actual data).
• Comparator: compares the information from the sensor to the standard (e.g. Variance
analysis).
• Effector: control action (e.g. Management action to minimise future adverse variances and
repeat favourable variances).
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Open-Loop System

An open-loop system is a system without feedback. There are two reasons for the absence of
feedback:

1. Feedback is not produced (e.g. Variance analysis not undertaken).

2. Feedback is produced but not used appropriately (e.g. Variances are not communicated to
the appropriate manager).

Positive And Negative Feedback

Positive feedback indicates the output exceeded the plan, while negative feedback indicates it fell
below the plan. Investigating negative feedback causes corrective action to reduce future
repetition. Investigating positive results, such as favourable variances, is crucial but requires
caution.

Feed-Forward Control

Feedback control systems often fail to correct deviations in the current period, leaving the current
period history. In contrast, feed-forward control systems compare predicted future results against
desired outcomes, allowing action to be taken if the desired outcome is not achieved. This is seen
in target costing, where expected cost per unit is compared with desired cost per unit.

Sources Of Data And Information

Data and information come from multiple sources − both internal (inside the business) and
external. Businesses need to capture and use information which is relevant and reliable.

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Difficulties In Changing The Approach To Budgeting

• Employee resistance: Unappreciated change value may hinder support.

• Scepticism: Senior management may lack support due to lack of understanding.
• Training: Investment in training for new budgeting methods is necessary.
• Additional costs: Additional time and costs, including consultants and staff overtime.

Factors That May Cause Uncertainty

• Economic performance: Economic growth can increase demand for products or services.
• Competitors' actions: New product launches can reduce demand.
• Employee performance: Estimating productivity and required workforce is challenging.
• Market prices of inputs: Volatile prices of commodities like metals and oil can affect prices.
• Uncertainty in demand for new products: Popularity unknown until product launch.
• Methods to deal with uncertainty: Flexible budgets, rolling budgets, and budget revisions at
end of period.

Flexible budgets

Flexible budgeting involves preparing two or more budgets, using different assumptions for each
about the level of sales or production. At the end of the financial period, the budget would be
flexed to the actual activity level for comparison to actual performance.

Advantages Of Flexible Budgets

• Managers must consider various forecasts.

• Actual results should be compared with budget for optimal activity level.

Disadvantages Of Flexible Budgets

• Difficulty in separating fixed and variable costs.

• Cost behaviour may not align with assumed linear or learning curve predictions.

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Flexed budgets

At year-end, budgets are flexed using original assumptions and actual activity levels, ensuring
more valid comparisons. Fixed costs may also be flexed if activity levels change.

Factors Which Influence Behaviour

In many organisations, managers are at least partly evaluated on how they perform in relation to
the budget. The budget is, therefore, likely to influence the behaviour of those managers. It is
hoped that the budget will motivate managers to achieve higher profits for the organisation.
Several factors will influence this.

Hopwood's Management Styles

One of the first management writers to consider the effect of budgets on behaviour was Hopwood,
who carried out a survey of budgeting practices during the 1970s to identify how budgets
influenced the behaviour of managers. He identified three different management styles in the
companies he visited: budget constrained, profit conscious and non-accounting.

Budget-Constrained Style
Managers are evaluated on their ability to meet budgets in the short term. Failure to meet budgets
means that managers will have poor evaluations, even if there was a good reason for exceeding
the budget.

Profit-Conscious Style
In the profit-conscious company, managers are judged more on their ability to contribute to long-
term success rather than simply meeting the budget. Budgets are used, but are applied more
flexibly. For example, if the budget was not reached, but there was a good reason for this, the
manager would not be penalised.

Non-Accounting Style

Accounting data is not important for performance evaluation. Qualitative factors are seen as more
important (e.g. Customer satisfaction).
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Setting The Level Of Difficulty Of The Budget

Research indicates that targets can motivate employees and increase their actual achievement.
However, too easy targets can demotivate individuals, while too difficult targets can be
demotivating. The optimal target may vary among individuals. It's important to consider adverse
variance in performance evaluations, and use a lower standard for performance evaluation to
avoid negative reactions.

Criticisms Of Traditional Budgeting

• Budgets take up too much time less benefit compared to time spent

• Traditional budgeting is irrelevant in the modern business environment

Continuous changes in markets

• Dysfunctional behaviour conflicts or confusion;

Beyond Budgeting Model

Beyond budgeting is a set of principles that aims to decentralize decision-making within an

organization by replacing traditional budgets with KPI-based targets, using "stretch goals" for
planning, evaluating managers based on benchmarks, delegating planning responsibility,
managing resources, and using KPIs for performance measurement.

Beyond budgeting uses relative targets or benchmarks, making targets more relevant and fair. In a
dynamic business environment, organizations need to react quickly to changes, and traditional
budgets limit this. In the beyond budgeting model, business unit managers and front-line staff
develop their own plans for maximizing customer satisfaction and shareholder wealth.
Funds are allocated to projects based on a "fast track" review process.

Controlling performance is exercised through cross-company interaction, using a more diverse

range of forward-looking indicators. Rolling forecasts and leading indicators provide managers
with a view of the organization's performance and help them make informed decisions.

Stretch Goal
Stretch goal – a goal that requires an organisation or person to push themselves to their limits.

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Advantages
• Increases motivation among managers by allowing autonomy for business unit planning.
• Fosters a competitive success climate through relative performance measures and external
benchmark comparisons.
• Allows faster response to customer needs changes and resource allocation for worthwhile
projects.
• Focuses performance on KPIs, reflecting overall organizational objectives.
• Promotes a customer-focused attitude among departments supplying other internal
departments.

Disadvantages

• May not support command-and-control style in senior managers.

• Not suitable in organizations with financial control.
• Not suitable in public sector with limited funds.

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Additional Notes

• In every variance reporting system with flexible budgets that compares budgeted and actual
profit, there must be a sales volume variance.
• Flexible budgets enable actual results to be compared with expected results for the same
volume of activity, such as production and sales. To reconcile an original budgeted profit to
actual profit with variances there must be a sales volume variance.
• Zero-based budgeting begins by looking at the minimum budgeted expenditure, and
building a budget from this zero base. This encourages employees to focus on wasteful and
unnecessary spending.
• Two reasons why ZBB is often considered more suitable for public sector service
organisations than for private sector companies. One is that ZBB is more suited to costs
where there is a lot of discretionary spending, as in the public sector services. The second
reason is that activities of public sector organisations are more easily definable and so can
usually be put into decision packages. (for example, the activities of a local authority can be
grouped into packages for local housing, local education, local refuse collection and waste
disposal, and so on.)
• ZBB is particularly useful for cost reduction exercises.
• A usual problem cited with regards to ZBB is that individual managers may not have the
necessary skills to construct decision packages and undertake the ranking process
• Another potential problem with ZBB is that information systems may not be capable of
providing suitable information and costly investment may be needed.
• Feedforward control is based on forecast results, i.e., if the forecast is poor then control
action is taken in advance of actual results.

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Summary

• A budgetary control system is a means by which management exercises control over the
organisation through setting budgets and comparing performance against the budget.
Action is taken to remedy deviations from the budget.
• The main objectives of a budgetary control system are planning, coordination of the
activities of the organisation and ensuring better resource utilisation.
• Budgets may also be used to delegate responsibility to managers, who are then evaluated
on how they perform relative to the budget.
• Budgets should contribute towards the long-term plans of the organisation.
• Top-down budgeting means that budgets are prepared by senior management and
imposed on the departments responsible for achieving them.
• Bottom-up budgeting means that departments participate in preparing their own budgets.
• A rolling budget is continuously updated and most likely to be suitable in a rapidly changing
environment in which the original budget quickly becoming out of date.
• Incremental budgeting is a traditional approach to budgeting which bases next year’s
budget on the current year's budget or actual figures.
• ZBB starts “from scratch” and requires the costs and benefits of all activities to be quantified
and justified. It is particularly useful in the public sector but costly and time-consuming to
implement.
• Activity-based budgets use ABC principles to calculate the budgeted overhead costs.
• Budgets influence the behaviour of managers, because their evaluation depends on
whether they achieve the budget. Research suggests that targets that are just out of reach
are optimal for motivation.
• The beyond budgeting model aims to replace traditional budgetary control systems with a
more modern approach which replaces financial targets with key performance indicators.

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 Analytical Techniques In Budgeting And Forecasting

ANALYTICAL TECHNIQUES IN BUDGETING AND FORECASTING

The Learning Effect

The learning effect occurs when workers become more familiar with repetitive tasks, leading to a
decrease in labour hours per unit. This phenomenon starts with the first unit/batch, and as
production doubles, the cumulative average time per unit falls to a fixed percentage of the
previous average time, known as the learning rate. The learning rate is expressed as a percentage
value, such as an 80% learning curve or a 70% learning curve.

Conditions for a Learning Curve to Apply

• Labour-intensive activity.
• Low labour turnover.
• No prolonged production breaks.
• Repetitive process required.
• Brand new product.
• Complex products.
• Applied on homogenous products.

Applications of Learning Curve Theory

• Standard setting: Labour standard should be revised based on expected learning effect.
• Budgeting: Variable costs expected to decrease with production increase, crucial for cash
budgeting.
• Pricing decisions: Accurate labour cost prediction.
• Work scheduling: Manpower planning.

Tabular Approach
The tabular approach is efficient but limited to calculating average times when cumulative output
doubles, with a fixed percentage decrease in average time per unit.

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Example 1

Time to make first unit = 50 hours

learning rate = 90%

Cumulative Cumulative average Total time Incremental total Average

output(units) time per unit (hours) time hours/unit

1 50 50

2 45 90 40 40 (40/1)

4 40.50 162 72 36 (72/2)

8 36.45 291.6 129.6 32.4 (129.6/4)

Example 2
Company has designed a new type of sailing boat, for which the cost of the first boat to be
produced has been estimated as follows.
$

Materials 5,000

Labour (800 hrs ´ $5 per hr) 4,000

Overhead (150% of labour cost) 6,000

Total cost 15,000

Profit mark-up (20%) 3,000

Sales Price 18,000

It is planned to sell all the units at full cost plus 20%. An 80% learning curve is expected to apply to
the production work. The management accountant has been asked to provide cost information so
that decisions can be made on what price to charge.

Required
a) What is the selling price of second unit ?
b) What would be the total cost for the first 4 units ?

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Algebraic Approach

Learning Curve Formula

Y = axb

Y = cumulative average time per unit to produce x units

a = time taken for the first unit of output

x = the cumulative number of units produced

b = the index of learning (log LR/log 2)

LR = the learning rate as a decimal

Example 3

Suppose that an 80% learning curve applies to production of a new product item ABC. The time to
make the very first unit of ABC was 120 hours.

Required

Calculate the time required to make the 31st unit.

Steady State

A steady state occurs when the learning process stops, with no further improvements made. The
time taken per unit remains constant, establishing a standard time and labour cost for the product.

Estimating the Learning Rate

Example 4
BL is planning to manufacture a new product, product A. The labour hours for the first unit is
estimated to be 720 , while the total labour hours for producing first four units will be 1620.

Required

Calculate the rate of learning

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Limitations (Reservations) About the Learning Curve

• Assumptions about learning rate for new products may not always align with past
production.
• The learning curve is useful in continuous production, but breaks can lead to skill
forgetfulness.
• Modern business world often uses tailor-made products, making mass production of
identical items unsuitable.
• "Go slow" agreements in unionized industries may prevent full capacity work.
• Applicable only in labour-intensive, repetitive, and skilled operations.
• Assumptions about employee motivation for learning.
• Difficulty in accurately determining the learning curve effect.

Correlation

Correlation is the closeness of a linear relationship between two or more variables, measured and
interpreted through correlation analysis, involving changes in one variable accompanied by
another. for eg:
total variable cost and production units
selling price of a product and its demand

Types of Correlation

Positive and Negative correlation

• Positive correlation − when an increase in one variable is associated with an increase in the
other
• Negative correlation − when an increase in one variable is associated with a decrease in
the other

Perfect , Partial and No Correlation

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Correlation Coefficient (r)

• The correlation coefficient, r, is a measure of the degree of linear correlation between two
variables.

• The value of the correlation coefficient will always lie between −1 and 1

o r = +1 denotes perfect positive correlation.

o r = −1 denotes perfect negative correlation .
o r = 0 means that the variables are uncorrelated.

Where:

n = the number of pairs of values

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Spurious Correlation

A spurious correlation refers to a high correlation between two variables that may not necessarily
indicate a causal relationship. This can occur due to indirect connections or a coincidence, where
both variables depend on a third variable.

Example

The following details are available for a company for the past 6 months

Month Output (‘000 of units) Cost ($’000)

1 2 9

2 3 11

3 1 7

4 4 13

5 3 11

6 5 15

Required

Assess whether there is any correlation between output and cost

Coefficient of Determination (r2)

The coefficient of determination, calculated as the square of the correlation coefficient, indicates
how much of a change in one variable can be explained by another.

Regression

Regression analysis is a widely used business analysis tool, studying the relationship between
variables. It involves a dependent variable, which is explained by a regression model, and an
independent variable, which is used to predict the dependent variable.

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Equation
Y = a + bx
Where,
Y = Dependent variable
X = Independent variable
a = intercept
b = gradient or slope

The values of a and b can be determined by least squares method of regression which computes
the “line of best fit” mathematically.

Example

The following details are available for a company for the past 6 months

Month Output (‘000 of units) Cost ($’000)

1 2 9

2 3 11

3 1 7

4 4 13

5 3 11

6 5 15

Required

Determine the linear equation between units and total cost

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Benefits of Correlation and Regression Analysis
• Indicates associations between variables.

• More accurate than high-low method.

• Combines with regression to show relationship strength.

Limitations of Correlation and Regression Analysis

• Limited data can reduce forecast reliability.
• Linear regression analysis assumes a linear relationship, which may not be valid.
• Forecasts extrapolating values outside past data range may be invalid and require caution.

High-Low Method

The high-low method estimates fixed and variable elements of semi-variable costs, enabling
accurate cost forecasts. It collects data from different activity levels and assumes linear costs, but
limitation of regression
caution is advised when using extreme values.
limitation/risk of high low method

Total Cost Function

Total cost = Fixed cost + Variable cost/unit * Units

TC = FC + VC/U * U

Example
Company has recorded the following total costs during the last five years

Year Output volume (Units) Total cost ($)

20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000

Required

Calculate the total cost that should be expected in 20X5 if output is 85,000 units.

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The High-Low Method With Stepped Fixed Costs
Example
The following data relate to the total cost at two activity levels

Units produced Total cost

12,750 $73,950
15,100 $83,585

When more than 14,000 units are produced there will be a step up in fixed cost of $4700

Required

Calculate the estimated total cost for 14,500 units

Time Series
future values
A time series analysis is a method used to predict values by analysing a series of figures that
reflects the changing value of a variable over time, often following a specific pattern.

Components of a Time Series

• Trend (T) PM SYLLABUS

• Seasonal variations (S) PM SYLLABUS
• Cyclical variations (C)
• Random variations due to non-recurring influences (I)

Trend
avg movement/ avg value
A trend refers to the long-term movement of values, describing the general movement of recorded
data over time.

Identifying the Trend

• A “line of best fit” drawn on a graph;

• The least squares method of linear regression
• The calculation of moving averages.

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Moving Averages Method
The moving averages method removes seasonal variations from data by averaging results from a
fixed number of periods. It smooths out data sets to reveal their overall trend, ignoring outlying
data points. To calculate the trend, calculate a "moving" total for a normal cycle and divide by the
number of periods.

Seasonal Variations
Seasonal variations are short-term fluctuations in value due to varying circumstances occurring at
different times of the year.

Factors causing seasonal variations may include:

• The weather (e.g. Products selling better in hot rather than cold weather);
• Annual events (e.g. New year retail sales, “Black Friday”, etc);
• Customers having more time to shop (e.g. At the weekend rather than week days).

Additive Model

• Seasonal variations are the difference between actual and trend figures. An average of the
seasonal variations for each time period within the cycle must be determined and then
adjusted so that the total of the seasonal variations sums to zero.
• Seasonal variation = actual sales – trend
• Forecast sales = Trend + Seasonal variation

Multiplicative Model

• The seasonal variation expressed as a proportion of the trend is sometimes called a

seasonal index.
• Seasonal variation = actual sales / trend
• Forecast = Trend * Seasonal variation
• The average seasonal index should sum to the number of seasons in the time series (e.g.
12 for monthly variations, 4 for quarterly variations).
• The multiplicative model is better for forecasting purposes than the additive model if there is
an increasing or decreasing trend over time.

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Cyclical Variations
Cyclical variations are medium-term changes in values due to repeating factors in cycles, such as
economic cycles, which involve the alternation between booms and recessions.

Random Variations

Random variations in data, often due to unforeseen events, are irregular fluctuations that cannot
be predicted and can be positive or negative in nature.

Forecasting Using Time Series Analysis

• A trend can be used to predict future values, by extrapolating beyond the historic values
using a graph or an equation that describes the trend.
• Once a trend value has been calculated for a future period, it then needs to be adjusted for
seasonal variations using the additive or multiplicative model.

Example
A business is forecasting the value of their sales for the first quarter of the coming year. Current
year values to date are as follows :

Month Sales value

June 851
July 771
August 916
September 935
October 855
November 1000
December 1019

Required
Using 3 month moving averages calculate the forecast sales values for January to March using
additive model

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Example
Consider a business with the following actual results and trend values

Year Quarter Units Sold Trend

2001 1 65 60

2001 2 80 70

2001 3 70 80

2001 4 85 90

Required

Calculate the forecast sales for next year using additive and multiplicative models

Seasonally-Adjusted (de seasonalised) Data

Seasonally-adjusted data (i.e. Actual data that has been stripped of seasonal variations) can be
used to explore the trend and any remaining random component.

• For the additive model: subtract positive variations from actual data and add
negative variations to actual data;
• For the multiplicative model: divide actual data by the seasonal variation factors.

Benefits of Time Series Analysis

• Enables future predictions based on past experience.

• Facilitates accurate forecasting by analysing data into component parts.

Limitations of Time Series Analysis

• Data must be ordered over time for trend calculation.

• Forecast reliability depends on the amount of data used.
• Extrapolation becomes less reliable as forecasts become more distant

Simple Average Growth Models

Such models take average growth from the past, using the geometric mean, and assume that this
level of growth will continue in the future.

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Additional Notes

• One assumption of simple linear regression is that the dependent variable is only affected
by one independent variable.
• Another assumption is that what happened in the past will continue into the future.
• Simple linear regression is suitable when there is correlation between two variables. It can
be positive or negative correlation.
• Interpolation means forecasting within the range of the original data whereas extrapolation
means forecasting outside the range of the original data. Forecasting within the range is
more reliable because there is data to back up the forecast. It is more difficult to be sure
what the results will be if they are outside the range recorded in the past.
• Learning curves are more difficult to apply in teams with a high labour turnover, as it can
affect efficiency and knowledge significantly. Learning rates are affected by time gaps
between the production of additional units of a product, because acquired learning may be
forgotten with the passage of time unless the work continues regularly.
• The use of the learning curve is not restricted to the manufacturing industries that it is
traditionally associated with. It is also used in other less-traditional sectors, such as
professional practice, financial services, publishing and travel.
• Increasing staff training could lead to an extension of the learning curve as the higher
skilled employees should demonstrate an even greater improvement than if they were not
trained.

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Summary

• The high-low method is a simple and crude method used to find the relationship between
variables, which takes only the highest and lowest values from the observations.
• In a time series (i.e. a series of figures recorded over time), the trend is the underlying long-
term movement of data values. Seasonal variations are fluctuations due to differing
conditions that affect results at different times, leading to differences between actual results
and results predicted by the trend alone.
• A trend can be calculated using moving averages or least squares regression.
• Seasonal variations can be calculating using the additive model (Y = T + S) or the
multiplicative model (Y = T × S).
• Time series analysis can be used to forecast future results by extrapolating the trend and
making adjustments for seasonal variations.
• Correlation describes the relationship between changes in the value of two variables. It may
be positive, negative or zero. The correlation coefficient, r, measures the degree of
correlation between two variables.
• The coefficient of determination, r2, measures the proportion of the variation in the
dependent variable that is caused by the variation in the other variable.
• Linear regression analysis can be used to determine a line of best fit and hence forecast
the value of one of the variables.
• Learning curve theory is based on the concept that the time taken to make a unit of a
product or service falls as workers become more experienced.
• As cumulative output doubles, the cumulative average time taken falls to a fixed percentage
− the learning rate.
• The learning curve formula is provided in the exams.
• The steady state describes the point from which the learning effect ceases.
• There are two methods of calculating the learning effect; tabulation and an algebraic
approach. Only the algebraic approach can be used when information about the cumulative
average time is for only two levels of output that are not exponentials of 2.

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 Standard Cos+ng
STANDARD COSTING

Standard Costing

Standard costing is a system based on pre-determined costs and revenue per unit which are used
to compare actual performance and therefore provide useful feedback information to
management.

Standard Selling price

Standard Cost Standard Profit

Standard cost is the planned cost of a product or component in the near future, under current or
anticipated operating conditions. Standard cost is an estimated/budgeted unit cost

Standard Cost Card

A standard cost card shows full details of the standard cost of each product.

Standard Cost Card Under Absorption Costing

Per unit

Material cost 2 kg @ $3/kg $6

Labour cost 4 hrs @ $2/hr $8

Variable overhead 4 hrs @ $3/hr $12

Fixed overhead 4 hrs @ $5/hr $20

Standard cost per unit $46

Standard profit per unit $14

Standard selling price $60

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Standard Cost Card Under Marginal Costing

Per unit

Material cost 2 kg @ $3/kg $6

Labour cost 4 hrs @ $2/hr $8

Variable overhead 4 hrs @ $3/hr $12

Standard variable cost per unit $26

Standard contribution per unit $34

Standard selling price $60

Setting Standards

Standard setting involves combining expertise from various stakeholders, such as accountants,
buyers, engineers, and factory supervisors, to ensure efficient future operations. It can be
achieved through ideal or attainable levels of difficulty.

Ideal Standards

Ideal standards are ideal operating conditions that can be achieved without machine breakdowns,
schedule interruptions, or idle time. They serve as a reminder to improve efficiency, but can be
demotivating and difficult to assess due to unrealistic or inefficient operations.

Attainable Standards

Attainable standards are challenging but achievable under current conditions, allowing for normal
machine breakdowns and workforce breaks. They require high efficiency but are more likely to be
used due to their motivational benefits and ability to highlight abnormal conditions.

Current Standards

A current standard is set for a short period, reflecting current conditions, but is time-consuming
and costly to implement, requiring monthly recalculation.

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Basic Standards

A basic standard is a long-term average based on historical data, which has two weaknesses: it
may be outdated and too easy to achieve in the future.

Controllability Principle

The controllability principle suggests managers should be evaluated based on factors within their
control. In a system of responsibility accounting, managers' performance is assessed through
departmental variances, actual and budgeted revenues, costs, and profits, and their remuneration,
ensuring fair performance management.

Uses Of Standard Costing Systems

• Assists in planning by providing cost and profit insights.

• Helps establish budgets.
• Controls costs, motivates employees, and measures efficiencies.
• Highlights cost reduction opportunities.
• Simplifies product costing and facilitates timely cost reporting.
• Assigns cost to inventories and works in process.
• Provides cost basis for contract tendering and sales price setting.

Importance Of Flexed Budgets

A budget is prepared at the start of the year, based on estimates of sales and production volume.
However, actual performance may differ from the budget due to different activity levels. The
budget can be flexed at the end of the period, allowing a more valid comparison with actual
results.

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Additional Notes

• For standard costing to be useful for control purposes, it requires a reasonably stable
environment.
• Standard costing involves standardizing and repetitive processes, while TQM focuses on
continuous improvement through changes in procedures, input quantities, and prices,
without achieving a stable standard.
• Standard costing assumes that there is a target level of performance and achieving that
target represents success. With TQM the view is that performance can be improved
continually. There is no 'target'.
• Standard costing tends to be of little value in a rapidly changing environment, because
products are not standardised for a sufficient length of time to make the preparation of
standard costs worthwhile.
• The output of services functions is not as easily measurable as it is with goods which are
physically manufactured. This makes it difficult to establish standard unit rates, because
there are no easily available standard times or usages.
• The quantity of work achievable at standard performance in an hour this is the definition of
a standard hour.
• Attainable standards may provide an incentive to work harder as they represent a realistic
but challenging target of efficiency.
• Budgeted capacity is associated with current standards. Budgeted capacity is not
associated with basic standards. Practical capacity is associated with attainable standards.
Full capacity is associated with ideal standards.
• Budgets can be used in situations where output cannot be measured, but standards cannot
be used in such situations
• The standard labour rate should be the expected rate/hour, but allowing for standard levels
of idle time.

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Summary

• A standard cost is a planned cost for a product or service.

• When actual costs are compared against the standard, the resulting variances can be
investigated to identify the cause. Standard costing is therefore an important element in
financial control.
• Ideal standards, which assume perfect operating efficiency, are likely to be impossible to
achieve in practice, so their use is demotivating.
• Attainable standards should be challenging but achievable under existing operating
conditions.
• Controllability is the principle that managers should be evaluated only on that which they
can control.
• When actual activity levels vary from budget, the original budget must be flexed in order
to make meaningful the comparison with actual results. Flexing a budget means
recalculating the budget based on the original budget assumptions, at the actual level of
activity.

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 Variance Analysis
VARIANCE ANALYSIS

Variance Analysis

• The process by which the total difference between standard and actual results is analysed
is known as variance analysis.
• Variance is the difference between an actual amount and a budgeted, planned or past
amount.
• Variances are favourable if they resulted in an increase in profits or adverse if they lead to a
fall in profits.
• When computing variance, it must be shown whether the variance is favourable or adverse.

Standards and Variances

Management accounting categorizes inputs into quantity and price standards. Quantity standards
dictate the amount of resources needed to produce a unit of product or service, while price
standards dictate the cost per unit of resource. Different managers have different responsibilities
for buying and using inputs. Management should investigate significant variances to identify
causes and take corrective action. This facilitates "by exception" management, but identifying and
correcting underlying causes can prevent problems from recurring and worsening.

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 Variance Analysis
Forms Of Variance

• Sales volume
• Selling price
• Direct material cost
• Direct labour cost
• Variable overhead
• Fixed overhead

Direct Material Cost Variance

The materials total variance is the difference between the actual cost of direct material and the
standard material cost of actual production (flexed budget).

Example

Product x has a standard direct material cost as follows:

10 kilograms of material at $5 per kilogram = $50 per unit

During a period 1000 units of x were manufactured, using 11,700 kilograms of material y which
cost $48,600.

Required:

Calculate the following variances.

a) the direct material total variance

b) the direct material price variance
c) the direct material usage variance

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Direct Labour Cost Variance

The labour cost total variance is the difference between the actual direct labour cost and the
standard labour cost of the actual production (flexed budget).

Example

The standard direct labour cost of product x is as follows:

2 hours of labour at $5 per hour = $10 per unit of product x

During the period, 1,000 units of product x were made, and the direct labour cost of labour was
$8,900 for 2,300 hours of work.

Required:

Calculate the following variances.

a) the direct labour total variance

b) the direct labour rate variance
c) the direct labour efficiency (productivity) variance

Example

A company expected to produce 200 units of its product in 20x3. In fact, 260 units were produced.
The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour). The actual labour
cost was $18,600 and the labour force worked 2,200 hours although they were paid for 2,300
hours.

Required:

a) what is the direct labour rate variance for the company in 20x3?
b) what is the direct labour efficiency variance for the company in 20x3?

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Variable Overhead Variance

This is the difference between standard variable overheads for actual production and the actual
variable overheads.

Example

The standard variable overhead cost of product x is as follows: 2 hours at $5 per hour = $10 per
unit of product x.

During the period, 1,000 units of product x were made, and the total variable overhead cost was
$8,900 for 2,300 hours of work.

Required:

calculate the following variances.

a) variable overhead total variance

b) variable overhead expenditure variance
c) variable overhead efficiency variance

Fixed Overhead Variance

Fixed overhead total variance is the difference between absorbed fixed production overheads and
actual fixed production overheads (under or over absorbed overhead).

Fixed Overhead Variances Under Marginal And Absorption Costing System

Absorption Costing System

• It uses an absorption rate to absorb overheads.

• We calculate fixed overhead expenditure variance and the fixed overhead volume variance.

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Marginal Costing System

• No overheads are absorbed, the amount spent is simply written off to the income
statements.
• Fixed overhead variance is the difference between what was budgeted to be spent and
what was actually spent.
• There is only fixed overhead expenditure variance.

Example

Suppose that a company plans to produce 1,000 units of product e during august 20x3. The
expected time to produce a unit of e is five hours, and the budgeted fixed overhead is $20,000.
The standard fixed overhead cost per unit of product e will therefore be as follows:

5 hours at $4 per hour = $20 per unit

Actual fixed overhead expenditure in august 20x3 turns out to be $20,450. The labour force
manage to produce 1,100 units of product e in 5,400 hours of work.

Required:

calculate the following variances.

a) the fixed overhead total variance

b) the fixed overhead expenditure variance
c) the fixed overhead volume variance
d) the fixed overhead volume efficiency variance
e) the fixed overhead volume capacity variance

Sales Price Variance

Sales price variance is the measure of change in sales revenue as a result of variance between
actual and standard selling price.

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Sales Volume Profit Variance

Sales volume profit variance is the measure of change in profit as a result of the difference
between actual and budgeted sales quantity.

Note
• Under absorption costing, the difference between actual and budgeted sales is multiplied by
the standard profit per unit.
• Under marginal costing, the difference is multiplied by the standard contribution per unit.

Example

Suppose that a company budgets to sell 8,000 units of product j for $12 per unit. The standard full
cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.

Required:

calculate sales price and sales volume variances.

Operating Statements

Differences between actual results and the budget or standard are reported in monetary terms as
variances, and variances can be used to reconcile budgeted profit and actual profit in an operating
statement.

General Causes

• Planning errors (e.g. Inaccurate standards)

• Measurement errors (e.g. Time recording errors)
• Random factors (e.g. Natural disasters)
• Operational factors (e.g. Management policies).

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 Variance Analysis
Interdependence Of Variances Only a chance , not surety

• If material price variance: adverse; usage variance – favourable

• If labour rate variance: adverse; efficiency variance – favourable
• If material price: adverse; labour efficiency – favourable
• If labour rate variance: adverse; usage variance – favourable
• If sales price variance: adverse; sales volume variance – favourable

Further Investigation Of Variance

Factors to consider:

• Materiality
• Trend
• Controllability
• The type of standard being used
• Interdependence between variances
• Costs of investigation

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Summary
• Variance analysis is a detailed investigation into why actual profits differ from budget; it
compares the actual costs against the standards.
• Formulae for the variances are as follows:
o Notation:
§ AQ = Actual quantity (AH = Actual hours)
§ BQ = Budgeted quantity (SH = Standard hours)
§ AP = Actual price (AR = Actual rate)
§ SP = Standard price (SR = Standard rate)
§ SMn = Standard margin
o Sale variances:
§ Sales volume: (AQ − BQ) SMn
§ Sales price: (AP − SP) AQ
o Materials variances:
§ Price: (SP − AP) AQp
§ Usage: (SQ − AQu) SP
o Labour variances:
§ Rate: (SR − AR) AHp
§ Idle time: (AHw − AHp) SR
§ Efficiency: (SH − AHw) SR
o Variable overheads:
§ Rate: (SR − AR) AHw
§ Efficiency (SH − AHw) SR
o Fixed overheads:
§ Expenditure: Budget − Actual
§ Volume: (AQ − BQ) × Standard rate per unit or (SH – BH) SR (Absorption
costing only)
§ Capacity: (AH − BH) SR (Absorption costing only)
§ Efficiency: (SH − AH) SR (Absorption costing only)
§ Capacity + Efficiency = Volume
• The budgeted quantity in usage variances and standard hours in efficiency variances is
always "budgeted for actual production".
• The only differences between variance analysis using absorption and marginal costing are:
o Sales volume variance is valued at standard profit per unit for absorption, and
standard contribution per unit for marginal.

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 Variance Analysis
o There is only one fixed overhead variance for marginal costing; the expenditure

overhead.
• Variances could be caused by planning, measurement, random factors or operational
factors. As far as investigating variances are concerned, operational factors are more
important.

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 Material Mix And Yield Variances
MATERIAL MIX AND YIELD VARIANCES

Multiple Materials

Example 1

A company produces and sells a product and the standard cost for one unit being as follows:

Direct material A: 10 kilograms at $20 per kg $200 per unit

Direct material B: 5 litres at $6 per litre $30 per unit

During April the actual results were as follows:

Production 800 units

Material A 7,800 kg used, costing $159,900

Material B 4,300 litres used, costing $23,650

Required:

Calculate price and usage variances for each material.

Example 2

The standard cost for one unit of a product is as follows

$/unit

Direct material A: 1 kg at $2 per kg 2

Direct material B: 2 kg at $5 per kg 10

Actual results were as follows:

Production 1 unit

Material A 1.5 kg used

Material B 1.5 kg used

Required:

Calculate material usage variance.

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Example 3

The standard cost for one unit of a product is as follows

$/unit

Direct material A: 1 kg at $2 per kg 2

Direct material B: 2 kg at $5 per kg 10

Actual results were as follows:

Production 1 unit

Material A 2 kg used

Material B 4 kg used

Required:

Calculate material usage variance.

Material Mix and Yield Variances

• The materials usage variance can be subdivided into a materials mix variance and a
materials yield variance when more than one material is used in the product and the
management is in a position to control the mix of materials used in a production.
• A mix variance occurs when the materials are not mixed or blended in standard proportions
and it is a measure of whether the actual mix is cheaper or more expensive than the
standard mix.
• Favourable mix variance means the actual mix is cheaper than the standard mix.
Adverse ---> actual mix is expensive
• A yield variance occurs when the actual input for output differs from the expected level,
resulting in a difference between the standard and actual loss.
• A favourable yield variance means that actual output exceeds output expected for the given
input units. and viceversa

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 Material Mix And Yield Variances
Example 4

A company manufactures a chemical using two compounds A and B. The standard materials
usage and cost of one unit are as follows:

A: 5 kg at $2 per kg 10

B: 10 kg at $3 per kg 30

In a particular period, 80 units were produced from 600 kg of A and 750 kg of B.

Required:

Calculate the materials usage, mix and yield variances.

Inter-Relationship Between Price, Mix And Yield Variances

Materials price variances can be unpredictable, influenced by seasonal or market rates. Managers
may obtain cheaper inputs from alternative suppliers, leading to favourable price variances but
potentially increasing waste and yield variances. Using less expensive materials can also cause
unfavourable outcomes.

Wider Issues Relating to Product Mix Yield variance ---> Adv

• Balancing mix and yield − using a cheaper "mix" of materials often leads to a lower yield.
• Quality − a cheaper mix may lead to lower cost, but this may also lower the quality.

Reasons For Varying The Mix

• The price of materials may change away from the standard, so one becomes relatively
more or less expensive.
• Inaccurate measurement of inputs due to carelessness or mistake.
• Intentionally using a cheaper mix to get a favourable mix variance.

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 Material Mix And Yield Variances
Alternative Methods Of Controlling Production Processes

If production managers are evaluated on materials mix and yield variances, they may take actions
to improve the measured variances at the expense of other important factors − particularly quality
To overcome this undesirable consequence, performance evaluation of a manager should also
consider additional measures. This can include rates of wastage or conversion rates of input.
Customer satisfaction and quality are also important.

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Additional Notes

• Mix and yield variances measure costs and output quantities, not quality. A potential
problem is that persistent favourable mix variances may have an adverse effect on sales
volume variances and direct labour efficiency variances, because the cheaper materials mix
may affect the quality of the product sold to customers and also make the product more
difficult to handle. These consequences could lead to adverse sales volume and labour
efficiency variances.
• Mix variances should only be calculated when a product contains two or more materials that
can be mixed together in different proportions.

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 Material Mix And Yield Variances
Summary

• Materials mix variances measure the effect of using a different mix of inputs in the
production process.
• Materials yield variances compare actual output with expected output, given the input
material quantities and standard wastage.

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 Sales Mix And Quantity Variances
SALES MIX AND QUANTITY VARIANCES
Example 1

Company makes and sells two products A and B

The budgeted sales and profit are as follows:

Product Budgeted sales unit Budgeted profit per unit

A 2 $3

B 4 $7

Actual sales were

A: 3

B: 3

Required:

Calculate the sales volume variance.

Example 2

Company makes and sells two products A and B

The budgeted sales and profit are as follows:

Product Budgeted sales unit Budgeted profit per unit

A 2 $3

B 4 $7

Actual sales were

A: 3

B: 6

Required:

Calculate the sales volume variance.

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 Sales Mix And Quantity Variances
Sales Mix And Quantity Variances

• Where the company sells more than one product, the sales volume variance can be
analysed further into a sales mix variance and a sales quantity variance. This may be useful
where management is in a position to control the sales mix.
• Sales mix variance is the difference in product proportions from budget, comparing actual
quantities to standard mix, indicating the impact on profit or contribution.
• An adverse mix variance means that customers are buying less of the higher-margin
products and instead buying lower-margin ones.
• Sales quantity variance compares actual quantity of goods sold in the standard mix with the
budgeted quantity, indicating the difference in contribution/profit due to changes in sales
volume.
• An adverse variance may be due to poor economic conditions or a new competitor.

In principle, the calculation of sales mix variance is similar to the material mix variance

Example 2

Company makes and sells two products, C and S.

The budgeted sales and profit are as follows:

Product Units Sales Revenue ($) Costs ($) Profit ($)

C 400 8,000 6,000 2,000

S 300 12,000 11,100 900

Actual sales were 280 units of C and 630 units of S.

Required:

Calculate the sales volume variance, the sales mix variance and the sales quantity variance.

Inter-Relationships Between Variances

An adverse sales mix variance may be due to customers switching to cheaper ranges or brands
as these may be considered better value. If these "better value" products attract customers from
other products too, this will lead to a favourable quantity variance.

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 Sales Mix And Quantity Variances
Summary

• Sale mix variances show how changing the mix of products affected contribution.
• Sales quantity variances show the effect on budgeted sales of selling a higher or lower
quantity.
• The budgeted sales mix has no significance when product sales are unrelated.
• Sales volumes of different products may be inter-related, for example, a sales decrease in
one product may be compensated by a sales increase for a substitute product.
• Because of the relationship between price and demand, an unfavourable sales price
variance will usually lead to a favourable volume variance (and vice versa).

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 Planning And Operational Variances

PLANNING AND OPERATIONAL VARIANCES

Revision Of Budgets Or Standards

Revising a budget or standard cost is sometimes necessary, but variances should be reported
separately from those caused by the revision. It's allowed if something beyond the manager's
control makes the original budget unsuitable for performance management. Budgets can be
revised at the end of a period to account for unexpected changes in the environment. Principles
for revising budgets include addressing unachieved goals, avoiding inefficiencies, and approving
with sufficient evidences
only appropriate revisions by senior management.

Planning And Operational Variances

The planning and operational approach to variance analysis divides total variance into planning
variances resulting from inaccurate planning or faulty standards, and operational variances caused
by operational performance compared to a revised standard. Planning variances are calculated by
comparing the original budget/standard cost with the revised budget/standard cost, while
operational variances are calculated by comparing actual results with the revised budget/standard
cost.

Planning and operational variances can be calculated for

• Material price variance

• Material usage variance
• Labour rate variance
• Labour efficiency variance
• Sales price variance
• Sales volume variance

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 Planning And Operational Variances
Example 1

KSO budgeted to sell 10,000 units of a new product during 20X0. The budgeted sales price was
$10 per unit, and the variable cost $3 per unit. Actual sales in 20X0 were 12,000 units and variable
costs of sales were $30,000, but sales were only $5 per unit. With the benefit of hindsight, it is
realised that the budgeted sales price of $10 was hopelessly optimistic, and a price of $4.50 per
unit would have been much more realistic.

Required:

Calculate planning and operational variances for sales price.

Example 2

PG budgeted sales for 20X8 were 5,000 units. The standard contribution is $9.60 per unit. A
recession in 20X8 means that the market for PG's products declined by 5%. Actual sales were
4,500 units.

Required:

Calculate planning and operational variances for sales volume.

Example 3

Product X had a standard direct material cost in the budget of: 4 kg of Material M at $5 per kg =
$20 per unit. Due to disruption of supply of materials to the market, the average market price for
Material M during the period was $5.50 per kg, and it was decided to revise the material standard
cost to allow for this. During the period, 6,000 units of Product X were manufactured. They
required 26,300 kg of Material M, which cost $139,390.

Required:

Calculate;

a) The material price planning variance

b) The material price operational variance
c) The material usage (operational) variance

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 Planning And Operational Variances
Advantages

• Distinguishes between variances from bad planning and operating factors.

• Adverse operating variances provide feedback for corrective processes.
• Planning variances update standards to current conditions.
• Improves motivation by assessing only under their control. when comparing performance based on
achievable, realistic targets

Disadvantages

• Requires extra data like market size. to revise standards

• More time-consuming.
• Managers may attribute variances to external and internal causes. managers may manipulate ,
saying it may due to external
• Operational managers may attribute variances to poor standard setting.
factors, even though it is because
their mistakes

Budget Manipulation and Revision

• Budgets and standards prepared at the start of the year may need revision at the end of the
year due to external factors.
• Managers may hide adverse variances by revising budgets and standards.
• Strict rules are needed to prevent manipulation, ensuring budget revisions are only when
appropriate.
• Revisions should only be permitted with independent, verifiable evidence.

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 Planning And Operational Variances
Further Aspects Of Standard Costing And Variance Analysis

Effect on Staff Motivation and Action

Standard costing and variance analysis can be used to evaluate managers and staff performance,
potentially impacting motivation. However, insensitive use of variance information can lead to poor
morale, as employees may conceal or take actions to ensure favourable variances, which may not
be in the company's best interest. Accurate standard preparation can be challenging, and labour
quantity standards and efficiency variances may not accurately reflect the actual output or the
fixed cost of a [Link] costing is only applicable when identical units are produced (manufacturing
sector)

it is not suitable for non-identical, contract work according to customer requirement

Variances and Performance Evaluation

• Identify the Cause of the Variance investigate reasons
evaluate, interdependence, cause
• Identify Who Is Responsible standards ---> planning variance |
• Consider Whether the Standard Was Fair variance
operational managers fault ---> operational

• Only take quantitative measures and, not qualitative factors

Non-financial Factors such as quality, customer satisfaction etc.
• Improving Future Performance
correcting issues

Relevance Of Variances In The Modern Environment Of JIT And TQM

Variance analysis is argued to be irrelevant in the modern business world due to its overemphasis
on quantitative performance, neglect of qualitative aspects like customer satisfaction and
innovation, and less standardization in just-in-time (JIT) systems and flexible manufacturing.
Traditional standard setting may be too inward-looking in a competitive market, while
benchmarking considers external information and practices of other organizations.
JIT & TQM gives Variance analysis focuses on quantitative measures
priority to quality and such a increase/decrease in price, cost , profit etc.
speed

Behavioural Problems In Rapidly Changing Environmentsvolatile market condition

Standard costing and variance analysis can negatively impact a company's behaviour in a rapidly
changing environment. Meeting standards may not guarantee survival, and focusing on trends in
variances may be necessary. Standardization should reflect learning curves and be appropriate for
new products, avoiding demotivation and challenge.

standards may become incorrect due to volatile market condition

standards in those conditions are not suitable to these market condition, resulting in adverse
variance
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 Planning And Operational Variances
Additional Notes
• Material usage is within the control of a production manager, whereas material price
variances are usually the responsibility of the purchasing manager. Line managers are
responsible for operational variances, but planning variances are commonly assumed to be
the responsibility of someone in senior management.
• Standard costing systems are not compatible with a Total Quality Management approach to
operations. With standard costing, the aim is to achieve standard cost or, perhaps, obtain
some favourable variances. With TQM, guiding principles are 'continuous improvement' and
'zero defects'. Existing standards and methods of operating are always unsatisfactory and
improvements should always be sought. This is not compatible with a standard costing
'philosophy'.
• Standard costing tends to be of little value in a rapidly changing environment, because
products are not standardised for a sufficient length of time to make the preparation of
standard costs worthwhile.
• Planning and operational variances are calculated when it is necessary to assess a
manager on results that are within his/her control.
• Revised standards are required because variances may arise partly due to an unrealistic
budget, and not solely due to operational factors.

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 Planning And Operational Variances
Summary

• Actual performance is compared with budgets at the end of each budget period. Prior to
performing this comparison, it may be appropriate to revise the budget if it turns out to be
unrealistic in retrospect or if factors outside the control of the relevant manager occurred
which make the original budget inappropriate.

• Standards also may be revised prior to performing variance analysis:

o Operational variances compare actual performance against a revised budget or

standard.
o Planning variances compare the original standard with the revised standard
for actual output.
• Traditional cost variances can be analysed into planning and operational as follows:
o Price (rate) planning variance:
(Actual quantity × Original standard price) − (Actual quantity × Revised standard
price)
o Operational price (rate) variance:
(Actual quantity × Actual price) − (Actual quantity × Revised standard price)
o Planning usage (efficiency) variance:
(Revised SQ for actual output − Original SQ for actual output) × Original standard
price
o Operational usage (efficiency) variance:
(Actual quantity − Revised SQ for actual output) × Original standard price.
• The sales volume variance can also be analysed into a market size (planning) variance and
a market share (operational) variance.
• A revised budgeted sales quantity is found by multiplying the budgeted market share with
the actual market size.
o Market size variance is (Original budget quantity − Revised standard quantity) x
Standard contribution/profit per unit.
o Market share variance is (Revised standard quantity − Actual sales quantity) x
Standard contribution/profit per unit.
• The use of standard costing and variance analysis aims to improve operational efficiency.
Managers need to be aware of the potential adverse effects which variance analysis can
have on behaviour.

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 Performance Measurement And Control

PERFORMANCE MEASUREMENT AND CONTROL

Objectives Of Performance Measurement

Directors define objectives in an organisation's corporate strategy, organized into a performance

hierarchy. Performance measurement aims to demonstrate successful achievement of these
objectives. Performance indicators are part of the control system, focusing on consistent
measures, setting quantifiable targets, developing reward schemes, and fair management.

The Performance Hierarchy

Typically the hierarchy consists of:

• Mission: The primary reason for the organization's existence.

• Corporate Objectives: Practical goals for primary stakeholder groups.
• Subsidiary Objectives: Goals related to other stakeholder groups.
• Unit Objectives: Objectives for operating departments contributing to subsidiary and
corporate objectives.

Financial Performance

Returns on Capital

• ROCE measures the return on long-term capital invested in a company, comparing it to

other companies or the company's cost of capital.
• Match profit with appropriate capital, divide after interest by equity or before interest by
equity plus long-term debt, as profit will be shared between debt and equity finance
providers.

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Methods to Improve Return on Capital Employed

• ROCE is validly improved by investing in projects that generate a higher return on capital.
Other methods of increasing ROCE that are not actually improvements include:

o Profits and capital employed may be affected by the use of different accounting policies.
o Delaying investment in new plant and machinery or reducing investment in intangible
assets. As the existing non-current assets become depreciated, their carrying amount
falls, reducing the capital employed, and therefore improving ROCE.

Profit Margins

Gross Profit Margin

• Gross profit represents the profit after deducting costs of buying or making products,
reflecting the performance of the company's products.

• A falling gross profit margin indicates a decline in the company's selling price or an increase
in production costs, which are not passed onto customers.

Methods to Improve Gross Profit Margins

• Introduce popular products for higher margins.

• cost reduction.

Net Profit Margin

• Net profit describes "bottom line" profit after deducting all costs. Net profit margin shows
overall profits as a percentage of revenue.

• Net profit margin, a percentage of revenue, reflects a company's performance based on

product popularity, administrative control, and debt financing costs, influenced by changes
in debt and interest rates.

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Ways to Improve the Net Profit Margin

• Introduce popular products for higher margins.

• reduce costs.
• Increase sales volume.
• Improve control over administrative expenses like salaries.
• Use less debt finance.

Asset Turnover Ratio

• Relates revenue to business capital investment.

• Indicates appropriate capital investment based on sales revenue value.

• Excessive capital leads to low turnover ratio.

Ways to Improve the asset turnover ratio

• Selling surplus non-current assets.

• Recognizing impairments and recording asset value.

• Improving working capital management.

• Collecting receivables quickly and reducing inventory levels.

Analysis of Return on Capital Employed

• ROCE is the product of operating profit margin and asset turnover.

• It provides insights into a business's ROCE.
• Decline in ROCE could be due to a decrease in asset turnover, profit margin, or both ratios.

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Liquidity Ratios

Liquidity ratios measure an organization's ability to meet liabilities, such as suppliers and interest
on loans. Companies with positive operating cash flows are less likely to face liquidity problems.

Current Ratio

The current ratio measures the balance between current assets and current liabilities, with a ratio
less than 1 indicating that current liabilities exceed current assets.

Quick Ratio (Acid Test Ratio)

The quick ratio measures immediate liquidity by removing inventory from current assets, a
conservative version of the current ratio. A low ratio suggests inability to meet liabilities due to
insufficient cash flows or large investments.

Inventory Holding Period

Inventory holding period measures inventory storage time in days, with shorter periods reducing
holding costs and allowing faster cash conversion.

Receivables Collection Period

The receivables collection period measures the time held before collection, with shorter periods
indicating lower financing costs, faster cash conversion, and lower risk of bad debt.

Payables Payment Period

The payables payment period measures the days payables are held before payment, indicating
more cash retention and lower financing costs. However, it must balance access to financing with
supplier availability.

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Gearing

• Gearing refers to the portion of a company's finance provided by debt, which is a relatively
cheap source of financing due to preferential repayment in default and tax-deductible
interest on debt. However, excessive debt increases risk.

• High gearing ratios can increase risk in companies with fluctuating profits, as a decrease in
profits may lead to difficulty repaying interest on loans.

Interest Cover
Interest cover shows the extent to which the interest is covered by profit. This measure is used by
lenders to determine vulnerability of interest payments to a fall in profit.

Approach to Financial Performance Evaluation Exam Questions

• Candidates should comment on the numbers and calculations to demonstrate their
understanding of the organization's performance.
• The approach involves reviewing the "big picture" - revenue growth, profit growth, and other
major trends.
• Limiting the number of ratios needed to investigate trends identified in the analysis.
• Calculating return on capital employed if capital is given to indicate the organization's return
on investment.
• Reviewing the scenario to identify clues that might explain the trends.
• Writing the answer, commenting on each trend identified, should state what happened, why,
link it to other related items, and express an opinion.
• Ratio calculations should be shown separately in an appendix for a professional look.

Limitations of Financial Performance Indicators (FPI)

• Traditional performance measurement relies heavily on financial measures.
• FPIs may lead to excessive focus on cost reduction, affecting long-term performance.
• FPIs often overlook drivers of business success, such as quality, delivery, customer
satisfaction, and after-sales service.
• FPIs can be influenced by accounting policies and "window dressing" to enhance
performance.
• Despite their importance, FPIs do not guarantee success.
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Short-Termism and Financial Manipulation

Short-termism is a common issue in organizations where managers focus on achieving short-term

financial targets, ignoring the long-term benefits. This can be due to factors like the attractiveness
of bonuses, high management turnover, or shareholder disappointment. However, some actions to
improve current profits can harm the business in the long term, such as not investing in worthwhile
projects, cutting down on value-building activities. To mitigate short-termism, organizations should
use NFPI measures, focus on long-term growth drivers.

Short-term Financial Gain vs Long-term Sustainability

Focusing on short-term financial gain can erode an organization's value-creation ability in the long
run. Negative effects on the external environment can also hinder future returns. For example, a
hotel's delayed refurbishment may decrease its attractiveness.

Critical Success Factors (CSF) And Key Performance Indicators (KPI)

• Companies often identify critical success factors (CSF) at the strategic level, usually from
their mission statement, objectives, and strategy.
• Key performance indicators (KPIs) measure how well an organization meets these CSFs.
• KPIs should be specific, measurable, and relevant, focusing on product features valued by
customers and aiming to outperform the competition.

Advantages of NFPI

• Easier to calculate than financial reports.

• Provides quick, flexible measures.
• Less affected by financial policy changes.

Qualitative Areas of Performance

• Quality of product or service

• Customer satisfaction
• Delivery
• After-sales service etc
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 Performance Measurement And Control
Difficulties of Setting Targets for Qualitative Areas

• Identifying drivers of improved performance: Identifying staff's actions to enhance customer

satisfaction is challenging and requires judgement.

• Measuring qualitative factors: Measuring "friendliness of staff" is challenging.

• Staff behaviour in response to set targets: Staff may not achieve targets in expected ways.

• Setting target difficulty: Excessively difficult targets can demotivate staff and hinder
performance improvement.

The Balanced Scorecard

• The objective of the balanced scorecard is to provide top management with an integrated
set of performance measures.
• The balanced scorecard looks at performance from four different perspectives:
o Customer perspective – how do our customers see us?
process efficiency with less wastage and with
o Internal business process perspective – at what must we excel?
minimum time
o Learning (or innovation) and growth perspective – how can we continue to grow and
change in the modern dynamic business environment?
o Financial perspective – how do we look to shareholders?

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 Performance Measurement And Control
Setting Measures and Performance Targets

• Objective are specific, measurable statements of what will be done to achieve goals within
a defined time frame.
• Performance measure are quantitative or qualitative characterisation of performance used
to evaluate progress toward an objective.
• For each perspective, management needs to identify:
o Objectives – what are the main objectives?
o Measures – how can the performance be measured against the objectives?
o Targets – what targets should be set for each of the measures?
o Initiatives – what actions could be taken to improve performance?

Leading and Lagging Indicators

• Lagging (downstream) indicators show the results from past decisions. Example : Financial
performance
• Leading (upstream) indicators drive future financial performance. These are the non-
financial performance indicators relating to customers, internal business processes and
learning and growth.

Advantages Of The Balanced Scorecard

• Provides a broader view of performance, avoiding distorting financial aspects.

• Links performance measurement to the organization's objectives and strategy, ensuring
relevance.
• Uses a small number of KPIs to focus on important aspects, avoiding confusion from
excessive performance indicators.

Disadvantages Of The Balanced Scorecard

• Requires training and cultural change, leading to initial scepticism

• Difficulty in identifying appropriate measures.
• Difficulty in obtaining data to assess measure achievement.
• Focuses on owners and customers.
• Insufficient selection of appropriate KPI can lead to analysis of conflicting KPI
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 Performance Measurement And Control
Service Industries

Building Block Model

Fitzgerald and Moon designed the Building Block model as a framework for service companies to
use in designing a system of performance evaluation, linked to reward schemes for managers.

There are three "blocks" – dimensions, standards and rewards.

Dimensions

• Dimensions are the aspects of performance which must be measured. There are six
dimensions in the Fitzgerald and Moon model.

• The six dimensions are:

1. Financial performance
2. Competitiveness
3. Quality
4. Resource utilisation
5. Flexibility
6. Innovation.
• Financial performance and competitiveness are referred to as results, while quality,
resource utilisation, flexibility and innovation are described as the determinants. If the
organisation performs well in the determinants, this will lead to good performance in the
results.

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 Performance Measurement And Control
Standards

There are three principles that should be applied in setting targets for managers:

1. Ownership – managers should take ownership of the targets. Managers who participate
in setting targets will be more likely to believe in them.
2. Achievability – targets should be challenging but achievable; otherwise, managers will
dismiss the targets rather than be motivated to achieve them.
3. Equity – the organisation should maintain a realistic level of difficulty for its standards
across all business areas and be fair and unbiased when assessing performance.

Rewards

Reward schemes may be linked to performance by paying managers bonuses if they achieve
targets. Three principles apply:

1. Clarity – employees must understand the performance measurement scheme.

2. Motivation – bonuses should motivate staff to achieve the targets.
3. Controllability – managers' performance evaluations should only measure factors they
control.

Non-Profit Sector

Types of Not-for-profit Organisation

• Public sector bodies such as schools and hospitals.

• Not-for-profit (NFP) organisations (e.g. Charities) and non-governmental organisations
(NGOs).

Difficulties In Measuring And Ranking Objectives

• The objectives are difficult to quantify.

• The achievement of some objectives may be simpler to measure than others.
• Achievement of some objectives may be subjective.
• Many non-profit bodies have multiple stakeholders, each with potentially conflicting
objectives.
• There may be no clear primary objective.
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 Performance Measurement And Control
Charities

Charities are not for profit organizations that benefit specific groups in society, are registered with
a regulator, have restricted activities, rely on public and business support, and rely heavily on
voluntary managers and workers. They may engage in commercial activities, but their primary
objective remains their purpose.

Value for Money

• The Value for Money (VFM) framework evaluates the performance of non-profit
organizations by assessing how well they achieved their objectives with the funding they
received.
• Three performance indicators (the "3Es”) measure VFM:

1. Economy – minimising inputs in terms of lowest cost for the quality required
2. Efficiency – maximising the output/input ratio;
3. Effectiveness – achievement of objectives.

Importance of Non-Financial Performance Indicators

• Non-financial objectives make financial measures insufficient for performance evaluation.

• Not for profit organizations, especially in the public sector, have multiple objectives
reflecting different stakeholder needs.
• Identifying a cost unit in Not for profit organizations can be challenging, making financial
performance measurement more challenging. cost per unit

Issue when setting goals/ objectives

Setting Targets

Targets are used to enhance performance, with actual performance compared to targets, and
management investigates missed targets, similar to comparing financial performance against
budgets or standard costing and variance analysis

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 Setting targets in qualitative areas
Performance Measurement And Control
Difficulties In Setting Qualitative Targets

• Determining the appropriate level of difficulty for the target is difficult.

• Meaningful targets need to take into account differences in the external environment.
• Managers who are judged by the performance measures need to "buy into" the targets that
have been set. managers may get demotivated if they are not included in the target setting process
• Identifying measures for qualitative areas can be difficult enough, even before consideration
of setting the target.
• Targets are often based on results rather than effort.

Other Approaches

• Zero-based budgeting
• Benchmarking – this compares the performance of a public sector organisation to that of a
"best-in-class" organisation.
• League tables – these institutional rankings are used in areas such as health, policing and
education.

External Considerations

• Stakeholders
• Market Conditions and Competitors

Sustainability

Since the 1990s, stakeholders have recognized the importance of sustainability in organizations'
impact on society and the environment. The increasing demand for environmentally friendly
products and processes presents both challenges and opportunities for adopting a sustainable
business model, with a direct link between environmental behaviour and performance.

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Additional Notes
• Not-for-profit organisations do have financial objectives, which may sometimes be
described as financial constraints.
• Outputs of not-for-profit organisations cannot be measured as easily because they often
have many different objectives, each measured in different ways.
• Making repeat orders is possibly a measure of customer satisfaction, and so might be used
as a measure of performance from a customer perspective in a balanced scorecard. The
growth in the product range is more relevant to innovation, and speed of order processing
and orders per sales representative are measures of operational efficiency and
effectiveness, rather than customer attitudes to the organisation and its products.
• Quantitative performance measures are something that can be actually measured and a
value assigned. Volume of customer complaints, employee revenue, defective products per
batch and repeat business are all performance measures which can be regularly monitored,
values assigned and benchmarks made.
• Qualitative performance measures are more difficult to measure and are based on
judgement. It is only possible to gain an opinion as opposed to a concrete value. They are
still important as many decisions are swayed by the strength of the qualitative arguments
rather than the cold facts presented as part of qualitative analysis. Customer needs,
customer satisfaction, employee morale and brand recognition are all examples of
qualitative performance measures. They are very difficult to measure accurately and their
rating tends to be based on judgement. There are still ways to devise quantitative measures
for these areas.
• Effectiveness is the relationship between an organisation's outputs and its objectives (i.e.
getting done what was supposed to be done). Efficiency is the relationship between inputs
and outputs (i.e. getting out as much as possible for what goes in). Economy is attaining the
appropriate quantity and quality of inputs at lowest cost (i.e. spending money frugally).
• Holding on to heavily depreciated assets gives a low figure for 'capital employed' which, in
turn, gives a higher figure for ROI which could lead to bonuses for divisional managers.
However, there are likely to be higher running costs for an old machine, making the
organisation less profitable than it might be.
• When a manufacturing division uses absorption costing, building high inventory levels will
result in a large proportion of production overheads being carried from one period to the
next in inventory. This increases the return figure benefiting the divisional managers if these
are linked to bonuses but would only benefit the company if those units of inventory can be
sold in the following period.

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Summary

• Performance measurement aims to show how well an organisation achieves its stated
objectives.
• An organisation can rank its objectives in a hierarchy from its mission, strategic objectives
and critical success factors, down to lower level objectives designed to support strategic
objectives.
• Traditional performance measurement systems focus on financial measures. There are
many different financial performance indicators. The most important categories are:
o Return on capital
o Profit margins
o Asset turnover ratios
o Liquidity ratios
o Gearing ratios
o Interest cover.

• Financial measures exclude important factors that drive the financial performance of an
organisation. NFPI should be used in addition to financial measures to overcome the
inherent weaknesses of financial measures.
• A critical success factor is a performance outcome that is required by an organisation to
achieve success.
• NFPI can be used to measure qualitative aspects of performance (e.g. Product quality,
customer satisfaction and staff morale).
• The balanced scorecard approach to performance measurement aims to ensure that
performance measures support the organisation’s overall strategy. It considers
performance from four perspectives – customer, internal processes, learning and growth,
and financial.
• Performance measurement in the service sector is more difficult to measure than in the
manufacturing sector, due to:
o Simultaneity
o Perishability
o Heterogeneity
o Intangibility

• The six dimensions of Fitzgerald and Moon’s Building Block model for performance
measurement in service businesses are:
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 Performance Measurement And Control
o Financial performance
o Competitiveness
o Quality of service
o Resource utilisation
o Flexibility
o Innovation

• Performance measurement in non-profit organisations is more difficult due to:

o Difficulty in quantifying the objectives;
o Multiple stakeholder interests.

• Performance measurement in the non-profit sector is often based on the "3Es" (i.e.
Economy, efficiency and effectiveness).
• Sustainability (i.e. Meeting the needs of the present without compromising the ability of
future generations to meet their own needs) is not only a challenge but an opportunity for
organisations.

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 Divisional Performance
DIVISIONAL PERFORMANCE

Decentralisation
• Decentralisation is the delegation of decision-making authority to subordinates in
organizations. It involves creating autonomous business units to align responsibility with
decentralized authority.
• These units can be:
o Revenue centres – managers are responsible for decisions about revenue
generation;
o Cost centres – managers are responsible for decisions about costs;
o Profit centres – managers are responsible for decisions about costs and revenues;
o Investment centres – managers are responsible for decisions about cost and
revenues and investments in assets.

Benefits
• Allows senior management to focus on strategy.
• Facilitates faster decision making.
• Provides better decision making due to specialist managers' better understanding of their
business.
• Increases motivation.
• Provides training and career progression for divisional managers.
• Offers tax advantages by locating divisions in areas with tax incentives or government
grants.

Problems
• Risk of goal congruence: divisional managers may not align with organizational objectives.
• Increased information requirements: divisional performance monitoring requires new
reporting systems.
• Lost economies of scale: duplication of activities may increase costs.
• Loss of central control: top management loses control to divisional managers, leading to
potential conflict.

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 Divisional Performance
Conditions for Successful Decentralisation
Decentralisation risks dysfunctional decisions, so senior management must monitor divisional
performance to ensure decisions by junior managers align with the company's objectives. A good
performance measurement system should encourage goal congruence, provide timely reporting,
and assess performance under divisional managers' control.

Possible Measures
• Variance analysis − taking care to identify controllability ;
• Ratio analysis ;
• Non-financial measures;
• Return on investment;
• Residual income .

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 Divisional Performance
Controllable and Traceable Profit
Controllable profit statements are commonly used in profit centres. Here is an example of a pro-
forma statement:

$ $

External sales X

Internal sales X

Variable costs X

Fixed costs X

Total cost Controllable by manager (X)

Controllable divisional profit X

Divisional costs outside manager's control (X)

Traceable divisional profit X

Allocated head-office costs (X)

Divisional net profit X

Note
• The performance of a manager should be assessed only on costs and revenues under their
control. However, the success of the division should be assessed on costs and revenues
that are traceable to the division. For example, depreciation on divisional plant and
equipment would not be a controllable cost in a profit centre. It would, however, be included
as a traceable fixed cost in assessing the performance of the division.
• Controllable profit is used to assess the manager's performance.
• Traceable profit is used to assess the division's performance.

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 Divisional Performance
Return On Investment (ROI)
• Return on investment (ROI) the return on capital employed which compares income with
the operational assets used to generate that income.
o Profit is before interest and tax because interest is affected by financing decisions
and tax is an appropriation.
• Divisional performance is favourable if ROI is greater than the cost of capital.
• It is a measure of divisional performance. It is not an investment appraisal method. In
practice, however, divisional managers often use ROI for investment appraisal.

Advantages of ROI
• As a relative measure, it is easy to compare divisions.
• Similar to ROCE used externally by analysts.
• Focuses attention on scarce capital resources.
• Encourages reduction in non-essential investment by:
o Selling off unused non-current assets; and
o Minimising the investment in working capital.
• Easily understood percentages (especially by non-financial managers).
• Can be further analysed (i.e. Between profit margin and asset turnover).

Disadvantages of ROI
• Risk of dysfunctional decision making
• Definition of capital employed is subjective. For example, should non-current assets be
valued using:
o Carrying amount (i.e. Net book value);
o Historical cost; or
o Replacement cost?
o Should leased assets and intangible assets be included?
• If net book value is used, ROI will become inflated over time because of depreciation.
• Risk of window-dressing; inflating reported ROI by:
o Under investing; and/or
o Cutting discretionary costs

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 Divisional Performance
Residual Income (RI)
• Residual income (RI) is the profit less imputed interest charge for capital invested.
• Residual income focuses on the creation of wealth by deducting an imputed interest
expense, which represents the cost of capital invested, from profit.
• Accept a project/investment if residual income is positive.

Imputed Interest
• Imputed interest is a notional interest charge on the division by the head office
• Imputed interest = Capital employed × Interest rate
• The company's cost of capital is often used as the basis for the interest rate.

Advantages
• Overcomes issues with ROI like dysfunctional behaviour and asset retention.
• Linked to net present value for optimal investment decisions.
• Maximizing residual income leads to increased net present value and shareholder wealth.
• Risk-adjusted cost of capital reflects different risk positions in different divisions.

Disadvantages
• Definition of capital employed.
• Effect of depreciation.
• Window dressing
• Difficult to compare divisions of different sizes
• Less easily understood than a percentage.

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 Divisional Performance
Additional Notes
• When divisional performance is measured by residual income, a fair comparison of
divisional performances is not possible, because the divisional residual incomes are not
related to the size and asset value of each division.
• The investment centre manager would have power to make decisions over granting credit
to customers and the level of inventory carried. This affects the investment centre's level of
working capital and hence is the responsibility of the investment centre manager.
• There is a risk of dysfunctional decision making and a lack of goal congruence with
divisionalisation. Divisional managers may base investment decisions on whether they will
improve ROI, which is inappropriate. Transfer pricing disputes, too, may lead to bad
decisions by divisional managers. However, the risk can be avoided or minimised if
divisional management and head office management are aware of the potential problem.
Authority is delegated to divisional managers; therefore there is some loss of head office
control over operations, but decision making at 'local' operational level should be faster,
since the decision does not have to be referred to head office for a decision. There is likely
to be some duplication of costs, since each division will have its own administration
activities.
• ROI is measured as divisional operating profit: this is after deducting depreciation charges.
Residual income is calculated after deducting both depreciation on non-current assets and
notional interest on the division's capital employed.
• One of the problems with using ROI as a performance measure is that it can be
manipulated. Allowing non- current assets to depreciate (giving a lower NBV) and delaying
payments to suppliers, both reduce the capital employed and therefore increase the ROI.
• Accepting all projects with a positive NPV may not necessarily increase the ROI.
• ROI is calculated using profit before interest and so interest makes no difference to the
ROI.
• An investment centre could not operate without the support of head office assets and
administrative backup.
• The asset base of the ratio can be altered by increasing/decreasing payables and
receivables (by speeding up or delaying payments and receipts).
• Residual income is more flexible, since a different cost of capital can be applied to
investments with different risk characteristics.
• ROI is a relative measure, therefore small investments with a high rate of return may
appear preferable to a larger investment with lower ROI. However, the larger investment
may be worth more in absolute terms.

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 Divisional Performance
Summary
• Decentralisation allows senior managers to focus on strategy rather than operations. It
promotes faster and better decision making, and may better motivate divisional managers.
It may, however, result in loss of central control, incongruence of goals and strategies, and
increased information requirements.
• Divisional performance measures should be goal congruent, timely and controllable by the
divisional manager.
• The most suitable measures of divisional performance depend on whether the business unit
is a cost centre, profit centre or investment centre.
• Controllable profit is within the manager's control. Traceable profit is after charging
divisional costs outside the manager's control.
• The calculation of return on investment (ROI) is based on:
o Controllable profit (for evaluation of manager); or
o Traceable profit (for evaluation of division).
• Divisional ROI will increase as the manager approves projects with greater project ROI.
• Residual income is controllable profit less an imputed interest charge. Incongruent
decisions also can be minimised when a division accepts projects with positive residual
income.
• The major drawback of the residual income approach is measuring returns from divisions of
different sizes.

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 Transfer Price
TRANSFER PRICE

Transfer Price
• Transfer price is the price at which one division transfers goods or services to another
division within a company or from one subsidiary to another within a group.
• A transfer pricing policy is necessary when an organization is decentralized into divisions
and inter-divisional trading of goods or services occurs.

Objectives Of Transfer Pricing

• Goal congruence
• Divisional autonomy
• Divisional performance evaluation

Goal Congruence

• Transfer prices promote divisional trade for overall company profit maximization.
• Encourage divisional managers to make decisions in the organization's best interest.

Divisional Autonomy

• Divisional managers should have autonomy in decision-making.

• A transfer pricing system can reduce head office involvement.
• Autonomy can boost manager motivation.

Divisional Performance Evaluation

• Fair transfer prices for objective assessment.
• Allows divisions to profit.
• Profits motivate performance.

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 Transfer Price
Transfer Price Calculation

Full Cost Plus

• Under the full cost plus method, the supplying division charges full absorption cost plus a
mark-up.
• Standard costs should be used rather than actual costs.

Advantages
• Easy to calculate if standard costing system exists.
• Covers all costs of the selling division.
• May approximate to market price.

Disadvantages
• The fixed costs of the selling division become the variable costs of the buying division −
may lead to dysfunctional decisions.
• If the selling division has spare capacity it may lead to dysfunctional decisions.
• Mark-up is arbitrary.

Variable Cost Plus

• Variable cost plus is similar to full cost plus.

Marginal Cost

• Marginal cost = variable cost + any incremental fixed costs

Advantages

• Optimal for goal congruence when:

o The selling division has spare capacity; or
o No external market exists.

Disadvantages
• May be difficult to calculate (variable cost is often used as an approximation)

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 Transfer Price
Example 1

An entity has two divisions, Division A and Division B, Division A makes a component X which is
transferred to Division B. Division B uses component X to make end-product Y.
Details of budgeted annual sales and costs in each division are as follows:

Division A Division B

Units produced/sold 10,000 10,000

$ $

Sales of final product - 350,000

Costs of production

Variable costs 70,000 30,000

Fixed costs 80,000 90,000

Required:

What would be the budgeted annual profit for each division if the units of component X are
transferred from Division A to Division B:

a) at marginal cost
b) at full cost

Supplying Division Perspective

• The selling division will accept a minimum transfer price equal to:
o Marginal (variable cost) + opportunity cost

Scenario 1 – Spare Capacity And No Production Constraints

In this situation, opportunity cost is zero because internal transfers do not reduce contribution from
external sales.

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 Transfer Price
Example 2
Details of selling division A
Total production capacity = 6,000 units
Total external demand = 3,000 units
Total internal demand = 2,000 units
Variable cost per unit of the component = $12
External selling price = $20
Required:
Calculate the minimum transfer price for 2,000 units.

Scenario 2 – No Spare Capacity

An opportunity cost arises when an internal sale sacrifices an external sale.

Example 3
Details of selling division A
Total production capacity = 3,000 units
Total external demand = 3,000 units
Total internal demand = 2,000 units
Variable cost per unit of the component = $12
External selling price = $20
Required:
Calculate the minimum transfer price for 2,000 units.

Buying Division Perspective

• The maximum transfer price will be the lower of:
o The external market price (if an external market exists); or
o The net revenue of the buying division.
§ The net revenue means the ultimate selling price of the goods sold by the
buying division, less the cost of those goods incurred by the buying division.

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 Transfer Price
Economic Transfer Price Rule
• Minimum (per selling division) transfer price ≥ marginal cost of selling division; And
• Maximum (per buying division) transfer price ≤ the lower of:
o External market price (if an external market exists); and
o Net marginal revenue of buying division.

Market Price Method

• A market price may be used if divisions can buy/sell externally at market price. However, it
may need to be adjusted downwards if internal sales incur lower costs than external sales.

Advantages
• Optimal for goal congruence if the selling division is at full capacity.
• Encourages efficiency − the supplying division must compete with external competition.

Disadvantages
• Only possible if a perfectly competitive external market exists.
• Market prices may fluctuate

Incongruent Goal Behaviour

All the practical approaches suffer from the potential problem that the transfer price may lead to
behaviour that is not congruent with the overall goals of the company (or group). The selling
division may set a price too high for the buying division, leading the buying division to buy
externally or forgo production.

Dual Pricing

• Dual pricing is used when there is no acceptable transfer price for both buying and selling
divisions, or when the head office wants both to trade for non-financial reasons.
• Dual pricing works as follows:
o A higher price is used when calculating the revenue of the selling division
o A lower price is used when calculating the costs in the buying division for the goods
supplied to it by the selling division.

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 Transfer Price
Additional Notes
• Internal transfers should be preferred to external purchases because the company will have
better control over output quality from division a and the scheduling of production and
deliveries.
• Transfer prices determine how total profit will be shared between the divisions.
• Transfers should not be at actual cost, because there is no incentive for the transferring
division to control the costs of the transferred item. A transfer price based on actual cost
plus would be even worse, since the transferring division would make a profit on any
overspending that it incurs. Standard cost plus is preferable to standard cost because the
profit margin provides an incentive for division a to make and transfer the item.
• Transfer pricing is almost inevitably required when a business is structured as more than
one division and some divisions provide goods or services to other divisions.
• Where a perfect external market price exists and unit variable costs and unit selling prices
are constant, the opportunity cost of transfer will be external market price or external market
price less savings in selling costs.

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 Transfer Price
Summary
• Transfer prices are needed when goods or services are bought and sold within the same
company or between subsidiaries in the same group.
• The primary objective of a transfer pricing system is goal congruence.
• A division with no external market for a product or spare capacity has zero opportunity cost
because transfers do not reduce contribution from external sales. The minimum transfer
price is then marginal cost.
• A division with an external market and no spare capacity would lose external sales by an
internal transfer. The minimum transfer price is then marginal cost plus the lost contribution.
• The maximum transfer price acceptable to the buying division is the lower of:
o The external market price (if there is one); or
o Its net revenue.
• An economic transfer price must lie between the minimum acceptable to the selling division
and the maximum acceptable to the buying division.
• Alternative cost-based approaches all suffer from the potential problem of incongruent
divisional and overall corporate goals.

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