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WELCOME TO
PERFORMANCE MANAGEMENT
(F5)
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CHAPTER 1: COSTING
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COSTING

PP phân bổ chi phí toàn bộ

I. Absorption costing

PP phân bổ chi phí cận biên

II. Marginal costing

III. Compare absorption costing and marginal costing

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Absorption costing is a method of product costing which aims to include in the total
cost of a product (unit, job, and so on) an appropriate share of an organisation's total
overhead, which is generally taken to mean an amount which reflects the amount of
time and effort that has gone into producing the product.
Product: material, labour, overhead
Under absorption costing, costs can be divided into 2 types:

A direct cost is a cost that can be traced in full to the product, service or department
that is being costed.

An indirect cost (overhead) is a cost that is incurred in the course of making a product,
providing a service or running a department, but which cannot be traced directly and in
full to the product, service or department.

Mục tiêu chính của PP absorption:

phân bổ overhead vô các Product
A,B,C,...
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The cost classification is illustrated as follow:

Total costs

Direct costs Indirect costs/Overheads

Non-production
Production overhead
overheads

Absorbed Over/Under
overheads absorbed overheads

Production costs Other costs

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The aim of traditional absorption costing is to determine the full production cost per unit
Absorption costing is carried out through a 3-stage process:

03
02 Overhead absorption
01 Apportionment
Allocation

Cost Production Production Production Unit

items 1 cost center 1 cost center 1 cost center 1 cost 1

Cost Production Production Production Unit

items 2 cost center 2 cost center 2 cost center 2 cost 2

Cost Service cost Service cost Unit

items 3 center 1 center 1 cost 3
…

Cost General cost

items n center
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2.1 Allocation

Allocation is the process by which whole cost items are charged directly to a cost unit or
cost center.

Rule to allocate is as follow:

Cost item

Direct cost Overheads

Clearly identifiable NOT Clearly identifiable

with cost centers with cost centers

Cost units Cost centers General cost centers

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2.1 Allocation

There are some types of cost center:

Type of cost center Type of overheads charged

Production department
Production overheads
Production area service department

Administrative department Administration overheads

Selling or distribution department Sales and Distribution overheads

Items of expense are shared by several

Overhead cost center
departments (rent and rates, heat and light,
(General cost center)
canteen)
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2.2 Apportionment

There are 2 steps of overhead apportionment:

Step 1: Apportion general cost centers to cost centers using a fair basis of apportionment

Step 2: Apportion service cost centers to production cost centers

Some basis for apportioning general cost centers to cost centers:

Overhead to which the basis applies Basis

Rent, rates, heating and light, repairs and
Floor area occupied by each cost center
depreciation of buildings
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages Number of employees, or labor hours
and cost offices, first aid worked in each cost center

The basis of apportioning service cost centers must also be fair. Different apportionment basis may
be applied for each service cost center.

Service center to be apportioned Possible basis of apportionment

Stores Number or cost of material requisitions
Maintenance Hours of maintenance done per cost center
Direct labor hours worked in each production
Production planning
center.
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2.3 Overhead absorption

Overhead absorption is the process whereby overhead costs allocated and apportioned
to production cost centers are added to unit, job or batch costs based on Overhead
Absorption Rates (OAR).

4 steps to absorb the overhead:

Step 1: Estimate overhead likely to be incurred during the coming period

Step 2: Estimate activity level for the period (upon which the OAR are to be based)

Step 3: Calculate OAR = Estimated overhead/Budgeted activity level

Step 4: Absorb the overhead into the cost unit by applying calculated absorption rate

However, OAR is based on estimates in the budget, it could be not the same actually
occurs. So, there are 2 cases:

• Over-absorption: overheads charged to the cost of production or sales are greater

than overheads actually incurred

• Under-absorption: insufficient overheads have been included in the cost of

production or sales.
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Example 1 (Question):

A company is preparing its production overhead budgets and determining the

apportionment of those overheads to products. Cost center expenses and related
information have been budgeted as follows:
Machine Machine Assembly Canteen Maintenance Total
shop A shop B $ $ $ $
$ $
Indirect wages 8,586 9,190 15,674 29,650 15,460 78,560
Consumable 6,400 8,700 1,200 600 - 16,900
materials
Rent 16,700
Power 8,600
Depreciation 40,200
(machinery)

Machine Machine Assembly Canteen Maintenance Total

shop A shop B $
Power usage 55 40 3 - 2 100
(%)
Area (sq ft) 10,000 12,000 15,000 6,000 2,000 45,000
Machine 7,200 18,000 25,200
usage (hours)
Direct labor 8,000 6,200 20,800 35,000
(hours)
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Example 1 (Question):

The total production overhead expenditure of the company was $176,533 and its
actual activity was as follows:
Machine Machine Assembly Total
shop A shop B
Direct labour 36,600
8,200 6,500 21,900
hours
Machine usage 26,000
7,300 18,700 -
hours
Required: Calculate the under- or over-absorption of overheads and comment on
the implications of the figures calculated.
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Example 1 (Answer):

Stage 1: Allocation
There is only overheads under cost items here.
• Overheads clearly identifiable with cost centers: Indirect wages and
Consumable materials
• Overheads NOT clearly identifiable with cost centers: Rent, Power and
Depreciation. They are allocated to general cost centers.
Stage 2: Apportionment
Step 1: Apportion general cost to cost centers using a fair basis of
apportionment
There are 5 cost centers namely machine shop A, machine shop B, assembly,
canteen and maintenance.
At this step, we need apportioning rent, power and depreciation costs for these
cost centers.
Using a fair basis of apportionment:
• Rent is apportioned based on area
• Power is apportioned based on power usage
• Depreciation is apportioned based on machine usage
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Example 1 (Answer):

Stage 2: Apportionment
Step 1: Apportion general cost to cost centers using a fair basis of apportionment

Shop A Shop B Assembly Canteen Maintenance Total

$ $ $ $ $ $
Indirect wages 8,586 9,190 15,674 29,650 15,460 78,560
Consumable
materials 6,400 8,700 1,200 600 - 16,900
Rent (W1) 3,711 4,453 5,567 2,227 742 16,700
Power 4,730 3,440 258 - 172 8,600
Depreciation 11,486 28,714 40,200
Total 34,913 54,497 22,699 32,477 16,374 160,960

Working
Calculation of rent overheads apportionment for Machine shop A is set out below.
Calculations of power, depreciation overheads apportioned for other departments
could be solved using the same mindset.
(W1) Overhead apportioned by area
Area occupied by department
Rents overheads in shop A = Total area x Budgeted overhead
10,000
= 45,000 x 16,700 = 3,711
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Example 1 (Answer):

Step 2: Apportion service cost centers to production cost centers

There are 2 service cost centers namely canteen and maintenance and 3
production cost centers namely machine shop A, machine shop B and assembly.
Using a fair basis of apportionment:
• Canteen is apportion based on direct labor as labor uses mainly this service
• Maintenance is apportion based on machine usage
Shop A ($) Shop B ($) Assembly Canteen Maintenance Total
($) ($) ($) ($)
General costs 34,913 54,497 22,699 32,477 16,374 160,960
from step 1

Apportion 7,423 5,753 19,301 (32,477)

canteen (*)
Apportion 4,678 11,696 (16,374)
maintenance
(**)
Total 47,014 71,946 42,000 - - 160,960

(*) Apportion canteen = $32,477/35,000 x Budgeted direct labor hours

(**) Apportion maintenance = $16,374/25,200 x Budgeted machine usage hours
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Example 1 (Answer):

Stage 3: Overhead absorption

Budgeted overhead absorption rates for each of the production departments

Shop A Shop B Assembly

Step 1: Estimate overhead likely to be incurred during the coming period
Estimated overheads 47,014 71,946 42,000
Step 2: Estimate activity level for the period (upon which the OAR are to be
based)
Budgeted activity level (*) 7,200 18,000 20,800
Step 3: Calculate OAR = Estimated overheads/ Budgeted activity level
OAR 6.53 4 2.02

(*) Budgeted activity level of shop A and B are based on the machine usage, of
assembly is based on the direct labor.
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Example 1 (Answer):

Stage 3: Overhead absorption

Under-or over-absorption of overheads is as follows:
Actual activity $ $
Actual overheads 176,533
Absorbed amount using OAR:
Actual activity
Machine shop A [6.5 x 7,300] 47,669
Machine shop B [4 x 18,700] 74,800
Assembly [2.02 x 21,900] 44,238
166,707
Under-absorption overheads 9,826
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Example 1 (Answer):

Comment on the implications of the figures calculated

The budgeted overheads is much lower than actually incurred, so the company
should consider to make adjustments to budgeted process, if needed.

It is obvious that the main reason of the under-absorption overheads is that more
machine hours and direct labour were used than expected. Further investigation
needs to be conducted to determine whether budget is too low or actual
production is inefficient. The under-absorption overheads is not good as in many
case, the company does not have enough resource to compensate for the cost
increase, which causes serious consequences such as not be able to fulfill orders,
loss customer goodwill.

In this case, the adjustment should be debit overheads of $9,826.

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Marginal cost is the cost of one unit of a product/service which could be avoided if that
unit were not produced/provided.
Contribution is the difference between sales revenue and variable (marginal) cost of
sales.
Marginal costing is a method of product costing which focus on variable costs for
consideration and making decision.

Rules of marginal costing:

Total costs

Production costs Non-production costs

Variable costs Variable costs

(Variable production Fixed costs (direct materials, direct Fixed costs
overheads) labour, direct expenses)

Cost of goods sold

(Marginal Other variable costs
production costs)

Unit cost Period cost (deduct profits)

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Example 2 (Question):

SAP Co makes and sells a single product. At the beginning of period 1, there are no
opening inventories of the product, for which the variable production cost is $4 and the
sales price $6 per unit. There are no variable selling costs. Fixed costs are $2,000 per
period, of which $1,500 are fixed production costs. Normal output is 1,500 units per
period.
In period 1, sales were 1,200 units, production was 1,500 units.
In period 2, sales were 1,700 units, production was 1,400 units.
Required: Calculated profit for each period and for the two periods using marginal
costing.

Guidance:
The question requires to determine profit:
• Profit (Step 5) = Contribution (Step 4) – Period costs
• Contribution (Step 4) = Sales revenue (Step 1) - All variable costs (Step 3)
• All variable costs (Step 3) = COGS (Step 2) + Other variable costs

Step 1: Calculate Sales revenue = Sales volume x Selling price

Step 2: Calculate COGS (Marginal production costs)
COGS = Opening inventory + Variable production overheads – Closing inventory
Step 3: Calculate all variable costs
Step 4: Calculate contribution
Step 5: Calculate profit
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Example 2 (Question):

Step 1: Calculate Sales revenue = Sales volume x Selling price

Period 1 Period 2 Total

Sales volume (units) 1,200 1,700 2,900
Selling price ($/unit) 6 6 6
Sales revenue ($) 7,200 10,200 17,400

Step 2: Calculate COGS (Marginal production costs)

COGS = Opening inventory + Purchase - Closing inventory
Under marginal costing, only variable costs of $4/unit are charged to cost of
sales.
Period 1 Period 2 Total
4×1,400
Opening inventory 0 1,200
4×1,500
Add: Variable 6,000 5,600 11,600
production overheads
Less: Closing inventory 1,200 0
4×(1,500- 4×(300+
1,200) 1,400-
COGS 4,800 6,800 11,600
1,700)
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Example 2 (Question):

Step 3: Calculate all variable cost

All variable costs = COGS (Step 2) + Other variable costs
There is no other variable costs. Therefore, all variable costs = COGS (Step 2)

Step 4: Calculate contribution

Period 1 Period 2 Total
$ $ $
Sales revenue 7,200 10,200 17,400
COGS 4,800 6,800 11,600
Contribution 2,400 3,400 5,800

Step 5: Calculate profit

Period 1 Period 2 Total
$ $ $
Contribution 2,400 3,400 5,800
Period costs (Fixed costs) 2,000 2,000 4,000

Profit 400 1,400 1,800

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Example 3 (Question):

SAP Co makes and sells a single product. At the beginning of period 1, there are no
opening inventories of the product, for which the variable production cost is $4 and
the sales price $6 per unit. There are no variable selling costs. Fixed costs are $2,000
per period, of which $1,500 are fixed production costs. Normal output is 1,500 units
per period.
In period 1, sales were 1,200 units, production was 1,500 units.
In period 2, sales were 1,700 units, production was 1,400 units.
Required: Calculated profit for each period and for the two periods using absorption
costing.

Guidance:
The question still requires determining profit for each period, so the basic calculation
process is the same in example 2 above. However, under absorption costing, as full
costs are charged to the cost of sales, not only variable costs  a difference in the
determination of COGS.
Unit fixed cost is determined through OAR of fixed production costs = Estimated
overhead/ Budgeted activity level.
As budgeted activity level (normal output) is 1,500 units per period but production
was 1,400 units in period 2, which means there is an under-absorption overhead here.
Therefore: Profit = Sales revenue - (COGS + Under-absorption overhead + Other
expenses)
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PD

PD
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Example 3 (Answer):

Step 1: Determine sales revenue  Same as example 2.

Step 2: Determine COGS
Under absorption costing, fixed production cost are charged to COS.
$/unit
Direct cost 4 1,500/1,500
Overhead 1
(Estimated overhead/Budgeted activity level)
Full cost 5

Period 1 Period 2 Total

Opening inventory - 1,500 -
Purchase 7,500 7,000 5x1,400 14,500

Closing inventory 1,500 5x(1,500 - -

- 1,200)
COGS 6,000 8,500 14,500
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Example 3 (Answer):

Step 3: Calculate profit.

Period 1 Period 2 Total
$ $ $
Sales revenue 7,200 10,200 17,400
Less: COGS 6,000 8,500 14,500
Less: Under-absorption overhead (*) - 100 100
Gross profit 1,200 1,600 2,800
Other expenses [2,000-1,500] 500 500 1,000
Profit 700 1,100 1,800

(*) As production in the period 2 was only 1,400 units, which is lower than normal
output, thus there is under-absorption overhead
(1,500 - 1,400) x $1 = $100
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Example 3 (Answer):

Compare the answers

Thus, profit for 2 periods are $1,800 for both absorption costing and marginal
costing methods. But there is a difference of profit of each period. Details are as
follows:
Period 1 Period 2 Total
$ $ $
Absorption costing (Example 2) 700 1,100 1,800
Marginal costing (Example 3) 400 1,400 1,800
Difference 300 300 0
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Absorption costing Marginal costing

Similarity
Used to determine production costs; In the long run, total profit will be the same
Differences
COGS calculation Full production costs Only variable costs
Fixed production
Traced in to cost unit Treated as period costs
costs
Inventory levels
Profit higher Profit lower
increase
Gross profit or
Gross profit Contribution
contribution?
Reporting to Needed for financial reporting Useful for decision-making
management purposes purposes

Notes: Explanation of profit figures when inventory levels increase between absorption
costing and marginal costing:
• COGS = Opening inventory + Purchase - Closing inventory
• Profit = Sales revenue - COGS - Other expenses
• If inventory levels increase between in the period, under absorption costing, some
of the fixed production overhead incurred during the period will be carried forward
in closing inventory, so closing inventory will increase, leading to COGS will reduce.
Finally, profit under absorption costing is higher.
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CHAPTER 2A:
ACTIVITY BASED COSTING
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ACTIVITY BASED COSTING (ABC)

I. Overview of ABC

II. Compare absorption costing and ABC

III. Discussion about ABC

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Activity based costing (ABC) is a method of costing which involves identifying the costs
of the main support activities and the factors that 'drive' the costs of each activity.
Support overheads are charged to products by absorbing cost based on the product's
usage of the factor driving the overheads.
A cost driver is a factor which has most influence on the cost of an activity.

Below is some cost drivers for overheads:

Overheads Cost driver

Production set-up costs Number of production set ups

Machine oil and machine repairs Number of machine hours

Supervisor salary Number of labor hours

Ordering costs: handling customer orders Number of orders

Materials handling costs Number of production runs

It is obvious that ABC is an extension of traditional absorption costing specifically

considering what causes each type of overhead category to occur. Each type of overhead
is absorbed using a different basis depending on the cost driver.
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Example 1:
SAP Co manufactures 2 products X and Y. Total incurred overheads costs is
$31,000 which includes 2 categories namely supervisor salary costs and
materials handling costs. In order to unit cost for each product, it is necessary to
absorb overheads.
Under the traditional absorption costing, both supervisor salary and materials
handling costs are likely to be absorbed based on number of the labor hours.
However, under ABC, cost driver attached to the activities which causes
overheads is considered carefully. Thus, supervisor salary costs are absorbed
based on number of the labor hours, but materials handling costs are absorbed
based on number of production runs as production runs is factor which has most
influence on these cost, not labor hours is.
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ABC is carried out through 5 steps:

Step 1: Identify an organisation's major supporting activities

Step 2: Identify overheads to each activities

Step 3: Identify cost driver of each activity

Step 4: Calculate a cost per unit of cost driver

Cost per unit of cost driver = Overheads (Step 2)/ Total units of cost drivers (Step 3)

Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
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Example 2 (Question):

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

Output Number of Material Direct labor Machine

units production runs cost per unit hours per hours per
in the period $ unit unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14

Direct labor cost per hour: $5.

Overhead costs $
Short-run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800

Required: Prepare unit costs for each product using ABC.

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Example 2 (Answer):

Step 1: Identify an organisation's major support activities

There are 4 major supporting activities namely short-run variable, set-up,
expediting and scheduling and material handling.
Step 2: Identify overheads to each activities
Overheads are allocated for 4 support activities as follows:
$
Short-run variable 3,080
Set-up 10,920
Expediting and scheduling 9,100
Materials handling 7,700

Step 3: Identify cost driver of each activity

Activity Cost driver

Short-run variable Machine hours
Set-up Number of production runs
Expediting and scheduling Number of production runs
Materials handling Number of production runs
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Example 2 (Answer):

Step 4: Calculate a cost per unit of cost driver

Total of cost Cost per unit
Activity Cost driver Overheads
driver of cost driver
($) (units) ($)
Short-run
Machine hours 3,080 440 (*) 7
variable
Number of
Set-up 10,920 14 780
production runs

Expediting and Number of

9,100 14 650
scheduling production runs

Materials Number of
7,700 14 550
handling production runs

(*) Total machine hours = Machine hour per unit x Output units
= 1x10 + 3x10 + 1x100 + 3x100 = 440 hours
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Example 2 (Answer):

Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
W X Y Z
Activity $ $ $ $
Short-run variable 70 210 700 2,100
Set-up 1,560 1,560 3,900 3,900
Expediting and
scheduling 1,300 1,300 3,250 3,250
Materials handling 1,100 1,100 2,750 2,750
4,030 4,170 10,600 12,000

Thus, product costs per unit are as follows:

W X Y Z
$ $ $ $
Direct material costs (**) 200 800 2,000 8,000
Direct labour costs (***) 50 150 500 1,500
Overheads 4,030 4,170 10,600 12,000
Total costs 4,280 5,120 13,100 21,500
Units produced 10 10 100 100
Cost per unit 428 512 131 215

(**) Direct material costs = Material cost per unit x Output

(***) Direct labor costs = Direct labor hours per unit x Output
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II. COMPARE ABSORPTION COSTING AND ABC
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Example 3 (Question):

Suppose that SAP Co manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows.
Output Number of Material Direct labor Machine
units production runs cost per unit hours per hours per
in the period $ unit unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
Direct labor cost per hour: $5.
Overhead costs $
Short-run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800
Required: Prepare unit costs for each product using absorption costing
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Example 3 (Answer):

Absorption costing is a method of product costing, which is mentioned in chapter

1 Costing. Accordingly, the absorption rate for overheads based on direct labor
hours or machine hours.
Total direct labor hours = Total machine hours = 440 hours
OAR = $30,800/ 440 hours = $70/hour
So, product costs per unit are as follows:
W X Y Z
$ $ $ $
Direct material costs 200 800 2,000 8,000
Direct labour costs 50 150 500 1,500
Overheads
[OAR x Machine hours] 700 2,100 7,000 21,000
Total costs 950 3,050 9,500 30,500
Units produced 10 10 100 100
Cost per unit 95 305 95 305
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Example 3 (Answer):

See that production costs per unit is significant difference between 2 methods.
Details are as follows:
Product Absorption costing ABC Difference per unit Difference in total
$ $ $ $
W 95 428 +333 +3,330
X 305 512 +207 +2,070
Y 95 131 +36 +3,600
Z 305 215 -90 -9,000

The difference is because of overheads absorbed to each product.

Overheads
Direct labor/
Output under Overheads
Product Machine hours Difference
units absorption under ABC
per unit
costing
$ $ $
W 10 1 700 4,030 +3,330
X 10 3 2,100 4,170 +2,070
Y 100 1 7,000 10,600 +3,600
Z 100 3 21,000 12,000 -9,000
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Example 3 (Answer):

There are 2 main reasons for the distinction in overheads:

Overheads = Allocated criteria (1) x Cost per unit of allocated criteria (2)
(1) Allocated criteria: It is obvious that under absorption costing, there is only
allocated criteria namely machine hours but under ABC, there are 2 allocated
criteria for overheads activities namely machine hours and number of production
runs.
(2) Cost per unit of allocated criteria: each product uses criteria.
• Overheads will be lower for low-volume products (here, W and X) and
reverse, for Y and Z, overheads will be higher
• Overheads will be lower for smaller products (here W and Y, with just
one hour of work needed per unit) and reverse, for X and Z, overheads
will be higher.
Due to which, production cost per unit is not accurate. When making pricing
decision for products W, X and Y, there is a risk that there is a loss as production
cost is determined too low.
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Thus, there are some differences between ABC and absorption costing:

Absorption costing ABC

• Allocate overheads based on the • Allocate overheads based on the

unique criterion, always labor hours number of cost driver that activity
or machine hours uses

• Easy to understand and calculate • Complicated, take time to

calculate. Sometimes, costs could
• Overheads are allocated outweigh benefits
unreasonably
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Using ABC has some following benefits and limitations:

• Cost control and reduction by Limitations

the efficient management of
cost drivers • It is time consuming and
• Better costing information expensive
used to assist pricing decisions • It will be of limited benefit if
• Facilitate a good overhead costs are primarily
understanding of what drives volume related
overhead costs • The benefit is reduced if the
• A more realistic estimate of company is producing only
costs and profits which can be one product or a range of
used in a performance products with similar costs
appraisal • Complex situations may have
multiple cost drivers
Benefits

Therefore, ABC is suitable for larger organisations and the service sector. Details are as
follows:
• When production overheads are high relative to prime costs such as service sector
• When production overheads are high relative to prime costs
• When there are considerable differences in the use of resources by products
• Where consumption of resources is not driven by volume.
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CHAPTER 2B: TARGET COSTING

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TARGET COSTING

I. Overview of target costing

II. Closing a target cost gap

III. Target costing in service industry

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Under traditional costing method: To sell product or service, target costing

1. Firstly, cost is always determined method is used. Under this method:
2. Secondly, expected profit is set 1. Firstly, selling price is set based on
3. Finally, selling price is formed market price
2. Secondly, identify required profit
But this method is no longer suitable in margin
competitive market. 3. Finally, target cost is formed

Traditionally Target costing

Step 1: Step 1: Identify

Identify cost selling price
Step 3: Step 3:
Determine Determine
selling price target cost
Step 2: Step 2: Set
Set expected profit expected profit
(% mark-up cost) (% mark-up cost)

Note: There is a difference between a mark-up and a margin

• A mark-up is the profit expressed as a percentage of cost (cost is 100%)
• A margin is the profit expressed as a percentage of the sales price (sales is 100%)
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Thus, target costing was born.

Target costing involves setting a target cost by subtracting a desired profit margin
from a target selling price.

Target cost is the cost at which a product must be produced and sold in order to
achieve the required amount of profit at the target selling price.

When a product is first planned, its estimated cost will often be higher than its target
cost.

The aim of target costing is then to find ways of closing this target cost gap and
producing and selling the product at the target cost.

Achieving a target cost will usually require some redesigning of the product and the
removal of unnecessary costs. Target costing therefore encourages a business to
examine its processes and costs carefully.
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Target costing is carried out through 7 steps:

1 Define product specification and estimate sales volume (if any)

2 Decide a target selling price

3 Estimate required profit based on profit margins or return on investment

4 Calculate target cost = Target selling price (step 2) - Target profit (step 3)

Estimate cost for the product based on the product specification and
5
current cost levels

6 Calculate target cost gap = Estimated cost (step 5) - Target cost (step 4)

7 Make efforts to close the cost gap (see section II)

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Example 1 (Question)

SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.
Cost information for the new hutch is as follows:
• Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
• Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
• Wire: 1m of wire is needed at a cost of $1.50 per metre
• Labour: 2 hours are required. Labour is paid at a rate of $7/hour
• Variable overhead: These will be incurred at a rate of $1.50 per labour hour.
Required: Calculate the target cost gap of the new product.
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Example 1 (Answer)

Step 1: Define product specification and estimate sales volume (if any)
Product is rabbit hutch, which is made from timber, felt and wire.
Sales volume: no information is mentioned in the question.

Step 2: Decide a target selling price

Target selling price is $125

Step 3: Estimate required profit based on profit margins or return on investment

Profit is required at a margin 25% on sales.
So, target profit = 25% x $125 = $31.25

Step 4: Calculate target cost

Target cost = Target selling price (step 2) - Target profit (step 3)
= $125 - $31.25 = $93.75
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Example 1 (Answer)

Step 5: Estimate cost for the product based on the product specification and
current cost levels

Estimated costs $
Timber 48.0
Felt roofing material [17.5 x $2] 35.0
Wire [1 x $1.5] 1.5
Labour [2 x $7] 14.0
Variable overhead [2 x $1.5] 3.0
Total 101.5

Step 6: Calculate target cost gap

Target cost gap = Estimated cost (step 5) - Target cost (step 4)
= $101.5 - $93.75 = $7.75
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To close a target cost gap, it is important to understand which features of the product
are essential for customers and to maintain product quality. This is known as value
analysis.

Value analysis involves examining the factors which affect the cost of a product or
service, so as to come up with ways of achieving the intended purpose most
economically at the required standards of quality and reliability.

Value can be viewed from a number of different perspectives:

Cost value Exchange value Use value Esteem value

The cost of The market value The purposes it The prestige the
producing and of the product or fulfils (performance, customer attaches
selling an item service reliability) to the product

Value analysis seeks

• to refine the design of the product to reduce unit cost
• to provide the same use value at the lowest cost
• to maintain or enhance the esteem value of a product at the lowest cost
The aim of value analysis is to reduce cost without compromising other aspects of value.
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Management can then set benchmarks for improvement towards the target cost, by
improving production technologies and processes, such as:

Reduce the number of components

Use cheaper staff (where this does not affect quality)

Use standard components wherever possible

Acquire new, more efficient technology

Training staff in more efficient techniques

Cut out non-value added activities

Use different materials (identified through activity analysis that is an analysis of

how much is being spent on particular activities)
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Example 2 (Question)

SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.

Cost information for the new hutch is as follows:

• Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
• Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
• Wire: 1m of wire is needed at a cost of $1.50 per metre
• Labour: 2 hours are required. Labour is paid at a rate of $7/hour
• Variable overhead: These will be incurred at a rate of $1.50 per labour hour.

Required:
From Example 1 result, target cost gap = $7.75
Recommend appropriate strategies for House Co to close the cost gap.
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Example 2 (Answer)

As above mention, raising the selling price is not an appropriate strategy for
closing the cost gap.

As rabbit hutch is a top new product, its quality depends on main material and
skill labour. Thus, there is a risk that using lower quality timber and labour would
be likely to reduce the quality of the finished product and so would not be
suitable strategies here.

SAP Co could consider some following strategies:

• Make the hutch smaller
• Make the window bigger which helps to increase the proportion of wire and
reduce the proportion of wood
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Services industries and problems with target costing
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Services are any activity or benefit that one party can offer to another that is essentially
intangible and does not result in the ownership of anything. Its production may or may not be
tied to a physical product.

Unlike manufacturing, service industries have the following characteristics which make cost and
performance measurement more difficult:

Characteristic Explanation Problem with target costing

Some of the features of service cannot be

Unlike goods, there are no properly specified, so it is difficult to know
substantial material or physical what a customer receive exactly
Intangibility
aspects to a service: no taste, When services do not have any material
feel, visible presence, and so on content, it is not possible to reduce costs
to a target level by reducing material costs

Services are created at the same

Inseparability
time as they are consumed

When services are variable, it is possible

It is difficult to maintain
to calculate an estimated average cost,
Variability consistency in the standard of
but this is not specific and so not ideal for
service offered
target costing

Perishability Services are innately perishable

As service has no physical

No transfer of
aspects, it cannot transfer
ownership
ownership as goods or property
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CHAPTER 2C:
LIFE CYCLE COSTING
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LIFE CYCLE COSTING

I. Product life cycle

II. Life cycle costs

III. Discussion about life cycle costing

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The product life cycle (PLC) can be divided into five stages:
(1) Development
(2) Introduction
(3) Growth
(4) Maturity
(5) Decline

(1) (2) (3) (4) (5)

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Details of 5 stages in PLC are as follows:

Stage Explanation Sales volume Costs

The product is
(1) Research and
researched or designed None
Development development (R&D)
and developed

The product is Very high fixed costs such

(2)
launched to the Very low levels as non-current assets,
Introduction
market advertising

Increase in variable costs

(3) The product gains a Some fixed costs increase
Rapid increase
Growth bigger market such as increased number
of factories

Sales of product have

(4) Stable and high
reached a peak and are Primarily variable costs
Maturity volume
fairly stable

Primarily variable costs

(5) The product is decided decreased
Falling demand
Decline to stop selling Some fixed costs such as
decommissioning costs
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Life cycle costs of a product are all the costs attributable to the product over its entire
life, from product concept and design to eventual withdrawal from the market.

The elements of a product's cost over its life cycle could include the followings:

R&D costs Cost of purchasing any

technical data required
• Design costs
Purchasing the right from another
• Cost of making a prototype organization to use a patent

Training costs Production costs

Initial operator training and • Direct material
skills updating • Labour costs

Distribution costs Marketing and advertising

Transportation and handling • Customer service
costs • Field maintenance

Retirement and disposal costs

Inventory costs
• Decommissioning costs
• Holding spare parts
• Costs of cleaning up a
• Warehousing
contaminated site
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Under traditional costing techniques:

Costs of a product could be determined from incurred costs which is based on the
financial accounting year.

The profitability of a product could be assessed wrongly as:

• Some products have a very long development phase, possibly more than a financial
year.
• At development phase, it does not generate revenue but requires a huge cost.

So, it is reasonable to tracks and accumulates costs and revenues attributable to each
product over its entire product lifecycle.

Thus, life cycle costing was born.

Life cycle costing is the accumulation of costs over a product's entire life.

Life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be
generated from selling this product at different target prices throughout the product’s
life.
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Example 1 (Question)

Solaris specializes in the manufacture of solar panels. It is planning to introduce a new

slimline solar panel specially designed for small houses. Development of the new panel
is to begin shortly, and Solaris is in the process of determining the price of the panel. It
expects the new product to have the following costs:
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay $500 for a
solar panel but the Financial Director believes this will not cover all the costs
throughout the life cycle.
Required: Calculate the cost per unit looking at the whole life cycle and comment on
the suggested price.
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Example 1 (Answer)

Cost per unit is determined as follows:

Year 1 Year 2 Year 3 Year 4 Total

$’000 $’000 $’000 $’000 $’000
R&D costs 1,900 100 - - 2,000
Marketing costs 100 75 50 10 235
Production cost (*) 1,000 6,750 8,000 2,250 18,000
Customer service costs (**) 100 600 800 200 1,700
Disposal costs 300 300

Total life cycle costs 22,235

Total production
2 15 20 5 42
(‘000 units)
Cost per unit 529.4

(*) Production cost = Units manufactured and sold x Production cost per unit
(**) Customer service costs = Units manufactured and sold x Customer service costs
per unit
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Life cycle costing has some following benefits:

Help management to assess profitability

over the full life of a product, thanks to
which, they decide whether to develop the
product, or to continue making the product

Be useful for developing products with a

relatively short life as management may be
possible to estimate sales volumes and
prices with reasonable accuracy

Help management to decide earlier actions

to generate more revenue or cut more
costs
Help management to make better
decisions as they are able to assess
revenues and costs more accurately and
realistically, at least within a particular life
cycle stage

Provide more useful information for

enterprises to prepare long-term business
plan
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3.r eMaximising return over the product life cycle
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There are a number of ways that return can be increased over the life cycle.
Details are as follows:

Approximately 70%–90% of a product’s life cycle costs are

Design
determined at the design and development stage. Thus,
costs out of design and production teams must work together to ensure
products costs are minimised

Minimise When a new product launched, it is vital to get it into the

marketplace as quickly as possible to increase market
the time to
share, cut more incurred extra costs and extend the life
market span of product

Minimise BET is time that revenue from the product has covered all
breakeven life cycle costs, so BET is very important for liquidity
time (BET) purposes

Extend the The longer the life cycle, the greater the profit that will be
length of generated. The life cycle could be maximized through finding
the life other uses for a product or staggering the launch of the
cycle itself product in different markets.
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CHAPTER 2D: THROUGHPUT

ACCOUNTING
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I. Theory of constraints

II. Throughput accounting

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There are some terminologies needed to remember:

Definition

An approach to production management which aims

Theory of to maximize sales revenue less material cost. It
constraints (TOC) focuses on bottlenecks which act as constraints to
the maximization of throughput.

The money generated from sales minus the cost of

the materials used in making the items sold.
Throughput
Throughput = Sales – Material costs

Bottleneck
resources An activity which has a lower capacity than
(Binding preceding or subsequent activities, thereby limiting
constraints) throughput.
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Bottleneck resource should be considered in production scheduling in some following

ways:

There is always bottleneck

resource during normal production
process; therefore, idle time of
other resources are inevitable and
should be accepted.

Production must be
fully utilized to the limit
of bottleneck resource’s
capacity to avoid work-
in-progress which brings
back no profit.
Buffer inventory should be
maintained as in Just-in-time
(JIT) system.
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2. Production scheduling and the bottleneck resource
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Example 1:

Machine X can process 600 kg of raw material per hour, machine Y can process
only 400 kg per hour. With an input of 600 kg, 200 kg of processed material must
wait on the bottleneck machine (machine Y) at the end of an hour of processing
because machine Y does not have enough capacity.

Input 600 kg

Machine X
600 kg
(1000kg/hour)

Machine Y
400 kg 200 kg
(400kg/hour)

in capacity
wait Machine Y to be processed
 incur additional costs but
out of capacity
earn no money
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Goldratt devised a five-step approach to summarise the key stages of TOC.

Step 1: Identify
Identify the binding
constraint/ bottleneck

5 5 stages to 2
deal with
bottleneck
activity
4 3
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Example 2 (Question):

Demand for a product made by P Ltd is 500 units per week. The product is made in
three consecutive processes – A, B and C. Process capacities are:
Process A B C
Capacity per week 400 300 250
The long-run benefit to P Ltd of increasing sales of its product is a present value of
$25,000 per additional unit sold per week.
Investigations have revealed the following possibilities:
(1) Invest in a new machine for process A, which will increase its capacity to 550
units per week. This will cost $1m.
(2) Replace the machine in process with an upgraded machine, costing $1.5m. This
will double the capacity of process B.
(3) Buy an additional machine for process C, costing $2m. this will increase capacity
in C by 300 per week.
Required: What is P Ltd.’s best course of action?
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Example 2 (Answer):

Actions Process Demand Production

Step 1: Identify Process A Process B Process C

Process C is constraint
with lowest capacity 400 units 300 units 250 units

Step 2: Exploit
Highest possible output 400 units 300 units 250 units 500 units 250 units
must be achieved from
process C – 250 units

Step 3: Subordinate
Process A, B operate at
the same speed as 250 units 250 units 250 units 500 units 250 units
process C – 250
units/week

Step 4: Elevate
Elevate process C
Choose option (3): 250 units
• Buy additional 400 units 300 units + 300 units 500 units 300 units
machine costing
$2,000,000 550 units
• Capacity increases in Apply option (3) to increase
process C’s capacity by 300 units
C by 300 units/week
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Example 2 (Answer):

After elevating process C, the lowest of the capacities is 300 on process B now so we
will be able to produce and sell this amount hence this is the production figure.

The production & sales have gone from 250 to 300 so a 50 increase.

Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 50 =

1,250,000.

With the cost of machine of $2,000,000, this doesn’t give us a benefit.

 It is worth investigating further. Process B is bottleneck now so we can attempt

to resolve this. Let’s consider the following slide.
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Example 2 (Answer):

Actions Process Demand Production

Step 1: Identify Process A Process B Process C

Process B is constraint
now after elevating 400 units 300 units 550 units
process C

Step 2: Exploit
Highest possible output 400 units 300 units 550 units 500 units 300 units
must be achieved from
process B – 300 units

Step 3: Subordinate
Process A, C operate at
300 units 300 units 300 units 500 units 300 units
the same speed as
process B – 300
units/week

Step 4: Elevate
Elevate process B
Choose option (2): 300 units
• Upgrade machine 400 units x2 550 units 500 units 400 units
costing $1.5m
• Capacity doubled per 600 units
Apply option (2) to
week double process B’s capacity
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Example 2 (Answer):

After elevating process B, the lowest of the capacities is 400 on process A now so we
will be able to produce and sell this amount hence this is the production figure.

The production & sales have gone from 250 to 400 so a 150 increase.

Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 150 =
3,750,000.

With the cost of machine of $2,000,000 (Process C’s machine) & $1,500,00 (Process
B’s machine), it give a net benefit of $250,000.

 Whilst this is good, it could be better so it is worth seeing whether we should do

all three options. Let’s consider the following slide.
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Example 2 (Answer):

Actions Process Demand Production

Step 1: Identify Process A Process B Process C

Process A is constraint
now after elevating 400 units 600 units 550 units
process C & B

Step 2: Exploit
Highest possible output 400 units 600 units 550 units 500 units 400 units
must be achieved from
process A – 400 units

Step 3: Subordinate
Process B, C operate at
the same speed as 400 units 400 units 400 units 500 units 400 units
process A – 300
units/week

Step 4: Elevate
Elevate process A
Choose option (1): 400 units
• Invest new machine + 150 units 600 units 550 units 500 units 550 units
costing $1,000,000
• Capacity increases in 550 units
Apply option (1) to increase process A’s
A to 550 units/week capacity to 550 units
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Example 2 (Answer):

After elevating process A, the lowest of the capacities is 550 on process A & C now.
We can produce this amount but there is no point as we only have demand of 500
so that becomes our production level.

Sales demand is our bottleneck.

The production & sales have gone from 250 to 500 so a 250 increase.

Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 250 =
6,250,000.

With the cost of machine of $2,000,000 (Process C’s machine) & $1,500,00 (Process
B’s machine) & $1,000,000 (Process A’s machine), it give a net benefit of $1,750,000.
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Throughput accounting (TA) is an approach to production management which aims to

maximize sales revenue less material cost, while also reducing inventory and
operational expense.

TA is based on the following concepts, all derived from the TOC:

In the short run, all cost in the factory (except for material
costs) are fixed costs and called Total Factory Costs (TFC)

Ideal inventory level is zero. WIP should be valued at material

cost only, so no profit earned until the sale takes place.

Profitability is determined based on how quickly goods can be

produced to sell.
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cost accounting

Throughput accounting Conventional cost accounting

Inventory Inventory
Inventory is not an asset. Inventory is an asset
It is result of unsynchronized
manufacturing and is barrier to
making profit.

Cost classification Cost classification

Such classifications are no longer Costs can be classified either as
useful direct or indirect.

Labour cost Labour cost

All labor costs are part of TFC, which Direct labor is a variable cost
are fixed costs

Profitability Profitability
Profitability is determined by the rate Product profitability can be determined
at which money and throughput is by deducting a product cost from
earned selling price

Profit Profit
Profit can be increased by reducing Profit is a function of material cost, TFC
cost elements and throughput.
Profit = Throughput – TFC
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Throughput accounting will be tested mostly on application to production industry using

be guidance below, service industry will apply the same mindset.
The following guidance should be followed:

Step 1
Determine the bottleneck resource

Step 2 Calculate the throughput per unit for

each product

Step 3 Calculate throughput per bottleneck resource

(*)

Step 4
Rank product

Step 5 Allocate resources to arrive at

optimum production plan

(*) In Step 3, there are 2 ways to produce optimum production plan (throughput
maximized):
• Calculate throughput per unit per bottleneck resource
• Calculate throughput accounting ratio (TPAR)
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3.1 Use throughput ranking

Example 3 (Question):

WR Co manufactures three (03) products. A, B, and C. Product details are as follow:

Product A Product B Product C

$ $ $
Sales price 2.8 1.6 2.4
Materials cost 1.2 0.6 1.2
Direct labor cost 1.0 0.8 0.8
Weekly sales demand 4,000 units 4,000 units 5,000 units

Machine hours per unit 0.5 hours 0.2 hours 0.3 hours

Machine time is a bottleneck resource and maximum capacity is 4,000 machine

hours per week. Operating costs including direct labor costs are $10,880 per week.
Direct labor workers are not paid overtime and work a standard 38-hour 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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3.1 Use throughput ranking

Example 3 (Answer):

Step 1: Determine the bottleneck resource

The bottleneck resource is machine time (4,000 machine hours available each week).
Step 2: Calculate the throughput per unit for each product

Product A Product B Product C

$ $ $
Sale price 2.8 1.6 2.4
Less: Materials cost (1.2) (0.6) (1.2)
Throughput per unit 1.6 1.0 1.2
Step 3: Calculate throughput per unit of limiting factor (machine hours)

Product A Product B Product C

$ $ $
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Throughput per machine hour $3.2 $5 $4

$1.6 throughput per

unit/0.5 hours
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3.1 Use throughput ranking

Example 3 (Answer):

Step 4: Rank product

Product A Product B Product C

3rd 1st 2nd

Step 5: Allocate resources to arrive at optimum production plan

The profit-maximizing weekly output and sales volumes are as follow:
Bottlenecks Throughput
Total Total
Product Units resource per hour
hours throughput ($)
hours/unit ($)
B 4,000 0.2 hours 800 5.0 4,000
C 5,000 0.3 hours 1,500 4.0 6,000
2,300
A (balancing -β) 3,400 0.5 hours 1,700 3.2 5,440
4,000 15,440
1,700/0.5
Less: operating expenses (10,880)

Profit per week 4,560

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3.1 Use throughput ranking

The throughput accounting ratio (TPAR ratio) is the ratio of the throughput per unit of
bottleneck resource to the factory per unit of bottleneck resource. This ratio should be
as high as possible, and certainly more than 1.

The formula of TPAR ratio:

Throughput per unit of bottleneck resource
TPAR ratio = Factory cost per unit of bottleneck resource

Note:
• ‘Per unit of bottleneck resource’ means the same with ‘per factory hour’ in this
context
• ‘Total factory costs’ (TFC) are also described as ‘Total operating costs’. (These are
cost other than material cost, and regarded as fixed cost per period)
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3.2 Use throughput accounting ratio (TPAR) ranking

Interpretation of TPAR ratio:

• TPAR ratio should exceed 1.0. This means total throughput should exceed total
factory costs otherwise the organization will make a loss.

• In terms of performance measurement, products can be ranked in order of priority

for manufacture and sale in order of their TPAR ratios. (Higher TPAR ratios should
be given priority over lower TPAR ratios).

However, ranking products in order of priority according to their TPAR ratio will always
give the same ranking as putting them in order of throughput per unit of bottleneck
resource.
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3.2 Use throughput accounting ratio (TPAR) ranking

Example 4 (Question):

Corrie Company produces three (03) products, X, Y and Z. The capacity of Corrie’s
plant is restricted by process Alpha. Process Alpha is expected to operate for 8 hours
per day and can produce 1,200 units of X per hour; 1,500 units of Y per hour and 600
units of Z per hour.
Selling prices and material costs for each product are as follow.
Selling price Material cost
Product
$ per unit $ per unit
X 150 80
Y 130 40
Z 300 100

Operating costs are $720,000 per day.

Required:
(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,5000
units of Y and 1,200 units of Z.
(b) Calculate the TPAR for each product.
(c) In the absence of demand restrictions for the three products, advise Corrie’s
management on the optimal production plan.
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3.2 Use throughput accounting ratio (TPAR) ranking

Example 4 (Answer):

(a)
Profit = Throughput (W) – TFC = Sales – Material cost – TFC (or operating costs)
= 1,065,000 – 720,000 = 345,000

(W)
Product Selling price Material cost Throughput Total
units $ per unit $ per unit $ per unit throughput

X = 6,000 150 80 70 420,000

Y = 4,500 130 40 150-80 90 405,000

Z = 1,200 300 100 200 240,000
1,065,000
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3.2 Use throughput accounting ratio (TPAR) ranking

Example 4 (Answer):

(b)
Throughput per unit of bottleneck resource (i)
TPAR ratio =
Factory cost per unit of bottleneck resource(ii)

(ii) Factory cost per unit of bottleneck resource = Operating cost per factory hour =
$720,000/8 hours = $90,000
Throughput per unit * total unit per
(i) factory hour = 90 * 1,500

Product X Y Z

Throughput per factory hour 84,000 135,000 120,000

Cost per factory hour $90,000 $90,000 $90,000

TPAR 0.93 1.50 1.33
Ranking 1 2
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3.2 Use throughput accounting ratio (TPAR) ranking

Example 4 (Answer):

(c)
Since Product Y is ranked 1st, highest TPAR, it should be prioritized to be made
and sold first. If only Product Y is made and sold (no limit on sales demand):
$
Total output per day (units) 12,000 1,500 units
per hour
Total throughput ($90/unit) 1,080,000
× 8 hours
Operating costs (720,000)
Total profit per day 360,000

This is $15,000 ($360,000 - $345,000) per day more than the profit from the
production mix in part (a).
TPAR ratio of Product X is 0.93, below 1. This means it makes less throughput per
hour than its factory cost per hour. Corrie should stop production for X.
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3.2 Use throughput accounting ratio (TPAR) ranking

How to improve TPAR ratio?

The ratio is increased by either:

Detail actions

Increase selling price of product

Increase throughput per Reduce material costs

bottleneck hour
Improve efficiency, and increase the number of units or
product that are made in each bottleneck hour

Reduce expenditure on operating costs/ factory costs

Reduce the operating
cost per bottleneck hour Elevate the bottleneck, so there are more hours
available of the bottleneck resource

Note:
Throughput accounting approach is similar to approach of maximizing contribution per
unit of scarce resource which you will see later in Chapter 6: Limiting factor analysis.
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CHAPTER 3:
RELEVANT COST ANALYSIS
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RELEVANT COST ANALYSIS

I. Apply relevant cost analysis for specific situations

II. Opportunity costs

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Relevant costs are future cash flows arising as a direct consequence of a decision

3 conditions for costs to be recognized as relevant costs:

Tuf Co decides to produce tofu to serve

Cost must be a cost that will
foreign customers, which require
occur in the future
soybeans for raw material. It is obvious
that cost of soybeans purchase is a
relevant cost as:
Cost must be a cost (or benefit)
that results in cash flow • It arising directly from decision of
producing tofu or it occur in the
future
• Cash flow of Tuf Co is affected
Cost is an incremental cost, • It is an incremental cost of Tuf Co
arising as a direct consequence arising directly from decision of
of the decision producing tofu
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Therefore, the followings are non-relevant costs:

SUNK COSTS
1 Sunk costs are costs already incurred. They are not relevant in decision-
making and are therefore ignored.

COMMITTED COSTS
2 Committed costs have already been committed to and so are not relevant to
the decision. Example is the cost of materials under a long-term contract.

NOTIONAL COSTS
3
Notional costs are non-cash items or accountancy entries

FIXED COSTS
4 Fixed costs are allocated, and general fixed costs are not specific to a
decision. Avoidable fixed costs would be relevant.
 96
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Y FOR SPECIFIC SITUATIONS

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2.1 Relevant cost of materials

There are several questions to consider when identifying relevant cost of material: “in
stock, regularly used or any alternative use?”
How to determine relevant cost of materials:

Note: At each step, when relevant cost is determined in full, the calculation should be
stopped.
 97
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Y FOR SPECIFIC SITUATIONS

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2.1 Relevant cost of materials

Example 1 (Question)

A company is considering making a new product which requires several types of raw
material:

Units in Units
Material Additional information
inventory required
A Nil 40 Current purchase price is $7/unit.
Current purchase price is $14/unit. The material
100
has no use in the company other than for the
B purchased 150
project under consideration. Units in inventory
for $10/unit
can be sold for $12/unit.
50 Current purchase price is $22/unit. The material
C purchased 120 is regularly used in current manufacturing
for $20/unit operations.

Required: What is the relvant cost of the materials required for manufacturing the
new product?
 98
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N

N
Y FOR SPECIFIC SITUATIONS

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2.1 Relevant cost of materials

Example 1 (Answer)

Step 1: Step 2: Step 3:

Relevant cost
in stock? regularly used? alternative use?
A.
No. Purchase cost.
40 needed in - -
40 = 40x7 = $280
total
Yes. No. Disposal cost.
B. 100 100 =100x12=$1,200
150 needed in No.
Purchase cost.
total 50 needed
=50x14=$700
more
Yes. Yes. Purchase cost.
C. 50 50 =50x22=$1,100
120 needed in No.
Purchase cost.
total 70 needed
=70x22=$1,540
more
 99
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or

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O

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N

N
Y FOR SPECIFIC SITUATIONS

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U

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2.2 Relevant cost of labor

How to determine relevant cost of labour:

Note: At each step, when relevant cost is determined in full, the calculation should be
stopped.
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N
Y FOR SPECIFIC SITUATIONS

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2.2 Relevant cost of labor

Example 2 (Question)

A company has a new project which requires the following three types of labor:
Hours required Additional information
Paid at $8 per hour and existing staff are fully
Unskilled 12,000 utilised. The company will hire new staff to meet
this additional demand.
Paid at $12 per hour. These employees are
difficult to recruit and the company retains a
number of permanently employed staff, even if
Semi-skilled 2,000 there is no work to do. There is currently 800
hours of idle time available and any additional
hours would be fulfilled by temporary staff that
would be paid at $14/hour.
Paid at $15 per hour. There is a severe shortage
of employees with these skills and the only way
that this labor can be provided for the new
Skilled 8,000 project would be for the company to move
employees away from making Product X. A unit
of Product X takes 4 hours to make and makes a
contribution of $24/unit.
Required: What is the relevant cost of the labor hours required for the new project?
 101
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N

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Y FOR SPECIFIC SITUATIONS

Y
U

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2.2 Relevant cost of labor

Example 2 (Answer)

Step 1: Step 2:
Relevant cost
Spare capacity? Hire staff?
Unskilled Current rate of pay.
No. Yes.
12,000 hours = $12,000 × 8 =
12,000
required in total $96,000
Yes. Relevant cost.
Semi-skilled 800 =0
2,000 hours No. Current rate of pay.
Yes.
required in total 1,200 needed = $1,200 × 14 =
1,200
more $16,800
Variable costs.
= $8,000 ×
Skilled
No. No. 15=$120,000
8,000 hours
8,000 8,000 Lost contribution.
required in total
= $8,000 × (24/4)
= $48,000
 102
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Y FOR SPECIFIC SITUATIONS

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2.3 Relevant cost of machine use

Once a machine has been bought its purchase cost is a sunk cost.

As mentioned above, depreciation is not a relevant cost. However, using machinery may
involve some incremental costs such as:

Repair costs Fall in resale value

Hire charges
arising from use arising from use
 103
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N

N
Y FOR SPECIFIC SITUATIONS

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U

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2.3 Relevant cost of machine use

Example 3 (Question)

Co is considering whether to undertake some contract work for a customer. A special

cutting machine will have to be hired for three months for the work (the length of the
contract). Hire charges for this machine are $75 per month, with a minimum hire
charge of $300.
Required: What are the relevant costs?
 104
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Y FOR SPECIFIC SITUATIONS

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2.3 Relevant cost of machine use

Example 3 (Answer)

In order to undertake the contract, Co must hire further a cutting machine for 3
months (incremental costs).
• Rent cost = 3x75 = $225
• Minimum hire charge = $300

Thus, relevant costs = $300.

Note: Process to calculate relevant costs

• Identify correctly types of relevant costs (material, labour or machine use)
• Follow step by step as mentioned.
 105
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Opportunity cost may also be a type of relevant cost.

Opportunity cost is the value of a benefit sacrificed when one course of action is
chosen, in preference to an alternative.

The opportunity cost is represented by the forgone potential benefit from the best
rejected course of action.
 106
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Example 4 (Question)

A company has a new project which requires the following three types of labor:
Hours required Additional information
Paid at $8 per hour and existing staff are fully
Unskilled 12,000 utilised. The company will hire new staff to meet
this additional demand.
Paid at $12 per hour. These employees are
difficult to recruit and the company retains a
number of permanently employed staff, even if
Semi-skilled 2,000 there is no work to do. There is currently 800
hours of idle time available and any additional
hours would be fulfilled by temporary staff that
would be paid at $14/hour.
Paid at $15 per hour. There is a severe shortage
of employees with these skills and the only way
that this labor can be provided for the new
Skilled 8,000 project would be for the company to move
employees away from making Product X. A unit
of Product X takes 4 hours to make and makes a
contribution of $24/unit.
Required: What are the opportunity costs in this scenario?
 107
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Example 4 (Answer)

If the skilled labor does not undertake the new project, they could do product X to get
a contribution of $6 per hour. Thus, opportunity cost = 8,000 hours x $6 = $48,000.

The opportunity cost is the contribution forgone from not being able to put it to its
alternative use. Therefore, opportunity cost is a relevant cost but not versa.
 108
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CHAPTER 4:
SHORT TERM DECISIONS
 109
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Y OVERVIEW

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TARGET COSTING

I. Minimum price decisions

II. Make or buy decisions

III. Outsourcing

IV. Further processing decisions

V. Shutdown decisions
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The minimum price for a one-off decision is its total relevant costs. This is the price at
which the business would break-even.

Three steps to determine the minimum price is presented below:

Step 1
Identify relevant cost factors

Step 2
Calculate relevant costs for cost
factors determined at Step 1

Step 3
Determine the minimum price
 111
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Example 1 (Question)

JAPP Co has been approached by a customer to manufacture a specialized

machine. This would be a one-off order which JAPP Co would undertake in
addition to its normal budgeted production.
The assistant accountant has prepared the following quotation:
Notes $
Direct materials:
Aluminum plating (20 m2 @ $10 per m2 ) 1 200
Rivets (100 @ $1 each) 2 100
Direct labor:
Skilled (50 hours @ $16 per hour) 3 800
Semi-skilled (20 hours @ $10 per hour) 4 200
Overheads 5 100
1,400
Administration overhead @ 10% of production cost 6 140
1,540
Profit 20% of total cost 7 308
Selling price 1,848
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Example 1 (Question)

Notes:
(1) The aluminum plating is regularly used on other work within the business.
It has an inventory value of $10 per m2 although the current purchase
price has recently risen to $12 per m2 . There are 20 m2 of aluminum
plating in stock and these are used regularly.
(2) Rivets are currently held in inventory and cost $1 each although the
company has no further use for them. They could be sold to a scrap
merchant for $0.50 each.
(3) Skilled laborer are paid $16 per hour and are currently fully utilized on
other work. If the job was undertaken it would be necessary to work a
maximum of 40 hours of overtime (paid at time and a half) and/or reduce
the production of another product which earns contribution of $20 per
hour.
(4) There is currently 100 hours of idle semi-skilled labor time available.
(5) Overheads represent an apportionment to cover factory fixed costs.
(6) It is policy to add 10% to the production cost of each job to cover the
administration cost of orders accepted.
(7) Profit of 20% of total cost is added to each job as part of the standard
pricing policy.

Required: On a relevant cost basis, determine the minimum price which should
be quoted for the job.
 PD
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Example 1 (Answer)

Step 1: Identify relevant cost factors

Cost factor Relevant Explanation
cost?
Aluminum plating
Rivets They are future cash flows arising as a direct
Yes
Skilled labor consequence of undertaking the order
Semi-skilled labor
Overheads They will be incurred regardless of whether or not
Administration cost No
the order is accepted

Step 2: Calculate relevant costs for cost factors determined at Step 1

Cost factors include 2 groups namely material and labour.
(1) Relevant costs of material

Step 1: Step 2: Step 3:

Relevant cost
in stock? regularly used? alternative use?
Yes. Yes. Purchase cost.
Aluminum plating
10 10 = 10x12 = $120
20 m2 needed in
No. Purchase cost.
total
10 = 10x12 = $120
Rivets Yes. No. Disposal cost.
100 needed in total 100 100 =100x0.5=$50
Total $290
 114
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Example 1 (Answer)

Step 2: Calculate relevant costs for cost factors determined at Step 1

(2) Relevant costs of labor

Step 1: Step 2:
Relevant cost
Spare capacity? Hire staff?

Yes. Current rate of pay.

No.
40 = 40x24=$960
Skilled labor
Variable costs.
50 hours required in total
= 10x16=$160
No. No.
Lost contribution.
= 10x20 = $200
Semi-skilled Yes. Relevant cost = 0
20 hours required in total 20

Total $1,320

Step 3: Determine minimum price decision

The minimum price is total relevant costs = 290 + 1,320 = $1,610.
 115
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In reality, enterprise always face the decision to choose between making items in-house
or purchasing them from an external supplier.

MAKE BUY
Making items in-house VS. Purchasing from external supplier

Example: Example:

Manufacture its own components Buy the components from outsiders

Accounting service is carried out Accounting service is carried out

by an internal department by a hiring external organization

Some following factors need to be considered:

Direct control Quality of Time to complete Costs incurred

over the work achieved work the work from make or buy
decisions
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There are two types of make or buy decisions:

1 Without limiting factors 2 With limiting factors

• This type will be covered in this This type will be covered in

chapter Chapter 6: Limiting factors analysis
• The relevant costs for this type
are the mainly differential costs
between the two options.

Three steps to determine make or buy decisions is presented below:

Step 1 Step 2 Step 3

Identify relevant Calculate extra Conclude make
cost factors relevant costs of or buy decision
buying
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Example 2 (Question)

Mars Co makes units Pluto (P) and Jupiter (J), for which costs in the forthcoming
year are expected to be as follows:
P J
Production (units) 1,000 1,500

$ $
Direct materials 3 5
Direct labour 6 9
Variable production overheads 2 3
Total 11 17
Directly attributable fixed costs per annum and committed fixed costs:
$
Incurred as a direct consequence of making P 1,500
Incurred as a direct consequence of making J 3,000
Other fixed costs (committed) 10,000
Total 14,500
A sub-contractor has offered to supply units of P for $12 and J for $21.

Required: Should Mars make or buy the components?

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Example 2 (Answer)

Step 1: Identify relevant cost factors

Cost Relevant Explanation
cost?

Variable costs Yes They are future cash flows arising as a

Directly attributable fixed costs Yes direct consequence of making P and J
Committed fixed costs No They are not incremental costs

Reference: Chapter 3 Relevant cost analysis.

Step 2: Calculate extra relevant costs of buying
P ($) J ($)
Unit variable cost of making 11 17
Unit variable cost of buying 12 21
Extra costs of buying per unit 1 4
Production volume (units) 1,000 1,500
Extra variable cost of buying 1,000 6,000
Fixed costs saved by buying (1,500) (3,000)
Extra relevant costs of buying (500) 3,000
Step 3: Conclude make or buy decision
Mars Co should make J as extra cost of buying is obvious. In the case of P, the company
should consider further as some followings:
• Fixed costs incurred from making P is just estimated, so the saved total costs of
buying of $500 may be incorrect.
• Other factors such as control, time and quality should be reviewed.
 119
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Outsourcing is the use of external suppliers for finished products, components or services.

Considering whether to outsource, in fact, involves comparing the costs of making ‘in-
house’ products and the costs to buy products from outside, which is the same mindset of
‘make-or-buy’ 3-step process as in make-or-buy could be applied.
However, when considering outsourcing, non-financial factors below should be preferred:

Advantages Disadvantages

Cost savings Loss of control

Access to expertise Impact on quality

Releases capital Flexibility & reliance of supplier

Frees up capacity Potential loss of confidential information

Loss of in-house skill

Impact on employees’ morale

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Example 3 (Question)

Stunnaz is considering a proposal to use the services of a press cuttings agency.

At the moment, press cuttings are collected by a junior member of the marketing
department, who is also responsible for office administration, travel bookings, a
small amount of proofreading and making the tea. The total annual cost of
employing this person is $15,000 pa.
There is concern that the ability of this person to produce a comprehensive file
of cuttings is limited by the time available. They have calculated that they need
to spend about two hours of their seven-and-a-half-hour day simply reading the
national and trade press, but usually only have about five hours a week for this
job.
Press subscriptions currently cost $850 pa and are paid annually in advance.
The assistant makes use of a small micro-fiche device for storing cuttings. The
cuttings are sent to a specialist firm once a month to be put onto fiche. Stunnaz
pays $45 each month for this service. The micro-fiche reader is leased at a cost of
$76 per calendar month. This lease has another 27 months to run.
The cuttings service bureau has proposed an annual contract at a cost of $1,250.
Several existing users have confirmed their satisfaction with the service they
receive.
Required: Should Stunnaz outsource its press cuttings work?
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Example 3 (Answer)

Step 1: Identify relevant cost factors

Cost Relevant cost? Explanation

This person will still be paid even if we
Salary for junior member No outsource (because she does other
things as well)
Current subscriptions Yes
They are future cash flows arising as a
Fee of specialist firm service Yes direct consequence of outsourcing

Micro-fiche reader leasing It is a committed cost that must be paid

No
charge of $76 per month whatever the decision.
Reference: Chapter 3 Relevant cost analysis.

Step 2: Calculate extra relevant cost of outsourcing

$
Cost of in - house option:
Subscriptions 850
Specialist firm service [$45 x 12] 540
Total costs of in- house option 1,390
Cost of outsourcing 1,250
Extra relevant cost of outsourcing (140)
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Example 3 (Answer)

Step 3: Conclusion
It is obvious that if outsourcing is chosen, Stunnaz has potential to save $140 pa.
However, they should have further considerations:
• The in-house option should give management more direct control over the work,
but the outsource option often has the benefit that the external organization has a
specialist skill and expertise in the work.
• Will outsourcing create spare capacity? If exist, Stunnaz should do what to get more
benefit.
• Would the subcontractor be reliable with delivery times and quality?
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This decision often involves joint products from a common manufacturing process.

Joint products are two or more outputs from the same process, but which are
indistinguishable from each other up to their split-off point.

Split-off point: The point at which joint products become separately.

At the split-off point, enterprise decides whether they should sell immediately joint
products or whether they should be processed further before selling them.
Split-off point

Product A

Further process Product

Product B Profit 2
Input (Further processed)
Process 1 + input 2

Joint – product C

Sell immediately
By – product C Profit 1
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Rules to make further processing decision:

Profit created from selling products processed further is greater than profit created
from selling products immediately.
Profit (for each process) = Revenue created - Relevant costs incurred.

Three steps to determine further processing decisions is presented below:

Step 1 Step 2 Step 3

Identify relevant Calculate Make decision based
cost factors incremental revenue on the net profit of
and incremental cost processing further
between 2 option
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Example 4 (Question)

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

Required: Decide whether the company should sell Alash or Alashplus?

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Example 4 (Answer)

Step 1: Identify relevant cost factors

Cost Relevant Explanation
cost?
Extra fixed incurred from
Yes
processing Alash further They are future cash flows arising as
Variable costs incurred a direct consequence of further
from processing Alash Yes processing
further
Joint processing costs of They will be incurred regardless of
No
$150,000 what the decision is.

Step 2: Calculate incremental revenue and incremental cost between 2 options

Revenue of Alash: $1.25 x 100,000 = $125,000
Revenue of Alashplus: $3.25 x 60,000 = $195,000
Incremental revenue = $195,000 – $125,000 = $70,000
$
Incremental revenue 70,000
Incremental costs:
Fixed costs: (20,000)
Variable costs (30,000)
Net profit 20,000
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Example 4 (Answer)

Step 3: Make decision based on the net profit of processing further

The net profit of processing further is positive of $20,000.
 Alashplus gives a higher profit of $20,000, thus the company should process
further Alash into Alashplus and sell Alashplus.

Note: There is another approach for step 2 and step 3:

Step 2: Compare profit created from selling immediately and processed further
Alash Alashplus
$ (Further process)
1.25x100,000 $ 3.25x60,000

Sales revenue 125,000 195,000

Relevant costs:
Fixed costs 0 20,000 0.3x100,000
Variable costs 0 30,000
Total costs 0 50,000
Profit 125,000 145,000
Step 3: Make decision based on the more beneficial figures from Step 2
Alashplus gives a higher profit of $20,000 ($145,000 - $125,000), thus the company should
process further Alash into Alashplus and sell Alashplus.
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The consideration of a shutdown decision involves 2 things:

Why? Make losses or too expensive to run?

Time? Permanent or temporary

To make decision, 3 aspects need to be considered:

Factors Explanation

Financial factor Relevant costs incurred from the decision should be considered.

Timing of Enterprise needs to consider most appropriate timing for a shutdown.

shutdown Some costs may be avoidable in long run but not in short run.

• What impact will a shutdown decision have on the morale of

employees who remain?
• What signal will decision give to competitors? How will they react?
• How will customers react? Will they lose confidence in the
Others
company's products?
• How will suppliers be affected? If one supplier suffers
disproportionately there may be a loss of goodwill and damage to
future relations.
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Example 5:

Elen Co manufactures product X. Related information is as follows:

$
Sales revenue 40,000
Variable costs (25,000)
Contribution 15,000
Fixed costs (18,000)
Profit/ (Loss) (3,000)
Because of the loss result, Elen Co is considering whether they should stop
manufacturing X. They find that the total fixed costs of $18,000 includes direct
fixed costs of $5,000. Thus, if product X stopped, $5,000 is saved obviously. The
remained amount of $13,000 is fixed overhead is allocated for X, so it is clearly
they incurred regardless X is.

However, if product X is stopped, the profit will be reduced by $10,000 which

includes $15,000 of contribution and $5,000 of saved direct fixed costs.
Here is the financial aspect. Elen Co needs consider further other factors before
making decision.
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CHAPTER 5:
COST VOLUME PROFIT ANALYSIS
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Y OVERVIEW

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CVP ANALYSIS

I. Revision of CVP analysis

II. Application of CVP analysis

III. Breakeven chart

IV. Limitation of CVP analysis

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The aim of CVP analysis is to consider the effects of differing levels of activity on the profit
target of an enterprise by studying the relationship between costs, sale volume and
profit.

In particular, the enterprise needs to determine the break-even point to set prices and
output levels. If sales exceed the breakeven point the company will make a profit.

The breakeven point is the level of sales at which there is neither profit nor loss.
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Contribution/sale ratio (C/S ratio)

C/S ratio gives the amount of contribution earned per dollar of sales.

Contribution per unit = Unit selling price - Unit variable costs

Contribution
C/S ratio = Sales x 100%

Profit = (Sales volume × Contribution per unit) – Fixed costs

Breakeven point (BEP)

Breakeven point is the level of sales at which there is neither profit nor loss.

Total fixed costs

Breakeven point in units (*) =
Contribution per unit

Fixed costs
Sales revenue at breakeven point = x 100%
C/S ratio

(*) To understand this formular, please read the explanation of breakeven point in
units in the next slide.
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Margin safety
A measure of the amount by which sales must fall before enterprise starts
making a loss. A loss is made if sales volume is less than the BEP.

Margin of safety in units = Budgeted sales - Breakeven sales

Budgeted sales−Breakeven sales

Margin of safety in % = Budgeted sales x 100%

Target profit
Enterprise could use CVP analysis to find the volume needed to attain a
required profit level.

Fixed costs +Target cost

Sales volume to achieve target profit = Contribution per unit

Note: Explanation for breakeven point in units:

• Profit = Total sales revenue - Total variable costs - Total fixed costs
• 0 = (Selling price x Sales volume) - (Variable cost per unit x Sales volume) - Total fixed costs
• Total fixed costs = (Selling price - Variable cost per unit) x Sales volume
• Total fixed costs = Contribution per unit x Sales volume
Total fixed costs
• Thus, sales volume (BEP in units) = Contribution per unit
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CVP analysis is undertaken through following 5 steps:

Step 1
Determine contribution per unit

Step 2
Determine C/S ratio

Step 3
Determine breakeven point

Step 4
Determine margin of safety

Step 5 Determine sales or sales volume to

achieve target profit
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Example 1 (Question):

A company makes and sells a single product. The selling price is $12 per unit. The
variable cost of making and selling the product is $9 per unit and fixed costs per
month are $240,000.
The company budgets to sell 90,000 units of the product a month.
(a) What is the breakeven point?
(b) What is the margin of safety?
(c) What must sales be to achieve a monthly profit of $120,000?
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Example 1 (Answer):

(a) Breakeven point

Step 1: Determine contribution per unit
Contribution per unit = Unit selling price - Unit variable costs = $12 - $9 =$3
Step 2: Determine C/S ratio
C/S ratio = Contribution/ Sales x 100% = 3/12 x 100% = 25%
Step 3: Determine breakeven point
Total fixed costs $240,000
Breakeven point in units = = = 80,000 units
Contribution per unit 3
Fixed costs $240,000
Sales revenue at breakeven point = x 100% = 0.25 x 100% =
C/S ratio
$960,000
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Example 1 (Answer):

(b) Margin of safety

Step 4: Determine margin of safety
Margin of safety in units = Budgeted sales - Breakeven sales
= 90,000 unit – 80,000 unit = 10,000 units

Budgeted sales−Breakeven sales

Margin of safety in % = x 100%
Budgeted sales
10,000
= 90,000 x 100% = 11.1%

(c) Target profit of $120,000

Step 5: Determine sales or sales volume to achieve target profit
Fixed costs +Target cost 240,000 + 120,000
Sales volume =
Contribution per unit = 3 = 120,000 units

Sales = Sales volume x Selling price = 120,000 x $12 = $1,440,000

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To perform breakeven analysis for a multi-product organization, assume that a constant

sales mix for the products in order to calculate a weighted average contribution per unit
sold or a weighted average C/S ratio.

A constant sales mix for the products is whenever x units of product A are sold, y units
of product B and z units of product C are also sold.

Steps for multi - product breakeven analysis are as follows:

Step Determine weighted average of the breakeven, margin or target profit

1 (It is the same 5 steps of single product case)

Step Determine the breakeven, margin or target profit for each product
2 (Corresponding weighted average x Corresponding ratio of the product
in the mix)
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Example 2 (Question):

PL produces and sells two products, M and N. Product M sells for $8 per unit and
has a total variable cost of $3.8 per unit, while Product N sells for $14 per unit
and has a total variable cost of $4.3 per unit. The marketing department has
estimated that, for every five units of M sold, six units of N will be sold. The fixed
costs per period total $83,160. PL is planning to achieve sales revenue of
$150,040 and another plan to get profit of $39,960.
Required:
(a) What is the breakeven point in sales?
(b) What must sales be to achieve the target profit?
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Example 2 (Answer):

(a) Breakeven point

Step 1: Determine contribution per unit
NM
$/unit
$/unit
Selling price 148
Variable cost 3.8
4.3
Contribution 4.2
9.7
2
• Weighted average contribution per unit
$
Contribution from sale of 5 units of M [5 x $4.2] 21
Contribution from sale of 6 units of N [6 x $9.7] 58.2
Contribution from sale of 11 units 79.2

79.2
Thus, weighted average contribution per unit = 11 = $7.2 (per unit)
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Example 2 (Answer):

(a) Breakeven point

Step 2: Determine C/S ratio
• Weighted average sales revenue per unit
$
Sales revenue of 5 units of M [5 × $8] 2 40
Sales revenue of 6 units of N [6 × $14] 84
Sales revenue of 11 units 124

• Weighted average C/S ratio

Weighted average C/S ratio = Contribution/ Sales x 100% = 79.2/124 x100% =
63.87%
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Example 2 (Answer):

(a) Breakeven point

Step 3: Determine breakeven point
• Weighted average breakeven point
Breakeven point in units = Total fixed costs/ Contribution per unit
= $83,160/7.2 = 11,550 units
Sales revenue at breakeven point = Fixed
2 costs/ C/S ratio = $83,160/ 0.6387 =
$130,200
• Breakeven point for each product
Sales volume of M = 11,550 x 5/11 = 5,250 units
Sales volume of N = 11,550 x 6/11 = 6,300 units
Sales revenue of M = 40/124 x $130,200 = $42,000
Sales revenue of N = 84/124 x $130,200 = $88,200
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Example 2 (Answer):

(b) Target profit of $39,960

Step 5: Determine sales or sales volume to achieve target profit
Fixed costs +Target cost
Weighted average sales volume =
Contribution per unit
83,160 + 39,960
= = 17,100 units
7.2
For each product:
2
Product Sales volume Selling price Sales revenue
(units) ($/unit) ($)

M 7,773 8 62,184
(5/11*17,100)

N 9,327 14 130,578
(6/11*17,100)

Total 17,100 192,762

Exam focus point: Determine breakeven point, target profit, margin safety for
specific situations from given data
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A single product breakeven chart records costs and revenues on the vertical axis (y) and
the level of activity on the horizontal axis (x). Lines are drawn on the chart to represent
costs and sales revenue.
Following the step-by-step guidance below can help you to produce your own chart:

Draw the axes Oxy

Step 1
Horizontal axis (Ox): level of activity Vertical axis (Oy): revenue and costs

Determine and draw Fixed cost line

Step 2
This will be a straight line parallel to the horizontal axis at fixed cost level.

Determine and draw Total cost line

Step 3 • Calculate the total costs for the maximum sales level.
• Join it to the cost incurred at zero activity.

Determine and draw Revenue line

Step 4 • Calculate the revenue at maximum activity.
• Join it to the origin.

Determine breakeven point

Step 5
BEP can be read off where the total sales revenue line cuts the total cost line.
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After drawing single product breakeven chart, the area of margin of safety is also read off.
The margin of safety can be seen as the area to the right of the breakeven point up to the
forecast sales level.

It is the difference the budgeted level of activity and the breakeven level of activity.

y
$'000

360

320 x
x
280
BEP
240

200 Variable
costs
160

120

80
Fixed
40 costs
Margin of safety
x
2,000 4,000 6,000 8,000 10,000 12,000 14,000 Units
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Example 3 (Question):

A new product has the following data:

Selling price $60/unit, Variable cost $40/unit, Fixed costs $25,000 per month.
Forecast sales is 1,800 units per month.
Required: Determine the breakeven point through the breakeven chart.
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Example 3 (Answer):

Step 1: Draw the axes Oxy, whereas:

• Ox is monthly sales volume. The value is illustrated to 1,800 units
• Oy is monthly sales revenue. The highest value is 1,800 x $60 = $108,000
Step 2: Determine the Fixed cost line
This line will be a straight line parallel to the Ox axis at the $25,000 level
Step 3: Determine the Total cost line
This line will pass through 2 following points:
• Total costs at zero of sales volume is $25,000
• Total costs at sales volume of 1,800 units is $97,000 (25,000 + 40 x 1,800)
Step 4: Determine sales revenue line
This line will pass through 2 following points:
• Revenue at zero of sales volume is 0
• Revenue at sales volume of 1,800 units is $108,000
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Example 3 (Answer):

Step 5: Determine the breakeven point

The breakeven point is the intersection of the total cost line and revenue line.
This is illustrated by the below chart:
Align the perpendicular lines to the axes Ox and Oy, we determine the value of
breakeven sales volume of 1,250 units and revenue of $75,000.

$'000
y x
x
Breakeven
Point
80
75
Variable
costs
50 Fixed
costs
30
20
Margin of safety

400 800 1250 1800 x

1600
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2.r eSingle product contribution breakeven chart
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One of the problems with the single product breakeven chart (basic breakeven chart) is
that it is not possible to read contribution directly from the chart.

A contribution breakeven chart is based on the same principles but it shows the
variable cost line instead of the fixed cost line.

y
$'000

360

320 x
x
280 Fixed Contribution
BEP
costs
240

200

160

120

80

40
Margin of safety
x
2,000 4,000 6,000 8,000 10,000 12,000 14,000 Units
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As well as being able to carry out CVP calculations we may draw a breakeven chart in a
multiple product situation if a constant product sales mix is assumed.

We treat the whole mix as a single product and follow steps mentioned in case of single
product breakeven chart to draw multi-product breakeven chart.

Example 4 (Question):

SAPP Co sells three products, X, Y and Z, which have variable unit costs of $3, $4 and
$5 respectively. The sales price of X is $8, the price of Y is $6, and the price of Z is $6.
Fixed costs per annum are $10,000.
Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z.
A breakeven chart would make the assumption that output, and sales of X, Y and Z
are in the proportions 2,000: 4,000: 3,000 at all levels of activity.
Required: Determine the breakeven point through the breakeven chart.
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Example 4 (Answer):

We treat the whole mix is as a single product:

Sales Variable unit Variable Unit price Sales

volume costs costs ($/unit) ($)
(units) ($/unit) ($)
X 2,000 3 6,000 8 16,000
Y 4,000 4 16,000 6 24,000
Z 3,000 5 15,000 6 18,000
Total 9,000 37,000 58,000
Fixed
10,000
costs
Total 47,000

Step 1: Draw the axes Oxy, whereas:

• Ox is monthly sales volume. The value is illustrated to 9,000 units
• Oy is monthly sales revenue. The highest value is $58,000
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Example 4 (Answer):

Step 2: Determine the Fixed cost line

This line will be a straight line parallel to the Ox axis at the $10,000 level
Step 3: Determine the Total cost line
This line will pass through 2 following points:
• Total costs at zero of sales volume is $10,000
• Total costs at sales volume of 9,000 units is $47,000
Step 4: Determine sales revenue line
This line will pass through 2 following points:
• Revenue at zero of sales volume is 0
• Revenue at sales volume of 9,000 units is $58,000
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Example 4 (Answer):

Step 5: Determine the breakeven point

The breakeven point is the intersection of the total cost line and revenue line.
The breakeven point is approximately $27,500 of sales revenue and 4,500 units of
sales volume. This is illustrated by the below chart:

Costs and
revenue
($'000)

60 Profit
($11,000 at
budget)
breakeven
point

30

fixed costs
10

1000 5000 9000 Sale units

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The profit-volume chart (P/V chart) is another form of the breakeven chart, showing
a single line of profit or loss at each level of activity.

In a multi-product environment, two lines must be shown in P/V chart:

• One straight line: assumed constant mix of products
• One bow-shaped line: show how individual products contribute to profit rather than
a constant mix. The most profitable product is assumed to be sold first and so on.
The following steps should be followed:

Step 1: Calculate the C/S ratio of each product being sold, and rank the products in
decreasing order of profitability

Step 2: Calculate the cumulative sales and profit.

Step 3: Draw the graph, showing cumulative sales on the x-axis, profit earned on the
y-axis. The products are shown individually on a graph from left to right following
ranking (Step 1).

Step 4: Draw the straight line showing average profit earned by those products and
locate the breakeven point.
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Example 4 (Cont.):

The breakeven point of $27,500 as above could be shown as follow:

Profit/loss
($'000)

10
Profit
Budgeted
5 profit
20
Breakeven
40 58 Sale
Loss revenue
breakeven ($'000)
point
-10 appr = $27,500
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Example 4 (Cont.):

Step 1: Calculate the C/S ratio of each product being sold, and rank the products
in decreasing order of profitability
Product Contribution Sales C/S ratio Ranking
$ $ %
X 10,000 16,000 62.50 1
Y 8,000 24,000 33.33 2
Z 3,000 18,000 16.67 3
21,000 58,000 36.21

Step 2: Calculate the cumulative sales and profit.

Cumulative profit Cumulative sales

Product
$ $

-
X 16,000
($10,000 contribution - $10,000 fixed costs)
X and Y 8,000 40,000
X, Y and Z 11,000 58,000
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Example 4 (Cont.):

Step 3: Draw the graph, showing cumulative sales on the x-axis, profit earned
on the y-axis. The products are shown individually on a graph from left to right
following ranking from step 1.
• At output (sales) = 0, profit earned = fixed costs
• Plot the graph with (cumulative sales; cumulative profit) for each product
identified in step 2.

Profit
earned
($'000)
11 Z
8
Y
4

16 20 40 58 Sale
X revenue
($'000)
-10
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Example 4 (Cont.):

Step 4: Draw the straight line showing average profit earned by those products
and locate the breakeven point.

Profit
earned
($'000)
11 Z
8
Y
4

16 20 40 58 Sale
X revenue
breakeven ($'000)
-10 point
appr = $27,500
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4. Advantage
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4.1 Advantages

The using of CVP analysis have some following advantages:

Easy to understand
Be easily understood for non-financial managers as it is illustrated
by breakeven chart

Determine profit or loss

Be able to determine profit or loss at any level of activity

Focus
Focus on breakeven point and safety margin, so help managers to
assess risk better
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4.2 Limitations

Assumption Limitation

CVP analysis can apply to one CVP analysis is valueless in an organisation that
product only, or to more than one they sell more than one product, and a fixed sales
product only if they are sold in a mix is not exist.
fixed sales mix.

Fixed costs per period are same in This assumption may not hold true as:
total, and unit variable costs are a
• Fixed costs will change if output falls or
constant amount at all levels of
increases substantially
output and sales.
• The variable cost per unit will decrease
where economies of scale are made at
higher output volumes, but the variable cost
per unit will also eventually rise when
diseconomies of scale begin to appear at
even higher volumes of output.

Sales prices are constant at all This assumption may not hold true as if sales
levels of activity. volumes are to increase, sales price must fall.

Production volume = sales volume. This assumption may not hold true as inventory
levels are constant.
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CHAPTER 6:
LIMITING FACTORS ANALYSIS
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LIMITING FACTORS ANALYSIS

I. Limiting factors

II. Apply limiting factors analysis to decide optimum production plan

III. Apply limiting factor analysis to choose make or buy decisions

IV Slack, surplus and shadow price

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A limiting factor is any factor that is in scarce supply and that stops the organization
from expanding its activities further, so that there is a maximum level of activity at
which the organization can operate.

Example:

• Labor: limit of the total quantity of labor or employees with particular skills
• Material: be insufficient materials to produce
• Machine capacity: be insufficient machine capacity for the production required

Note:
An organization might be faced with just one or several limiting factors.
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Limiting factor analysis are techniques to analyze limiting factors in order to maximize
contribution: Contribution = Sales - Variable costs

Distinguish limiting factor and bottleneck resource

Limiting factor Bottleneck resource

Analyze limiting factors to VS. Analyze binding constraints to
maximize contribution maximize throughput

Contribution = Sales - Variable costs Throughput = Sales - Materials

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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
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Rule:
Identify contribution per unit of the limiting factor for each product, then choose
product with the highest of contribution per unit to produce.

3 steps to carry out:

Step 1
Identify limiting factor

Step 2
Calculate contribution per limiting factor for each product, compare and
rank for these figures

Step 3
Decide optimum production plan
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Example 1 (Question)

Sausage makes two products, the Mash and the Sauce. Unit variable costs are as
follows.
Mash Sauce
$ $
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
8 7
The sales price per unit is $14 per Mash and $11 per Sauce. During July the
available direct labor is limited to 8,000 hours. Sales demand in July is expected to
be as follows.
Mash 3,000 units
Sauce 5,000 units

Required: Determine the maximized profit of the production, assuming that fixed
costs per month are $20,000 and that there is no opening inventory of finished
goods or work in progress.
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Example 1 (Answer)

Step 1: Identify limiting factor

Mash Sauce Total
Labour hours per unit (hour) 6/3 = 2 3/3 = 1
Sales demand (unit) 3,000 5,000
Labour hours required (hour) 6,000 5,000 11,000
Labour hours available (hour) 8,000
Shortfall (hour) 3,000
Thus, labour hour is limiting factor.
Step 2: Calculate contribution per limiting factor for each product, compare and rank for
these figures
Mash Sauce
$ $
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 1
Contribution per labour hour 3 4
Ranking 2 1
Step 3: Decide optimum production plan
st
As the above ranking result, Sauce is prioritized 1 to produce.
Unit Labour hours Hours Contribution per
Contribution
produced per unit available labour hour
Sauce 5,000 1 5,000 4 20,000
Mash 1,500 2 3,000 (β) 3 9,000
8,000 29,000
Therefore, profit = 29,000 - 20,000 = $9,000.
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When there are at least 2 limiting factors, linear programming technique is used to
determine the maximum contribution or the minimum costs.

Linear programming technique includes 2 following methods:

• Graphical method
• Simultaneous equations

2.1 Graphical method

Step 1: Define the problem

• Define variable
• Establish constraints
• Construct objective function

Step 2:
Draw the constraints on a graph

Step 3:
Establish the feasible region for the optimal production

Step 4:
Determine the optimal solution using an iso-contribution line
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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

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U

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B

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2.1 Graphical method

Example 2 (Question)

SAP Co manufactures two products, M and N. Both products pass through two
production departments, mixing and shaping. The organization’s objective is to
maximize contribution to fixed costs.
Product M is sold for $1.50 whereas product N is priced at $2.00. There is unlimited
demand for product M but demand for N is limited to 13,000 units per annum. The
machine hours available in each department are restricted to 2,400 per annum. Other
relevant data are as follows.
Machine hours required Mixing hours Shaping hours
Product M 0.06 0.04
Product N 0.08 0.12
Variable cost per unit for M is $1.3/unit and for N is $1.7/unit.
Required: Determine the feasible region for the optimal production.
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or

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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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C
.c 2. Multiple limiting factors

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2.1 Graphical method

Example 2 (Answer)
Step 1: Define the problem
• Define variables
There are 2 variables are 2 products that SAP can make and sell
Let x = number of units of product MA produced and sold
Let y = number of units of product NB produced and sold
• Establish constraints
The number of units of product N is less than or equal to 13,000, so y ≤ 13,000
The number of machine hours cannot be greater in total than 2,400 hours, so:
0.06x + 0.08y ≤ 2,400 and 0.04x + 0.12y ≤ 2,400
• Construct objective function (maximise contribution)
Contribution on each type of product is as follows:
Product M: 1.5 - 1.3 = $0.2/unit
Product N: 2.0 - 1.7 = $0.3/unit
Therefore, in order to maximise contribution, it is needed to determine x and y for theto
value of (0.2x + 0.3y) is maximized and satisfied following constraints:
x, y ≥ 0
y ≤ 13,000
0.06x + 0.08y ≤ 2,400
0.04x + 0.12y ≤ 2,400
Step 2: Draw the constraints on a graph
Draw the following graphs:
y = 13,000
0.06x + 0.08y = 2,400
0.04x + 0.12y = 2,400
 172
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or

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O

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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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C
.c 2. Multiple limiting factors

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2.1 Graphical method

Example 2 (Answer)
Step 3: Establish the feasible region
The feasible region is the area contained within all of the constraint lines.
Step 4: Determine the optimal solution using an iso-contribution line
We do not know the maximum value of the objective function but we can draw an iso-
contribution line (iso means ‘equal’) that shows all the combinations of x and y that provide
the same total value for the objective function.
Suppose that SAP wishes to earn contribution of $3,000 (0.2x + 0.3y = 3,000), so:
• y = 0, x = 15,000 or SAP produce and sell 15,000 units of M and no N
• x = 0, y = 10,000 or SAP produce and sell no M and 10,000 units of N
Thus, the possible combinations required to earn contribution of $3,000 could be shown by
the straight line 0.2x + 0.3y = 3,000.
The contribution lines are all parallel to each
other. We were to move the contribution
line out any further, it would cease to lie in
the feasible region and greater contribution
could not be achieved.
In this case, the contribution line just passes
through the intersection of 0.06x + 0.08y =
2,400 and 0.04x + 0.12y = 2,400.

So x = 24,000 and y = 12,000.

The point (24,000; 12,000) will therefore give us the optimal allocation of resources (to
produce 24,000 units of M and 12,000 units of N)
 173
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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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C
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2.2 Simultaneous equations

It is conducted as Graphical method, except step 4. According to Simultaneous

Equations, enterprise will calculate contribution at some special points that they are
intersection of the constraint lines and within the feasible region, then choose the point
of the highest contribution.

Step 1: Define the problem

• Define variable
• Establish constraints
• Construct objective function

Step 2:
Draw the constraints on a graph

Step 3:
Establish the feasible region for the optimal production

Step 4:
Determine the optimal solution through calculating contribution of points
at which the constraint lines intersect and within the feasible region
 174
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or

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O

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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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k
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C
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2.2 Simultaneous equations

Example 3 (Example 2 - Question)

SAP Co manufactures two products, M and N. Both products pass through two
production departments, mixing and shaping. The organization’s objective is to
maximize contribution to fixed costs.
Product M is sold for $1.50 whereas product N is priced at $2.00. There is unlimited
demand for product M but demand for N is limited to 13,000 units per annum. The
machine hours available in each department are restricted to 2,400 per annum. Other
relevant data are as follows.
Machine hours required Mixing hours Shaping hours
Product M 0.06 0.04
Product N 0.08 0.12
Variable cost per unit for M is $1.3/unit and for N is $1.7/unit.
Required: Determine the optimal production using simultaneous equations.
 175
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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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C
.c 2. Multiple limiting factors

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2.2 Simultaneous equations

Example 3 (Answer)

Step 1, 2, 3: They are stated as example 2 above. The feasible region is as follows:

Step 4: Determine the optimal solution through calculating contribution of points at which the
constraint lines intersect and within the feasible region
These points are A, B, C and D.
• Point A (x = 0, y = 13,000)
Contribution A = 0.2x + 0.3y = 0.2 x 0 + 0.3 x 13,000 = $3,900
• Point B
B is the intersection of line y = 13,000 and line 0.04x + 0.12y = 2,400
0.04x + 0.12 x 13,000 = 2,400, so x = 21,000
Contribution B = 0.2x + 0.3y = 0.2 x 21,000 + 0.3 x 13,000 = $8,100
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O

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ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
Y

Y
U

U
B

B
to

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C
.c 2. Multiple limiting factors

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2.2 Simultaneous equations

Example 3 (Answer)

• Point C
C is the intersection of line 0.06x + 0.08y = 2,400 and line 0.04x + 0.12y = 2,400

So x = 24,000 and y = 12,000

Contribution C = 0.2x + 0.3y = 0.2 x 24,000 + 0.3 x 12,000 = $8,400
• Point D (x = 40,000 and y = 0)
Contribution D = 0.2x + 0.3y = 0.2 x 40,000 + 0.3 x 0 = $8,000
Contribution A < Contribution D < Contribution B < Contribution C, so the optimal solution is at
point C. SAP Co should produce 24,000 units of M and 12,000 units of N to get the maximized
contribution of $8,400.
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ANALYSIS TO CHOOSE MAKE OR BUY DECISION
Y

Y
U

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B
to

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C
How to apply limiting factor analysis in choosing make
.c a c or buy?

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Rule:
Make the decision to buy products which have the lowest variable costs per unit of
limiting factor.

Note: In case of make or buy decision related to relevant costing principles, we studied in
chapter 4 Short-term decisions.

3 steps to carry out:

Step 1
Identify limiting factor

Step 2
Calculate extra costs per limiting factor of buying for each product, compare
and rank these extra cost

Step 3
Determine the optimum production plan
 178
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ANALYSIS TO CHOOSE MAKE OR BUY DECISION
Y

Y
U

U
B

B
to

to
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om

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k
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C
How to apply limiting factor analysis in choosing make
.c a c or buy?

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Example 4 (Question)

SAP 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 of the final product is
as follows.
Product Machine hours Variable cost
S 3 20
A 2 36
T 4 24
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 per unit.

Required: Advise the optimum production plan for SAP.

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ANALYSIS TO CHOOSE MAKE OR BUY DECISION
Y

Y
U

U
B

B
to

to
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ww
om

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k

k
lic

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C

C
How to apply limiting factor analysis in choosing make
.c a c or buy?

.c
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Example 4 (Answer)
Step 1: Identify limiting factor
If produce all products as required, machine hours need is 4,000 x (3+2+4) = 36,000
hours, which is higher than machine hour limited at 24,000 hours.
Thus, machine hour is limiting factor.
Step 2: Calculate extra costs per limiting factor of buying for each product, compare
and rank these extra costs
S A T
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 2 4
Extra variable cost of buying per hour saved 3 2 2.5
Ranking 3 1 2
Step 3: Compare extra costs per unit of step 2 and determine the optimum production
plan
As the above ranking result, SAP should make on priority in order S, T and A.
Product Units Machine Total Variable Total
hours/unit
machine costs/unit costs
hours
S 4,000 3 12,000 20 80,000
Make
T 3,000 4 12,000 24 72,000
Total 24,000
The machine hour is full, additional amount of T and A must be bought:
T 1,000 34 34,000
Buy
A 4,000 40 160,000
Total 346,000
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IV. SLACK, SURPLUS AND SHADOW PRICE
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Surplus occurs when more than a minimum requirement of a resource or other

constraining factor is used.
Slack occurs when maximum availability of a resource or other constraining factor is not
used.

Slack is used to evaluate whether the use of the limiting factor is effective or not. In
particularly, at the optimal solution:
• Resource used = resource available
no spare capacity of a resource and no slack => effective
• Resource used < resource available
there is spare capacity of a resource and there is slack => ineffective
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IV. SLACK, SURPLUS AND SHADOW PRICE
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Example 5 (Question)

A company had the following limiting factors for Period 3:

Test time: 12,000 hours
Program time: 28,000 hours
The following information was established:
Product X Product Y
Test per unit 18 4
Program minutes per unit 36 14
Optimum production plan 20,000 66,000
(unit)

Required: What were the slack resources for test time and program time?

Example 5 (Answer)

Test time used: (20,000 x 18)/60 + (66,000 x 4)/60 = 10,400 hours

Therefore, slack hours = 12,000 – 10,400 = 1,600 hours

Program time used: (20,000 x 36)/60 + (66,000 x 14)/60 = 27,400 hours

Therefore, slack hours = 28,000 – 27,400 = 600 hours
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IV. SLACK, SURPLUS AND SHADOW PRICE
Y

Y
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Shadow price: This is the ‘increase in value which would be created by having available
one additional unit of a limiting resource at the original cost’.

Thus, a shadow price is:

The additional contribution generated from one additional unit

of limiting factor

The opportunity cost of not having the use of one extra unit of
Shadow price
limiting factor

The maximum extra amount that should be paid for one

additional unit of scarce resource

Example 6

Material is a limiting factor. If one extra kilogram becomes available then an

alternative production mix becomes optimal.

As a result, the contribution increases over the original production mix by $2.
Thus, the shadow price of a kilogram of material is $2
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CHAPTER 7:
PRICING DECISIONS
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Y OVERVIEW

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PRICING DECISIONS

I. Factors influencing price

II. Relationship between demand and price

III. Determine optimum selling price to maximize profit

IV. Decisions to increase production and sales

V. 8 price strategies
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Factors Explanation
Price sensitivity is the degree to which the price of a
product affects consumers' purchasing behaviors. Or, it's
Price sensitivity
how demand changes with the change in the cost of
products.

Price perception is the way customers react to prices.

Example: Customers may react to a price increase by
Price perception buying more. This could be because they hear information
from experts that selling price of the commodity will
continue to increase in the future, so they expect further
price increases to follow.

This is an aspect of price perception. In the absence of

other information, customers tend to judge quality by
Quality
price. Thus, a price rise may indicate improvements in
quality and a price reduction may signal reduced quality.

Products or services could be distributed to the market

through independent intermediaries. They have private
Intermediaries
price policies, so the products or services could be bought
at different price from different supplies.
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Factors Explanation

To attract customers, every competitor has a private price

Competitors
policy

Price of input risen, there is a price rise of product or

Suppliers
service produced from these inputs.

In periods of inflation, the price of products or service

Inflation
could be changed.

When a new product is introduced for the first time, it is

Newness
difficult to set a suitable price

If incomes are rising, price may be a less important than

product quality and convenience of access. However,
Incomes
income levels are falling and/or unemployment levels
rising, price will be more important.

When existing scarcity of goods, price of product or service

Ethics
could be push too high to take profit.
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However, the price of a product or service will be determined based on the market in
which it operates. There are 4 types of market:

Perfect competition Monopoly market

market
Many buyers and sellers deal an One seller who dominates many
identical product. Neither buyers. The monopolist can use
producer nor user has any their market power to set a
market power, and both must profit-maximizing price.
accept the prevailing market
price.

Monopolistic Oligopoly market

competition market
Many suppliers offer similar, but Where relatively few competitive
not identical, products. The companies dominate the market.
similarities ensure elastic demand While each large firm can
whereas the slight differences give influence market prices, the
some monopolistic power to the unpredictable reaction from the
supplier. other giants makes the final
industry price indeterminate.
Cartels are often formed.
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In general, a buyer will be willing to buy more at a lower price.

Price elasticity of demand (PED)

Price elasticity of demand (PED) is a measure of the extent of change in market

demand for a good in response to a change in its price. It is measured as:
% change in demand
PED = % change in price

PED has an important role to help enterprises to choose suitable price policies. Details are
as follows:
PED Explanation Price policy
Price increase, revenue will decrease and
When price increase/
PED >1 reverse. Thus, enterprise must consider
decrease 1%, demand will
(Demand is whether the increase level in cost is less
decrease/ increase more
elastic) or more than the increase in revenue to
than 1%
decide increase price
Enterprise should increase price of the
When price increase/
PED < 1 product as the price increase level is
decrease 1%, demand will
(Demand is more than the decrease level of output.
decrease/ increase less than
inelastic) Thus, revenue increase, costs decrease
1%
leading to profit increase
PED = 1 Changes in price yield
(Demand is unit equivalent (percentage)
elastic) changes in demand
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PED Explanation Price policy

Customers are not sensitive to the

PED = 0 There is no change in quantity
prices. Therefore, enterprise should
(Demand is demanded, regardless of
focus more on quality, service,
perfectly inelastic) change in prices
production mix and location

Customers will want to buy an

Enterprise should reduce elasticity by
PED = ∞ infinite amount, but only up
creating a customer preference which
(Demand is to a particular price. Any price
is unrelated to the price (through
perfectly elastic) increase above this level will
advertising and promotional activities)
reduce demand to 0

The below graph illustrates price elasticity of demand:

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Example 1:

The price of a good is $15 per unit and annual demand is 60 units. Market
research indicates that an increase in price of $3 per unit will result in a fall in
annual demand of 15 units.
Required: What is the price elasticity of demand?

Solution:
Annual demand at $15 per unit is 60 units.
Annual demand at $18 per unit is 45 units.
% change in demand = (15/60) × 100% = 25%
% change in price = ($3/$15) × 100% = 20%
% change in demand −25%
PED = % change in price = 20 % = -1.25

It means that the price increase/ decrease 1%, demand for the good will
decrease/ increase 1.25%. Demand is elastic.

Notes: The minus sign of PED is ignored as PED is expected to be negative since
demand will fall if price rises and vice versa.
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The demand equation shows the relationship between the price charged for a product
and the subsequent demand for that product.

Demand equation

When demand is linear the equation for the demand curve is P = a – bQ

where:
• P = the price
• Q = the quantity demanded
• b = change in price/change in quantity
• a = the price at which demand would be nil, a is constant and calculated as
follow:
Current quantity at current price
a = $(current price) + x $b
Change in quantity when the price is changed by $b

3 steps to determine demand curve:

Step 2: Step 3:
Step 1: Check the
Substitute the known value for b at Step 1
Calculate b equation
into the demand function to find a
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Example 2:

Using example 1 again.

Required: Determine the demand equation.

Solution:
Step 1: Calculate b (*)
b = change in price/change in quantity = 3/15 = 0.2
Step 2: Substitute the known value for b at Step 1 into the demand function to
find a
P = a - bQ
Or 15 = a - 0.2 x 60, so a = 27
Step 3: Check your equation
The demand equation is therefore P = 27 - 0.2Q
We can check this equation when P is $18
18 = 27 - 0.2Q, so Q = 45 units.

(*) Alternative approach to find b:

We substitute each price and demand level into the equation: P = a – bQ
Annual demand at $15 per unit is 60 units  15 = a – 60b (1)
Annual demand at $18 per unit is 45 units  18 = a – 45b (2)
Then we have (2) – (1):
3 = 15b  b = 3/15 = 0.2
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III. DETERMINE OPTIMUM SELLING PRICE TO
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MAXIMISE PROFIT
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1. Algebraic method
In accordance economic theory:

• Marginal revenue (MR) – revenue generated by selling another unit - will

continually fall as output rises whenever the firm is faced with downward-sloping
curve
• While marginal cost (MC) - the variables cost per unit for each additional unit that is
made or sold – may rise due to the law of diminishing return.
As you sell more, profit will grow as long as the extra revenue obtained is greater than the
extra cost incurred (extra revenue = MR, extra cost = MC) - see the graph below

It will continue to maximise only up to the output level where marginal cost has risen to
be exactly equal to the marginal revenue.

Therefore, profits are maximised at the point where MC = MR.

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1. Algebraic method
3 steps to determine the optimal price to maximise profit:

Step 1: Determine a and b in the demand equation P = a - bQ

Step 2: Determine quantity (Q) at maximized profit through the equation MC = MR

Step 3: Determine selling price (P) at maximized profit by substituting Q at Step 2 into
the demand function at Step 1

Example 3 (Question):

SAP Co 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: If MR = a – 2bQ when the selling price (P) = a - bQ, calculate the profit
maximising selling price for product G.
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1. Algebraic method

Example 3 (Answer):

Solution:
Step 1: Determine a and b in the demand equation P = a – bQ
b = change in price/change in quantity = 1/5 = 0.2
Substitute b in the demand equation to find a:
250 = a – 0.2 * 12,000  a = 2,650
Step 2: Determine quantity (Q) at maximized profit through the equation
MC = MR
MR = 2,650 - 2x0.2xQ = 2,650 - 0.4Q
MC = 80
MC = MR or 80 = 2,650 - 0.4Q, so Q = 6,425
Step 3: Determine selling price (P) at maximized profit by substituting Q at step
2 into the demand function at step 1
P = a - bQ = 2,650 - 0.2x6,425 = $1,365
Therefore, SAP Co should sell 6,425 units at selling price unit of $1,365 to
maximise profit.
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1. Algebraic method

Notes: Formula MR = a - 2bQ and MC = variable cost per unit are always provided in
the exam. However, it is very easy to determine them. Details are as follows:
• MR = a - 2bQ

From the demand equation P = a - bQ, total revenue (TR) = PQ = aQ - bQ2

MR = TR’(Q) = a - 2bQ
• MC = variable cost per unit
Total costs = Fixed cost + Variable cost = Fixed cost + Variable cost per unit x
Quantity
Or TC = Fixed cost + Variable cost per unit x Q
MC = TC’(Q) = Variable cost per unit

Exam focus point: Determine marginal cost and marginal revenue equations in order
to calculate optimum price and quantity.
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2. Tabular method (self-reading)

The optimum selling price can also be determined using tabulation. Whereby, it is needed
to calculate the marginal costs, revenues and profit at different combinations of output
and selling price.

Example 4 (Question):

The following data is available for prices and costs.

Output Sales price per unit Average cost of output
(Units) ($/unit) ($/unit)
0 - -
1 504 720
2 471 402
3 439 288
4 407 231
5 377 201
6 346 189
7 317 182
8 288 180
9 259 186
10 232 198
Required: Complete the table below to determine the output level and price at
which the organisation would maximise its profits.
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2. Tabular method (self-reading)

Example 4 (Answer):

Unit Total Total

Output MR MC Profit
price revenue costs
(Units) ($) ($) ($)
($) ($) ($)
0 - - - 600 - (600)
1 504 504 504 720 120 (216)
2 471 942 438 804 84 138
3 439 1,317 375 864 60 453
4 407 1,628 311 924 60 704
5 377 1,885 257 1,005 81 880
6 346 2,076 191 1,134 129 942
7 317 2,219 143 1,274 140 945
8 288 2,304 85 1,440 166 864
9 259 2,331 27 1,674 234 657
10 232 2,320 (11) 1,980 306 340

Therefore, profit is maximised at 7 units of output and a price of $317, when MR is

most nearly equal to MC.
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It is necessary to consider incremental costs, incremental revenues and other factors

before deciding to increase production and sales.

Incremental costs and revenues are the difference between costs and revenues for
the corresponding items under each alternative being considered.

4 steps to decide production and sales increase:

Step 1: Determine incremental revenue

Step 2: Determine incremental costs

Step 3: Calculate incremental profit

Step 4: Make decision to increase production and sales

(This could be considered through incremental profit at step 3 and further factors)
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Example 5 (Question):

SAP Co manufactures a product which uses two types of material: A and B. Each
unit of production currently sells for $10. A local trader has expressed an interest
in buying 5,000 units but is only prepared to pay $9 per unit. Current costs and
revenues are as follows:
$’000 $’000
Sales 350
Less: production costs
- Material A – 1 kg per unit 25
- Material B – 1 litre per unit 50
- Labour - 1 hour per unit 75
- Fixed overhead 76
- Non-production costs 25
Total cost 250
Budgeted profit 100
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Example 5 (Question):

The following additional information has also been made available:

(a) There is minimal inventory of material available and prices for new material
are expected to be 5% higher for Material A and 3% higher for Material B.
(b) SAP Co has been having problems with his workforce and is short of labour
hours. He currently has the capacity to produce 36,000 units but would have to
employ contract labour at $3.50 per hour to make any additional units.
(c) Included in the fixed production overhead is the salary of the production
manager. He is stressed and exhausted and has threatened to leave unless he
receives a pay rise of $5,000. SAP Co would not be able to fulfil any new orders
without him.
Required: Evaluate whether SAP Co should accept the new order.
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Example 5 (Answer):

Solution:
Step 1: Determine incremental revenues
Incremental revenues = 5,000 x $9 = $45,000
Step 2: Determine incremental costs
Current production = $350,000/ $10 = 35,000 units
Therefore: $
Current cost per unit of material A [$25,000/35,000] 0.71
Curret cost per unit of material B [$50,000/35,000] 1.43
Current cost of labour [$75,000/35,000] $2.14
Thus, incremental costs when accepting order of 5,000 units are as follows:
$
Material A [$0.71 x 105% x 5,000] 3,728
Material B [$1.43 x 103% x 5,000] 7,365
Labour [$2.14 x 1,000 + 4,000 *$3.50] 16,140
(Labour spare capacity of 1,000 units (36,000 units – 35,000 units) at
$2.14 and additional hiring costs to produce 4,000 units at $3.50)
Fixed overhead 5,000
(addition salary for production managers)
Total 32,233
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Example 5 (Answer):

Solution:
Step 3: Determine incremental profit
Incremental profit = Incremental revenues - Incremental costs = $45,000 -
$32,233 = $12,767
Step 4: Make decision to increase production and sales
It is obvious that if accepting this order to increase production, SAP Co could gain
more profit of $12,767. However, SAP Co should consider further followings:
• The current workforce and production manager will be able to fulfil the new
order with the same labour efficiency
• Whether it is happy for existing customers that they still buy product with
the unit selling price of $10 instead of $9.
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Y V. 8 PRICE STRATEGIES

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An enterprise could use one or more pricing strategies when selling their products to
maximize profits. Every period, they could apply different strategies. However, there are 8
below popular price strategies:

1. All forms of cost-plus 5. Product line

2. Skimming 6. Volume discounting

3. Penetration 7. Discrimination

4. Complementary
8. Relevant cost
product
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There are 2 types:

Full cost-plus pricing Marginal cost-plus pricing

This is a method of deciding the This is a method of deciding

sales price by adding a the sales price by adding a
Definition
percentage mark-up for profit profit margin to the marginal
to the full cost of the product. cost of the product.

Selling price = Total unit costs + Selling price = Marginal costs +

Calculation
Profit mark-up Profit margin

Quick, simple and cheap Simple and easy to use

Advantages Cover all of its costs and ensure Help management focus to
to make a profit. contribution

Price may need to be adjusted

to reflect market conditions Ignore fixed overheads so the
Quantity of product must be sales price must be sufficiently
Disadvantages
estimated accurately, otherwise high to ensure that a profit is
the selling price could be too made
high or too low.
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Example 6:

A company budgets to make 20,000 units which have a variable cost of

production of $4 per unit. Fixed production costs are $60,000 per annum.
Required: If the selling price is to be 40% higher than full cost, what is the selling
price of the product using the full cost-plus method?

Solution:
$
Variable unit costs 4
Fixed unit costs [$60,000/ 20,000] 3
Total unit costs 7
Profit mark-up [40% x $7] 2.8
Selling price 9.8
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Price skimming involves charging high prices when a new product is first launched on
the market, in order to maximise short-term profitability.

The aim of market skimming is to gain high unit profits early in the product's life, in the
hope of recovering the costs of investment quickly. This is useful for some followings:

The product is new and different, so that early adopters are prepared to pay
high prices to be seen to own the latest products.

High prices in the early stages of a product’s life might generate high initial
cash outflows, therefore, a firm with liquidity problems may prefer this.

The product has a short life cycle and needs to recover development costs
and make a profit quickly.

Example 7
Market skimming is often used for technological product, or “breakthrough” product.
In 2020 Samsung released Samsung Galaxy S20 with high original price of $999.
However, one year later, this price dropped to just $600.
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Penetration pricing is a policy of low prices when a product is first launched in order
to obtain strong demand for the product as soon as it is launched on the market. Low
prices should encourage bigger demand.

The aim is to entice customer to try a new product and build market share with the hope
of keeping new customers once price rises back to the normal levels. This is useful for
some followings:

The firm wants to The firm wishes to Demand is highly elastic

discourage new entrants shorten the initial period and so would respond
into the market of the product’s life cycle well to low prices

However, to implement this strategy, enterprises need a certain capital source, especially
for small and medium enterprises because the possibility of loss is quite high.

Example 8

Netflix is the perfect example of penetration pricing done right. Subscription fees of
Netflix starts at $9.99 then go up to $13.99 and maximum of $15 and one month of
free of subscription ending. However, people are completely fine with paying the
higher subscriptions for the unending flow of good media content.
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Complementary products are goods that tend to be bought and used together. If an
organisation makes and sells complementary products, it may wish to decide the
selling prices for the products in a single pricing policy decision.

Example 9
An electric toothbrush and replacement toothbrush heads are complementary
products. The electric toothbrush may be priced competitively to attract demand but
the replacement heads can be relatively expensive.
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A product line is a group of products that are related to one another. A product line
may be a range of branded products, and a consistent pricing policy should be applied
to all the products in the range.

Example 10
Common example can be seen in fast-food restaurants (e.g "meal deals" containing a
burger, soft drink and french fries for less than the total price of the individual items)
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A volume discount is a reduction in price given for larger than average purchases.

The aim of a volume discount is to increase sales from large customers.

However, when applying this strategy, it is important to consider carefully between the
reduced costs of a large order and the loss of revenue from offering the discount.

Example 11:

SAP Co sells a product X with a selling price is $10/ unit. A customer approaches
SAP Co and suggests that he would buy 500 units X in case unit selling price is
down to $7.
See that the loss of revenue from offering the discount = ($10-$7) x 500 units =
$1,500
SAP Co detects that total fixed costs will decrease $1,000 when production
reaches 450 units.
Thus, it is obvious that the reduced costs of $1,000 is smaller than the loss of
revenue of $1,500, it means that SAP Co makes a loss of $500 if accepting the
orders. SAP Co should consider further. In case, this is a key customer and SAP Co
doesn’t want to affect goodwill with customer. They could agree this deal.
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Price discrimination is the practice of charging different prices for the same product to
different groups of buyers when these prices are not reflective of cost differences.

This is useful for some followings:

The market must be segmentable in price terms, and different sectors must
show different intensities of demand.

There must be little or no chance of a black market developing (this would

allow those in the lower priced segment to resell to those in the higher one)

There must be little or no chance that competitors can or will undercut the
firms’ prices in the higher priced (and/or most profitable) market segment.

The cost of segmenting and administering the arrangement should not exceed
the extra revenue derived from the price discrimination strategy.
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Example 12

Pricing discrimation can be used in the different number of cases:

• By market segment: Items such as cinema tickets and hairdressing services

are often available at lower prices to over 60s, students or juveniles

• By product version: For example, some car models have added on extras

• By place: Theatre seats are usually sold according to the type of seat and
its location in the theatre auditorium

• By time: This is perhaps the most popular type of price discrimination. For
example, off-peak travel bargains, hotel prices.
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A relevant cost approach is to identify a price at which the organization will be no

better off, but no worse off, if it sells the item at that price. Any price in excess of this
minimum price will add to net profit.

Thus, this is useful for special orders which may require a relevant cost approach to the
calculation. For example, a company might have a capacity of 500,000 units per month
but only be producing and selling 300,000 units per month. It could therefore consider
special orders to use up some of its spare capacity.

Relevant costs can be used to arrive at a minimum tender price for a one-off tender or
contract. The minimum price should be equal to the relevant costs.

Notes: The principles to determine relevant costs were mentioned in Chapter 3

Relevant cost analysis.
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Price strategy Conditions

• There is no market price to compare, and enterprise wants

Cost-plus pricing
that profit is guaranteed
• Enterprise wants to focus on contribution in short-term
Marginal cost-
decisions concerning the use of excess capacity or one off
plus pricing
contracts
• Where the product is new and different and has little direct
competition
• Where products have a short life cycle, and there is a need to
recover their development costs quickly and make a profit
Skimming
• Where the strength of demand and the sensitivity of demand
to price are unknown
• A firm with liquidity problems and hope to generate high cash
flows early on
• A firm wishes to increase market share
• A firm wishes to discourage new entrants from entering the
Penetration market
• If demand is highly elastic and so would respond well to low
prices
• The main product will be priced at a low price, the profit that
Complementary
the business earns mainly from the high price in
product
supplementary products.
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Price strategy Conditions

• Company must decide the price differences between the

Product line
upgrades of a product or service
• Sales margin is substantial allowing profits to be made even
Volume after discounting
discounting • Products with a limited shelf life such as fashion items may
be discounted to shift them

• The market must be segmentable in price terms, and

different sectors must show different intensities of demand
• Customers cannot buy at the lower price in one market and
sell at the higher price in the other market
• There must be little or no chance that competitors can and
Discrimination
will undercut the firm’s prices in the higher priced market
segments
• The cost of segmenting and administering should not exceed
the extra revenue derived from the price discrimination
strategy
• When there are special orders which are one-off revenue-
Relevant cost
earning opportunity
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CHAPTER 8:
RISK AND UNCERTAINTY
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RISK AND UNCERTAINTY

I. Definition of risk and uncertainty

II. Techniques to reduce uncertainty

III. Rules to make decisions

IV Means of decisions

V. Value of information
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Uncertain events are events where the outcome cannot be estimated with a statistical
probability.

Risk involves situations or events which may or may not occur, but whose probability of
occurrence can be estimated statistically.

Example 1

Uncertainty
The same oil company may dig for oil in a previously unexplored area. The company
knows that it is possible for them to either find or not find oil but it does not know the
probabilities of each of these outcomes.

Risk
Based on past experience of digging for oil in a particular area, an oil company may
estimate that they have a 60% chance of finding oil and a 40% chance of not finding oil.
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A person's attitude to risk and uncertainty may affect the decision that is taken.
There are 3 following attitude groups:

Risk seeker
This is a decision-maker who is interested in the best outcomes, no matter
how small the chance that they may occur.

Risk neutral
This is a decision-maker who balances risk and return. They are willing take
on more risk, but only if the expected profit or return is higher. They will also
accept a lower return for lower risk.

Risk adverse
This is a decision-maker who acts on the assumption that the worst outcome
might occur and will make a decision that limits or minimises the risk
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There are two techniques to reduce uncertainty:

• Market research
• Outcome estimates

Market research is the systematic process of gathering, analysing and reporting data
about markets to investigate, describe, measure, understand or explain a situation or
problem facing a company or organisation.

Data can be either quantitative or qualitative:

QUANTITATIVE DATA QUALITATIVE DATA

in the form of numbers and tells us why consumers think, buy or
measurements act the way they do

Example, they do statistics how Example, consumers buy Adidas

many people buy Adidas shoes and shoes instead of Nike shoes
how many people buy Nike shoes
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This technique is constructed based on a pay-off table.

Pay-off tables identify and record all possible outcomes (or pay-offs) in situations where
there are two or more decision options and the outcome from each decision depends
on the eventual circumstances that arise ('worst possible', 'most likely' or 'best
possible').

A pay-off table is a table or matrix where:

• One side of the table has a different row (or column) for each decision option
• The other side of the table has a column (or row) for the eventual circumstances
that may arise
Then, based on the stated rules or attitude of the decision-maker, they will choose a
specific decision.

Note:
The stated rules are clearly explained in the following section III. Rules to make decision.
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Example 2 (Question)

SAP Co is trying to set the sales price for one of its products. Three prices are
under consideration, and expected sales volumes as table follows.

Pricing

$4 $4.3 $4.4

Circumstances
(expected sales demand):

Best possible 16,000 14,000 12,500

Most likely 14,000 12,500 12,000

Worst possible 10,0000 8,000 6,000

Fixed costs are $20,000 and variable costs of sales are $2 per unit.
Required: Prepare a pay-off table and what is decision for a risk averse?
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Example 2 (Answer)

Here we need to prepare a pay-off table showing pay- off (profit), dependent on:
• Different selling price options
• Different levels of sales demands based on eventual circumstances (best
possible, most likely & worst possible)
The table is completed by entering the total profit for each different selling price,
given 3 possible circumstances.
Working to prepare pay-off table:
Unit price $4 $4.3 $4.4
Unit variable cost ($2) ($2) ($2)
Unit contribution $2 $2.3 $2.4
Contribution (*) $ $ $
Best possible 32,000 32,200 30,000
Most likely 28,000 28,750 28,800
Worst possible 20,000 18,400 14,400
Fixed cost (20,000) (20,000) (20,000)
Profit (**) $ $ $
Best possible 12,000 12,200 10,000
Most likely 8,000 8,750 8,800
Worst possible 0 (1,600) (5,600)
(*) Contribution = Unit contribution x Sales demand
(**) Profit = Contribution - Fixed costs
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Example 2 (Answer)

We have pay-off table as follows:

Pricing

$4 $4.3 $4.4

Circumstances
(expected profit)

Best possible 12,000 12,200 10,000

Most likely 8,000 8,750 8,800

Worst possible 0 (1,600) (5,600)

It is obvious that only when selling price of $4 guarantees that SAP Co would not
make a loss, even if the worst possible outcome occurs.
Therefore, a risk averse might prefer a price of $4.
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In order to make a decision, a decision-maker might base on 4 below rules:

(1) Expected value
(2) Maximin rule
(3) Maximax rule
(4) Minimax regret rule

The expected value (EV) of the outcome can be calculated simply by multiplying the
value associated with each potential outcome by its probability.

Rule to make decision: The decision option with the highest EV of benefit or the lowest
EV of cost should be selected.

BENEFITS LIMITATIONS
• EV is a weighted average outcome,
• Easy to understand and calculate
so it could never occur
• Takes uncertainty into account by • EV is an average value, it ignores the
considering the probability of each extreme outcomes, so this might be
possible outcome and using this suitable for risk neutral
information to calculate an expected • EV is a long-term average, so will
value not be reached in the short term
and is therefore not suitable for one
off decisions
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Example 3 (Question)

Suppose a manager has to choose between mutually exclusive options A and B,

and the probable outcomes of each option are as follows.
Project A Project B
Profit Profit
Probability Probability
($) ($)
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000

Required: Which of the project is chosen under expected value?

Example 3 (Answer)

EV of each project is calculated as follows:

• EV(A) = 0.8 x 5,000 + 0.2 x 6,000 = $5,200

• EV(B) = 0.1 x (2,000) + 0.2 x 5,000 + 0.6 x 7,000 + 0.1 x 8,000 = $5,800

As EV is based on the profit and EV(B) > EV(A), so project B should be chosen.
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Maximin means maximise the minimum achievable profit.

Rule to make decision: Decision-maker should select offer that maximises the minimum
profits.

Three steps to carry out:

Step 1
Draw the payoff table

Step 2
Choose minimum payoffs of all decisions

Step 3
Choose the maximum of all the payoffs chosen in Step 2
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Example 4 (Question)

Suppose that a manager is trying to decide which of three mutually exclusive

projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Net profit if outcome turns out to be
Project I II III
A $50,000 $65,000 $80,000
B $70,000 $60,000 $75,000
C $90,000 $80,000 $55,000
Probability 0.2 0.6 0.2

Required: Which project would be chosen under maximin rule?

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Example 4 (Answer)

Step 1: Draw the payoff table (per question)

I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000
Step 2: Choose minimum payoffs of all decisions
For each project (each decision), we need choose minimum outcome
I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000
Step 3: Choose the maximum of all the payoffs chosen in Step 2
The maximum of minimum profit is $60,000. Thus, project B should be chosen.

Note: Assess maximin rule

• This rule does not consider the probability of each outcome occurring
• This rule is conservative but does not try to maximise profit, so it is suitable
for risk averse
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Maximax means maximise the maximum achievable profit.

Rule to make decision: Decision-maker should select offer that maximises the
maximum profits.

Three steps to carry out:

Step 1
Draw the payoff table

Step 2
Choose maximum payoffs of all decisions

Step 3
Choose the maximum of all the payoffs chosen in Step 2
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Example 5 (Example 4 - Question)

Suppose that a manager is trying to decide which of three mutually exclusive

projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Net profit if outcome turns out to be
Project I II III
A $50,000 $65,000 $80,000
B $70,000 $60,000 $75,000
C $90,000 $80,000 $55,000
Probability 0.2 0.6 0.2

Required: Which project would be chosen under maximax rule?

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Example 5 (Answer)

Step 1: Draw the payoff table

It is the same as step 1 of maximin rule
I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000
Step 2: Choose maximum payoffs of all decisions
For each project (each decision), we need choose maximum outcome
I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000
Step 3: Choose the maximum of all the payoffs chosen in Step 2
The maximum of maximum profit is $90,000. Thus, project C should be chosen.

Note: Assess maximax rule

• This rule does not consider the probability of each outcome occurring
• This rule is overly optimistic but does not care for risk, so it is suitable for
risk seeker
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Minimax regret means minimise the maximum potential regret.

Rule to make decision:

• This approach attempts to minimise the regret from making the wrong decision.
• Regret is the opportunity lost through making the wrong decision.

Three steps to carry out:

Step 1
Draw the regret payoff table
Regret for the decision option = Profit from the best decision option - Profit
from the decision option, given the outcome circumstances or situation

Step 2
Choose the maximum payoffs of all decisions

Step 3
Choose the minimum of all the payoffs chosen in Step 2
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Example 6 (Example 4 - Question)

Suppose that a manager is trying to decide which of three mutually exclusive

projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Net profit if outcome turns out to be
Project I II III
A $50,000 $65,000 $80,000
B $70,000 $60,000 $75,000
C $90,000 $80,000 $55,000
Probability 0.2 0.6 0.2

Required: Which project would be chosen under minimax regret rule?

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Example 6 (Answer)

Step 1: Draw the regret payoff table

Regret = Profit from the best decision option - Profit from the decision option
Steps to identify regret payoff as below:
1.1 Draw a payoff table (per question)
I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000

1.2 Identify profit from the best decision option, given each circumstance
I II III
Project A $50,000 $65,000 $80,000
Project B $70,000 $60,000 $75,000
Project C $90,000 $80,000 $55,000

1.3 Calculate regret

If outcome 1 arises, the best profit ($90,000) is obtained from project C:
- Regret if company choose project C = 0
- Regret if company choose project B = 90,000 – 70,000 = $20,000
- Regret if company choose project A = 90,000 – 50,000 = $40,000
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Example 6 (Answer)

Step 1: Draw the regret payoff table

We then apply the same approach if outcome II & III arise, which results in this
regret table below:
I II III
Project A $40,000 $15,000 $0
Project B $20,000 $20,000 $5,000
Project C $0 $0 $25,000

Step 2: Choose the maximum regret payoffs of all decisions

For each project (each decision), we need choose maximum outcome
I II III
Project A $40,000 $15,000 $0
Project B $20,000 $20,000 $5,000
Project C $0 $0 $25,000

Step 3: Choose the minimum of all the payoffs chosen in Step 2

The minimum of maximum regret is $20,000. Thus, project B should be chosen as
it leads to lowest regret in the worst circumstances.
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In many cases, in order to make a final decision, the manager needs to go through several
stages. Each stage will have corresponding possibilities and outputs to choose.
Therefore, decision trees were born.

Decision trees are diagrams which illustrate the choices and possible outcomes of a
decision.

A decision tree is drawn from left to right. Guidance to draw a decision tree:
• Start with a square which is the decision point
• Draw subsidiary branches which are decision options
• Draw circles which are outcome points

Then, decision maker considers possible outcomes illustrated in the decision tree and use
rules mentioned in part III Rules to make decisions to make final decision.
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Example 7 (Question)

SAP Co considers launching a new product to the market. The information related
to the new product is as follows:
• Unit selling price could be $14 or $18
• In case, unit selling price is $18, SAP Co could sell 8,000 units. Unit cost is
either $10 or $11 with probabilities of 0.4 and 0.6.
• If selling price $14/unit, either 10,000 units or 15,000 units could be sold
with probabilities of 0.8 and 0.2. Unit cost is $6 or $8 with probabilities of 0.7
and 0.3.

Required: Draw a decision tree and what is the decision under EV rule?
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Example 7 (Answer)
Decision tree could be prepared as follows: Cost $6/unit
0.7
Sell 10.000 units
D
0.8
Cost $8/unit
Sell 0.3
B
$14/unit
Cost $6/unit
0.7
Sell 15.000 units
0.2 D
Launch Cost $8/unit
A
to market 0.3
Cost $10/unit
Decision 0.4
Sell Sell 8.000 units
Do not C E
launch $18/unit
Cost $11/unit
0.6
Expected value outcome at each point:
• Cost at point D: $6 x 0.7 + $8 x 0.3 = $6.6
• Cost at point E: $10 x 0.4 + $11 x 0.6 = $10.6
• Profit at point B: (10,000 x 0.8 + 15,000 x 0.2) x ($14 - $6.6) = $81,400
• Profit at point C: 8,000 x ($18 - $10.6) = $59,200

Therefore, there are 3 possible outcomes which needs to be considered:

• Launch the new product and sell at $14/unit to make a profit of $81,400
• Launch the new product and sell at $18/unit to make a profit of $59,200
• Do not launch the new product to not care about profit or loss
Under EV rule, SAP Co should select option that maximises the profits.
Thus, SAP Co should launch the new product and sell at $14/unit.
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Sensitivity analysis is a term used to describe any technique whereby decision options
are tested for their vulnerability to changes in any ‘variable’, such as expected sales
volume, sales price per unit, material costs and labour costs.

There are 2 approaches to sensitivity analysis:

• Calculating the maximum percentage change in a variable before the decision would
change
• Assessing if the decision would change if a variable changed by x% of estimate

Thanks to which, sensitivity analysis concentrates management attention on variables

that are the most important for the decision under review.
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Example 8 (Question)

SAP Co has estimated the following sales and profits for a new product which it
may launch on to the market.
$ $
Sales (2,000 units) 4,000
Variable costs: Materials 2,000
Labour 1,000
(3,000)
Contribution 1,000
Incremental fixed costs (800)
Profit 200

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

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Example 8 (Answer)

• Sensitivity of the project to the fixed costs: 200/800x100% = 25%

It means that if fixed costs increase more than 25% estimate, the project would
be loss

• Sensitivity of the project to materials: 200/2,000x100% = 10%

It means that if material costs increase more than 10% estimate, the project
would be loss

• Sensitivity of the project to labour costs: 200/1,000x100% = 20%

It means that if labour costs increase more than 20% estimate, the project would
be loss

• Sensitivity of the project to selling price, assuming that there is no change in

sales volume: 200/4,000x100% = 5%
It means that if selling price decreases more 5% estimate, the project would be
loss.
It is obvious that profitability is most sensitive in this example are the selling price
(5%) and material costs (10%). SAP Co shoud concentrate on these factors.
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Therefore, using sensitivity analysis has the following benefits and limitations:

Easy to understand

Highlight key variables which are crucial to the success of

BENEFITS the project, once identified these can be closely
monitored

It is unrealistic to assume that all changes are independent

Does not offer a clear decision rule, so appropriate

LIMITATIONS
management judgement is still required
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Perfect information is information that predicts with 100% accuracy what the outcome
situation will be.
Having perfect information removes all doubt and uncertainty from a decision, and
enables managers to make decisions with complete confidence that they have selected
the best decision option.

Value of perfect information is the difference between the EV of profit with perfect
information and the EV of profit with the information.

Three steps to determine value of perfect information:

Step 1
Determine expected value when having no perfect information (EV1)
Choose maximum EV if profit and minimum EV if costs

Step 2
Determine expected value when having perfect information (EV2)
The best decision option will be always selected

Step 3
Determine value of perfect information (EV)
EV = EV2 - EV1
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Example 9 (Question)

The management of SAP Co must choose whether to go ahead with either of two
mutually exclusive projects, A and B. The expected profits are as follows.
Profit if there is Profit if there is Profit/(loss) if there
strong demand moderate demand is weak demand
A $4,000 $1,200 $(1,000)
B $1,500 $1,000 $500
Probability of
demand 0.2 0.3 0.5

Required: Calculate the value of perfect information about demand

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Example 9 (Answer)

Step 1: Determine expected value when having no perfect information (EV1)

As no information to check, the project with the higher EV of profit would be
selected
Project A Project B
Demand Probability
Profit ($) EV ($) Profit ($) EV ($)
Strong 0.2 4,000 800 1,500 300
Moderate 0.3 1,200 360 1,000 300
Weak 0.5 (1,000) (500) 500 250
EV 660 850
Thus, project B with EV1 of $850 would be selected.
Step 2: Determine expected value when having perfect information (EV2)
Perfect information will indicate for certain whether demand will be weak,
moderate or strong. If demand is forecast 'weak', project B would be selected. If
demand is forecast as 'moderate' or ’strong’, project A would be selected.
Demand Probability Project chosen Profit ($) EV ($)
Strong 0.2 A 4,000 800
Moderate 0.3 A 1,200 360
Weak 0.5 B 500 250
EV2 1,410
Step 3: Determine value of perfect information (EV)
EV = EV2 - EV1 = 1,410 - 850 = $560
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Imperfect information helps to predict partial outcomes.

The value of imperfect information is the difference between the EV of profit with
imperfect information and the EV of profit without the information.

Three steps to determine value of imperfect information:

Step 1
Determine expected value without information (EV1)
Choose maximum EV if profit and minimum EV if costs

Step 2
Determine expected value when having imperfect information (EV2)

Step 3
Determine value of imperfect information (EV)
EV = EV2 - EV1
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Example 10 (Question)

SAP Co wants 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:
Option A Option B
Weak economy $50,000 $20,000
Strong economy $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 an 90%
probability that the research would predict this correctly.
Required: Calculate the value of imperfect information about demand
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Example 10 (Answer)

Step 1: Determine expected value without information (EV1)

State of Option A Option B
Probability
economy Profit ($) EV ($) Profit ($) EV ($)
Weak 0.6 50,000 30,000 20,000 12,000
Strong 0.4 60,000 24,000 100,000 40,000
EV 54,000 52,000
As no information to check, the option with the higher EV of profit would be
selected. Thus, option A with EV1 of $54,000 would be selected.
Step 2: Determine expected value when having imperfect information (EV2)
If research information is obtained, the decision will be to select Option A if the
research indicates a weak economy and to select Option B if the research
indicates a strong economy.
Actual state Research Option
Profit ($) Probability EV ($)
of economy prediction chosen
Weak Weak A 50,000 0.6x0.8 = 0.48 24,000
Weak Strong B 20,000 0.6x0.2 = 0.12 2,400
Strong Strong B 100,000 0.4x0.9 = 0.36 36,000
Strong Weak A 60,000 0.4x0.1 = 0.04 2,400
EV2 64,800
Step 3: Determine value of imperfect information (EV)
EV = EV2 - EV1 = 64,800 - 54,000 = $10,800
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Example 10 (Answer)

Step 1: Determine expected value without information (EV1)

State of Option A Option B
Probability
economy Profit ($) EV ($) Profit ($) EV ($)
Weak 0.6 50,000 30,000 20,000 12,000
Strong 0.4 60,000 24,000 100,000 40,000
EV 54,000 52,000
As no information to check, the option with the higher EV of profit would be
selected. Thus, option A with EV1 of $54,000 would be selected.
Step 2: Determine expected value when having imperfect information (EV2)
If research information is obtained, the decision will be to select Option A if the
research indicates a weak economy and to select Option B if the research
indicates a strong economy.
Research Option Actual state of Profit
Probability EV ($)
prediction chosen economy ($)
Weak A Weak 50,000 0.6x0.8 = 0.48 24,000
Weak A Strong 60,000 0.6x0.2 = 0.12 7,200
Strong B Strong 100,000 0.4x0.9 = 0.36 36,000
Strong B Weak 20,000 0.4x0.1 = 0.04 800
EV2 68,000

Step 3: Determine value of imperfect information (EV)

EV = EV2 - EV1 = 68,000 - 54,000 = $14,000
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CHAPTER 9:
BUDGETARY SYSTEMS
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Budgetary systems

I. Objectives of budgeting systems

II. The planning and control cycle

III. Planning and control in performance hierarchy

IV. Other aspects of budget preparation

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

7 objectives of budgeting systems:

Ensure the achievement of the organisation's objectives

Objectives of budgeting systems

Compel planning

Communicate ideas and plans

Co-ordinate activities

Provide a framework for responsibility accounting

Establish a system of control

Motivate employees to improve their performance

Notes: Distinguish a budget and a forecast:

• A budget is a plan of what to achieve and what it has set as a target
• A forecast is an estimate of what is likely to occur in the future
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7 steps of budgeting systems:

Step 1 Identify objectives

• Objectives should be met 5 factors 'SMART’.
(Specific, Measurable, Attainable, Relevant and Time limit)

Step 2 Determine strategies to achieve the objectives

• Gather information internally to find out what resources it
possesses (strengths & weakness).
• Gather information externally to assess its position in the
environment (threats & opportunities).

Step 3 Evaluate strategies

• The strategies must then be evaluated in terms of suitability,
feasibility and acceptability.

Step 4 Choose alternative courses of action

• Collect the chosen strategies together and co-ordinate them into
a long-term financial plan.
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7 objectives of budgeting systems:

Step 5 Implement the long-term plan

• Break the plan into smaller parts which is short-term plan or
budget.

Step 6 Measure actual results and compare with plan

• Actual results are recorded and analyzed and information about
actual results is fed back to management.

Step 7 Respond to divergences from plan

• Take control action if identifying anything has gone wrong, find
out why and correct.
• Do nothing if actual results are going better than planned.
• Alter the plan if actual results are different from the target and
nothing management can do.
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1. Planning
Planning is prepared at every performance hierarchy.

The plans made at the higher levels of the performance hierarchy provide a
framework within which the plans at the lower levels must be achieved.
The plans at the lower levels are the means by which the plans at the higher levels
are achieved.
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1. Planning
3 planning levels:

• Prepared at a strategic level by senior management.

Strategic • Focused on overall corporate performance.
plans • Environmental influence.
• Set overall plans and targets for units and departments.

• Prepared at lower management level, within guidelines set by

senior management.
• Time horizon typically 12 months.
Tactical
• Plans for individual departments or activities.
plans
• Provides a link between strategic plans at senior level and
operational planning.
• Budget targets should be consistent with strategic objectives.

• Prepared by managers at a fairly junior level.

• Based on objectives about 'what' to achieve in operational terms
and 'how’ something is achieved.
Operational
• Short time horizons.
plans
• Detailed specifications of targets and standards.
• Operational plans should be prepared that enable budget targets
to be achieved.
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1. Planning

Example 1:

SAP Co is an exporter of Vietnamese agricultural products. They plan for next 5-

year. Details are as follows:
• Strategic plan: Become the 3rd exporter in Vietnam, annual revenue growth
rate must be at least 6%;
• Tactical plan: New promotion campaign will be launched through online
channel;
• Operational plan: Each sales staff planned training development to improve
selling and communication skills
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2. Control
If the plan stage is to set targets, the control stage is to measure actual results against the
plan and take action to adjust actual performance to achieve the plan or to change the plan
altogether.

Feedback occurs when the results of a system are used to control it, by adjusting the
input or behaviour of the system.
Feedback is information produced as output from operations; it is used to compare
actual results with planned results for control purposes.
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2. Control
Details are as follows:

Therefore, control is impossible without planning.

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Information used in budgeting comes from a wide variety of sources. There are 2 main
sources of budget information:

Sales budget information Production budget information

Sales budget is often the primary This information will come from the
budget from which the majority of production department and a large
the other budgets are derived. They part of the traditional work of cost
include: accounting. They include:

• Past sales patterns • Labour costs: idle time, overtime

• The economic environment and standard output rates per
• Results of market research hour
• Pricing policies and discounts • Raw material costs: allowances
offered for losses during production
• Competition • Machine hours: expected idle
• Anticipated advertising time and expected output rates
• Changing consumer taste per machine hour
• Distribution
• Legislation
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Example 2:

Below is production and material budgets for the month of February of a

production company:

Product Trophies is made from 2 draw materials namely Mersey and Gatt. Each
unit of Trophy contains 5 kilos of Mersey and 3 kilos of Gatt.
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An organisation wishing to change its budgetary practices will face a number of

difficulties. Details are as follows:

Difficulties Explanations

Resistance by Employees will be familiar with the current system and may have
employees built in slack so will not easily accept new targets

Management may take time to adapt to the new system and

Loss of control
understand the implications of results

Costs of Any new system or process requires careful implementation

implementation which will have cost implications namely timing, labour, capital…

In order to prepare and implement budgets under the new

Training system, managers will need to be fully trained, which requires
time consuming and expensive costs

Lack of
Information could be not available for preparing the new style
accounting
budget
information
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Budgets are estimated, so preparing a budget involves uncertainty. Detailed causes are as
follows:

Difficulties Explanations

Customers They may decide to buy less or more than forecast

Products/ In the modern business environment, requirements of customers

services to products or services could be changed rapidly

Exchange rate fluctuations can affect the cost of imported

Inflation materials, and the price that foreign customers will have to pay,
which is likely to affect demand

Materials Cost of raw materials may change unexpectedly

They may steal some of an organisation’s expected customers, or

Competitors
somecompetitors’ customers may change their buying allegiance

Employees They may not work as hard as was hoped

Machines They may break down unexpectedly

Unrest or There may be political unrest, social unrest or minor or major

disaster natural disasters
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CHAPTER 10: TYPES OF BUDGET

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Types of budget

I. Top-down and bottom-up

II. Fixed and flexible budgets

III. Rolling Budget

IV. Incremental Budget

V. Zero Based Budgeting

VI. Activity based budget

VII. Beyond Budgeting

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Top-down and bottom-up are two reverse approaches to budget preparation. Details are as follows:

Top-down budgeting Bottom-up budgeting

Budget targets are set at senior This is when the budgeting process
management level for organization as a starts at a relatively low level of
whole and for each major department management
or activity within organization

Senior management level set Lowest managers draft

a whole budget specific budgets
Definition

Departmental managers set Supervisor managers combine

departmental budgets lower-level budgets

Managers lower down to set Senior management co-ordinates

specific budget to a whole budget

• Take much less time and planning • Created based on real operation,
effort so be attainable
Advantages
• Senior management could bring a • Promote motivational advantages
strategic budget for organization as all management levels join to
prepare budget

• Budget could be not achievable • Take more time and planning effort
• This does not bring properly co-ordination • Specific budgets submitted could
Disadvantages
between levels of employee be easy to reach
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A fixed budget is a budget which remains unchanged throughout the budget period,
regardless of differences between the actual and the original planned volume of output
or sales.

Fixed budget is based on budgeted volumes and

costs/revenues and as such is often unrealistic

Major purpose of a fixed budget is for planning

and is the master budget prepared before the
beginning of the budget period
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A flexible budget is a budget which, by recognising different cost behavior patterns, is changed
as the volume of output and sales changes. It recognises cost behavior patterns such as changes
in sales revenue and variable costs as sales volumes change, and step changes in fixed costs as
activity levels rise or fall by more than a certain amount.

Example 1:

SAP Co prepared a budgeted sales revenue of $10m during the next year. Budgeted fixed and
variable costs are correspondingly $3m and $1m. At the end of the first quarter next year,
actual revenue is just $8m, fixed and variable costs are $4m and $2m respectively.

Required: What is the flexible budget?

Answer:
SAP Co could prepare flexible budget based on the comparing the rate between actual and
original fixed budget.
Fixed budget Actual Flexible budget Budget variance
($m) ($m) ($m) ($m)
(a) (b) (c) (d) = (c)-(b)
Sales
10 8 8 0
revenue
Fixed costs A
(3) (4) 1x8/10 1
(3)
Variable A
(1) (2) (0.8) 1.2
costs
Profit 6 2 4.2 2.2 A
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A flexible budget has the following advantages and disadvantages:

Advantages Disadvantages

Show different results from Take more time, money and

possible activity levels effort to prepare

Difficult to prepare exactly

Have a higher value
in advance
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A rolling budget is a budget which is continuously updated by adding a further

accounting period (a month or quarter) to the end of the budget when the
corresponding period in the current budget has ended.
As a result, a number of rolling budgets are prepared each year and each rolling budget
covers the next 12-month period.

Example 2 (Question):

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 using rolling budget.

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Example 2 (Solution):

Actual sales for January - March were $74,640 and sales growth per quarter
should be 2.5%. Thus, sales revenue for next quarters are as follows:

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

$ $ $ $ $
Sales 76,506 78,419 80,379 82,389 317,692

[74,640x102.5%] [76,506x102.5%] [78,419x102.5%] [80,379x102.5%]

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A rolling budget has the following advantages and disadvantages:

Advantages Disadvantages

Take more time, money and

Reduce uncertainty
effort to prepare

More realistic May demotivate managers

There is always a budget Put additional pressure on the

that extends into the future accounts department

Encourage managers to
think about the future

Notes: Rolling budget is suitable in case:

• Accurate forecasts cannot be made
• Any area of business that needs tight control.
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Incremental budget is a method of budgeting in which next year's budget is prepared by

using the current year's actual results as a starting point, and making adjustments for
expected inflation, sales growth or decline and other known changes.

Example 3 (Question):

SAP Co produces two products, A and C. In the last year (20X4) it produced 640
units of A and 350 units of C incurring costs of $672,000. Analysis of the costs has
shown that 75% of the total costs are variable. 60% of these variable costs vary in
line with the number of A produced and the remainder with the number of C.
The budget for the year 20X5 is now being prepared using an incremental
budgeting approach. The following additional information is available for 20X5:
• All costs will be 4% higher than the average paid in 20X4.
• Efficiency levels will remain unchanged.
• Expected output of A is 750 units and of C is 340 units
Required: What is the budgeted total variable cost of products A and C for the full
year 20X5?
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Example 3 (Solution):

In the year 20X4

Total variable costs =75% x $672,000 = $504,000
Variable costs Sales volume Unit variable cost
Product ($) (Units) ($)

A [504,000x60%] 302,400 640 472.5

C [504,000x40%] 201,600 350 576

In the year 20X5

Unit variable cost Increase rate of cost Sales volume Variable costs
Product ($) (%) (Units) ($)

A 472.5 4 750 368,550

C 576 4 340 203,674

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An incremental budgeting has the following advantages and disadvantages:

Advantages Disadvantages

Be simple, cheap and easy

inefficiencies continue
to understand

Be relatively quick to not suitable for changing

administer environments

not produce challenging

performance targets

not encourage finding ways

of improving

Notes: Incremental budget is suitable for stable businesses, where costs are not expected
to change significantly.
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Zero based budgeting (ZBB) involves preparing a budget for each cost centre or activity
from a zero base. Every item of expenditure has then to be justified in its entirety in
order to be included in the next year's budget.

Thus, ZBB rejects the assumption inherent in incremental budget that next year's budget
should be based on the current financial year results and based on the followings:

The current year's results Budget activities should be

may include wasteful reviewed and assessed
spending and inefficiencies to consider whether
they are still suitable
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3 steps to prepare a ZBB:

Step 1: Define decision packages

There are 2 types of decision packages:
• Mutually exclusive packages: contain alternative methods of
getting the same job done
• Incremental packages: divide one aspect of an activity into
different levels of effort

Step 2: Evaluate and rank each decision package

• Based on its benefit to the organisation
• Minimum work requirements and work that meets legal
obligations will be given high priority

Step 3: Allocate resources to decision packages

• According to funds available and the evaluation in Step 2

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Example 4

The head teacher of a school considers using a ZBB for the provision or facilitation
of school lunches.

Step 1: Define decision packages

• The catering manages will have the following incremental packages:
- Level 1: providing an area where students can bring their own cold food to,
with some sandwiches and other cold food and drinks being prepared and sold by
catering staff
- Level 2: providing a self-service cafeteria with hot and cold food and drinks
available
- Level 3: providing a full, hot food, catered service for pupils
• The school head, on the other hand, consider 2 mutually exclusive packages:
providing a service internally or outsourcing the whole catering activity to an
external provider
Step 2: Evaluate and rank each decision package
The catering manager will rank the numerous decision packages that he prepares.
Then, the headmaster will rank the catering packages amongst all the packages
prepared for the rest of the school.

Step 3: Allocate resources to decision packages

The resources are then allocated based on order of priority up to the spending
level.
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Using of a ZBB has following benefits and limitations:

Advantages Disadvantages

Identify/remove inefficient Time-consuming

or obsolete operations

Force employees to avoid Difficult to define decision

wasteful expenditure packages and ranking

Increase motivation of staff Detriment of long-term

benefits

Respond to changes in the

business environment

Notes: ZBB is suitable in case:

• Allocating resources in areas where spend is discretionary
• Public sector organisations such as local authorities
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Activity based budgeting (ABB) involves defining the activities that underlie the financial
figures in each function and using the level of activity to decide how much resource
should be allocated and how well it is being managed and to explain variances from
budget.

ABB focuses on 4 following principles:

Activities drive costs is managed, thanks to which, plan and control of

long-term costs will be better

Not all activities add value, so activities must be examined and split up
according to their ability to add value

Demand and decisions beyond the control of a department’s manager

drive many departmental activities

Traditional financial measures of performance are unable to fulfil the

objective of continuous improvement, so should add more measures
which focus on drivers of costs, the quality of activities undertaken and
the responsiveness to change

Notes: ABB can only be used in organisations which use Activity based costing (ABC)
• ABC is mentioned in chapter 2a Activity based costing
• A cost driver is a factor which has most influence on the cost of an activity
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Beyond budgeting is a budgeting model which proposes that traditional budgeting

should be abandoned and focus on adaptive management processes.

Beyond budgeting is based on 2 principles:

Use adaptive management processes rather than

the more rigid annual budget

• Managers should plan on a more adaptive,

rolling basis, but with the focus on cash
forecasting, rather than purely on cost control.
• Performance is monitored against world-class
benchmarks, competitors and previous periods.

Move towards devolved networks rather than

centralised hierarchies:

• The emphasis is on encouraging a culture of

personal responsibility by delegating decision-
making and performance accountability to
line managers.
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Using of beyond budgeting has following benefits and limitations:

Advantages Disadvantages

May be resistance to
Encourages innovation
change in adopting

Need to plan, even if there

Increases motivation
are lots of uncertainties

Allows faster responses to

threats and opportunities
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CHAPTER 11: QUANTITATIVE

ANALYSIS IN BUDGETING
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Types of budget

I. High-low method

II. Learning curves

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The high-low method is a quantitative technique for analysing total costs at the highest
and lowest activity levels to determine fixed cost and variable cost elements.

5 steps to conduct:

Step 1: Review records of costs in previous periods

• Select the period with the highest activity level
• Select the period with the lowest activity level

Step 2: Adjust inflation factor (if any)

Step 3: Determine variables for activity levels:

Total costs Total costs Total units Total units

at highest at lowest at highest at lowest
activity level activity level activity level activity level
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The high-low method is a quantitative technique for analysing total costs at the highest
and lowest activity levels to determine fixed cost and variable cost elements.

5 steps to conduct:

Step 4: Calculate the variable cost/unit

Total costs at highest activity level −Total costs at lowest activity level
Total units at highest activity level −Total units at lowest activity level

Step 5: Calculate the fixed cost

Total cost at highest Total units at highest Variable cost

activity level activity level per unit
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Example 1 (Question):

SAP Co wishes to develop a method of predicting its total costs in a period. The
following data have been recorded.

Activity level Cost

Month
(Units) ($)
Jan 1,600 28,200
Feb 2,300 29,600
Mar 1,900 28,800
Apr 1,800 28,600
May 1,500 28,000
Jun 1,700 28,400

Required: The total cost model for a period could be represented by what equation?
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Example 1 (Solution):

Step 1: Review records of costs in previous periods

Period with highest activity level: Feb (2,300 units)
Period with lowest activity level: May (1,500 units)

Step 2: Adjust inflation factor (if any)

The question does not mention inflation factor, so transfer step 3.

Step 3: Determine variables for activity levels:

Total costs at highest activity level: $29,600
Total costs at lowest activity level: $28,000
Total units at highest activity level: 2,300 units
Total units at lowest activity level: 1,500 units

Step 4: Calculate the variable cost/unit

Total costs at highest activity level −Total costs at lowest activity level
Total units at highest activity level −Total units at lowest activity level =
(29,600−28,000)
= $2
(2,300−1,500)

Step 5: Calculate the fixed cost

Total cost at highest activity level - (Total units at highest activity level × Variable
cost per unit) = $29,600 - (2,300x$2) = $25,000
Total costs (y) = fixed costs + Variable costs = 25,000 + 2x where x is the volume of
activity in units.
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Therefore, using the high low method has some following benefits and limitations:

Benefits Limitations

Separate total costs into Result could be not suitable

fixed and variable costs to current conditions

Results may be distorted

Easy to understand and use
due to random variations
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In practice, it is often found that the resources required to make a

product decrease as production volumes increase.

The first unit The 100th unit

of a product of a product

The workers are likely to

Economies of scale Reasons
become more efficient

Costs usually fall when Workers feel confident and

products are made on a knowledgeable about the
larger scale, such as bulk work as they gain
quantity discounts received experience. This means that
from suppliers it takes them less time to
complete the work
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Learning curve theory applies to situations where the workforce as a whole improves in
efficiency with experience.
The learning effect or learning curve effect describes the speeding up of a job with
repeated performance.

Where a learning curve applies, there is a learning rate and a learning effect.

• Learning rate is expressed as a percentage value. For example: 70% learning curve

• Learning effect is that, as the workforce learns from experience how to make the
new product, there is a big reduction in the time taken to make additional units.

The learning process starts as soon as the first unit/batch comes off the production line

The cumulative output The average time to produce a

of the product doubles unit falls buy a learning rate

The learning effect

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The below diagram shows that

When output is low, The curve becomes The curve becomes a

the learning curve flatter as cumulative straight line when the
is really steep output increases learning effect ends

Steep

Becoming flatter

Straight line
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The theory of learning curves will be applied if any or all of the following conditions satisfy:

Made largely by labour effort (rather than by a highly

mechanised process) or where labour skill is an
important factor in the production process

Brand new or relatively short lived (the learning process

does not continue indefinitely)

Complex and made in small quantities for special orders

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There are two methods that can be used to deal with a learning curve scenario:

Approaches to
learning curve

The tabular The algebraic

approach approach
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3.1 The tabular approach

The tabular approach can only be used to calculate average times when cumulative output
doubles.

Rule: Every time that cumulative output doubles the average production time is x% of
what is was before, where x is the learning rate.

Example 1 (Question):

Where an 80% learning effect occurs, the cumulative average time required per
unit of output is reduced to 80% of the previous cumulative average time when
output is doubled.
The first unit of output of a new product requires 100 hours. An 80% learning
curve applies.

Required: What is the total time to produce 8 units in total?

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3.1 The tabular approach

Example 1 (Solution):

The production times would be as follows:

Cumulative Cumulative Cumulative Incremental Incremental Time per
number of avg time per total time number of total time incremental unit
units unit (hours) (hours) units (hours) (hours)

1 100 100 - - -
2* 100x80% = 80 80x2 = 160 1 60 60
4* 80x80% = 64 64x4 = 256 2 96 48
8* 64x80% = 51.2 51.2x8 = 409.6 4 153.6 38.4

(*) Output is being doubled each time.

Therefore, total time to produce 8 units is 409.6 hours

Notes: The value of b should not be rounded less than 3 decimal places.
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3.2 The algebraic approach

The learning curve formula can be used to solve all learning curve scenarios.
Learning curve formula: Y = aXb
where: Y is the cumulative average time per unit taken to produce X units
a is the time taken to produce the first unit
X is the cumulative number of units
b is the index of learning (log LR/log 2)
LR = the learning rate as a decimal
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3.2 The algebraic approach

5 steps to determine timing/ cost of the Xth unit

01
Calculate the cumulative average time per unit to
produce x units
02
Multiply the result in Step 1 by x resulting in total
time to produce x units
03
Calculate the cumulative average time per unit to
produce (x-1) units
04
Multiply the result in Step 3 by (x-1) resulting in total
time to produce (x-1) units
05
Subtract result in step 4 by step 2 to determine time
consumed to produce the Xth unit
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3.2 The algebraic approach

Example 3 (Question):
Suppose that an 80% learning curve applies to production of a new product item
ABC. Up to now, 30 units of ABC have been produced. The time to make the very
first unit of ABC in January was 120 hours.

Required: Calculate the time required to make the 31st unit?

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3.2 The algebraic approach

Example 3 (Solution):
Step 1: Calculate the cumulative average time per unit to produce 31 units
Apply learning curve formula: Y = aXb
Where: a = 120
X = 31
b = log 0.8/ log 2 = - 0.3219281
So, Y (31) = 120 x 31-0.3219281 = 39.726 hours
Step 2: Multiply the result in Step 1 by 31 resulting in total time to produce 31 units
31 x 39.726 = 1,231.51 hours
Step 3: Calculate the cumulative average time per unit to produce 30 units
Y (30) = 120 x 30-0.3219281 = 40.147 hours
Step 4: Multiply the result in Step 3 by 30 resulting in total time to produce 30 units
30 x 40.147 = 1,204.41 hours
Step 5: Subtract result in step 4 by step 2 to determine time consumed to produce the 31st unit
1,231.51 - 1,204.41 = 27.1 hours

Notes:
The labour costs could be calculated by applying the labour hour rate to the number of
labour hours
Material costs is not affected by the learning effect.
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3.2 The algebraic approach

Example 4 (Solution):
Using example 3 again
Assuming that the budgeted production unit is five units next month and the labour cost is $10
per hour
Required: Calculate the budgeted total labour cost next month

Answer:
Cummulative average time per unit to produce 35 units:
Y (35) = 120 x 35-0.3219281
= 38.203 hours
Time to produce the first 35 units = 35 * 38.203 = 1,337.10 hours
Time to produce 5 units next month = 1,337.10 – 1,204.41 = 132.69 hours
Budgeted labour costs next month = 132.69 * $10 = $1,326.90
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Using learning curves has some following benefits and limitations:

Advantages Disadvantages

Help management has a Learning curve phenomenon

comprehensive view in is not always present
budget preparation
Stable conditions at work is
not always practicable

Difficult to determine
learning rate

Takes long time to emerge

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CHAPTER 12: BUDGETING

AND STANDARD COSTING
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Budgeting and standard costing

I. Standard cost

II. Flexible budgets

III. Principles of controllability

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A standard cost is an estimated unit cost.

Example
$/unit
Direct costs:
Direct materials [5 kg @ $3/kg] 15
Direct labour [3 hrs @ $6/hr] 18
33
Indirect costs:
Variable overheads 2
Fixed overheads 3
Full production costs 38

Standard costing involves the establishment of predetermined estimates of the costs of

products or services, the collection of actual costs and the comparison of the actual
costs with the predetermined estimates.
The predetermined costs are known as standard costs and the difference between
standard and actual cost is known as a variance.
The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
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Standard costing has 3 main uses:

Uses of standard costing Explanations

To value inventories It is an alternative to FIFO and average cost

When a standard per unit of product has

To budget production costs been established, budgeting production costs
becomes a fairly straightforward process

Compare actual costs with the expected

To control budget costs to understand existed variances and
find out solutions to proceed on time

Suited to mass production and repetitive assembly work, where large

quantities of a standard product are manufactured

Notes:
The concept of variance analysis will be mentioned in Chapter 13 Variance analysis.
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When preparing a standard cost, it is necessary to involve some aspects:

Aspect Explanations

Costs of direct materials per unit of raw material will be

estimated by the purchasing department based on:
• Purchase contracts already agreed
• Pricing discussions with regular suppliers
Material cost
• The forecast movement of prices in the market
• The availability of bulk purchase discounts
• The quality of material required by the production
departments

Direct labour rates per hour will be set based on:

• Payroll
Labour cost
• Any agreements on pay rises with trade union
representatives of the employees

Material usage Technical specifications must be prepared for each

and labour product by production experts (either in the production
efficiency department or the work study department)
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When preparing a standard cost, it is necessary to involve some aspects:

Aspect Explanations

Standard selling price will depend on several factors:

• Anticipated market demand
• Competing products
Sale price
• Manufacturing costs
and margin
• Inflation estimates
Standard sales margin is the difference between the
standard cost and the standard selling price.

The absorption rate of fixed production overheads will

Overheads be predetermined and based on budgeted fixed
production overhead and planned production volume
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There are 4 types of standards:

Impact on
Type Definition Advantage Disadvantage behavior of
employees

A standard which can be Be high standard Be not able to Employees may feel
Ideal standard

attained under perfect and perfect goal achieve that the goals are
operating conditions: no to toward unattainable and so
wastage, no inefficiency, they will not work so
no idle time, no hard
breakdowns

A standard which can be Can be used for Take more time Be an incentive to
attained if production is many purposes and resources work harder as
Attainable standard

carried out efficiently, namely they provide a

machines are properly production, cost realistic but
operated and/or and budget challenging target
materials are properly setting, so it is of efficiency
used. Some allowance is most often used
made for wastage and in practice
inefficiencies
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There are 4 types of standards:

Impact on
Type Definition Advantage Disadvantage behavior of
employees

A standard based on A good standard Will not create Will not motivate
standard

employees to do
Current

current working to budget as motivation to

conditions (current reflects current develop anything more
wastage, current capacity than they are
inefficiencies) currently doing

A long-term standard Be suitable to Be rarely used as Be easy to achieve

which remains evaluate standards are too the standards, so
Basic standard

unchanged over the performance for a low they become

years and is used to long-term period bored and lose
show trends. interest in what
they are doing if
they have nothing
to aim for.

Notes:
It is obvious that conditions to undertake each standard decreased from ideal standard
(under perfect operating conditions) to basic standard (basic conditions). Therefore, the
target results would be reduced respectively.
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Similarity between budgets and standards costing

Both budgets and standards involve looking to the future and forecasting what is
likely to happen given a certain set of circumstances and used for control purposes.

3 important differences are as follows:

Budgets costing Standard costing

Gives planned total

Shows the unit resource
aggregate costs for a
usage for a single task
function or cost centre

Limited to situations
Can be prepared for all
where repetitive actions
functions, even where
are performed and
output cannot be measured
output can be measured

Financial and
Financial targets
non-financial targets
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A flexible budget is a budget which, by recognising different cost behaviour patterns,

changes as volume of activity (output and sales) changes.

2 steps to prepare a flexible budget:

01 02

Produce a flexible
Identify fixed and budget using
variable costs marginal costing
techniques
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Example 1 (Question):

SAP has prepared a below budget for next month:

$m
Revenue 10
Costs:
Fixed costs 3
Variable costs 1
Profit 6
Up to the year end, actual revenue is just $8m, fixed and variable costs are $4m and
$2m respectively.

Required: Prepare a flexible budget and budgetary control analysis.

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Example 1 (Solution):

Step 1: Identify fixed and variable costs

Fixed costs: not affected by revenue fluctuation, so it is the same fixed budget
and is $3m
Variable costs: change based on revenue fluctuation as a rate of $1 variable costs
and $10 revenue
Step 2: Produce a flexible budget using marginal costing techniques
As mentioned in step 1, flexible budget is as follows:
$m
Revenue 8
Costs:
Fixed costs 3
Variable costs [1/10x8] 0.8
Profit 4.2
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Example 1 (Solution):

Budgetary control analysis is as follows:

Fixed budget Actual results Flexible budget Budget variance

$m $m $m $m
(a) (b) (c) (d) = (c)-(b)
Revenue 10 8 8 0
Fixed costs 3 4 3 1 A
Variable costs 1 2 0.8 1.2 A
Profit 6 2 4.2 2.2 A
A is an adverse or unfavourable variance.
See that in order to create $8m of revenue, the expected profit should not have
been the fixed budget profit of $6m, but the flexible budget profit of $4.2m.
Instead, actual profit was $2m that is lower $2.2m than we should have
expected. The main reason is that fixed and variable costs were higher than
expected $1m and $1.2m respectively.

Notes:
We studied the basic content of flexible budget in Chapter 10 Types of budget. In this
chapter, how to prepare and use a flexible budget are mentioned. The comparison of a
fixed budget with the actual results for a different level of activity is rarely used for
control purposes. Flexible budgets should be used to show what cost and revenues
should have been for the actual level of activity.
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Budgetary control is based around a system of budget centres. Each budget centre will
have its own budget and a manager will be responsible for managing the budget centre
and ensuring that the budget is met.
Thus, the selection of budget centres in an organisation is a key first step in setting up a
control system.

In order to ensure effectively, the control system needs 3 following features:

There is a Identify clearly Identify clearly

clear hierarchy of responsibilities responsibilities for
budget centres for achieving revenues, costs and
budget targets capital employed

Therefore, budgetary control and budget centres are part of the overall system of
responsibility accounting within an organization.

Responsibility accounting is a system of accounting that segregates revenue and costs

into areas of personal responsibility in order to monitor and assess the performance of
each part of an organization.
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Controllable costs are items of expenditure which can be directly influenced by a given
manager within a given time span.

Manager should distinguish between controllable costs and uncontrollable costs to aim
controls because of the followings:

A cost which is not A cost which is not

controllable by a junior controllable by a manager in
manager might be controllable one department may be
by a senior manager controllable by a manager in
another department
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Some costs should be specially cared:

Fixed costs Apportioned costs

It is not correct that all fixed costs are Managers should be held accountable
non-controllable in the short run for costs which they can control.

Committed fixed costs are costs Managers have no control.

to support the long-term needs Example, apportioned rent and
of the business and committed rates costs would not be
to by longer-term decisions controllable by the production
affecting longer-term needs. department manager

Discretionary fixed costs are Managers have some influence.

costs incurred as a result of a top Example, costs of raw materials
management decision but could might be the responsibility of the
be raised or lowered at fairly purchasing manager (prices) and
short notice. the production manager (usage)

Notes:
There is no clear rules to determine controllable and uncontrollable costs. In the exam, it
is important to consider carefully the given information and its behavioural impact.
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CHAPTER 13:
VARIANCE ANALYSIS
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Budgeting and standard costing

Sales variance

Material variances
Basic variances
Labour variances

Overhead variances

Under absorption costing

Operating
statements
Under marginal costing

Indicating factors
Variance analysis Investigating
variances
Investigation models

Materials mix Materials mix variance

and yield
variances Material yield variance

Sales mix and Sales mix variance

quantity
variances Sales quantity variance
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In order to understand basic variances, you need to understand the basic variances
brought forward from your earlier studies.

Terminologies Definitions

is the difference between an actual result and an

expected result. In standard costing, cost variances
Variance
are the difference between the standard costs and
actual costs of units produced.

is the process by which the total difference between

Variance analysis
standard and actual results is analysed.

Favourable variance (F) when actual results are better than expected results

Adverse variance (A) when actual results are worse than expected results
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Basic variances can be calculated for:

Sales
variances

Material variances
Basic
variances
Costs
Labor variances
variances

Overhead Variable overheads

variances Fixed overheads
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2.1 Sales variances

The sales variance is the monetary difference between actual and budgeted sales.
The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what the
sales revenue should have been for the actual quantity sold, and what it was.
The sales volume variance is the difference between the actual units sold and the
budgeted (planned) quantity, valued at the standard profit per unit. In other words, it
measures the increase or decrease in standard profit as a result of the sales volume
being higher or lower than budgeted.

Sales
Selling price Sales volume
revenue

Sales Selling price Sales volume

variance variance variance
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2.1 Sales variances

Sales
variance
Selling price variance Sale volume variance

Actual sales Actual sale Actual sales Budgeted sales

volume volume volume volume

Actual sales Standard sales Standard Standard

price price Margin (*) Margin (*)

(*) In which:

Contribution per unit (marginal costing)

Margin
Profit per unit (absorption costing)
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2.1 Sales variances

Example 1 (Question):

Jasper Co has the following budget and actual figures for 20X4.

Budget/standard Actual
Sales volume 600 620
Selling price per unit $30 $29

Standard full cost of production = $28 per unit.

Required:
Calculate the selling price variance and the sales volume profit variance.
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2.1 Sales variances

Example 1 (Solution):

Selling price variance Sales volume variance

Actual sales price $29 Actual sales volume 620 units

Standard sales price $30 Budgeted sales volume 600 units

$1 (A) Sales volume variance in units 20 units (F)

Actual sale volume 620 units Standard profit margin ($30 – $28) $2

Selling price variance $620 (A) Sales volume profit variance $40 (F)

Sales variance in this case = 620 (A) + 40 (F) = 580 ($) (A)
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Causes of sales variances

Favorable Adverse

Unexpected price increase due to: Unexpected price decrease due to:
• higher than anticipated • lower than anticipated
Sales price

customer demand customer demand

• lower than anticipated demand • higher than anticipated demand
for competitor's products for competitor's products
• an improvement in quality or • a reduction in quality or
performance performance

Unexpected increase in demand Unexpected fall in demand due to:

due to: • a higher price
• a lower price • lower quality or performance of
Sales volume

• improved quality or the product

performance • an increase in quality or
• a fall in quality or performance performance of competitor's
of competitor's products products
• a successful marketing • an unsuccessful marketing
campaign campaign

Notes:
The sales price and volume variance may be linked. For example, an increase in the price
of a product will result in a favourable sales price variance but may also result in an
adverse sales volume variance, due to a fall in demand.
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2.2 Material variances

The material total variance is the difference between what the output actually cost and
what it should have cost, in terms of material. It can be subdivided into the direct
material price variance and the direct material usage variance.
The material price variance is the difference between what the material did cost and
what it should have cost.
The material usage variance is the difference between the standard cost of the material
that should have been used and the standard cost of the material that was used.

Material cost Material price Material usage

Material Material price Material usage

variance variance variance
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2.2 Material variances

Price variance Usage variance

Actual quantity Actual quantity Actual quantity Standard

usage usage usage quantity usage

Actual price Standard price Standard price Standard price

Material total variance

Actual quantity usage Standard quantity usage

Actual price Standard price

Actual Standard
material costs material cost
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2.2 Material variances

Example 2 (Question):

Product X has a standard direct material cost as follows.

10 kilograms of material Y at $10 per kilogram = $100 per unit of X.
During period 4, 1,000 units of X were manufactured, using 11,700 kilograms of
material Y which cost $98,600.

Required:
Calculate the following variances.
(a) The material total variance
(b) The material price variance
(c) The material usage variance
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2.2 Material variances

Example 2 (Solution):

(a) The direct material total variance

This is the difference between what 1,000 units should have cost and what they
did cost.
Actual material cost $98,600
Standard material cost 1,000 units × $100 $100,000
$1,400 (F)
The variance is favourable because the units cost less than they should have cost.

(b) The material price variance

This is the difference between what 11,700 kg should have cost and what 11,700
kg did cost.

Actual price $98,600/11,700kg $8.42

Standard price $10
$1.58 (F)
Actual quantity usage 1,000 units × 10kg 11,700 kg
Material price variance $1.57 × 11,700kg $18,400 (F)
The variance is favourable because the material cost less than it should have.
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2.2 Material variances

Example 2 (Solution):

(c) The direct material usage variance

This is the difference between how many kilograms of Y should have been used
to produce 1,000 units of X and how many kilograms were used, valued at the
standard cost per kilogram.

Actual quantity usage 11,700 kg

Standard quantity usage 1,000 units × 10kg 10,000 kg
1,700 kg (A)
Standard price per kilogram $10
Material price variance $10 × 1,700kg $17,000 (A)
The variance is adverse because more material was used than should have been.

Summary

Price variance $18,400 (F)

Usage variance $17,000 (A)

Total variance $1,400 (F)

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2.2 Material variances

Causes of material variances

Favorable Adverse

• Poorer quality materials • Higher quality materials

Material price

• Discounts given for buying in • Change to a more expensive

bulk supplier
• Change to a cheaper supplier • Unexpected price increase
• Incorrect budgeting encountered
• Incorrect budgeting

• Higher quality materials • Poorer quality materials

Material usage

• More efficient use of material • Less experienced staff using

• Change in product specification more materials
• Incorrect budgeting • Change in product specification
• Incorrect budgeting

Notes:
The material price variance and the material usage variance may be linked. For example,
the purchase of poorer quality materials may result in a favourable price variance but an
adverse usage variance.
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2.3 Labour variances

The labour total variance is the difference between what the output should have cost
and what it did cost, in terms of labour. It can be subdivided into the labour rate
variance and the labour efficiency variance.
The labour rate variance is the difference between what the labour did cost and what it
should have cost.
The labour efficiency variance is the difference between the standard cost of the hours
that should have been worked and the standard cost of the hours that were worked.

Labour cost Labour rate Labour hour

Total labour Labour rate Labour effiency

variance variance variance
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2.3 Labour variances

Labour rate variance Labour efficiency variance

Actual hour Actual hour Actual hour Standard hour

Actual rate Standard rate Standard rate Standard rate

Total labour variance

Actual hour Standard hour

Actual rate Standard rate

Actual Standard
labour cost labour costs
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2.3 Labour variances

Example 3 (Question):

The standard direct labour cost of product X is as follows.

2 hours of grade Z labour at $5 per hour = $10 per unit of product X.
During period 4, 1,000 units of product X were made, and the direct labour cost
of grade Z 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
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2.3 Labour variances

Example 3 (Solution):

(a) The direct labour total variance

This is the difference between what 1,000 units should have cost and what they
did cost.
Actual labour cost $8,900
Standard labour cost $10,000
$1,100 (F)
The variance is favourable because the units cost less than they should have done.

(b) The labour rate variance

This is the difference between what 2,300 hours should have cost and what 2,300
hours did cost.
Actual rate $8,900/2,300 hours $3.87
Standard rate $5
$1.13 (F)
Actual labour hours 2,300 hours
Labour rate variance $1.13 × 2,300 hours $2,600 (F)

The variance is favourable because the labour cost less than it should have.
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2.3 Labour variances

Example 3 (Solution):

(c) The labour efficiency variance

Standard labour hours 1,000 units × 2 hours 2,000 hours

Actual labour hours 2,300 hours
300 hours (A)
Standard rate per hours $5
Labour efficiency variance $5 × 300 hours $1,500 (A)

The variance is adverse because more hours were worked than should have been
worked.

Summary

Labour rate variance $2,600 (F)

Labour efficiency variance $1,500 (A)

Total labour variance $1,100 (F)

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2.3 Labour variances

Causes of labour variances

Favorable Adverse

• Lower skilled staff • Higher skilled staff

Labour rate

• Cut in overtime/ bonus • Increase in overtime/bonus

• Incorrect budgeting • Incorrect budgeting
• Unforeseen wage increase
Labour efficiency

• Higher skilled staff • Lower skilled staff

• Improved staff motivation • Fall in staff motivation
• Incorrect budgeting • Incorrect budgeting

Notes:
The labour rate variance and the labour efficiency variance may be linked. For example,
employing more highly skilled labour may result in an adverse rate variance but a
favourable efficiency variance.
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2.4 Overhead variances

Overhead
variance

Variable overhead variances Fixed overhead variances

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2.4.1 Variable overhead variances

The variable production overhead total variance is the difference between what the
output should have cost and what it did cost, in terms of variable production overhead.
It can be subdivided into the variable production overhead expenditure variance and the
variable production overhead efficiency variance (based on actual hours).
The variable production overhead expenditure variance is the difference between the
amount of variable production overhead that should have been incurred in the actual
hours actively worked and the actual amount of variable production overhead incurred.
The variable production overhead efficiency variance is the difference between the
standard cost of the hours that should have been worked for the number of units
actually produced and the standard cost of the actual number of hours worked.

Notes:
Variable overhead variances is closely similar to material/labour cost variances.
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2.4.1 Variable overhead variances

Expenditure variance Efficiency variance

Actual hour Actual hour Actual hour Standard hour

worked worked worked worked

Actual rate Standard rate Standard rate Standard rate

Total variable overhead variance

Actual hour worked Standard hour worked

Actual rate Standard rate

Actual variable Standard variable

overhead cost overhead cost
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2.4.1 Variable overhead variances

Example 3 (Question):

Suppose that the variable overhead cost of product X is as follows.

2 hours at $1.50 = $3 per unit
During period 6, 1,000 units of product X were made. The labour force worked
2,020 hours, of which 60 hours were recorded as idle time. The variable overhead
cost was $3,075.

Required:
Calculate the following variances.
(a) The variable overhead total variance
(b) The variable overhead expenditure variance
(c) The variable overhead efficiency variance
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2.4.1 Variable overhead variances

Example 3 (Solution):

(a) The variable overhead total variance

Actual variable overhead cost $3,075

Standard variable overhead cost $3,000
$75 (A)

The variance is adverse because actual variable overhead incurs more than
budgeted one.
(b) The variable overhead expenditure variance

Actual rate $3,075/(2,020 – 60) hours $1.57

Standard rate $1.5
Eliminate idle time
$0.07 (A)
Actual hours worked (2020 – 60) hours 1,960 hours
Variable overhead expenditure
$0.07 × 1,960 hours $135 (A)
variance
The variance is adverse because variable overhead incurred more than it should
have for the actual hour worked.
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2.4.1 Variable overhead variances

Example 3 (Solution):

(c) The variable overhead efficiency variance

Standard hours worked 1,000 units × 2 hours 2,000 hours
Actual hours worked (2020 hours – 60 idle hours) 1,960 hours
40 hours (F)
Standard rate per hours $1.5
Labour efficiency variance $5 × 300 hours $60 (F)
The variance is adverse because more hours were worked than should have been
Summary

The variable overhead expenditure variance $135 (A)

The variable overhead efficiency variance $60 (F)

The variable overhead total variance $75 (A)

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2.4.1 Variable overhead variances

Causes of variable overhead variances

Favorable Adverse
expenditure variance

•
Variable overhead

Unexpected increase in the cost of

• Unexpected saving in cost of services
services
• More economic use of services
• Less economic use of services
• Incorrect budgeting
• Incorrect budgeting

• As for labour efficiency • As for labour efficiency

efficiency variance
Variable overhead
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2.4.2 Fixed overhead variances

Fixed overhead total variance is the difference between fixed production overhead
incurred and fixed production overhead absorbed. In other words, it is the under- or
over-absorbed fixed production overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed
production overhead expenditure and actual fixed production overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted
production/volume multiplied by the standard absorption rate per unit.
Fixed overhead volume efficiency variance is the difference between the number of
hours that actual production should have taken and the number of hours actually taken
multiplied by the standard absorption rate per hour.
Fixed overhead volume capacity variance is the difference between budgeted hours of
work and the actual hours worked, multiplied by the standard absorption rate per hour.
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2.4.2 Fixed overhead variances

Using other overhead costing methods, fixed overhead variance is calculated by other
ways
Marginal costing system Absorption costing system

With a marginal costing profit Under absorption costing we

and loss, no overheads are use an overhead absorption rate
absorbed, the amount spent is to absorb overheads. Variances
simply written off to the income will occur if this absorption rate
statement. is incorrect.

The fixed overhead variance is The fixed overhead variance can be

the difference between what subdivided into the fixed overhead
was budgeted to be spent and expenditure variance and the fixed
what was actually spent. overhead volume variance.

Fixed overhead variance Fixed overhead variance

Expenditure variance Volume variance
Actual cost Budgeted cost
Volume Volume
capacity efficiency
variance variance
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2.4.2 Fixed overhead variances

Volume capacity Volume efficiency

variance variance

Budgeted hour Actual hour Actual hour Standard hour

Standard rate Standard rate Standard rate Standard rate

Expenditure variance Volume variance

Actual hour Budgeted hour Budgeted hour Standard hour

Actual rate Standard rate Standard rate Standard rate

Total fixed overhead variance

Actual hour Standard hour

Actual rate Standard rate

Actual fixed overhead cost Standard fixed overhead cost

Notes: Standard hours are absorbed hours of work, that means it is calculated by actual
produced units multiply standard rate (overhead absorption rate).
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2.4.2 Fixed overhead variances

These above variances can by determined by the following diagram:

Cost
$

Total Actual fixed overhead

Expenditure variance
variance Volume
variance
Budgeted fixed overhead

Budgeted Actual Number of units produced

units units
Rule:
Fixed overhead expenditure variance = the gap between Budgeted fixed overheads and
actual fixed overheads.
Fixed overhead volume variance = the gap between Point cost and budgeted fixed
overheads.
Total fixed overhead variance = the gap between Actual fixed overheads and Point cost.
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2.4.2 Fixed overhead variances

Example 3 (Question):

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 manages 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
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2.4.2 Fixed overhead variances

Example 3 (Solution):
Actual hours × standard cost per unit
(a) Fixed overhead total variance
Actual fixed overhead cost $20,450
Fixed overhead absorbed 1,100 units × $20 $22,000
Fixed overhead total variance
$1,550 (F)
(= over absorbed overhead)

The variance is favourable because less overheads incurred than budgeted.

Budgeted units × standard cost per unit

(b) Fixed overhead expenditure variance
Actual fixed overhead cost $20,450
Budgeted fixed overhead at standard rate 1,000 units × $20 $20,000
Fixed overhead expenditure variance $450 (A)

The variance is adverse because actual expenditure was greater than budgeted
expenditure.
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2.4.2 Fixed overhead variances

Example 3 (Solution):

(c) Fixed overhead volume variance

The production volume achieved was greater than expected. The fixed overhead
volume variance measures the difference at the standard rate.

Budgeted fixed overhead at standard rate $20,000

Fixed overhead absorbed 1,100 units × $20 $22,000
Fixed overhead volume variance $2,000 (F)

The variance is favourable because output was greater than expected.

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2.4.2 Fixed overhead variances

Example 3 (Solution):

(d) Fixed overhead volume capacity variance

The volume capacity variance is the difference between the initial budgeted hours
of work and the actual active hours of work (excluding any idle time).
Budgeted units × standard rate

Budgeted hours of work 1,000 units × 5 hours 5,000 hours

Actual hours of work 5,400 hours

Fixed overhead volume capacity variance

400 hours (F)
in hour

Standard fixed overhead absorption rate

$4
per hour

Fixed overhead volume capacity variance $4 × 400 hours $1,600 (F)

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2.4.2 Fixed overhead variances

Example 3 (Solution):

(e) Fixed overhead volume efficiency variance

The volume capacity variance is the difference between the budgeted hours of work
for the actual production volume and the actual active hours of work (excluding any
idle time).
Actual units × standard rate
Actual hours of work 5,400 hours
Standard hours of work 1,100 units × 5 hours 5,500 hours
Fixed overhead volume efficiency
100 hours (F)
variance in hour
Standard fixed overhead absorption
$4
rate per hour
Fixed overhead volume efficiency
$4 × 100 hours $400 (F)
variance
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2.4.2 Fixed overhead variances

Example 3 (Solution):

The variances may be summarised as follows

Overhead variance
$1,550 (F)

Expenditure variance Volume variance

$450 (A) $2,000 (F)

Volume Volume
capacity efficiency
variance variance
$1,600 (F) $400 (F)
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2.4.2 Fixed overhead variances

Causes of fixed overhead variances

Favorable Adverse

Fixed • Decrease in price • Increase in price

overhead
expenditure • Seasonal effects • Seasonal effects

• Increase in production • Decrease in production

volume volume
Fixed
overhead • Increase in demand • Decrease in demand
volume • Change is productivity of • Production lost through
labour strikes

Fixed overhead • Hours worked higher • Hours worked lower

volume
capacity than budget than budget

Fixed
overhead
volume • As for labour efficiency • As for labour efficiency
efficiency
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2.5 Labour idle time

Idle time occurs when employees are paid for time when they are not working

Machine breakdown Low demand Stockouts

Idle time Actual hours paid Actual hours worked

Idle time variance Idle time Standard rate

Idle time variance is always an adverse variance (A)

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Operating statements (also called statement of variances) show how the combination
of variances reconcile budgeted profit and actual profit.

There are several ways in which an operating statement may be presented. Perhaps the
most common format is one which reconciles budgeted profit to actual profit.

OPERATING STATEMENT

Under absorption costing Under marginal costing

Identifying the different effects of The operating statement under

each item of cost/income on profit marginal costing is the same as that
compared to the expected profit as under absorption costing except:
following. • A sales volume contribution
• Sales variances are reported variance is included instead of
first a sales volume profit variance
• the total of the budgeted profit • The only fixed overhead
and the two sales variances variance is the expenditure
results in a figure for 'actual variances
sales minus the standard cost • The reconciliation is from
of sales’ budgeted to actual
• The cost variances are then contribution then fixed
reported, and an actual profit overheads are deducted to
calculated. arrive at a profit.
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Here is a proforma for an operating statement under standard absorption costing.

Sales $ $ $
Budgeted profit X
Sales volume profit variance X
Standard profit from actual sales X

Variances (F) (A)

Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
X X X
Actual profit
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Example 5 (Question): Operating statement under absorption costing

Sydney manufactures one product, and the entire product is sold as soon as it is
produced. There are no opening or closing inventories and work in progress is
negligible. The company operates a standard costing system and analysis of variances
is made every month. The standard cost card for the product, a boomerang, is as
follows.
STANDARD COST CARD – BOOMERANG
$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00
Budgeted (planned) output for the month of June 20X7 was 5,100 units.
Actual results for June 20X7 were as follows.
• Production of 4,850 units was sold for $95,600.
• Materials consumed in production amounted to 2,300 kg at a total cost of $9,800.
• Labour hours paid for amounted to 8,500 hours at a cost of $16,800.
• Actual operating hours amounted to 8,000 hours.
• Variable overheads amounted to $2,600.
• Fixed overheads amounted to $42,300.
Required: Calculate all variances and prepare an operating statement for the month
ended 30 June 20X7.
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Example 5 (Solution): Operating statement under absorption costing

Budgeted (planned) sale volume: 5,100 units

Actual results summary
Units/kg/hours $
Sales 4,850 95,600
Direct materials 2,300 9,800
Direct labour 8,000 16,800
Variable overheads 2,600
Fixed overhead 42,300
500 hours is idle time
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Example 5 (Solution): Operating statement under absorption costing

SYDNEY – OPERATING STATEMENT JUNE 20X7

Sales $ $ $
Budgeted profit 30,600
Sales volume profit variance (2) 1,500 (A)
Standard profit from actual sales 29,100

Variances F A
Sales price (1) 1,400
Material price (3) 600
Material usage (4) 500
Labour rate (5) 200
Labour efficiency (6) 3,400
Labour idle time (7) 1,000
Variable overhead expenditure (8) 200
Variable overhead efficiency (9) 510
Fixed overhead expenditure (10) 4,560
Fixed overhead volume capacity
6,290
(11)
Fixed overhead volume efficiency
8,140
(12)
10,900 15,900 5,000 (A)
Actual profit 24,100
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Example 5 (Solution): Operating statement under absorption costing

Notice: This is a rounded figure, you

should use the figure appears on the
calculator screen to avoid arithmetic error
(1) Selling price variance

Actual sales price $95,600/4,850 units $19.7113

Budgeted sales price $20.00
$0.2887
Actual sale volume 4,850 units
Selling price variance $0.29 × 4,850 units $1,400 (A)

(2) Sale volume variance

Actual sales volume 4,850 units
Budgeted sales volume 5,100 units
Sales volume variance in units 250 units (A)
Standard profit margin $6
Sales volume profit variance $6 × 250 units $1,500 (A)
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Example 5 (Solution): Operating statement under absorption costing

Rounded
(3) Material price variance
Actual material price $9,800/2,300kg $4.2619
Standard material price $4
$0.2619
Actual quantity usage 2,300 kg
Material price variance $0.26 × 2,300 units $600 (A)

(4) Material usage variance Standard usage ×

actual sale volume
Actual quantity usage 2,300 kg
Standard quantity usage 0.5 kg × 4,850 units 2,425 kg
125 kg (F)
Standard price per kilogram $4
Material price variance $500 (F)
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Example 5 (Solution): Operating statement under absorption costing

Rounded
(5) Labour rate variance
Actual labour rate $16,800/8,500 hours $1.9765
Standard labour rate $2
$0.0235
Actual labour hours 8,500 hours
Labour rate variance $200 (F)

(6) Labour efficiency variance Standard hour ×

actual sale volume
Actual active labour hours 8,000 hours
Standard labour hours 2 hours × 4,850 units 9,700 hours
1,700 hours (F)
Standard rate per hours $2
Labour efficiency variance $3,400 (F)
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Example 5 (Solution): Operating statement under absorption costing

(7) Idle time variance: 500 hours × $2 = $1,000 (A)

(8) Variable overhead expenditure variance

Actual Variable overhead $2,600

Standard material cost
$0.3 × 8,000 hours $2,400
(of actual variable overhead hours)
Material price variance $200 (A)

(9) Variable overhead efficiency variance

Variable overhead efficiency variance in hours is the same as the labour efficiency
variance:
1,700 hours (F) × $0.30 per hour = $510 (F)

(10) Fixed overhead expenditure variance Budgeted hours

× standard rate
Actual fixed overhead cost $42,300
5,100 units x 2 hours
Budgeted fixed overhead at standard rate $37,740
× $3.70
Fixed overhead total variance
$4,560 (A)
(= under-/over-absorbed overhead)
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Example 5 (Solution): Operating statement under absorption costing

(11) Fixed overhead volume capacity variance

Budgeted hours of work 10,200 hours

Actual hours of work 8,000 hours
Fixed overhead volume capacity variance in hour 2,200 hours (A)
Standard fixed overhead absorption rate per hour $3.70
Fixed overhead volume capacity variance $8,140 (A)

(12) Fixed overhead volume efficiency variance

Acutal hours of work 8,000 hours
Standard hours of work (4,850 units * 2 hours) 9,700 hours
Fixed overhead volume efficiency variance in hour 1,700 hours (F)
Standard fixed overhead absorption rate per hour $3.70
Fixed overhead volume capacity variance $6,290 (F)
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Here is a proforma for an operating statement under standard marginal costing.

Sales $ $ $
Budgeted contribution X
Sales volume contribution variance X
Standard contribution from actual sales X

Variances (F) (A)

Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
X X X
Actual contribution X
Budgeted fixed costs X
Fixed costs expenditure variance X
Actual fixed overheads X
Actual profit X

Notes:
There is no fixed overhead volume variance (and therefore no fixed overhead volume
efficiency and volume capacity variances).
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Example 6 (Question): Operating statement under marginal costing

(example 5 continue)
Required:
Calculate all variances and prepare an operating statement under marginal costing
for the month ended 30 June 20X7.
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Example 6 (Solution): Operating statement under marginal costing

(example 5 continue)
Adjustments from operating statement under absorption costing
• Variable cost per unit = 2.00 + 4.00 + 0.60 = $6.60
• The standard contribution per unit of boomerang is $(20 – 6.60) = $13.40
• The budgeted contribution: $30,600 + budgeted fixed production costs $37,740
= $68,340
• The sales volume contribution variance: (5,100 units – 4,850 units) × $13.40 =
$3,350 (A)
• Other remaining variances are computed in the previous example.
• Actual contribution is highlighted in the statement.
• Budgeted (planned) fixed production overhead is adjusted by the fixed overhead
expenditure variance to show the actual fixed production overhead expenditure.
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Example 6 (Solution): Operating statement under marginal costing

(example 5 continue)
Therefore, a marginal costing operating statement might look like this.
SYDNEY – OPERATING STATEMENT JUNE 20X7
Sales $ $ $
Budgeted contribution 68,340
Sales volume contribution variance 3,350 (A)
Standard contribution from
64,990
actual sales

Variances (F) (A)

Sales price 1,400
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
4,610 3,200
1,410 1,410 (F)
Actual contribution 66,400
Budgeted fixed costs 37,740
Fixed costs expenditure variance 4,560 (A)
42,300
Actual fixed overheads 42,300 (A)
Actual profit 24,100
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Before management decide whether or not to investigate the reasons for the occurrence of
a particular variance. There are a number of factors which should be considered in assessing
the significance of the variance.

Factors Explanations

Because a standard cost is really only an average expected cost,

Materiality small variations between actual and standard are bound to occur
and are unlikely to be significant

Only controllable variances should be investigated.

Controllability Uncontrollable variances call for a change in plan, not an
investigation into the past.

The efficiency variance reported in any control period, whether

The type for materials or labour, will depend on the efficiency level set.
of standard • If an ideal standard is used, variances will always be adverse.
being used • If basic standards are used, variances are likely to be
favourable.

The trend provides an indication of whether the variance is

Variance trend fluctuating within acceptable control limits or becoming out of
control.
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Factors Explanations

One variance might be interrelated with another, and much of it

Interdependence might have occurred only because the other variance occurred
between too.
variances When two variances are interdependent (interrelated), one will
usually be adverse and the other favourable.

Costs of The costs of an investigation should be weighed against the

investigation benefits of correcting the cause of a variance.
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Variance investigation models can be used to determine whether a variance should be

investigated. There are three kinds of variance investigation models are commonly used.

Models Explanations

This involves deciding a limit:

The size of a variance is The size of a variance

within the limit exceeds the limit

Immaterial Material
The rule
of thumb
model
Variance size
Material threshold

time
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III. INVESTIGATING FOR BASIC VARIANCES
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Models Explanations

Historical data is used to calculate both a standard as an

expected average and the expected standard deviation
around this average when the process is under control.

Variance size

Statistical Upper material

significance threshold
model
time
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Models Explanations

By marking variances and control limits on a control chart,

investigation is signalled not only when
• A particular variance exceeds the control limit (including
characteristic of Statistical significance model)

Variance size
Statistical
control Upper material
charts threshold

time
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Models Explanations

By marking variances and control limits on a control chart,

investigation is signalled when
• The trend of variances shows a progressively worsening
movement in actual results.

Variance size

Statistical Immaterial
control
charts time

Variance size

Material

time
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.c Definition

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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.

Material variance

Price variance Usage variance

Mix variance Yield variance

Calculating a mix and yield variance is only meaningful for control purposes when
management is in a position to control the mix of materials used in production.

The financial impact of using a different proportion

The mix variance
of raw materials.

Represent

The financial impact of the input yielding a different

The yield variance
level of output to the standard.
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Mix variance: A mix variance occurs when the materials are not mixed or blended in
standard proportions and is a measure of whether the actual mix is cheaper or more
expensive than the standard mix.

For example:
More of an
expensive material
The cost
Variance adverse
will be higher
Less of a
cheap material

Method:

Actual Quantity, Actual Quantity,

Standard
Material Actual Mix Standard Mix Difference Variance
price
(AQAM) (AQSM)

(1) (2) (3) (4) (5)

M1 X kg A kg A–X $x $Var.(F/A)
M2 Y kg B kg B–Y $y $Var.(F/A)
M3 Z kg C kg C–Z $z $Var.(F/A)
Sum X+Y+Z A+B+C Mix (F/A)
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Write down the actual input of each material in a column (this is

1
the actual total quantity split in the actual mix = AQAM).

Take the actual input in total and copy across to another column.
2 Then, work it back in the standard proportions (this is the actual
total quantity split in the standard mix = AQSM). A+B+C = X+Y+Z

3 Calculate the difference between the standard mix (AQSM) and the
actual mix (AQAM).

Multiply the difference by the standard price per kilogram (We are
4
calculating material usage variance).

5 This gives the mix variance in financial term.

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Example 7 (Question): Mix variance

Hondru operates a standard costing system. The standard direct materials to produce
1,000 units of output is as follows:

Material grade Input quantity (kg) Standard price per kg ($)

A 600 1.10
B 240 2.40
C 360 1.50
Total 1,200
During April the actual output of the product was 21,000 units. The actual materials
issued to production were:
Material grade Quantity (kg)
A 14,000
B 5,500
C 5,500
Total 25,000

Required:
Calculate the material mix variance for each material, and in total. Comment on the
figures calculated.
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Example 7 (Guidance): Mix variance

In order to calculate mix variance, we have to calculate:

• AQAM: Actual quantity split in actual mix for each material
• AQSM: Actual quantity split in standard mix for each material

Step 1 Step 2

Calculating the AQAM, AQSM Using Material mix variance method

to calculate Material mix variance
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Example 7 (Guidance): Mix variance

Step 1: Calculating the AQAM, AQSM

As we have known AQAM (per question), we then need to identify

AQSM & variances by these following steps:

Standard Actual total Actual Quantity, Standard Mix

Material
mix quantity usage (AQSM)

A 600/1,200 600/1,200 × 25,000kg = 12,500 kg

B 240/1,200 25,000 kg 240/1,200 × 25,000kg = 5,000 kg

C 360/1,200 260/1,200 × 25,000kg = 7,500 kg

Sum 1 25,000
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Example 7 (Guidance): Mix variance

Step 2: Using Material mix variance method to

calculate Material mix variance.

Actual Actual
Standard Quantity, Quantity, Standard
Material Difference Variance
mix Actual Mix Standard Mix price
(AQAM) (AQSM)
A 600/1200 14,000 kg 12,500 kg 1,500 (A) $1.10 $1,650 (A)
B 240/1200 5,500 kg 5,000 kg 500 (A) $2.40 $1,200 (A)
C 360/1200 5,500 kg 7,500 kg 2,000 (F) $1.50 3,000 (F)
Sum 25,000 25,000 0 150 (F)

Material mix variance in total is 150 (F).

Comment: The favourable mix variance is due to more of materials A and B

being used in place of material C.
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Yield variance: A yield variance arises because there is a difference between what the
input should have been (considering the output achieved) and the actual input.

A yield variance measures the efficiency of turning the inputs into outputs.

Yield variance Actual input is higher than

is adverse the expected input.

This could be due to the following reasons:

Labour inefficiencies Higher waste Inferior materials Cheaper mix with

a lower yield
Method:

Actual Quantity, Standard Quantity,

Standard
Material Standard Mix Standard Mix Difference Variance
price
(AQSM) (SQSM)
(1) (2) (3) (4) (5)
M1 X kg A kg A–X $x $Var.(F/A)
M2 Y kg B kg B–Y $y $Var.(F/A)
M3 Z kg C kg C–Z $z $Var.(F/A)
Sum X+Y+Z A+B+C Yield (F/A)
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1 Copy Actual Quantity, Standard Mix (AQSM) from the mix variance.

Calculate Standard Quantity, Standard Mix (SQSM) for EACH material

2
using the following formula:
• Material quantity used from standard cost card × Total actual
output produced/Material output quantity produced by the standard
cost card.
Or
• Calculate the total standard quantity of all materials used to
produce the actual output then share this out between the different
materials using the standard proportions calculated from the
standard cost card.

Calculate difference between the Standard Quantity, Standard Mix

3
(SQSM) and Actual Quantity, Standard Mix (AQSM) for each material.

Multiply by the difference by the standard price per kilogram (We are
4 calculating material usage variance)

5 This gives the yield variance in financial term.

Notes: Yield variances for the individual method are meaningless variances
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Example 8 (Question): Yield variance

Hondru operates a standard costing system. The standard direct materials to produce
1,000 units of output is as follows:

Material grade Input quantity (kg) Standard price per kg ($)

A 600 1.10
B 240 2.40
C 360 1.50
Total 1,200
During April the actual output of the product was 21,000 units. The actual materials
issued to production were:
Material grade Quantity (kg)
A 14,000
B 5,500
C 5,500
Total 25,000

Required:
Calculate the material yield variance
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Example 8 (Solution): Yield variance

In order to calculate yield variance, we have to calculate:

• SQSM: standard material quantity split in standard mix for each material given the
actual output.
• AQSM: actual material quantity split in standard mix for each material
As we have known AQSM (per example 8), we then need to identify SQSM by the
following table:
Standard materials quantity for producing 21,000 units
(Standard quantity, standard mix).
Input quantity (kg)
Material grade
for 1,000 units for 21,000 units
A 600 600 × 21 = 12,600
B 240 240 × 21 = 5,040
C 360 360 × 21 = 7,560
Sum 1,200 25,200
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Example 8 (Solution): Yield variance

Then the yield variance is calculated as follows:

Actual Quantity, Standard Quantity,

Standard
Material Standard Mix Standard Mix Difference Variance
price
(AQSM) (SQSM)

Kg Kg Kg $ $
A 12,500 12,600 100 (F) 1.10 110 (F)
B 5,000 5,040 40 (F) 2.40 96 (F)
C 7,500 7,560 60 (F) 1.50 90 (F)
Sum 25,000 25,200 200 (F) 296 (F)

The material yield variance is 296 (favourable).

Notes: The examining team has noted in the past that some candidates calculate the
variances in kg but do not convert them into a monetary value using the standard costs for
each ingredient. Variances need to be given a value in order to be used properly within a
business. It is not sufficient to simply stop at quantity and you will lose marks.
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3. Interpretation
.c of material mix and yield variances

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Material mix and yield variances may be interrelated

MIX Yield
A favorable total An adverse total
mix variance yield variance

Higher proportion of a cheaper

material is being used Less output has been
achieved for a given input
Reduce the overall
average cost per unit
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.c 4. Issues involved in changing the mix

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Material mix and yield variances may be interrelated

The materials Cost of a change in Wider

mix variance Indicate the mix of materials implications

The yield Productivity of the

Indicate
variance manufacturing process

Changing the mix of

material can impact on
Cost Quality Performance measurement

The production manager’s performance may be measured by mix and yield

variances, however these performance measures may fail to indicate problems
with falling quality and the impact on other areas of the business.

Quality targets may also be needed.

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5. Alternative methods of controlling production processes
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As well as variances, organisations can also use other performance measures and targets for
controlling production processes.

Quality measures
(Reject rate, time spent reworking goods, % waste, % yield,…)

Average cost of inputs Average cost of outputs

Average prices achieved

Average margins
for finished products

Percentage of on-time
Customer satisfaction ratings
deliveries

Detailed timesheets Percentage of idle time

Note:
• The examining team report for June 2017 noted that a common error was to use
standard cost per unit in the mix and yield calculations instead of standard cost per kg.
Make sure you think about this carefully!
• The examining team report for June 2018 noted that a question on material variances
was poorly answered by many. Make sure you know that:,
o Total material cost variance = material price variance + material usage variance
o Material usage variance = material mix variance + material yield variance
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V. SALES MIX AND QUANTITY VARIANCES
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.c Definition

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ac ac
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The sale volume variance can be subdivided into a sales mix variance and a sales
quantity variance.

Sale variance

Selling price variance Sale volume variance

Sales mix Sales quantity

variance variance

In Performance management (F5), a firm may prefer to calculate combined sales mix and
sales quantity variances instead of separate sales volume variances Where:

Management can control the Management The same basic product is

allocation of the advertising may be able sold in different sizes or
and sales promotion budget to control the packaging, such as large size
between different products sales mix and small size

Note:
It is possible to analyse the overall sales volume variance into a sales mix variance and a
sales quantity variance If a company sells more than one product.
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The sales mix variance occurs when the proportions of the various products sold are
different from those in the budget.

A sales mix variance indicates the effect on profit of changing the mix of actual sales from
the standard mix.

Method:
The difference between the actual total quantity sold in the standard mix and the actual
quantities sold, valued at the standard profit per unit:

Actual Quantity, Actual Quantity,

Standard
Products Actual Mix Standard Mix Difference Variance
margin
(AQAM) (AQSM)

(1) (2) (3) (4) (5)

M1 X units A units A–X $M1 $Var.(F/A)
M2 Y units B units B–Y $M2 $Var.(F/A)
M3 Z units C units C–Z $M3 $Var.(F/A)
Sum X+Y+Z A+B+C Mix (F/A)
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Write down the actual sales quantity for each product in a column
1 (this is the actual total sales quantity split in the actual mix =
AQAM).

Take the actual sales quantity in total and copy across to another
2 column. Then, work it back in the standard proportions (this is the
actual total sales quantity split in the standard mix = AQSM).

3 Calculate the difference between the standard mix (AQSM) and the
actual mix (AQAM).

4 Multiply the difference by the standard margin per unit.

5 This gives the sales mix variance in financial terms.

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Example 10 (Question): Sales mix variances

CAB Co operates an absorption costing system and sells three products S, A and PP
which are substitutes for each other. The following standard selling price and cost
data relate to these three products:
Product Unit selling price Direct material/unit Direct labour/unit
S $14.00 3 kg @ $1.80/kg 0.5 hours @ $6.50/hour
A $15.00 1.25 kg @ $3.28/kg 0.8 hours @ $6.50/hour
PP $18.00 1.94 kg @ $2.50/kg 0.7 hours @ $6.50/hour

Budgeted fixed production overhead for the last period was $81,000.
This was absorbed on a machine hour basis. The standard machine hours for each
product and the budgeted levels of production and sales for each product for the last
period are as follows:
Product S A PP
Standard machine hours per unit 0.3 hours 0.6 hours 0.8 hours
Budgeted production and sales 10,000 units 13,000 units 9,000 units
Actual volumes and selling prices for the three products in the last period were as
follows:
Product S A PP
Actual selling price per unit $14.50 $15.50 $19.00
Actual production and sales 9,500 units 13,500 units 8,500 units
Required:
Calculate the sales mix variances for overall sales for the last period.
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Example 10 (Solution): Sales mix variances

Actual Actual
Standard
Quantity, Quantity,
Products Std mix Difference margin Variance
Actual Mix Standard Mix
[w2]
(AQAM) (AQSM)
Units Units Units Units $ $
S 10,000 9,500 9,843.75 343.75 (A) 4.00 1,375 (A)
A 13,000 13,500 12,796.875 703.125 (F) 3.00 2,109.375 (F)
PP 9,000 8,500 8,859.375 359.375 (A) 5.00 1,796.875 (A)
Sum 32,000 31,500 31,500 0 $1,062.5 (A)

For example, this figure is calculated by: Total mix variance

9,000
31,500 ×
32,000
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Example 10 (Solution): Sales mix variances

Working 1: Overhead absorption rate (OAR)

$81,000
OAR= = $4.5 per machine hour
3,000 +7,800 +7,200

 Absorbed overhead cost for each product:

Product S A PP
$1.35 $2.70 $3.60
Absorbed overhead
($4.5 × 0.3 hours) ($4.5 × 0.6 hours) ($4.5 × 0.8 hours)

Working 2: Standard profit

Product S A PP
Materials $5.40 $4.10 $4.85
Labour $3.25 $5.20 $4.55
Absorbed overheads [w1] $1.35 $2.70 $3.60
Total cost $10.00 $12.00 $13.00
Selling price $14.00 $15.00 $18.00
Standard margin $4.00 $3.00 $5.00
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The sales quantity variance shows the difference in contribution/profit because of a

change in sales volume from the budgeted volume of sales.

A sales quantity variance indicates the effect on profit of selling a different total quantity
from the budgeted total quantity.
Method:
The difference between actual sales volume in the standard mix and budgeted sales valued
at the standard profit per unit.

Actual Quantity, Budgeted Quantity,

Standard
Product Standard Mix Standard mix Difference Variance
margin
(AQSM) (BQSM)

(1) (2) (3) (4) (5)

P1 X units A units X–A $M1 $Var.(F/A)
P2 Y units B units Y–B $M2 $Var.(F/A)
P3 Z units C units Z–C $M3 $Var.(F/A)
Total sales
Sum X+Y+Z A+B+C
quantity (F/A)
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Copy Actual Quantity, Standard Mix (AQSM) from the mix variance
1
method 1.

Copy the budgeted sales units under the column Budget Sales
2
Quantity, Standard Mix (BQSM).

Calculate difference between the Actual Sales Quantity, Standard

3 Mix (AQSM) and Budgeted Sales Quantity, Standard Mix (BQSM) for
each product.

4 Multiply by the difference by the standard margin per unit.

5 This gives the sales quantity variance in financial terms.

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Example 11 (Question): Sales quantity variances (example 10 continued)

CABCo operates an absorption costing system and sells three products S, A and PP
which are substitutes for each other. The following standard selling price and cost
data relate to these three products:
Product Unit selling price Direct material/unit Direct labour/unit
S $14.00 3 kg @ $1.80/kg 0.5 hours @ $6.50/hour
A $15.00 1.25 kg @ $3.28/kg 0.8 hours @ $6.50/hour
PP $18.00 1.94 kg @ $2.50/kg 0.7 hours @ $6.50/hour

Budgeted fixed production overhead for the last period was $81,000.
This was absorbed on a machine hour basis. The standard machine hours for each
product and the budgeted levels of production and sales for each product for the last
period are as follows:
Product S A PP
Standard machine hours per unit 0.3 hours 0.6 hours 0.8 hours
Budgeted production and sales 10,000 units 13,000 units 9,000 units
Actual volumes and selling prices for the three products in the last period were as
follows:
Product S A PP
Actual selling price per unit $14.50 $15.50 $19.00
Actual production and sales 9,500 units 13,500 units 8,500 units
Required:
Calculate the sales quantity variances for overall sales for the last period.
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Example 11 (Solution): Sales quantity variances (example 10 continued)

These figures are mentioned in

previous example

Actual Quantity, Budgeted Quantity,

Standard
Product Standard Mix Standard mix Difference Variance
margin
(AQSM) (BQSM)

Units Units Units $ $

S 9,843.75 10,000 156.25 A 4 625.00 (A)
A 12,796.875 13,000 203.125 A 3 609.375 (A)
PP 8,859.375 9,000 140.625 A 5 703.125 (A)
$1,937.50 (A)

Check:

Actual total quantity (units) 31,500

Budgeted total quantity (units) 32,000

Variance in unit 500 (A)
× Standard margin ($) 3.875

Sales quantity variance ($) 1,937.50 (A)

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Example 11 (Solution): Sales mix and quantity variances

Sales volume variance

$3,000 (A)

Sales mix variance Sales quantity variance

$1,062.50 (A) $1,937.50
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CHAPTER 14:
PLANNING AND OPERATIONAL
VARIANCES ANALYSIS
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Y OVERVIEW

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Reasons for revising a

Revising a budget or standard cost
budget or
standard cost
Manipulation issues
Planning and
operational Planning and operational
variances analysis variances for sales
Planning and
Planning and operational
operational
variances for materials
variances
Planning and operational
variances for labour
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The standard is set as part of the budgeting process which occurs before the period to
which it relates.

Difference
Due to an between Not solely due to
unrealistic budget standard and operational factors
actual

The budget may need to be revised to enable

actual performance to be compared with a
standard that reflects these changed conditions.
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1.1 Reasons for revising a budget or standard cost

Occasionally, circumstances may occur that make the original budget or standard cost
invalid or inappropriate.

Criteria Asumption Changes

The sales May have been based Market size may be much larger or
budget on expectations of the smaller than first assumed due to:
total size of the market • Unexpected change in economic
for the organisation’s conditions
product • Unexpected technological change
• Radical change in customer
attitudes
• Unexpected new regulations

may be based on an A major change in the market, the

Standard assumption about available market price for the
cost of what the market price materials may become much higher
materials for the materials or much lower than originally
should be. expected
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1.1 Reasons for revising a budget or standard cost

Criteria Asumption Changes

Standard May be based on An unexpected change in specification,

quantity of product specification requiring much more or much less of
materials the material in the product content
made

Standard May be based on Become unrealistic due to an

labour cost expected labour rates unexpected increase in pay rates for
employees

Standard May be estimated Be affected by a change in the labour

time to based on expected grade or upgraded machinery or
produce a time to produce one other unexpected reasons
unit of unit
product
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1.1 Reasons for revising a budget or standard cost

In these circumstances:

Variances reported to
If the budget or standard cost is not revised
operational managers
in these circumstances
will be unrealistic

Original budget Variances will be due to

It may be appropriate to changes that are outside
revise the budget the control of the
or revise the operational managers.
standard cost
Revised budget Uncontrolable cost

Notes:
• These types of situations do not occur frequently. The need to report planning and
operational variances should therefore be an occasional, rather than a regular, event.
• If the budget is revised on a regular basis, the reasons for this should be
investigated. It may be due to management attempting to shift the blame for poor
results or due to a poor planning process.
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1.2 Calculating a revised budget

The syllabus requires you to be able to calculate a revised budget, which could involve
revising standards for sales, materials and/or labour so that only operational variances
are highlighted when actual results are compared to the revised budget.

Example 1 (Question): Revise the budget

A company produces Widgets and Splodgets which are fairly standardised products.
The following information relates to Period 1.
Sales revenue
The standard selling price of Widgets is $50 each and Splodgets $100 each.
In Period 1, there was a special promotion on Splodgets with a 5% discount being
offered. All units produced are sold and no inventory is held.
Material cost
To produce a Widget they use 5kg of X and in Period 1, their plans were based on
a cost of X of $3 per kg. Due to market movements, the actual price changed; if
Material X
they had purchased efficiently, the cost would have been $4.50 per kg. Production
of Widgets was 2,000 units.
A Splodget uses raw material Z, but again the price of this can change rapidly. It
was thought that Z would cost $30 per tonne but in fact they only paid $25 per
Material Z tonne and if they had purchased correctly the cost would have been less, as it was
freely available at only $23 per tonne. It usually takes 1.5 tonnes of Z to produce
one Splodget and 500 Splodgets are usually produced.
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1.2 Calculating a revised budget

The syllabus requires you to be able to calculate a revised budget, which could involve
revising standards for sales, materials and/or labour so that only operational variances
are highlighted when actual results are compared to the revised budget.

Example 1 (Question): Revise the budget

Labour cost
Each Widget takes three hours to produce and each Splodget two hours. Labour is
paid $5 per hour. At the start of Period 1, management negotiated a job security
package with the workforce in exchange for a promised 5% increase in efficiency –
that is, that the workers would make the Widgets and Splodgets in 95% of the time
stated in the original budget.
Overhead
Fixed overheads are usually $12,000 every period and variable overheads are $3 per
labour hour.

Required:
Produce the original budget and a revised budget allowing for controllable factors
in a suitable format.
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1.2 Calculating a revised budget

Example 1 (Solution): Revise the budget

Original budget for Period 1

$
Sales revenue (2,000 × $50) + (500 × $100) 150,000
Material costs X 2,000 × 5 kg × $3 30,000
Material costs Z 500 × $30 × 1.5 22,500
Labour costs (2,000 × 3 × $5) + (500 × 2 × $5) 35,000
Variable overheads (2,000 × 3 × $3) + (500 × 2 × $3) 21,000
Fixed overheads 12,000
Profit 29,500

Revised budget for Period 1

$
Sales revenue (2,000 × $50) + (500 × $100) 150,000
Material costs X 2,000 × 5 kg × $4.5 45,000
Material costs Z 500 × $23 × 1.5 17,250
Labour costs ((2,000 × 3 × $5) + (500 × 2 × $5)) × 0.95 33,250
Variable overheads ((2,000 × 3 × $3) + (500 × 2 × $3)) × 0.95 19,950
Fixed overheads 12,000
Profit 22,550
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1.3 Revising budgets: manipulation issues

Revisions to the budget or standard To prevent manipulation,

cost may be manipulated to make there should be strict rules
operating results seem much better about revising a budget or
than is really. standard cost.

In particular, the revision to the budget or standard cost should ideally be based on
independent and verifiable evidences (that could not be manipulated).

Example 2

The change in The evidences must be obtained should ideally be

market price • an official price index
for materials • price benchmark
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1.4 Advantages and disadvantages of revising the budget

Here are some advantages and disadvantages of revising the budget:

Advantages Problems

Highlights those variances Determination of revised budget

which are controllable • Biased
• Need external information
Ensures that operational
performance is appraised by Use of revised budget may
reference to realistic targets undermine original budget as
a target and as a motivator.
Should ensure that future
budgets are more realistic
Employees may use this
system to their advantage by
excusing operating problems
as poor planning if this
method is used.
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A planning and operational approach to variance analysis divides the total variances into:

Operational variances Planning variances

Caused by adverse or Have arisen because of

favourable operational inaccurate planning or
performance, compared faulty standards
with a standard which has
been revised in hindsight
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Benefits and problems of planning and operating variances

Advantages Problems

In volatile and changing Element of subjectivity for

environments, standard costing example in setting the revised
and variance analysis are more standards.
useful using this approach
A large amount of labour time
Provide up to date information involved in continually establishing
about current levels of efficiency. up to date standards and
calculating additional variances.

Make the standard costing

system more acceptable and to There is a great temptation to put
have a positive effect on as much as possible of the total
motivation. variances down to outside,
uncontrollable factors.

It emphasises the importance of

the planning function in the There can then be a conflict
preparation of standards. between operating and planning
staff.

Helps to identify planning

deficiencies.
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Planning and operational variances may be calculated for:

Planning and
operational variances

Sales Materials Labour

The operating statement would include a separate line for each variance calculated.
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Overview
The sales variance can be sub-divided into a planning and operational variance:

Sales variance

Revise budgeted sales price Revise budgeted sales volume

Sales price variance Sales volume variance

Sales price Sales price Sales volume Sales volume

planning operational planning operational
variance variance variance variance

Market size Market share

variance variance
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1. Planning and operational variances for sales volume
As there has been no change in the budgeted sales price or standard cost of products,
these two variances can be converted from units into a monetary value

Variance in units The standard margin (*)

Original budget Revise budget Actual

Original Revised
Actual sales
budgeted sales budgeted sales

Standard margin* Standard margin* Standard margin*

Market size variance Market share variance

(sales volume planning variance) (sales volume operational variance)

(*) Margin = contribution per unit (marginal costing) or profit per unit (absorption costing)
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1. Planning and operational variances for sales volume

Example 3 (Question): Operational and planning variance for sales volume

PG budgeted sales for 20X8 were 5,000 units. The standard contribution is $9.60
per unit. A recession in 20X8 meant that the market for PG's products declined by
5%. PG's market share also fell by 3%. Actual sales were 4,500 units.

Required: Calculate planning and operational variances for sales volume.

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1. Planning and operational variances for sales volume

Example 3 (Solution): Operational and planning variance for sales volume

Sales volume planning variance (Market size variance)

Original budgeted sales 5,000 units

Revised budget sales (–5%) 5,000 units × 95% 4,750 units
250 units (A)
Standard contribution per unit $9.60
Sales volume planning variance $9.60 × 250 units $2,400 (A)

Sales volume operational variance (Market share variance)

Revised budget sales (–5%) 4,750 units

Actual sales 4,500 units
250 (A)
Standard contribution per unit $9.60
Sales volume operational variance $9.60 × 250 units $2,400 (A)
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2. Planning and operational variances for sales price
There may be a situation where a revision is made to the budgeted or standard selling
price for a product. When this happens, a sales price planning variance and a sales price
operational variance can be calculated.

Original budget Revise budget Actual

Original budgeted Revised budgeted ‘Normal’ sales

sales price sales price price

Actual sales Actual sales Actual sales

Sales price planning variance Sales price operational variance

Notes:
The planning variance is generally outside the control of sales management, but the
operational sales price variance is a sales management responsibility.
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2. Planning and operational variances for sales price

Example 4 (Question): Planning and operational variances for sales price

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 revenue was 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.
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2. Planning and operational variances for sales price

Example 4 (Solution): Planning and operational variances for sales price

Sales price planning variance

Original budgeted sales price $10

Revised budget sales price $4.5
$5.5 (A)
Actual sales volume 12,000 units
Sales price planning variance $5.5 × 12,000 units $66,000 (A)

Sales price operational variance

Revised budget sales price $4.5
Actual sales price price $5
$0.5 (F)
Actual sales volume 12,000 units
Sales price operational variance $0.5 × 12,000 units $6,000 (F)
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Overview

Planning and operational variances can be reported for direct materials, when the
standard cost is revised for the material price, material usage per unit, or both.

The traditional variances we have seen so far can be investigated further to look at the
elements driven by a wrong standard (planning variances) and the elements that were
within the manager’s control (operational variances).

Material variance

Revise standard material price Revise standard material usage

Material price variance Material usage variance

Material price Material price Material usage Material usage

planning operational planning operational
variance variance variance variance
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1. Planning and operational variance for material price

Material price variance can be subdivided into material price planning variance and the
material price operational variance.

Material price
variance
Material price Material price
planning variance operational variance

Original budget Revised budget Actual

Original standard Revised standard Actual material

material price material price price

Actual usage Actual usage Actual usage

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1. Planning and operational variance for material price

Example 5 (Question): Planning and operational variances for material price

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 variance.
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1. Planning and operational variance for material price

Example 5 (Solution): Planning and operational variances for material price

• The original standard cost was $5 per kg
• The revised standard cost is $5.50 per kg
• Actual material cost per kilogram is $139,390/26,300kg = $5.3 per kg
(a) Material price planning variance
Original standard material price $5
Revised standard material price $5.5
$0. 5 (A)
Actual materials usage 26,300 kg
Material price planning variance $0.5 × 26,300 kg $13,150 (A)

(b) Material price operational variance

Revised standard material price $5.5
Actual material price $5.3
$0.2 (F)
Actual materials usage 26,300 kg
Material price operational variance $0.2 × 26,300 kg $5,260 (F)
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1. Planning and operational variance for material price

Example 5 (Solution): Planning and operational variances for sales price

(c) The material usage variance

Actual usage 26,300 kg
Standard usage 6,000 units × 4 kg 24,000 kg
2,300 kg (A)
Original standard price per kg $5
Material usage variance $5 × 2,300 kg $11,500 (A)

Notes:
This variance is calculated by comparing the actual material usage with the standard
usage (because only material price is altered), but it is then converted into a monetary
value by applying the original standard price for the materials, not the revised standard
price.
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1. Planning and operational variance for material price

Example 5 (Solution): Planning and operational variances for material price

The variances may be summarised as follows.

Material variance
$19,390 (A)

Material price variance Material usage variance

$7,890 (A) $11,500 (A)

Material price Material price

planning operational
variance variance
$13,150 (A) $5,260 (F)

Check
6,000 units of Product X at original std cost ($20) $120,000
Actual material cost $139,390
Total material cost variance 19,390 (A)
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2. Planning and operational variance for material usage

Material usage variance can be subdivided into material usage planning variance and the
material usage operational variance.

Material usage
variance
Material usage Material usage
planning variance operational variance

Original budget Revised budget Actual

Original standard Revised standard Actual material

material usage material usage material usage

Original standard Original standard Original standard

price price price
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2. Planning and operational variance for material usage

Example 6 (Question): Revise standard material usage

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 the change in product specification, the average usage for Material M during
the period was 5 kg per unit, and it was decided to revise the material standard
usage to allow for this.
During the period, 6,000 units of Product X were manufactured. They required
26,400 kg of Material M, which cost $137,280.

Required:
Calculate:
(a) The material usage planning variance.
(b) The material usage operational variance.
(c) The material price variance.
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2. Planning and operational variance for material usage

Example 6 (Solution): Revise standard material usage

• The original standard usage was 4 kg per unit.

• The revised standard usage is 5 kg per unit.
• Actual material usage per unit is 26,400kg/6,000 units = 4.4kg per unit.

(a) Material usage planning variance

Original standard material usage 6,000 units × 4kg 24,000 kg

Revised standard material usage 6,000 units × 5kg 30,000 kg
6,000 kg (A)
Original standard material price $5
Material usage planning variance $5 × 6,000kg $30,000 (A)

(b) Material usage operational variance

Revised standard material usage 30,000 kg
Actual material usage 26,400 kg
3,600 (F)
Original standard material price $5
Material usage operational variance $5 × 3,600kg $18,000 (F)
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2. Planning and operational variance for material usage

Example 6 (Solution): Revise standard material usage

(c) The material price variance

• Actual material price is $137,280/26,400kg = $5.2 per kg.

Actual material price $5.2

Original standard material price $5
$0.2 (A)
Actual usage 26,400 kg
Material price variance $0.2 × 26,400kg $5,280 (A)
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2. Planning and operational variance for material usage

Example 6 (Solution): Revise standard material usage

The variances may be summarised as follows.

Material variance
$17,280 (A)

Material price variance Material usage variance

$5,280 (A) $12,000 (A)

Material usage Material usage

planning operational
variance variance
$30,000 (A) $18,000 (F)

Check
6,000 units of Product X at original std cost ($20) $120,000
Actual material cost $137,280
Total material cost variance 17,280 (A)
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1. Planning and operational variance for labour

Example 7 (Question): Labour variances and the learning curve

Num Co hires temporary workers on six-month contract whenever production

requirements increase. Last month Num Co started producing a new product.
The standard labour cost of the new product is 5 hours × $20.00 per hour = $100.00.
Actual production of 520 units in the first month took 1,092 hours at a cost of
$21,840.
In retrospect it was realised that the standard labour hours per unit (5 hours) was
actually the time taken to produce the first unit and that a learning rate of 90%
should have been applied. The standard cost was revised to take this into account.
The learning index for a 90% learning curve is –0.1520.

Required:
Calculate the labour efficiency planning and operational variances after taking
account of the learning effect.
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1. Planning and operational variance for labour

Example 7 (Solution): Labour variances and the learning curve

Firstly, we calculate the revised hours for the actual production by applying the
learning curve formula.
Y = [Link]
Where:
• Y = the cummulative average time per unit taken to produce X units
• a = the time taken to produce the first unit = 5 hours (given)
• X = the cumulative number of units = 520 units (given)
• b = the index of learning = –0.1520 (given)
 Y = 5 × 520–0.1520 = 1.9326
Therefore, revised time for 520 units = 520 × 1.9326 = 1,005 hours.
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1. Planning and operational variance for labour

Example 7 (Solution): Labour variances and the learning curve

Labour efficiency planning variance

Revised standard labour hours 1,005 hours

Original standard labour hours (520 units * 5 hours) 2,600 hours
1,595 hours (F)
Original standard price per hour $20
Labour efficiency planning variance $31,900 (F)

Labour efficiency operational variance

Actual labour hours 1,092 hours

Revised standard labour hours 1,005 hours
87 hours (A)
Original standard rate per hour $20
Labour efficiency operational variance $1,740 (A)
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Advantages and limitations
There are some advantages and limitations of a system of planning and operational
variances:

Advantages Disadvantages

• The analysis highlights those • Difficult to decide what the

variances which are controllable realistic standard should have
(operational variances) and those been.
which are non-controllable
(planning variances). • Too easy to justify all the
variances as being due to bad
• Using variances for performance planning, so no operational
measurement is likely to increase variances will be highlighted.
if they know they will not be held
responsible for poor planning and • Revising and analysing variances
faulty standard setting. into planning and operational will
take time and can be costly.
• The planning and standard-setting
processes should improve • Managers may be resistant to the
very idea of variances and refuse
• Standards should be more to see the virtues of the approach.
accurate, relevant and
appropriate.

• Provide a more realistic and ‘fair’

reflection of actual performance
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CHAPTER 15:
PERFORMANCE ANALYSIS
AND BEHAVIOURAL ASPECTS
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Evaluating past performance

Using variance
analysis
Improving performance in the future

Motivation
Behavioural
implications
Poor attitudes when setting budgets

Establishment
Setting the
Target Standard
difficulty level
Performance for a budget
analysis and Effect on staff action
behavioural
aspect
Participation in
budgeting Top-down Bottom-up Negotiated
budgeting budgeting budgeting

Variances in a Variance in JIT

JIT or TQM
environment Variance in TQM

Standard costs in a
rapidly changing
environment
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Variance analysis is used to

Analyse and evaluate past performance

Control purposes: significant variances may indicate that an aspect

of performance is out of control and that measures should be taken
to improve performance in the future.

Evaluating past Variance Improving performance

performance analysis in the future
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Basic principles of variance reporting are that:

The managers responsible

The monetary value
for variances
that is given to variances
(Adverse or favourable)

Should be a reasonable indication of Should be identified, and they should

how much profit has been made or be expected to account for the
lost as a result of actual performance variance and, where appropriate,
differing from the budget or standard. indicate what corrective or control
measures they are taking.

Responsibility Responsibility
for planning for operational
variances variances

Notes:
For the exam, you also need to show an awareness of what variances tell us, and what
control measures management should take when a variance is reported.
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1.1 Responsibility for planning variances

Planning variances arising because the budget or standard cost was inappropriate
should not be attributed to operational management.

In many cases, revisions to a budget or standard cost are due to causes outside the
control of the planners. Such as:

An unexpected increase in the market price for materials, for example,

is beyond the control of planners.

An unexpected collapse in market demand for an industry's products,

resulting in an adverse sales volume planning variance.

Even so, planning variances, where they occur, should be identified separately.
Therefore

Planning variance are Management may not

deemed not controllable by be held responsible for
management. planning variances
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1.2 Responsibility for operational variances

An operational variance Management is held

is deemed controllable responsible for
by management. operational variances.

Organisation
Responsibility
structure and
between
the division of
management
authority

Responsibility
for operational
variances

Managers who are in a position of authority and

control over operations where the variances occur
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1.2 Responsibility for operational variances

Example 1:

A material price variance is the difference between actual and standard purchase
costs of materials.

 The operational manager responsible for this variance should be the

manager who makes the decisions about buying materials. This may be the
head of buying in one organisation, and the production manager in a
different organisation.
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1.2 Responsibility for operational variances

Variance Responsibility

Sales price variance Sales or marketing management

• Normally sales or marketing management

Sales volume variance • If sales are less than budget due to problems with
production, the production manager is responsible

The manager responsible for purchasing materials –

Material price variance
Purchasing manager

Material usage variance Normally the production manager

• The manager responsible for pay rates. This may be

senior management or HR management.
Labour rate variance • The production manager will be responsible for any
adverse rate variances caused by working overtime
and paying employees a premium rate per hour.
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1.2 Responsibility for operational variances

Variance Responsibility

Labour efficiency
Normally the production manager
variance

This depends on the cause of the idle time.

Caused by Responsibility
Lack of sales orders Sales management
Idle time variance Inefficient production Production
management management
Delays in deliveries of
Purchasing manager
key raw material
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Variance analysis provide guidance for operational management about aspects of

performance that need improving. Variances should be a guide to control action and
improving future performance.

It is important to understand that:

A reported variance is a
Control action affects the
measurement that relates
future, not the past.
to historical performance

Example 2:

If an adverse labour efficiency variance of $10,000 is reported one month, and

the production manager takes measures to improve efficiency:
• The effect of the control measures should be to improve efficiency, but the
value of the efficiency improvement in future months is unlikely to be
$10,000. Control measures may result in savings of more or less than
$10,000 per month, depending on how effective the measures are.
• The effect of control measures should have a reasonably long-term impact,
so control measures may result in savings not just in the following control
period but also for a reasonably long time into the future.
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2.1 The significance of variances

Control action to improve future performance should only be taken when a variance
seems significant.

Some variances are inevitable, because it is most unlikely that actual results will be exactly
the same as the budget or standard.

Both favourable and adverse variances should be investigated if they

seem significant. Control action to improve poor performance may
seem an obvious requirement.

Variances need not be investigated if they do not seem significant.

Management may not use variances in a single reporting period as a

guide to control action.

Since a variance in one month may be due to a once-only event. Management may monitor
cumulative variances over a period of time, and identify those that should be investigated
on the basis of performance or trend over a number of months.
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2.2 The cost of control action

Taking control measures to deal with the cause of a variance takes effort and costs
money.

Control measures should only be taken if it seems probable that

The costs of investigating

The benefits arising from
the causes of the variance
improved performance
and taking control action

Insignificant
variances
are not
investigated
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2.3 Improving performance

Notes:
An exam question may ask about the nature of control action that an operational
manager may take to deal with the cause of an adverse variance and so improve
performance.

The appropriate control measures will obviously depend on the circumstances and the
reasons why a variance occurred.

Use common sense and judgement in

dealing with any question on this topic.
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2.3 Improving performance

A few ideas are set out in the following table to give you an idea of the issues that may be
considered.

Variance Possible control action

Consider reducing the sales price in order to increase sales

Adverse sales
demand, although this will result in an adverse sale price
volume variance
variance

Search for a supplier who is prepared to offer a lower price

Adverse material
Consider purchasing in bulk quantities in order to obtain
price variance
large-order discounts

Consider providing training for the workforce, with the

Adverse material
objective of improving labour efficiency and reducing
usage variance
wastage of materials
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The appropriate use of control information from the budgetary control and variance
reporting system depends not only on the content of the information itself but also on the
behaviour of its recipients.
 This is because control in business is exercised by people.

A number of behavioural problems can arise:

The managers who set the budget or standards are often not the managers who
are then made responsible for achieving budget targets.

Dysfunctional behaviour: the goals of the organisation as a whole, as expressed in

a budget, may not coincide with the personal aspirations of individual managers.

Control is applied at different stages by different people.

• A supervisor may receive weekly control reports, and act on them;
• Their superior may receive monthly control reports, and decide to take
different control action.
• Different managers can get in each other's way, and resent the interference
from others.

When setting the budget, there may be budgetary slack.

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Budgetary slack is a deliberate over-estimation of expenditure and/or under-estimation

of revenues in the budgeting process.

Meaningless variances and a budget

which has no use for control purposes
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Motivation is what makes people behave in the way that they do. It comes from
individual attitudes, or group attitudes.

Individuals will be motivated by personal desires and interests.

In line with the objectives Unrelated to the objectives

of the organisation of the organisation

It is vital that the goals of management and the employees harmonise with the goals of
the organisation as a whole. This is known as goal congruence.
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Little organizational Successful congruence,

accomplishment high achievement environment

Degree of
Degree of attainment
attainment
Organization
Organization goal
goal

Although obtaining goal congruence is essentially a behavioural problem, it is possible to

design and run a budgetary control system which will go some way towards ensuring that
goal congruence is achieved.
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Poor attitudes or hostile behaviour towards the budgetary control system can begin at
the planning stage.

If managers are involved in preparing a budget the following may happen.

Managers may complain that they are too They may build 'slack' into their
busy to spend much time on budgeting. expenditure estimates.

They may argue that formalising a budget They may set budgets for their budget
plan on paper is too restricting and that centre and not co-ordinate their own
managers should be allowed flexibility in plans with those of other budget centres.
the decisions they take.

They may base future plans on past results, instead of using the opportunity
for formalised planning to look at alternative options and new ideas.

On the other hand, managers may not be involved in the budgeting process.
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Not be involved in the

Subordinate managers
budgeting process

Set up
Senior management or
Budget
administrative decision

Do not achieve goal congruence

It is hard for people to be motivated to achieve targets set by someone else

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2.1 Poor attitudes when putting plans into action

Poor attitudes also arise when a budget is implemented.

Managers may put in only just enough effort to achieve budget targets, without
trying to beat targets.

A formal budget may encourage rigidity and discourage flexibility.

Short-term planning in a budget can draw attention away from the longer-
term consequences of decisions.

There may be minimal co-operation and communication between managers.

Managers will often try to make sure that they spend up to their full budget
allowance, and do not overspend, so that they will not be accused of having
asked for too much spending allowance in the first place.
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2.2 Poor attitudes and the use of control information

The attitude of managers towards the accounting control information they receive might
reduce the information's effectiveness.

Management accounting control reports could well be seen as having a relatively

low priority in the list of management tasks. Managers may take the view that
they have more pressing jobs on hand than looking at routine control reports.

Managers may resent control information; they may see it as part of a system of
trying to find fault with their work. This resentment is likely to be particularly
strong when budgets or standards are imposed on managers without allowing
them to participate in the budget-setting process.

If budgets are seen as pressure devices to push managers into doing better,
control reports will be resented.

Managers may not understand the information in the control reports because
they are unfamiliar with accounting terminology or principles.

Managers may have a false sense of what their objectives should be. A
production manager may consider it more important to maintain quality
standards regardless of cost. They would then dismiss adverse expenditure
variances as inevitable and unavoidable.
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2.2 Poor attitudes and the use of control information

The attitude of managers towards the accounting control information they receive might
reduce the information's effectiveness.

If there are flaws in the system of recording actual costs, managers will dismiss
control information as unreliable.

Control information may be received weeks after the end of the period to
which it relates, in which case managers may regard it as out of date and no
longer useful.

Managers may be held responsible for variances outside their control.

Management accountants and senior management should try to implement

systems that are acceptable to budget holders and which produce positive effects.
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2.3 Pay as a motivator

Pay can be an important motivator when there is a formal link between higher pay (or
other rewards) and achieving budget targets.

Individuals are likely to work harder to achieve budget if they know that they will be
rewarded for their successful efforts.

However, there are problems with using pay as an incentive.

Formal reward and performance evaluation systems can encourage

dysfunctional behaviour.

The targets must be challenging but fair, otherwise individuals will become
dissatisfied. Pay can be a demotivator as well as a motivator.
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The level of difficulty in a standard cost may range from very challenging to fairly
undemanding:
• Many establish either a target or a currently attainable level of performance
• Standard costs may be ideal
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1. Establishing either a target or a
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currently attainable level of performance
'Aspirations' budgets can be used as targets to motivate higher levels of performance but a
budget for planning and decision-making should be based on reasonable expectations.
Budgets can motivate managers to achieve a high level of performance.

But how difficult should budget targets or standard levels of efficiency be?

How might people react to targets of differing degrees of difficulty in achievement?

There is likely to be a demotivating effect where an ideal

A high standard standard of performance is set.
of performance
 Adverse efficiency variances will always be reported.

A low standard of efficiency is also demotivating, because there

A low standard is no sense of achievement in attaining the required standards.
of performance The targets will be achieved easily, and there will be no
impetus for employees to try harder to do better than this.

A budgeted level of attainment could be the same as the level

An unchanged that has been achieved in the past.
budget level  Arguably, this level will be too low. It might encourage
budgetary slack.
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1. Establishing either a target or a
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currently attainable level of performance
Academics have argued that each individual has a personal 'aspiration level'. This is a level
of performance, in a task with which individuals are familiar, which individuals undertake for
themselves to reach.

Individual aspirations might be much higher or much lower than the organisation's
aspirations, however.

The solution: Having two budgets:

Expectations A budget for planning and decision-making based on reasonable

budget expectations.

Aspirations A budget for motivational purposes, with more difficult targets of

budget performance.
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Similarly, the level of difficulty in a standard cost may vary.

Type of standard Characteristics

• A desirable target, but not at all achievable at the moment.

Ideal • Reported variances will always be adverse. This can be
demotivating for the managers responsible for performance.

• The targets are not unrealistic.

• The value of target standards depends on the strength of

Target motivation of management to improve performance.

• An incentive scheme may be needed to persuade managers to

'buy in' to the target standard.

Currently • They do not provide an incentive to improve performance,

attainable although they may encourage management to avoid a
standard deterioration in performance.

• It is used to measure trends and changes in performance

Basic standard standards over time.

• It is not a useful type of standard for control purposes.

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3. The effect of reported variances on staff action
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Reported variances Managers take control

if significant and adverse action to improve performance

The success of a variance reporting system in achieving this objective will depend on several
factors.

Factors Explanations

The manager who is considered responsible for the

Appropriate manager variance should agree and accept that the cause of the
variance is their responsibility

The manager should consider the reported variance to

be 'fair'. This is a reason
• Why it is advisable to separate planning variances
Realistic measure from operational variances when a budget or
standard needs revision.
• Why variances reported using ideal standards may
be demotivating.
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O
N

N
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
Y

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3. The effect of reported variances on staff action
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Factors Explanations

The manager should want to do something to deal

Motivation with the causes of the variance.
 Incentives and motivation are important factors

Report variance as soon as reasonably practical.

If a reported variance relates to events occurring a long
A timely manner
time ago, managers will be reluctant to investigate
them 'now' because the variance will seem out of date.

The manager must believe that the cause of the

variance is something they are in a position to control.
If a manager considers the cause of a variance to be
Control area
outside their sphere of authority, or to be due to a
factor that they cannot do anything to change, they will
not be motivated to look for control measures.

Provoke a defensive reaction, with the manager trying to justify what has gone wrong.

In contrast, if there is an 'improvement culture', variances are considered as useful

indicators for control action and improving performance.
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Participation in the budgeting process will improve motivation and so will improve the
quality of budget decisions and the efforts of individuals to achieve their budget targets.

However, obviously this will depend on:

The nature of the task

The personality of The organisational
(narrowly defined
the individual culture.
or flexible)

There are basically three ways in which a budget can be set:

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Y IV. PARTICIPATION IN BUDGETING

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1.
r e Top-down budgeting (Imposed budgeting)
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In this approach to budgeting, top management prepare a budget with little or no input
from operating personnel which is then imposed on the employees who have to work
to the budgeted figures.

2. Bottom-up budgeting (Participative budgeting)

In this approach to budgeting, budgets are developed by lower-level managers who

then submit the budgets to their superiors. The budgets are based on the lower-level
managers perceptions of what is achievable and the associated necessary resources.
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In this approach to budgeting, different levels of management often agree budgets by a

process of negotiation. Negotiated budgeting is a budgeting process that combines both
top-down budgeting and bottom-up budgeting.

Final budgets are therefore most likely to lie between what top management would really
like and what junior managers believe is feasible.

The budgeting process is a bargaining process and it is this bargaining which is of vital
importance
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O

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V. VARIANCES IN A JIT OR TQM ENVIRONMENT
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1. Variances and a JIT environment

In a JIT manufacturing environment, production is managed on the principle that items

should not be produced until they are required to meet sales orders. There should be no
accumulation of inventories of work in progress and finished goods.

A JIT approach implies that if there are no sales orders, production resources should be kept
idle.
In addition, the volume of production should be restricted to the output capacity of the
bottleneck resource, meaning that there will inevitably be idle capacity for all resources that
are not the bottleneck resource.

In JIT manufacturing, idle time should therefore be expected.

In a system of standard costing, idle time is an adverse labour efficiency

variance, and is undesirable.
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If idle time variances are reported for a manufacturing operation that is based on JIT
methods:

Idle time variances are reported for a manufacturing operation

that is based on JIT methods

The variances will encourage managers to use idle capacity in

a productive way

By producing more and building up inventories

With increases in inventory, there will be a higher reported profit.

But this is unacceptable in a JIT environment.

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V. VARIANCES IN A JIT OR TQM ENVIRONMENT
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2.1 TQM and standard costing

Total Quality Management (TQM) is an approach to management that originated from

different sources, and has a number of different aspects.

1
The view
that work
should be
“right first
time”

Total Quality
2 3
Management
Items should be (TQM) The principle
produced only of continuous
when they are improvement
needed for the or “kaizen”
next stage in the
Improvements should
production
be made continually
process
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V. VARIANCES IN A JIT OR TQM ENVIRONMENT
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2. Variances and a TQM environment

2.1 TQM and standard costing

Each of these principles of TQM may be inconsistent with standard costing and variance
analysis. The inconsistency between standard costing and the view that production
resources should be kept idle until required has already been discussed in the context of JIT.

TQM Standard costing

Do not Allow for normal loss so, The philosophy

Taking account of allowance for
it is more consistent with in TQM of 'right
wastage in the standard cost.
environmental cost accounting. first time'

The principle of ‘kaizen’ or

A standard cost is based on an
continuous improvement is that The principle of
assumption of a desirable
a steady state of production 'kaizen' or
steady-state, this view is
will never be achieved because continuous
inconsistent with the principle
further improvements will improvement
of continuous improvement.
always be possible
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V. VARIANCES IN A JIT OR TQM ENVIRONMENT
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2.2 Can standard costing and TQM coexist?

Arguably, there is little point in running both a Total Quality Management program and a
standard costing system simultaneously.

Predetermined standards are at odds with the philosophy of continual

improvement inherent in a TQM program.

Continual improvements are likely to alter methods of working, prices, quantities

of inputs, and so on, whereas standard costing is most appropriate in a stable,
standardised and repetitive environment.

Material standard costs often incorporate a planned level of scrap. This is at odds
with the TQM aim of zero defects and there is no motivation to 'get it right first
time'.

Attainable standards which make some allowance for wastage and inefficiencies
are commonly set. The use of such standards conflicts with the elimination of
waste which is such a vital ingredient in a TQM programme.

Standard costing control systems make individual managers responsible for the
variances relating to their part of the organisation's activities. A TQM
programme, on the other hand, aims to make all personnel aware of, and
responsible for, the importance of supplying the customer with a quality product.
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VI. STANDARD COSTS IN
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Overview

Standard costs have limited relevance and value in the modern business world, where
the environment is continually changing, and the life cycle of products can be very short.

Standard costs are appropriate for a 'steady state' production environment where the
manufacturing system produces standard products, often in large quantities, using standard
and repetitive production methods and processes.
Traditional
Modern environment Impacts of standard costing
manufacturing
High labour cost, Low labour cost, Overhead variances do not have enough detail to
low overhead high overhead aid performance measurement.

Stable environment/ Rapidly changing Regular revision of standards can be demotivating

products environment/products for employees as the goal posts keep moving.

Differences between products make developing a

standard difficult. Resulting variances may not be
Standard product Customised product
meaningful and certain employees may be unfairly
penalised.

Variance analysis encourages cost control. Desired

Focus on cost Focus on quality
quality may drive adverse price variances.

Raw material and

finished goods Inventory may be built up in an effort to improve
JIT philosophy
inventories are efficiency variances.
important
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A RAPIDLY CHANGING ENVIRONMENT
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Overview

The role of standards and variances in modern business

However, a survey by Drury et al (1993) indicated the continued widespread use of standard
costing systems. Although this survey is now somewhat out of date, the following points
should be noted.

Criteria Explanation

Even in a TQM environment, budgets will still need to be

quantified.
For example, the planned level of prevention and
Planning
appraisal costs needs to be determined. Standards, such
as returns of a particular product should not exceed 1%
of deliveries during a budget period, can be set.

Cost and mix changes from the plan will still be relevant
Control
in many processing situations

Existing standards can be used as the starting point in the

Decision-making
construction of a cost for a new product.
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U

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Overview

Criteria Explanation

If the product mix is relatively stable, performance

Performance
measurement may be enhanced by the use of a system
measurement
of planning and operational variances.

Target costs may be compared with current standards,

and the resulting 'cost gap' investigated with a view to
Product pricing
reducing it or eliminating it using techniques such as
value engineering.

Improvement and change Variance trends can be monitored over time

Although the operation of a JIT system in conjunction

with backflush accounting will reduce the need for
Accounting valuations. standard costs and variance analysis, standards may be
used to value residual inventory and the transfers to cost
of sales account.
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CHAPTER 16: INFORMATION

SYSTEMS AND DATA ANALYTICS
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Y OVERVIEW

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Information systems and data analytics

I. Overview of information

II. Types of information system

III. Closed and open systems

IV. Big data

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Data consists of numbers, letters, symbols, raw facts, events and transactions, which have
been recorded but not yet processed into a form that is suitable for making decisions.

Information is data that has been processed in such a way that it has meaning to the
person that receives it, who may then use it to improve the quality of their decision-
making.

The conversion of data into information is illustrated as follows:

Analysed and processed

Data Information
to be meaningful
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1.
r e The need of information for management
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It is a vital requirement within any business to use information for management. Details are
as follows:

Information provides records, both current and historical

Information analyses what is happening within the business

Information provides the basis of decision making in the short and long term

Information monitors the performance of the business by comparing actual

results with plans and forecasts

Furthermore, numerous third parties require information about the business such as
shareholders, customers and suppliers and government agencies.
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There are 3 management levels for planning, control and decision-making within an
organisation:

Strategic planning is the process of deciding on objectives of the organisation, changes

in these objectives, the resources used to attain these objectives, and the policies that
are to govern the acquisition, use and disposition of these resources.

Management control (Tactical planning) is the process by which managers assure that
resources are obtained and used effectively and efficiently in the accomplishment of the
organisation's objectives.

Operational control (Operational planning) is the process of assuring that specific tasks
are carried out effectively and efficiently.
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3 these levels have significant differences. Details are as follows:

Management level Key characteristics Example

• Takes place at the top of The board might decide that more
the organisation capital is needed and that factoring
Strategic
• Concerned with setting debts or invoice discounting might
planning
a future course of action offer useful ways of raising cash
for the organisation balances.

• Concerned with the Credit control managers will be

effective use of concerned to follow up slow paying
Management
resources to achieve customers to ensure that bad debts
control
targets set at strategic are minimised and that cash flow is
planning kept healthy.
Sales ledger staff will be posting the
• Concerned with the day-
sales leger accounts, sending out
Operational to-day implementation
statement, dealing with accounts
control of the plans of the
queries and approve credit for new
organisation
orders.
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As mentioned above, information is necessary for management activity of a business. Each

level of management requires a corresponding level of information.

Management level Information level

Top
Strategic information

Strategic
Middle
Tactical information
Tactical

Bottom
Operational Operational information
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1 Strategic information

Strategic information would relate to the longer-term strategy on the company's market
share, which in turn informs the production plan.

Pre-determine the level of investment required in capital equipment in

the longer term

Investigate new methods and technology.

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2 Tactical information

The information would be in a summarised form but detailed enough to allow tactical
planning of resources and manpower.

Example

The short-term budget for 12 months and would show the budgeted machine
use in terms of machine hours for each item of plant.

The total machine hours being predetermined from the production budget
for the period
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3 Operational information

The information must be detailed and precise.

Example

Operational information would include a current week's report for a cost

centre on the capacity of the plant used in the period.
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Information systems refer to the provision and management of information to support the
running of the organization.

Information systems are also seen as a valuable strategic source which can help an
organisation gain competitive advantages. Details are as follows:

Link the organisation to customers or suppliers

Create effective integration of the use of information in a value-adding process

Enable the organisation to develop, produce, market and deliver new products
or services based on information

Give senior management information to help develop and implement strategy.

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In order to operate smoothly, an organization needs numerous systems to process, analyse

and hold information. There are 4 main information systems:

Types of information systems

Management Executive Enterprise

Transaction
information information resource planning
processing
systems systems systems
systems (TPS)
(MIS) (EIS) (ERPS)

Operational Management Strategic

control control planning
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1 Transaction processing system

A transaction is an event that generates or modifies data which is eventually stored on

an information system.

Transaction processing systems (TPS) collect, store, modify and retrieve the
transactions of an organization.

TPS has the following characteristics:

Characteristics Explanations

Controlled processing Processing must support an organisation's operations

Every transaction to be processed in the same way regardless

Inflexibility
of user or time

Rapid response Input must become output in seconds

Reliability Back-up and recovery procedures must be quick and accurate

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1 Transaction processing system

2 types of TPS:

Batch transaction Real time transaction

processing (BTP) processing (RTTP)

Transaction data is collected as a • Data is processed immediately

group and processes it later, after a • Use a terminal workstation to
time delay, as batches of identical enter data + display results and
data provides instant confirmation
Definition • A large number of users can
perform transactions at the
same time but access to a
central online database is
required

Cheque clearance. Reservation systems for flight or train

The payee cannot withdraw the bookings and hotel reservations,
money until the cheque is cleared. which require an acceptable response
Examples
Cheques are cleared in a group for 3 time, as transactions are made in the
working days presence of customers.

Notes: TPS are used mainly by operational managers to make basic decisions
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2 Management information system

MIS extracts, processes and summarises data from the TPS and provide periodic (weekly,
monthly, quarterly) reports to managers.
5 characteristics of a MIS:

Support structured decisions at operational and management control levels

Designed to report on existing operations

Little analytical capability

Relatively inflexible

An internal focus
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2 Management information system

4 types of MIS:

Types of MIS Description

Database Process and store information, which becomes the

systems organisation’s memory

Direct control Monitor and report on activities such as output levels, sales
systems ledger and credit accounts in arrears

Enquiry Based on databases to provide specific information such as the

systems performance of a department or an employee

Support Provide computer-based methods and procedures for

systems conducting analyses, forecasts and simulations.

Notes: MIS is useful for middle managers.

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3 Executive information system

Executive information systems (EIS) provide a generalised computing and

communication environment for senior managers to support strategic decisions.

An EIS summarises and tracks strategically critical information from the MIS and includes
data from external sources such as competitors, legislation. A model of a typical EIS shown
below:
EIS
workstation
• Menus
• Graphics
• Communications
• Local processing

EIS Internal data External data EIS

workstation workstation
• Menus TPS/MIS data Share prices • Menus
• Graphics Financial data Market research • Graphics
• Communications Office systems Legislation • Communications
• Local processing Modelling/analysis Competitors • Local processing
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4 Enterprise resource planning system

Executive resource planning systems (ERPS) are modular software packages designed to
integrate the key processes in an organisation so that a single system can serve the
information needs of all functional areas.

ERP systems primarily support business operations - those activities in an organisation that
support the selling process, including order processing, manufacturing, distribution,
planning, customer service, human resources, finance and purchasing.

Operations
Controls inventory throughout the supply chain,
from procurement to distribution

Finance ERP software Accounting

Reports customer’s Manages information flow Records sales and
credit rating and among all database payments and tracks
current selling applications business performance

Marketing Human resources

Co-ordinates sales activities and Recruits, trains, evaluates and
handles customer relationship compensates employees
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4 Enterprise resource planning system

ERP systems offer:

On-line/real-time Standardisation of data Common data files for

information throughout across the entire all functions, thereby
all the functional areas organization saving duplication.
of an organization
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A closed system is isolated and shut off from the environment. Information is not
received from or provided to the environment.

Example

A production line is a closed system within an organization.

The daily work that takes place on production or assembly lines can be insulated
from outside factors such as day-to-day meetings between upper-level
executives, or information from other similar, competing production lines.
Instead, workers on an assembly line are generally only responsible for
completing their tasks on the line, depending on what type of line it is.

• Closed systems are rare because interaction with the environment is

necessary for business survival.
• These systems will not provide adequate information for performance
management.
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System
Subsystem 1
Environment boundary
System
Subsystem 2

It can be seen that systems sit in their environments and are separated from their
environment by the systems boundary. Thus, a closed system has some below limitations:

Have only short lives because without input, closed systems will usually run
out of energy, material, information or some other resource

Normally become increasingly irrelevant as environmental changes are not

reflected in the system so the system becomes out of date

Internal information is easy for organisations to capture, but that is not

enough to ensure success, that requires external information which is much
more difficult to know and capture that reliably.
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As disadvantages of closed systems, open systems should be preferred to use.

An open system is connected to and interacts with the environment and is influenced by
it.

As disadvantages of closed systems, open systems should be preferred to use.

Subsystem 1
Input System Output
Subsystem 2

Example (Question)

SAP Co manufactures sports clothing for professional athletes. Products are

designed to prevent injury and aid the post-exercise recovery process. The
company regularly seeks feedback from athletes regarding the effectiveness of
products and recommendations to take forward.

Required: Explain which kind of system the organisation has.

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As disadvantages of closed systems, open systems should be preferred to use.

An open system is connected to and interacts with the environment and is influenced by
it.

As disadvantages of closed systems, open systems should be preferred to use.

Subsystem 1
Input System Output
Subsystem 2

Example (Question)

It is obvious that SAP Co operates an open system because it interacts with its
environment. Details are as follows:

• It takes feedback from its customers about the effectiveness of its products
and accordingly advises the product design department about customer
preferences.
• Based on customer feedback, SAP Co may decide to alter product design and
specification.
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Using an open system has following advantages and disadvantages:

Advantages Disadvantages

Encourage strong communication, Non-linear relationships could

which helps to operate efficiently exist among variables such as a
and become effective small change in one variable could
cause a large change in another
Adapt to changing business
environment
Difficult to measure the success of
Support management by helping the system such as input,
them to understand overall processing and output.
structures, to determine what
must do

Help planning by identifying

desired results, what measures or
outputs, what processes will
produce those outputs, and what
inputs are required.
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Big data refers to the mass of data that society creates each year, extending far beyond
the traditional financial and enterprise data created by companies.

3 characteristics of big data:

• The scale of information can now be created

and stored is staggering
• Advances in data storage technology & a fall
in price have allowed for captured data to be
stored for further analysis
Volume

Characteristics Timeliness is a key factor to decision makers

Velocity
(Three Vs)

Big data consists of both structured and

Variety
unstructured data
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Big data is used for numerous purposes. Details are as follows:

Purposes Comment

Big data and Big data can be used to analyse opportunities to increase
business value revenue and reduce costs, thereby increasing profit

Big data and Understanding the customer is a key benefit of big data
the customer analytics

• After identifying how value can be improved,

requirements of the customer, business priorities can
be determined
Big data and
• Big data is a key source of innovation, helping to create
corporate strategy
new products and services
• Volume and velocity of data helps speed up decision
making.
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Data analytics is the process of collecting and examining data in order to extract
meaningful business insights, which can be used to inform decision making and improve
performance.

There are numerous potential benefits to performance improvements of organisations

when big data analytics used. Details are as follows:

Benefits Comment

Big data analytics helps business identify how well it is

Better understanding meeting customers’ needs and potential changes needed to
of customer behaviour its products or service to meet customers’ needs more
effectively

Targeted marketing Big data could facilitate targeted promotions and

messages advertising

Improves Better data analysis helps management to take advantage

organisational of current social trends, in real time to to manage
decision making inventories and pricing
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Data analytics is the process of collecting and examining data in order to extract
meaningful business insights, which can be used to inform decision making and improve
performance.

There are numerous potential benefits to performance improvements of organisations

when big data analytics used. Details are as follows:

Benefits Comment

Big data could provide new business opportunities in their

New products
own right by introducing new products that is similar
and services
interests with customers

Big data can provide more detailed and up-to-date

Performance
information for performance measurement to react quickly
measurement
to variances

Improved data about customers and internal operations

Cost reduction
may help to reduce costs.
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Beside mentioned above benefits, using big data could have some below risks and
challenges:

Risks and challenges Comment

Not more data, more better decisions made. In order to be

Quality of data
useful, data has to be relevant and reliable

In order to be valuable, data needs to be reliable and

Veracity validated. Enterprises should maintain strong governance
on data quality

It is expensive to establish the hardware and analytical

Cost software needed and to comply with data protection
regulations which vary from country to country

The scale and complexity of data sets may require

Skills organisations to have staff with necessary analytical skills
for data mining, deriving algorithms and predictive analytics

Companies could face legal action if data is stolen so they

Loss and theft of data need to consider data protection and privacy issues to
ensure to comply with current legislation.
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CHAPTER 17: SOURCES OF

INFORMATION AND
MANAGEMENT REPORTS
(ADDITIONAL READING)
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Sources of information and management reports

I. Sources of management information

II. Management reports

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As studied in chapter 16. Information systems and data analytics, information is necessary
for management activity of a business.

Management information is gathered from 2 sources:

Sources of
Internal sources management External sources
information
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Internal sources of information include the financial accounting records and other
systems closely tied to the accounting system.
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1.1 Sources of internal information

Types of internal sources of information:

Sources Information

• Number and value of invoices

• Volume of sales
Sales ledger system
• Value of sales, analysed by customer
• Value of sales, analysed by product
• Number and value of invoices
Purchase ledger system
• Value of purchases, analysed by supplier
• Number of employees
• Hours worked; Wages earned
Payroll system
• Output achieved
• Tax deducted
• Date of purchase; Initial cost; Location
• Depreciation method and rate
Fixed asset system
• Service history
• Production capacity
• Machine breakdown times
Production
• Number of rejected units
• Types of customer
Sales and marketing
• Market research results
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1.2 Costs of internal information

Costs of internal information can be divided into 3 types:

Costs Examples

• Use of bar coding and scanners in retailing and manufacturing

• Use of OCR (Optical Character Recognition) to capture data
from printed documents
Direct data
• Use of ICR (Intelligent Character Recognition) to capture data
capture
from hand written documents
• Use of RFID (Radio Frequency Identification) tags to identify,
locate and track vehicles, staff, inventory

• Payroll department time spent processing and analysing

Processing personnel costs
• Time for personnel to input data

• Information collected but not needed

Indirect costs • Information stored long after it is needed
of producing • Information disseminated more widely than necessary
information • Collection of the same information by more than one method
• Duplication of information
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External sources of information include information from outside the organization.

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2.1 Sources of external information

There are many sources of external information. Details are as follows:

Sources Information

• Bid information
• Operational information
Suppliers
• Pricing information
• Technology

• Share price
• Information on competitors
Newspapers, journals
• Technological developments
• National and market surveys

• Industry statistics
• Taxation policy
Government • Inflation rates
• Demographic statistics
• Forecasts for economic growth
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2.1 Sources of external information

There are many sources of external information. Details are as follows:

Sources Information

• Product requirements
Customers
• Price sensitivity

• Wage demands
Employees
• Working conditions

• Information on potential customers

Banks
• Information on national markets

• Information on competitors
Business enquiry agents
• Information on customers

• Almost everything via databases, discussion

Internet
groups and mailing lists
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2.2 Benefits and limitations of external information

Using external information has following advantages and disadvantages:

Advantages Disadvantages

• The quality of decisions is ensured • Information may not be accurate,

as information is considered old and out of date so the source
of information must always be
• Risk/uncertainties avoided by checked
having information
• Sample used to generate the
• Ability to respond appropriately secondary data may be too small
to environment or to improve its
performance • Company publishes information
may not be reputable

• Information may not meet the

exact needs of the business

• Difficult to gather information.

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2.3 Costs of external information

Costs of external information can be divided into 5 types:

Costs Examples

• Cost of a marketing research survey

Direct search • Subscriptions to online databases
costs • Subscriptions to magazines, services
• Download fees
• Management and employee time spent finding useful
information
• Wasted management and employee time on unsuccessful
Indirect access searches for information
costs • Spurious accuracy/ redundancy
• Wasted management and employee time on excessive
searching
• Wasted time on trying to find spurious accuracy
• Recording, processing and dissemination of external
Management information
costs • Wasted time due to information overload
• Wasted time on excessive processing
• Installation and maintenance of computer networks,
Infrastructure
servers, landlines to facilitate internet searching and
costs
internal electronic communication
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2.3 Costs of external information

Costs of external information can be divided into 5 types:

Costs Examples

• Wasted time caused by abuse of internet and email access

facilities
Time theft • Lost time
• Cost of monitoring and disciplinary procedures
• Information overload.

Notes:
Information always comes with costs; however, companies should ensure that the
benefit received from management information exceeds the costs of gaining that
information.

Exam focus: Identify and discuss costs of information from the given data.
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Information of an organization will often consist of information that is either confidential or

commercially sensitive. Thus, controls will be required when generating and distributing this
information.

3 types of control:

Types of control over

generating and distributing information

Input Process Output

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1.1 Controls over input

Inputs should be complete, accurate and authorised. Detailed methods are as follows:

Method Purposes

Help to ensure data is authorised and they provide a software

Input
audit trail

Help to ensure data is accurate.

Range tests
Example: Month fields to be in the range 1-12

Help to ensure data is accurate.

Format checks
Example: All account numbers must be in the format A123

Help to ensure data is accurate.

Check digits Example: Specially constructed numbers which comply with a
mathematical test

Help to ensure data is completed.

Sequence checks
Example: Ensuring all cheques are accounted for

Primarily addresses completeness.

Matching Example: A system checking that each employee has input a
time sheet for the month
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1.2 Controls over processing

Processing should be initiated by appropriate personnel and logs should be kept of any
processing.
Some methods could be considered:

Passwords and software audit trails are important to track what processing was
carried out

Programs should not be altered without authorisation and testing; otherwise,

incorrect or fraudulent processing could be carried out.
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1.3 Controls over output

Output should be available to authorised persons and third parties only.

Some methods could be considered:

Each password allocated suitable access rights

Sensitive printed output could have a distribution list and should be physically
safeguarded.
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In order to protect highly confidential information that is not for external consumption,
businesses may use a number of following procedures:

Procedures Comment

To access a system the user first needs to enter a string of

characters. If what is entered matches a password, the
Passwords
system permits access. Otherwise the system shuts down
and may record the attempted unauthorised access.

This prevents those who already have access to a terminal or

a computer from gaining access to data or software through
Logical access 3 operations:
systems • Identification of the user
• Authentication of user identity
• Check on user authority

Database This is conducted by limiting the number of queries or

controls controlling the overlap between questions

This is used to prevent unauthorised internet users from

Firewalls accessing private networks connected to the internet,
especially intranets
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In order to protect highly confidential information that is not for external consumption,
businesses may use a number of following procedures:

Procedures Comment

Anti-virus software is carried out as follows:

• Scanning files to look for known viruses
• Identifying suspicious behavior
Anti-virus and Anti-spyware software combats spyware in 2 ways:
anti-spyware • Real-time protection prevents the installation of
software spyware
• Detection and removal of spyware by scanning software
and removing files and entries that match known
spyware

Data is encoded in a way that makes it extremely difficult for

Encryption people to decode and then use data if they were to gain
access to it

Personnel Recruitment, training and supervision needs to be in place to

security ensure the competence of those responsible for
planning programming and data entry.

Exam focus: Determine and discuss control methods and procedures applied from the
given data.
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The output reports produced for management should contain good information. A good
information should be:

Accurate

Complete

Cost < benefit

Understandable

Relevant to avoid information overload

Adaptable to needs of users

Timely

Easy to use
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However, before any report is created the following controls should be adopted:

Undertake cost/benefit analysis to ensure benefits from the reports is

higher costs spent to achieve the

Consider making a prototype of reports

Check that the report is not duplicated to avoid inefficient reports.

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CHAPTER 18:
DIVISIONAL PERFORMANCE
AND TRANSFER PRICING ISSUES
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Characteristics and needs

in a divisional organization

Decentralisation
Divisionalisation
Problems associated with
divisional structures

Responsibility accounting

Divisional Divisional Return on investment (ROI)

performance and performance
Transfer pricing measurement Residual income (RI)

General theory

Criteria for designing a

Transfer pricing
transfer pricing policy

Setting the transfer price

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In general, a large organisation can be structured in one of two ways:

All activities of a similar type within a company, such as

Functionally production, sales and research, are under the control of the
appropriate departmental head

Split into divisions in accordance with the products or

Divisionally
services made or provided.

Divisionalisation is a term for the division of an organisation into divisions. Each

divisional manager is responsible for the performance of the division
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1. tInformation characteristics and needs in a divisional torganisation
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The divisional form is characterised by autonomy given to managers lower down the line.
The prime coordinating mechanism is a standardisation of outputs.

There are three types of division:

Types of division

Cost center Profit center Investment center

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1.1 Characteristics of divisionalisation

Divisionalisation is the division of a business into autonomous

regions or product businesses, each with its own revenues,
expenditures and profits.

Communication between divisions and head office is restricted,

formal and related to performance standards. Influence is
maintained by headquarters' power to hire and fire the managers
who are supposed to run each division.

Headquarters management influences prices and therefore

profitability in divisions when it sets transfer prices between
divisions.

Divisionalisation is a function of organisation size, in numbers and

in product-market activities.
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1.1 Characteristics of divisionalisation

The multi-divisional structure might be implemented in one of two forms:

Multi-divisional structure organised by product-market areas

• This enables concentration on particular product-market areas.
• Problems arise with the power of the head office, and control of the resources.

Organization ‘s head office

Division A Division B Division C

Functions Functions Functions

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1.1 Characteristics of divisionalisation

The multi-divisional structure might be implemented in one of two forms:

Holding company organisational structure

• The holding company (group) structure is a radical form of divisionalisation.
• Subsidiaries are separate legal entities.

Holding company

Subsidiary A Subsidiary B Subsidiary C

Sub-Subsidiary D Sub-Subsidiary E Sub-Subsidiary F

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1.2 Information needs of divisional structures

In a divisional structure each division is self-contained and based on geography or

product/service area.

Divisional managers have more authority to act autonomously than in a

functional structure (where planning and control are exercised centrally).

Divisional organisations tend to be more decentralised than functional ones.

Divisional managers are clear about an organisation's strategy and objectives,

so that they can ensure that their divisions perform according to that strategy -
the goal congruence.

Performance information needs to be available to all these managers.

Managers will be accountable for, and rewarded on the basis of, divisional
performance. Accordingly, divisional performance measures can be
appropriate here.
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1.2 Information needs of divisional structures

In a divisional structure each division is self-contained and based on geography or

product/service area.

Divisional managers are therefore responsible for all operations

(production, sales, and so on) relating to their product, the
functional structure being applied to each division.

It is possible that only part of a company is divisionalised and activities such

as administration are structured centrally on a functional basis with the
responsibility of providing services to all divisions.
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Generally, a company with several divisions will be a decentralised organisation. In such

organisations, divisional managers tend be responsible for making their own decisions
concerning the operation of the division.

A divisional structure will lead to decentralisation of the decision-making

process and divisional managers may have the freedom to:

Choose suppliers Make product mix Set selling prices

and output decisions

Decentralisation is a matter of degree, depending on how much freedom divisional

managers are given.
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.c 2. Decentralisation

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There are some advantages and disadvantages of decentralisation in a corporation:

Advantages Disadvantages

Decisions made more Potential for dysfunctional

quickly decision making

Increased motivation of Duplication amongst divisions

management leading to greater cost

Reduced head office Senior management loss of

bureaucracy control

Better training for all levels

of management

Notes:
Appropriate performance evaluation methods are therefore needed in order to
counteract the possible disadvantages.
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3. Problems
.c associated with divisional structures

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Before looking at the methods for divisional performance appraisal it is worth noting that
divisional structures may result in the following problems:

Co-ordination
How to co-ordinate different divisions to achieve overall corporate objectives.

Goal congruence
Managers will be motivated to improve the performance of their division, possibly at
the expense of the larger organisation.

Controllability
Divisional managers should only be held accountable for those factors that they can
control. The performance of a division's manager must be appraised separately to the
performance of the division. It may be difficult to determine exactly what is and what is
not controllable.

Inter-dependence of divisions
The performance of one division may depend to some extent on others, making it
difficult to measure performance levels.

Head office costs

Whether or how head office costs should be reapportioned.

Transfer prices
How transfer prices should be set as these effectively move profit from one division to
another.
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Responsibility accounting is the term used to describe decentralisation of authority,

with the performance of the decentralised units measured in terms of accounting
results.

Responsibility accounting is used to measure performance of decentralised units

Responsibility Manager’s area of Principal performance
structure responsibility measures
Cost centre • Controllable costs • Variance analysis
• Efficiency measures
Revenue centre • Revenues only • Revenues
Profit centre • Controllable costs • All of the above PLUS:
• Sales prices (including • Total sales and market
transfer prices) share.
• Profit.
• Sales variances.
• Working capital ratios
(depending on the
division concerned).

Investment centre • Controllable costs • All of the above PLUS:

• Sales prices (including • Return on investment
transfer prices) • Residual income
• Output volumes • Other financial ratios
• Investment in non-current
assets and working capital
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Within an investment centre, as well as being responsible for profits, managers also have
responsibility over investments and assets. To measure their performance purely on say
profit would be focusing only on part of the picture. To overcome this, we use two methods
that measure the assets and the profit they generate.

Performance of
Return in investment Residual income
an investment
(ROI) (RI)
centre
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Return on investment (ROI) shows how much profit has been made in relation to the
amount of capital invested.

ROI is generally regarded as the key performance measure. The main reason for its
widespread use is that it ties in directly with the accounting process, and is identifiable
from the statement of profit or loss and statement of financial position.
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1.1 Measuring ROI

Popular formula:
Divisional controllable profit
ROI = × 100%
Divisional investment
Where:
• Divisional controllable profit = profit before interest and tax (PBIT).
• Divisional investment = opening book value of total assets less current liabilities OR
an average book value of net assets may be used.

If ROI > cost of capital (required return), then accept the project or
Decision rules
appraise the division as performing favourably.

Notes:
• ROI is the divisional equivalent of ROCE.
• There is no generally agreed method of calculating ROI, and it can have behavioural
implications and lead to dysfunctional decision-making when used as a guide to
investment decisions
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1.1.1 Profits

The performance of the investment centre manager

It should seem reasonable to base profit on the revenues and costs controllable
by the manager and exclude service and head office costs except those costs
specifically attributable to the investment centre.

The performance of the investment centre

The inclusion of general service and head office costs would seem reasonable.
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1.1.2 Elements of the investment base

Although we have looked at how the investment base should be valued, we need to
consider its appropriate constituent elements.

The manager's performance evaluation

• Only those assets which can be traced directly to the division and are
controllable by the manager should be included.
• Head office assets or investment centre assets controlled by head office should
not be included.
For example, only those cash balances actually maintained within an investment
centre itself should be included.

The evaluation of the performance of the investment centre

A proportion of the investment in head office assets would need to be included

because an investment centre could not operate without the support of head office
assets and administrative backup.
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1.1.3 Problems with ROI

Using ROI as a divisional performance measure can incur the following problems:

Dysfunctional behaviour – only projects which increase ROI will be accepted;

1
this could be at the expense of growth in corporate profits

2 The ratio will be distorted by the age of the assets

3 Profit can be manipulated

Manipulating the ROI

• If a manager’s bonus depends on ROI being met, the manager may feel pressured
into manipulating the measure.
• The asset base of the ratio can be altered by increasing/decreasing payables and
receivables (by speeding up or delaying payments and receipts).

Notes: Exam focus point

You must learn the problems with using ROI. A Section C question could contain a
scenario in which ROI is being used and abused. You would need to use the scenario to
demonstrate each problem.
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1.2 ROI and new investments

If investment centre performance is judged by ROI, we should expect that the managers of
investment centres will probably decide to undertake new capital investments only if these
new investments are likely to increase the ROI of their centre.

Example 1 (Question): ROI and new investment

Suppose that an investment centre, A, currently makes a return of 40% on capital

employed. The manager of centre A would probably only want to undertake new
investments that promise to yield a return of 40% or more, otherwise the
investment centre's overall ROI would fall.
If investment centre A currently has assets of $1,000,000 and expects to earn a
profit of $400,000.

Required:
How would the centre's manager view a new capital investment which would
cost $250,000 and yield a profit of $75,000 pa?
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1.2 ROI and new investments

Example 1 (Solution): ROI and new investment

Without the new investment With the new investment

Profit $400,000 $475,000
Capital employed $1,000,000 $1,250,000
ROI 40% 38%

The new investment would reduce the investment centre's ROI from 40% to 38%,
and so the investment centre manager would probably decide not to undertake
the new investment.
If the group of companies of which investment centre A is a part has a target ROI
of 25%, the new investment would presumably be seen as beneficial for the
group as a whole.
But even though it promises to yield a return of 75,000/250,000 = 30%, which is
above the group's target ROI, it would still make investment centre A's results
look worse.
 The manager of investment centre A would be motivated to do not what is
best for the organisation as a whole, but what is best for his or her division.
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1.2 ROI and new investments

Notes:
The June 2018 examining team report highlighted an error that students continue to
make with regard to investments and ROI. You must read exam questions carefully. If
the ROI of an investment is asked for, rather than the ROI of the division as a whole, you
must only include the profits and capital flows relating to the investment itself. If the
question asks for the ROI of the division after an investment has been made, then you
would include the other business's profit and assets in the calculation.

From above example, we see that:

ROI should not be used to guide investment decisions as there is a difficult
motivational problem.
If management performance is measured in terms of ROI, any decisions which
benefit the company in the long term but which reduce the ROI in the immediate
short term would reflect badly on the manager's reported performance.

Good investment decisions would make a manager's performance seem

worse than if the wrong investment decision were taken instead
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1.2 ROI and new investments

Notes:
The June 2018 examining team report highlighted a question on performance
management that caused problems for students in the exam. The question related to
decisions made by a manager which could lead to a bonus without benefiting the
organisation. Make sure you understand the relationship between ROI, investments and
bonuses. The examining team said, '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. Low
depreciation charges may also hide this but cash flow would be affected.'
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1.3 Evaluation of ROI as a performance measure

ROI is a popular measure for divisional performance but has some serious failings which
must be considered when interpreting results.

Advantages Disadvantages

It is widely used and accepted It may lead to dysfunctional

since it is line with ROCE which is decision making.
frequently used to assess overall
business performance. ROI increases with the age of the
asset if NBVs are used, thus giving
As a relative measure it enables managers an incentive to hang on
comparisons to be made with to possibly inefficient, obsolescent
divisions or companies of different machines.
sizes.
It may encourage the manipulation
It can be broken down into of profit and capital employed
secondary ratios for more detailed figures to improve results.
analysis (profit margin and asset
turnover). Different accounting policies can
confuse comparisons.
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1.3 Evaluation of ROI as a performance measure

Example 2 (Question): (December 2017 - Q32a)

Sports Co is a large manufacturing company specialising in the manufacture of a

wide range of sports clothing and equipment. The company has two divisions:
Clothing (Division C) and Equipment (Division E). Each division operates with little
intervention from Head Office and divisional managers have autonomy to make
decisions about long-term investments.
Sports Co measures the performance of its divisions using return on investment
(ROI), calculated using controllable profit and average divisional net assets. The
target ROI for each of the divisions is 18%. If the divisions meet or exceed this
target the divisional managers receive a bonus.
Last year, an investment which was expected to meet the target ROI was rejected
by one of the divisional managers because it would have reduced the division’s
overall ROI. Consequently, Sports Co is considering the introduction of a new
performance measure, residual income (RI), in order to discourage this
dysfunctional behaviour in the future. Like ROI, this would be calculated using
controllable profit and average divisional net assets.
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1.3 Evaluation of ROI as a performance measure

Example 2 (Question): (December 2017 - Q32a)

The draft operating statement for the year, prepared by the company’s trainee
accountant, is shown below:

Division C Division E
$’000 $’000
Sales revenue 3,800 8,400
Less variable costs (1,400) (3,030)
Contribution 2,400 5,370
Less fixed costs (945) (1,420)
Net profit 1,455 3,950
Opening divisional controllable net assets 13,000 24,000
Closing divisional controllable net assets 9,000 30,000
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1.3 Evaluation of ROI as a performance measure

Example 2 (Question): (December 2017 - Q32a)

Notes:
(1) Included in the fixed costs are depreciation costs of $165,000 and $460,000 for
Divisions C and E respectively.
30% of the depreciation costs in each division relates to assets controlled but not
owned by Head Office.
Division E invested $2m in plant and machinery at the beginning of the year, which is
included in the net assets figures above, and uses the reducing balance method to
depreciate assets. Division C, which uses the straight-line method, made no
significant additions to non-current assets. It is the policy of both divisions to charge
a full year’s depreciation in the year of acquisition.
(2) Head Office recharges all of its costs to the two divisions. These have been
included in the fixed costs and amount to $620,000 for Division C and $700,000 for
Division E.
(3) Sports Co has a cost of capital of 12%.
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1.3 Evaluation of ROI as a performance measure

Example 2 (Question): (December 2017 - Q32a)

Required:
(i) Calculate the return on investment (ROI) for each of the two divisions of Sports
Co.
(ii) Discuss the performance of the two divisions for the year, including the main
reasons why their ROI results differ from each other. Explain the impact the
difference in ROI could have on the behaviour of the manager of the worst
performing division.
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1.3 Evaluation of ROI as a performance measure

Example 2 (Solution): (December 2017 - Q32a)

(i) Formula:
Controllable profit
Return on investment = Divisional investment
Controllable profit

Division C Division E
$’000 $’000
Net profit 1,455 3,950
Add back depreciation on non-controllable assets 49.5 138
Add back Head Office costs 620 700
Controllable profit 2,124.5 4,788

Divisional investment = Average divisional net assets

Division C Division E
$’000 $’000
Opening assets 13,000 24,000
Closing assets 9,000 30,000
Average assets 11,000 27,000
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1.3 Evaluation of ROI as a performance measure

Example 2 (Solution): (December 2017 - Q32a)

ROI for each division:

Division C Division E
$’000 $’000
Controllable profit 2,124.5 4,788
Average assets 11,000 27,000
ROI 19.3% 17.7%

(ii) Division performance

Whilst Division C has exceeded the target ROI, Division E has not. If controllable
profit in relation to revenue is considered, Division C’s margin is 56% compared to
Division E’s margin of 57%, so Division E is actually performing slightly better.
However, Division E has a larger asset base than Division C too
 Hence the fact that Division C has a higher ROI.
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1.3 Evaluation of ROI as a performance measure

Example 2 (Solution): (December 2017 - Q32a)

Explanation:
• Higher net assets
Since Division E appears to be a much larger division and is involved in sports
equipment manufacturing, then it could be expected to have more assets. Division
E’s assets have gone up partly because it made substantial additions to plant and
machinery.
• Lower profit
This means that as well as increasing the average assets figure, the additions will
have been depreciated during the year, thus leading to lower profits. This may
potentially have had a large impact on profits since Division E uses the reducing
balance method of depreciation, meaning that more depreciation is charged in the
early years.
Division manager evaluation
Based on the ROI results, the manager of Division C will get a bonus and the
manager of Division E will not. This will have a negative impact on the motivation
level of the manager of Division E and may discourage him from making future
investments, unless a change in the performance measure used is adopted.
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An alternative way of measuring the performance of an investment centre, instead of using

ROI, is residual income (RI).

Residual income is a measure of the centre’s profits after deducting a notional or

imputed interest cost.

The centre's profit is after deducting depreciation on capital equipment.

The imputed cost of capital might be the organisation's cost of borrowing

or its weighted average cost of capital.

RI can sometimes give results that avoid the behavioural

problem of dysfunctionality.
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2.1 Measuring RI

Formula:
RI = Controllable profit – Notional interest on capital
Where:
• Controllable profit is calculated in the same way as for ROI – it may be PBIT.
• Notional interest on capital = the capital employed × notional cost of capital.
o Capital employed is calculated in the same way as for ROI.
o Cost of capital could be the company’s average cost of funds (cost of capital) or
other interest rates might be selected (the current cost of borrowing, or a
target ROI).

If the RI is positive:
Decision rules • Accept the project
• Appraise the division as performing favourably.
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2.1 Measuring RI

Example 2 (Question): Residual income

A division with capital employed of $400,000 currently earns an ROI of 22%. It can
make an additional investment of $50,000 for a five-year life with nil residual value.
The average net profit from this investment would be $12,000 after depreciation.
The division's cost of capital is 14%.
Required:
What are the residual incomes before and after the investment?

Solution:

Before investment After investment

$ $
Divisional profit 88,000 100,000
($400,000 × 22%)
Imputed interest 56,000 63,000
(400,000 × 0.14) (450,000 × 0.14)
Residual income 32,000 37,000
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2.2 Evaluation of RI as a performance measure

Compared to using ROI, RI has several advantages and disadvantages:

Advantages Disadvantages

It reduces the problems of ROI, i.e. It is difficult to decide upon an

dysfunctional behaviour and appropriate cost of capital.
holding onto old assets.
It does not facilitate comparisons
Interpreting the result is simple; if between divisions since the RI is
the RI is positive then the division is driven by the size of the divisions
generating a return above that and their investment.
required by the finance providers.
It does not always result in
decisions that are in the best
The cost of financing a division is
interests of the company.
brought home to divisional
managers.
Different accounting policies can
confuse comparisons.
Different costs of capital can be
applied to different divisions based
on their risk profiles. It is based on accounting measures
of profit and capital employed
which may be subject to
manipulation.
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2.2 Evaluation of RI as a performance measure

Example 2 (Question): December 2017 - Q32a

Sports Co is a large manufacturing company specialising in the manufacture of a

wide range of sports clothing and equipment. The company has two divisions:
Clothing (Division C) and Equipment (Division E). Each division operates with little
intervention from Head Office and divisional managers have autonomy to make
decisions about long-term investments.
Sports Co measures the performance of its divisions using return on investment
(ROI), calculated using controllable profit and average divisional net assets. The
target ROI for each of the divisions is 18%. If the divisions meet or exceed this target
the divisional managers receive a bonus.
Last year, an investment which was expected to meet the target ROI was rejected
by one of the divisional managers because it would have reduced the division’s
overall ROI. Consequently, Sports Co is considering the introduction of a new
performance measure, residual income (RI), in order to discourage this
dysfunctional behaviour in the future. Like ROI, this would be calculated using
controllable profit and average divisional net assets.
 569
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2.2 Evaluation of RI as a performance measure

Example 2 (Question): December 2017 - Q32a

The draft operating statement for the year, prepared by the company’s trainee
accountant, is shown below:

Division C Division E
$’000 $’000
Sales revenue 3,800 8,400
Less variable costs (1,400) (3,030)
Contribution 2,400 5,370
Less fixed costs (945) (1,420)
Net profit 1,455 3,950
Opening divisional controllable net assets 13,000 24,000
Closing divisional controllable net assets 9,000 30,000
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2.2 Evaluation of RI as a performance measure

Example 2 (Question): December 2017 - Q32a

Notes:
(1) Included in the fixed costs are depreciation costs of $165,000 and $460,000 for
Divisions C and E respectively.
30% of the depreciation costs in each division relates to assets controlled but not
owned by Head Office.
Division E invested $2m in plant and machinery at the beginning of the year, which is
included in the net assets figures above, and uses the reducing balance method to
depreciate assets. Division C, which uses the straight-line method, made no
significant additions to non-current assets. It is the policy of both divisions to charge
a full year’s depreciation in the year of acquisition.
(2) Head Office recharges all of its costs to the two divisions. These have been
included in the fixed costs and amount to $620,000 for Division C and $700,000 for
Division E.
(3) Sports Co has a cost of capital of 12%.

Required:
Calculate the residual income (RI) for each of the two divisions of Sports Co and
briefly comment on the results of this performance measure.
 571
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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

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B

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to

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.c 2. Residual income (RI)

.c
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2.2 Evaluation of RI as a performance measure

Example 2 (Solution): December 2017 - Q32a

Residual income

Division C Division E
$’000 $’000
Controllable profit 2,124.5 4,788
Less: imputed charge on assets at 12% (1,320) (3,240)
Residual income 804.5 1,548

Comment
From the residual income results, it can clearly be seen that both divisions have
performed well, with healthy RI figures of between $0·8m and $1·55m.
The cost of capital of Sports Co is significantly lower than the target return on
investment which the company seeks, making the residual income figure show a
more positive position.
 572
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O

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N

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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

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B

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to

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.c 3. ROI versus RI

.c
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.

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Used more frequently

ROI RI Technically superior
in practice

ROI is consistent with corporate assessment (ROCE).

Ratios are more easily understood compared with, say, costs of capital
and are more appropriate for comparing divisions of different sizes.

Calculation of the cost of capital in RI is subjective and time-consuming.

A company may feel that the dysfunctional behaviour associated with

ROI, such as underinvestment, is unlikely to occur.

For example, if a company is using ROI as a part of a balanced scorecard then

customer, internal business and innovation measures should all highlight the impact
of underinvestment.
 573
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O

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N

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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

U
B

B
to

to
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ww
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k

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C
.c 3. ROI versus RI

.c
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w
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.

.
ac ac
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Using ROI or RI can lead to different decision whether a marginally profitable investment
should be undertaken or not.

Return on investment (ROI) VS Residual income (RI)

A marginally profitable investment A marginally profitable investments

would be less likely to be undertaken are likely to be undertaken by the
because it would reduce the average investment centre manager. Because
ROI earned by the centre as a whole. Residual income will increase if

• Earned profit in excess of the

imputed interest charge on the
acquisition.

• The investment only just exceeds

the imputed interest charge.
 574
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O

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N

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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

U
B

B
to

to
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om

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k

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C
.c 3. ROI versus RI

.c
w

w
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.

.
ac ac
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Example 3 (Question): ROI versus RI

Suppose that Department H has the following profit, assets employed and an
imputed interest charge of 12% on operating assets.

$ $
Operating profit 30,000
Operating assets 100,000
Imputed interest (12%) 12,000
Return on investment 30%
Residual income 18,000
Suppose now that an additional investment of $10,000 is proposed, which will
increase operating income in Department H by $1,400. The effect of the investment
would be:
$ $
Operating profit 31,400
Operating assets 110,000
Imputed interest (12%) 13,200
Return on investment 28.5%
Residual income 18,200

Required: Assess the projects using both ROI and RI.

 575
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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

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B

B
to

to
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om

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k

k
lic

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C
.c 3. ROI versus RI

.c
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w
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.

.
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Example 3 (Solution): ROI versus RI

If the Department H manager is made responsible for the department's

performance, since there would be a marginal increase of $200 in RI from the
investment, but a fall of 1.5% in ROI.
They would resist the new investment if they were to be judged on ROI
They would welcome the investment if they were judged according to RI

The marginal investment offers a return of 14% ($1,400 on an investment of

$10,000) which is above the 'cut-off rate' of 12%. Since the original return on
investment was 30%, the marginal investment will reduce the overall divisional
performance.

Indeed, any marginal investment offering an accounting rate of return of less

than 30% in the year would reduce the overall performance.

Notes:
Examination questions on residual income may focus on the sort of behavioural aspects
of investment centre measurement that we have discussed above; for example, why it is
considered necessary to use residual income to measure performance rather than ROI,
and why residual income might influence an investment centre manager's investment
decisions differently.
 576
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or

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W

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O

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N

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II. DIVISIONAL PERFORMANCE MEASUREMENT
Y

Y
U

U
B

B
to

to
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ww
om

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k

k
lic

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C
.c 3. ROI versus RI

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

Both ROI and RI are calculated based on “profit” and “divisional investment”, so the
following problem with calculation can arise:

Calculation of ‘profit’ Calculation of ‘investment’

May need to be adjusted to reflect Historical, net book or

controllable and traceable items replacement value.
only
Using net book value (NBV)
Transfer prices or quantities may discourages replacement.
be imposed or set at non-
commercial rates. Replacement value is complex
to obtain and update
Both ignore tax.
Cash may be controlled by the
company’s treasury department.
Intangible assets may have no
accounting value or may be
complex to update. Hard to apply
to service divisions (create more
value from intangible assets).
 577
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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k

k
lic

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C
.c 1. General theory

.c
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.

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ac ac
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A transfer price is the price at which goods or services are transferred from one
department to another, or from one member of a group to another.

Within a decentralised organisation, there may be a division which makes units that
are then transferred to another division.
It will usually be necessary to charge the receiving division for the goods that it has
received in order for performance to be measured equitably.

The price charged is called a transfer price and it can be calculated in several different ways.

Transfer Organization ‘s head

pricing office

Division A Division B Division C

Transfer
pricing

The transfer pricing policy will have a significant impact on responsibility accounting and
performance measurement.
 578
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Y III. TRANSFER PRICING

Y
U

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B

B
to

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C
.c 1. General theory

.c
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.
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It is vital that the transfer price is carefully selected to ensure all parties act in the best
interest of the company. The overriding question should be:

Whether the transfer is in the company’s best interest

Objectives of a transfer pricing system

Terms Explanations

The decisions made by each profit centre manager should be

Goal congruence
consistent with the objectives of the organisation as a whole.

The buying and supply divisions will be treated as profit

centres. The transfer price should allow the performance of
Performance
each division to be assessed fairly.
measurement
Divisional managers will be demotivated if this is not
achieved.

The system used to set the transfer price should seek to

Autonomy maintain the autonomy of the divisional managers.
This autonomy will improve managerial motivation.

Recording the
movement of goods Assist in recording the movement of goods and services
and services
 579
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O

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Y III. TRANSFER PRICING

Y
U

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B

B
to

to
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C
.c 1. General theory

.c
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.

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ac ac
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Example 4: Transfer pricing illustration

Subsidiary A might make a component that is used as part of a product made by

subsidiary B of the same company, but that can also be sold to the external market,
including makers of rival products to subsidiary B's product. There will therefore be
two sources of revenue for A.
• External sales revenue from sales made to other organisations.
• Internal sales revenue from sales made to other responsibility centres within
the same organisation, valued at the transfer price.
The diagram below shows how two divisions of a company could make decisions
that are not in the best interests of the whole company.

This is an essential described

diagram for transfer pricing
 580
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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ww
om

om
k

k
lic

lic
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C
.c 1. General theory

.c
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w
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.

.
ac ac
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Example 4: Transfer pricing illustration

May want to sell their products to external customers as

The Supply
they are willing to pay a higher price than the internal
division
transfer price

The Receive May be able to source the products cheaper from an

division external supplier

Overall, these decisions may have negative impacts (both financial and
non-financial) on the company as a whole, so a transfer price must be
set at a level that satisfies both divisions
 581
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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om

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k

k
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C
2.r eCriteria for designing a transfer pricing policy
.c

.c
w

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.

.
ac ac
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Transfer prices shoule be set in a way that:

Promote but still control divisional autonomy

Ideally when not prejudicing divisional performance measurement

Avoid discouraging overall corporate profit maximisation (goal congruence)

 582
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Y III. TRANSFER PRICING

Y
U

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B

B
to

to
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om

om
k

k
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C
2.r eCriteria for designing a transfer pricing policy
.c

.c
w

w
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.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

2.1 Divisional autonomy

Logic:
Transfer prices are particularly appropriate for profit centres because if one profit
centre does work for another, the size of the transfer price will affect the costs of one
profit centre and the revenues of another.

However, the following problem may arise:

A danger with profit centre accounting is that the business

organisation will divide into a number of self-interest segments, each
acting at times against the wishes and interests of other segments.

A profit centre manager might take decisions in the best interests of

their own part of the business, but against the best interests of other
profit centres and possibly the organisation as a whole.
 583
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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ww
om

om
k

k
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C
2.r eCriteria for designing a transfer pricing policy
.c

.c
w

w
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.

.
ac ac
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2.1 Divisional autonomy

With the problem, following solutions are suggested:

A task of head office is therefore to try to prevent dysfunctional decision

making by individual profit centres. To do this, it must reserve some power
and authority for itself and so profit centres cannot be allowed to make
entirely autonomous decisions.

A balance ought to be kept between divisional autonomy to provide

incentives and motivation, and retaining centralised authority to ensure that
the organisation's profit centres are all working towards the same target, the
benefit of the organisation as a whole (in other words, retaining goal
congruence among the organisation's separate divisions).
 584
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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om

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k

k
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C
2.r eCriteria for designing a transfer pricing policy
.c

.c
w

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tr tr re
.

.
ac ac
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2.2 Divisional performance measurement

Logic:
Profit centre managers tend to put their own profit performance above everything else.
Since profit centre performance is measured according to the profit they earn, no profit
centre will want to do work for another and incur costs without being paid for it.

Profit centre managers are likely to dispute the size of transfer prices
with each other, or disagree about whether one profit centre should
do work for another or not. Transfer prices affect behaviour and
decisions by profit centre managers.
 585
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or

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!

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W

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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
2.r eCriteria for designing a transfer pricing policy
.c

.c
w

w
tr tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

2.3 Corporate profit maximization (goal congruence)

Logic:
When there are disagreements about how much work should be transferred between
divisions, and how any sales the division should make to the external market, there is
presumably a profit-maximising level of output and sales for the organisation as a
whole.

However, unless each profit centre also maximises its own profit at
this same level of output, there will be interdivisional disagreements
about output levels and the profit-maximising output will not be
achieved.
 586
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O

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N

N
Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
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There are 2 main methods available:

Method Impact on supply division Impact on buying division

In perfect • Earns same profit as • Happy to accept transfer

market external sales or higher. (cannot buy cheaper
Market- • Equitable performance elsewhere)
based management • Equitable performance
In imperfect
market management

No incentive to transfer Happy to accept (if less than

Full cost
unless spare capacity market price)

Variable cost No incentive to transfer Happy to accept

Cost- Covers all costs and May not accept as price
based Full cost plus contributes to profit so could be higher than market
% happy to sell price

Variable cost May not cover all fixed costs Will accept if lower than
plus % market price
 587
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

3.1 Market-based approach

Market-based approach will be used where there is an external market for the product
being transferred.

The choice of the market price of a product that is equivalent and comparable to the
intermediate product is one option for the determination of a transfer price.
Now, we remind the transfer pricing diagram from Example 4:
 588
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

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k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
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3.1.1 Market-based approach in the perfect market

In a perfect market, the following conditions must apply:

Transactions of the company

A market for the intermediate
divisions may not influence the
product or a full substitute exists
market price

The market price should fit the

There is a uniform market price decision. It should not be affected
by short-term price considerations.

Therefore, in the perfect market, there is one and only one price of the transferred product
on the market. That means the price of external sales is equal to its of the alternative
supplier.
 589
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
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ww
om

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k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
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.

.
ac ac
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3.1.1 Market-based approach in the perfect market

Example 8 (Question): Transferring goods in a perfect market

A company has two profit centres, A and B. Centre A sells half of its output on the
open market and transfers the other half to B. Costs and external revenues in an
accounting period are as follows. Assume that, Division A sells goods externally at
market price and the market is perfect.

A B Total
$’000 $’000 $’000
External sales 8 24 32
Costs of production 12 10 22
Company profit 10

Required: What are the consequences of setting a transfer price at market value?
 590
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

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.

.
ac ac
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3.1.1 Market-based approach in the perfect market

Example 8 (Solution): Transferring goods in a perfect market

If the transfer price is at market price, A would be happy to sell the output to B for
$8,000, which is what A would get by selling it externally instead of transferring it.
A B Total
$’000 $’000 $’000 $’000 $’000
Market sales 8 24 32
Transfer sales 8 -
Total sales 16 24
Transfer costs - (8)
Own cost (12) (10) (22)
Total cost (12) (18)
Profit 4 6 10
The consequences, therefore, are as follows:
• A earns the same profit on transfers as on external sales. B must pay a
commercial price for transferred goods, and both divisions will have their profit
measured fairly.
• A will be indifferent about selling externally or transferring goods to B because
the profit is the same on both types of transactions. B can therefore ask for and
obtain as many units as it wants from A.
 591
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

3.1.1 Market-based approach in the perfect market

Notes:
• A market-based transfer price can only be applied if a valid market price is
available for the goods being transferred between the divisions. That means if a
perfectly competitive market exists for the product, then the market price is the
best transfer price.
• Adjusted market price: care must be taken to ensure the division's product is the
same as that offered by the market (for example, quality and delivery terms are the
same). If not, an adjusted market price should be used.
 592
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
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.

.
ac ac
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3.1.1 Market-based approach in the perfect market

Advantages Disadvantages

Divisional autonomy
• Division A has the freedom to sell The market price may not be perfect -
on the open market, or with B affected temporarily perhaps by adverse
• Simply B can decide whether to buy economic conditions, or dumping, or
from the open market or from A depend on the volume of output supplied
• So autonomy is good using a to the external market
market-based transfer price

Corporate Profit Maximisation Similarly, products may not be identical in

• Using market price, strangely you the market
can still expect B to buy from A - as
there should be a better quality of A market price works better when
service, greater flexibility, and Division A is at full capacity
dependability of supply.
• Division A will more likely sell to B
than the open market due to If Division A has the spare capacity (it
cheaper costs of administration, means no more demand from the
selling and transport. external market) then charging a market
• A market price as the transfer price price doesn't make sense
would therefore result in decisions
that would be in the best interests
of the group as a whole.
 593
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

3.1.2 Market-based approach in the imperfect market

In an imperfect market, where the market price is affected by factors such as the amount
the company setting the transfer price supplies to it, or there is only a limited external
demand

The market prices which is issued by other parties are different

Apply for transfer pricing diagram, we have prices of external sales and the alternative
supplier are different.
For example,

$10 Per product $11 Per product

$9 Per product

In this case, there is no way to set an optimal transfer price, but we ought to determine the
range of internal transfer price
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Y III. TRANSFER PRICING

Y
U

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B

B
to

to
ww

ww
om

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k

k
lic

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.c 3. Setting the transfer price

.c
w

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tr re tr re
.

.
ac ac
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3.1.2 Market-based approach in the imperfect market

a. Transfer price range (Range of potential agreement – ROPA)

The limits within which transfer prices should fall are as follows.

Minimum

The sum of the supplying division's marginal cost and the opportunity cost of the item
transferred.

Maximum

The lower of external market price and net marginal margin, less any internal cost
savings in packaging and delivery.
 595
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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

3.1.2 Market-based approach in the imperfect market

a. Transfer price range (Range of potential agreement – ROPA)

The limits within which transfer prices should fall are as follows.
 596
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Y III. TRANSFER PRICING

Y
U

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B

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to

to
ww

ww
om

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k

k
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C
.c 3. Setting the transfer price

.c
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.

.
ac ac
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3.1.2 Market-based approach in the imperfect market

a. Transfer price range (Range of potential agreement – ROPA)

Opportunity cost is defined as the 'value of the best alternative that is foregone when a
particular course of action is undertaken'

The opportunity cost included in determining the minimum limit will be one of the
following.

The maximum contribution is forgone by the supplying division in transferring

internally rather than selling goods externally.

The contribution is forgone by not using the same facilities in the producing division
for their next best alternative use.
 597
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Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

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C
.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.1.2 Market-based approach in the imperfect market

a. Transfer price range (Range of potential agreement – ROPA)

Example 6:

Division X produces product L at a marginal cost per unit of $100. If a unit is

transferred internally to division Y, a $25 contribution is forgone on an external sale.
The item can be purchased externally for $150. Ignore internal cost-saving.

Maximum The lowest market price which is purchased externally

$150 $150
Transfer price

Minimum Marginal cost Opportunity cost

$125 $100 $25

The difference between the two results ($25) represents the savings from producing
internally as opposed to buying externally.
 598
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Y III. TRANSFER PRICING

Y
U

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B

B
to

to
ww

ww
om

om
k

k
lic

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C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Following the opportunity cost definition, there will only be an opportunity cost if the seller
does not have any spare capacity.

Scenario 1: The supply division has a surplus capacity (spare capacity)

Following the opportunity cost definition, there will only be an opportunity cost if the
seller does not have any spare capacity.

(*) The marginal cost of buying division final product

 599
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O

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

lic
C

C
.c 3. Setting the transfer price

.c
w

w
tr re tr re
.

.
ac ac
k e r- s o ft w a k e r- s o ft w a

3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Following the opportunity cost definition, there will only be an opportunity cost if the seller
does not have any spare capacity.

Scenario 2: The supply division does not have any surplus capacity (full capacity)

If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to
meet all external demand and internal demand

(*) The marginal cost of buying division final product

 600
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

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C
.c 3. Setting the transfer price

.c
w

w
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.

.
ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Question): Spare and full capacity

Until recently, Strike Co focused exclusively on making soles for work boots and
football boots. It sold these rubber soles to boot manufacturers. Last year the
company decided to take advantage of its strong reputation by expanding into the
business of making football boots. As a consequence of this expansion, the company
is now structured as two independent divisions, the Boot Division and the Sole
Division.
The Sole Division continues to make rubber soles for both football boots and work
boots and sells these soles to other boot manufacturers. The Boot division
manufactures leather uppers for football boots and attaches these uppers to rubber
soles. During its first year, the Boot Division purchased its rubber soles from outside
suppliers so as not to disrupt the operations of the Sole Division.
Strike management now wants the Sole Division to provide at least some of the
soles used by the Boot Division. The table below shows the contribution margin for
each division when the Boot Division purchases from an outside supplier.
 601
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Y III. TRANSFER PRICING

Y
U

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B

B
to

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ww

ww
om

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k

k
lic

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C
.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Question): Spare and full capacity

Boot Division Sole Division

$ $
Selling price of football boot 100 Selling price of sole 28
Variable cost of making boot
(45) Variable cost per sole (21)
(not including sole)
Cost of sole purchased from
(25)
outside suppliers
Contribution margin per unit 30 Contribution margin per unit 7
The information above indicates that the total contribution margin per unit is $37
($30 + $7).

Required:
What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot
Division?
 602
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Y
U

U
B

B
to

to
ww

ww
om

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k

k
lic

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.c 3. Setting the transfer price

.c
w

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tr re tr re
.

.
ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Solution): Spare and full capacity

The answer depends on how busy the Sole Division is – that is, whether it has spare
capacity.

Supply division Receive division

Sole Division Boot Division

Full capacity
The Sole Division charges $28 and derives a contribution margin of $7 per sole. The
Sole Division has no spare capacity and produces and sells 80,000 units (soles) to
outside customers.
 Opportunity cost has occurred.
Minimum price supply division will accept:
The Sole Division must receive from the Boot Division a payment that will at least
cover its variable cost per sole plus its lost contribution margin per sole (scenario 2).
The minimum transfer price that would be acceptable to the Sole Division is: $21
(variable cost) + $7 (opportunity cost) = $28
 603
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Y III. TRANSFER PRICING

Y
U

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to

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om

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k

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.c 3. Setting the transfer price

.c
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.

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ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Solution): Spare and full capacity

The Boot Division cannot cover the minimum selling price of Sole Division, it should
not sell soles to the Boot Division.
 604
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

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k

k
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.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Solution): Spare and full capacity

Spare capacity
The minimum transfer price is different if a division has spare capacity.
Assume the Sole Division produces 80,000 soles but can only sell 70,000 to the open
market. As a result, it has an available capacity of 10,000 units.
 The Sole Division does not lose its contribution margin of $7 per unit, and
therefore the minimum price it would now accept is $21 (variable cost) + $0
(opportunity cost) = $21
 605
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Y
U

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to

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om

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k

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.c 3. Setting the transfer price

.c
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ac ac
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3.1.2 Market-based approach in the imperfect market

b. The transfer price at full and spare capacity

Example 7 (Solution): Spare and full capacity

In this case, the Boot Division and the Sole Division should negotiate a transfer price
within the range of $21 and $25 (cost from an outside supplier).
 606
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Y
U

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to

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ww

ww
om

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.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.2 Cost-based approaches

Cost-based approaches to transfer pricing are often used in practice because in practice the
following conditions are common:

There is no external market for the product that is being transferred.

Although there is an external market, it is an imperfect one (because the

market price is affected by factors such as the amount the company setting
the transfer price supplies to it, or there is only a limited external demand).

In either case, there will not be a suitable market price on which to base the
transfer price.
 607
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Y
U

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to

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.c 3. Setting the transfer price

.c
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3.2 Cost-based approaches

The supply division may well just be a cost centre

Transfer prices determined on the the costs of the supplying division

(the recieve division only knows the transfer price afterwards)

The supply division would supply the goods at:

Cost Profit margin

A standard cost should be used rather Should be based on the cost of product
than the actual cost since: and presented under the percentage of
Actual costs do not encourage the cost.
supply division to control costs.
If a standard cost is used, the buying
division will know the cost in advance
and can therefore put plans in place.

Different standard costs that could

be used:
Marginal cost
Full cost
(variable cost)
 608
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Y
U

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to

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.c 3. Setting the transfer price

.c
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3.2.1 Transfer prices based on full cost & full cost plus

Under this approach, the full cost (including fixed overheads absorbed) incurred by the
supplying division in making the 'intermediate' product is charged to the receiving division.
If a full cost plus approach is used, a profit margin is also included in this transfer price.

An intermediate product is one that is used as a component of another product, for

example, car headlights or food additives.
 609
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Y
U

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to

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om

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.c 3. Setting the transfer price

.c
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ac ac
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3.2.1 Transfer prices based on full cost & full cost plus

Example 9 (Question): Transfers at full cost and full cost plus

S company has two profit centres, A and B. Centre A can only sell half of its
maximum output externally because of limited demand. It transfers the other half
of its output to B, which also faces limited demand. Costs and revenues in an
accounting period are as follows.
A B Total
$’000 $’000 $’000

External sales 8 24 32
Costs of production 12 10 22
Company profit 10

Note that:
• There are no opening or closing inventories.
• It does not matter here whether marginal or absorption costing is used and we
shall ignore the question of whether the current output levels are profit
maximising and congruent with the goals of the company as a whole.

Required:
What are the consequences of setting a transfer price at full cost?
 610
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Y
U

U
B

B
to

to
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om

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C
.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.2.1 Transfer prices based on full cost & full cost plus

Example 9 (Solution): Transfers at full cost and full cost plus

Transfer price at full cost only

If the transfer price is at full cost, A in our example would have 'sales' to B of $6,000
(costs of $12,000 × 50%). This would be a cost to B, as follows.
A B Total
$’000 $’000 $’000 $’000 $’000

Open market sales 8 24 32

Transfer sales 6 -
Total sales 14 24
Transfer costs - (6)
Own cost (12) (10) (22)
Total cost (12) (16)
Profit 2 8 10

The transfer sales of A are self-cancelling with the transfer costs of B so that
total profits are unaffected by the transfer items. The transfer price simply
spreads the total profit of $10,000 between A and B.
 611
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Y
U

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B

B
to

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om

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.c
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3.2.1 Transfer prices based on full cost & full cost plus

Example 9 (Solution): Transfers at full cost and full cost plus

Analysis
The obvious drawback to the transfer price at cost is that A makes no profit on its
work, and the manager of Division A would much prefer to sell output on the open
market to earn a profit, rather than transfer to B, regardless of whether or not
transfers to B would be in the best interests of the company as a whole. Division A
needs a profit on its transfers in order to be motivated to supply B.

Transfer pricing at cost is inconsistent with the use of a profit centre

accounting system.
 612
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Y
U

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B

B
to

to
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om

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lic

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C
.c 3. Setting the transfer price

.c
w

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.

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ac ac
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3.2.1 Transfer prices based on full cost & full cost plus

Example 9 (Solution): Transfers at full cost and full cost plus

Transfer price at full cost plus

An obvious way of solving this problem is to include a margin in the price which A
charges to B for its work. If the transfers are at cost, plus a margin of 25% for
example, A's sales to B would be $7,500 ($12,000 × 50% × 1.25).
A B Total
$’000 $’000 $’000 $’000 $’000
Open market sales 8 24 32
Transfer sales 7.5 -
Total sales 15.5 24
Transfer costs - (7.5)
Own cost (12) (10) (22)
Total cost (12) (17.5)
Profit 3.5 6.5 10

Compared to a transfer price at cost, A gains some profit at the expense of B.

However, A makes a bigger profit on external sales in this case because the profit
mark-up of 25% is less than the profit mark-up on open market sales. The choice of
25% as a profit mark-up was arbitrary and unrelated to external market conditions.
 613
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Y III. TRANSFER PRICING

Y
U

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B

B
to

to
ww

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om

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k

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lic

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C
.c 3. Setting the transfer price

.c
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ac ac
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3.2.2 Transfer price at variable cost (Marginal cost)

A variable cost approach entails charging the variable cost (which we assume to be the
same as the marginal cost) that has been incurred by the supplying division to the
receiving division.

The supply division (S) should transfer goods to the receive division at the variable cost
(marginal cost) of production if:

S has a spare capacity as the marginal costs reflect the true cost to the
company of the transfer taking place

S has no external market so could operate as a cost centre. If S is a profit

centre, it will be demotivated as fixed costs will not be covered
 614
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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

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om

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k

k
lic

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C
.c 3. Setting the transfer price

.c
w

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tr re tr re
.

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ac ac
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3.2.2 Transfer price at variable cost (Marginal cost)

Example 10 (Question): Transfers at marginal cost (example 9 continue)

S company has two profit centres, A and B. Centre A can only sell half of its
maximum output externally because of limited demand. It transfers the other half
of its output to B, which also faces limited demand. Costs and revenues in an
accounting period are as follows.
A B Total
$’000 $’000 $’000
External sales 8 24 32
Costs of production 12 10 22
Company profit 10

Note that:
• There is no opening or closing inventories.
• It does not matter here whether marginal or absorption costing is used and we
shall ignore the question of whether the current output levels are profit
maximising and congruent with the goals of the company as a whole.

Required:
What are the consequences of setting a transfer price at marginal cost?
 615
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!

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O

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N

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Y III. TRANSFER PRICING

Y
U

U
B

B
to

to
ww

ww
om

om
k

k
lic

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C
.c 3. Setting the transfer price

.c
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.

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ac ac
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3.2.2 Transfer price at variable cost (Marginal cost)

Example 10 (Solution): Transfers at marginal cost (example 9 continue)

A marginal cost approach entails charging the marginal cost that has been incurred
by the supplying division to the receiving division. As above, we shall suppose that
A's cost per unit is $15, of which $6 is fixed and $9 variable.
A B Total
$’000 $’000 $’000 $’000 $’000
Open market sales 8 24 32
Transfer sales ($6,000 × 9/15) 3.6 -
Total sales 11.6 24
Transfer costs - (3.6)
Own variable cost (7.2) (6)
Own fixed cost (4.8) (4) (22)
Total cost (12) (13.6)
Profit (0.4) 10.4 10
 616
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CHAPTER 19: PERFORMANCE

MANAGEMENT AND CONTROL
 617
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Performance management and control

I. Performance management in private organisation

II. Performance management in not-for-profit organisation

III. Other considerations in performance management

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1. Financial indicators – Financial ratios

1.1 Use of basic ratios

Ratio Formula Possible indications and ways to improve

Profitability

GPM Gross profit High GPM is desirable, indicating either

×100%
Revenue sales prices are high or production costs are
being kept well under control
Methods to improve:
• Introduce new product that match the
interest of customers so that it can be
sold at higher margin
• Use target costing for cost control

OPM Profit before interest and tax (PBIT) High OPM is desirable, indicating either
×100% sales prices are high or production costs &
Revenue
S&A expenses are being kept well under
control
Methods to improve:
• Introduce new product that match the
interest of customers so that it can be
sold at higher margin
• Use target costing for cost control
• Better control on selling &
administrative expenses
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1. Financial indicators – Financial ratios

1.1 Use of basic ratios

Ratio Formula Possible indications and ways to improve

Profitability

ROCE PBIT High ROCE is desirable; which could be

Capital employed (∗) x 100% or improved by investing in projects that
generate a higher return on capital.
More details: Besides, increase in ROCE could be achieved
ROCE = Asset turnover x Operating margin by:
PBIT Revenue PBIT • Increasing operating profit (e.g.
Capital employed = Capital employed x Revenue through increase in sales price or
better cost control)
(*) Capital employed = Shareholders′ equity+ • Reducing capital employed (e.g.
long-term liabilities (or total assets - current through the repayment of long term
liabilities) debt)
Other accounting manipulations to increase
ROCE (e.g delaying investment in new NCA
or intangible assets) should be avoided as
these techniques actually harm the business

Note:
As ROCE can be subdivided into Asset turnover and Operating profit margin, if the business is experiencing
a declining ROCE, this could be due to decline in these 2 ratios.
Make sure to analysize both Asset turnover and OPM to get better insight at ROCE when taking the exam
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1. Financial indicators – Financial ratios

1.1 Use of basic ratios

Ratio Formula Possible indications and ways to improve

Liquidity

Current Current assets This reflects how many times a company can pay its short-
ratio Current liabilities term liabilities with its short-term assets.
Acceptable level could be over 1.
Decrease in this ratio year on year or it is below industry
average could indicate liquidity problems.

Quick ratio Current assets − Inventories Same comment as above (a more conservative way of
Current liabilities current ratio)

Inventory Inventories This indicates the average number of days that inventory
x 365
holding COS items are held for.
period • Increase in this figure could indicate problems in
selling products, leading to obsolete inventory.
• Decrease in this figure should be investigated as the
company may struggle to manage liquidity
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1. Financial indicators – Financial ratios

1.1 Use of basic ratios

Ratio Formula Possible indications and ways to improve

Efficiency

Receivables Trade receivables An increase in the receivables collection period could

×365
collection Credit sales indicate that the company is struggling to management
period its debts. Possible steps to improve:
• Credit checks on customers
• Improve credit control
A decrease in the receivables collection to amount lower
than industry average may make the company less
competitive.

Payables Trade account payable An increase in payable period could indicate company is
×365
payment Purchases struggling to pay its debts when due. However, it could
period simply indicate the company is taking better advantage
of credit period offered.
A decrease in payable period could indicate an improved
ability to pay debts; however, it might also indicate the
company is taking less advantage of credit offer as a
source of finance
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1. Financial indicators – Financial ratios

1.1 Use of basic ratios

Possible indications and ways to

Ratio Formula
improve

Risk

Gearing Total long−term debt High level of gearing indicates a

x 100% potential of high risk as company relies
Shareholders′ equity + total long−term debt
heavily on debt to finance its long-term
needs.
This could be improved by reducing
level of long-term debt and raising
long-term finance using equity.

Interest Profit before interest and tax A decrease in the interest cover
cover Interest charges indicates that the company is facing an
increased risk of not being able to meet
its finance payments as they fall due.
The ratio could be improved by taking
steps to increase the operating profit

Notes:
In performance analysis exam questions, remember that financial ratios are one of the
indicators for the performance, its use will only be valuable if further investigated the
reasons behind those figures.
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1. Financial indicators – Financial ratios

1.2 Issues surrounding the use of financial indicator to monitor performance

Short-termism

Linking rewards to financial performance may tempt managers to make decisions

that will improve short-term financial performance but may have a negative
impact on long-term profitability.

For example: Managers may decide to cut investment or to purchase cheaper but
poorer quality materials.

Manipulation of results

In order to achieve financial target, manager may be tempted to manipulate

results by:

Accelerating Delaying Understanding Manipulation of

revenue costs a provision or accounting
accrual policies
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2. Non-financial indicators
The only use of financial indicators cannot convey the full picture regarding the factors
that will drive long-term profitability, e.g. customer satisfactions, quality.

When monitoring performance, a broader range of

measurement should be used.
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.1. Main perspectives

How we look to shareholder? How our customers see us?

Revenue Customer satisfaction
Expense Customer retention
Cash flow
Financial Customer
perspective perspective

Internal Learning/
process growth
At what must we perspective perspective How can we grow &
excel? change?
Orders Employee satisfaction
Resource allocation Employee skills
Quality control Employees turnover
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.2 Setting Objectives and Performance measures

Objectives Measures
How business determine
Something business want
whether the objectives have
to achieve
been met

Note:
In PM exam, the questions of determining objectives/goals and corresponding measures
of 4 aspects in balanced scorecard are highly examinable.
Specifically, for each aspect of the balanced scorecard, we need to determine:
• Objectives: What is the objective of this aspect?
• Measures: On what basis can the business determine that the goal has been
achieved?
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Example 1 (Question): (March/July 2020 Sample past exam extracted)

Exam focus point: Discuss the performance of an organisation under Balanced

scorecard perspectives
Hammock Co owns and operates a small chain of luxury vacation resorts. Hammock
Co’s management currently focus on two objectives:
(1) to make a profit long term;
(2) to create customer loyalty

Extracts from TripEvent, an influential online customer forum:

I love Hammocks Co; the service and attention to detail is exemplary and the
resorts are always pristine. However, their competitor “Loungers” has full
body driers, ionised water taps and a range of professional haircare
equipment in all their rooms.

Our third time back to Hammocks Co this year and we continue to be amazed
by the wonderful level of service. One thing though is the menus don’t seem
to have changed much from one visit to the next.
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Example 1 (Question): (March/July 2020 Sample past exam extracted)

We booked Hammocks Co on the spur of the moment but then found that
we couldn’t get a flight. We called Hammocks Co administration centre to
change our booking to another resort where we could get a flight to and
were told that it would not be a problem. However, it took two more calls
and three emails to get confirmation and then our credit card was charged
twice in error. Of course, it was eventually all resolved, the incorrect charge
refunded, a complimentary limousine provided to and from the airport and
we received the most amazing customer service at the resort, but it was
frustrating at the time.

When I made my booking, I was assured that my bed would be made with the
special anti-allergenic bedding which I need for a good night’s sleep and that
my favorite blend of tea would be available. When I arrived, neither of these
requirements were met. To be fair to Hammocks Co though, everything was
in order two hours later when I went to bed.
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Example 1 (Question): (March/July 2020 Sample past exam extracted)

Required:
Suggest and justify ONE goal and TWO performance measures for each of the TWO
perspectives of the balanced scorecard which are not currently addressed by
Hammock Co’s objectives. (9 marks)
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Example 1 (Solution): (March/July 2020 Sample past exam extracted)

Goals Measures
Justification for
(What possible Justification for goals (How are the
Perspective measures
goal representing (Why?) goal possibly
(Why?)
the perspectives) measured?)
Feedback on TripEvent Number of More corrections will
shows customer corrections to lead to more
complaints on poor booking due customer complaints
administration: to admin
• Repetitive errors
Internal Efficient and
calls/emails for
business effective
confirmation % customer Measuring the % of
process administration
• Double credit card requests met guest requests met
charge in error will identify when the
• Neither of special guest experience was
requirements not as expected
were met
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Example 1 (Solution): (March/July 2020 Sample past exam extracted)

Goals
Justification for Measures Justification for
(What possible
Perspective goals (How are the goal measures
goal representing
(Why?) possibly measured?) (Why?)
the perspectives)
Number of Show where
appliances in-room Hammock could
offered by improve to match the
Feedback said competition but not competition
Innovation Modernised by Hammocks
the competitors
and facilities and
offer better
learning services
facilities Number of new Show whether the
menu items menus are being kept
fresh for the
customers

Notes:
Remember that any reasonable goals and measures could absolutely be used!
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.3 Example of balanced scorecard

Notes:
This is a highly examinable topic, it is important to apply the knowledge from this
section, to the specifics of the scenario given.
It was noted in the December 2014 exam report, that candidates did not consider the
company in the question and instead presented a generic balanced scorecard. That will
not be awarded marks at this level
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2. Non-financial indicators

2.1 Balanced scorecard

2.1.4 Discussion about balanced scorecard

Advantages Disadvantages

Helps to clarify how sustained, good Potential information overload

financial performance can be achieved
Picking or inventing measures can be
Show how different aspects of the difficult and perhaps arbitrary
business result in good financial
performance Difficulty and cost in obtaining the
information needed
Highlight how poor performance in any
area can damage long-term prosperity. Conflict. For example, flexibility in
supplying a customer with a product
Measure and monitor all important might adversely affect the quality of
aspects of a company’s existence the product if it is made in a rush

Targets are set for current and future Too little attention to external factors
performance across a wide range of such as competitor activity. It focus
important activities and measures. on our innovation, our processes, our
customers.
Help to balance long-term and short-
term objectives.
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2. Non-financial indicators

2.2 Building block model

Fitzgeral and Moon’s Building block model (BBM) is an evolution of the Balanced
scorecard, developed to meet the needs of performance evaluation in service
organisations, which linked to reward schemes for managers

Dimensions
Results

Financial performance
Competitiveness
Determinants

Quality
Innovation
Flexibility
Resource utilisation

Standards Rewards

Ownership Clarity
Achievability Controlability
Equity Motivation
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2. Non-financial indicators

2.2 Building block model

2.2.1. Dimensions
Some performance measurement that might be used for each of these dimensions are as
follows

Dimensions Performance measures

Results - outcome of decisions and actions taken in the past

• Profitability

Financial performance • Profit growth

• Profit margin

• Growth in sales

Competitiveness • Retention rate for customers

• Success rate in converting enquiries into sales

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2. Non-financial indicators

2.2 Building block model

2.2.1. Dimensions

Dimensions Performance measure

Determinants – forward-looking dimensions of the model: what areas of future

performance are most important for a company to achieve positive financial and
competitive results?

• Number of complaints
Service quality • Customer satisfaction, as revealed by customer
opinion surveys

• Varied product ranges meet the needs of different

Flexibility customer segment.

• Speed in responding to customer requests

• Efficiency/ productivity measures

Resource allocation
• Capacity utilization rates

• Number of new services offered within the

Innovation previous year or two years
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2. Non-financial indicators

2.2 Building block model

2.2.2. Standards
After the organisations’s dimensions are understood, standards can be set. These will be
the benchmarks, targets, directly linked to performance metrics under headings for each
dimensions
There are three (03) aspects to consider in setting standards:

Ownership Who is responsible for achieving the standard?

Achievability What level are the standards set at?

Equity Can we use the standards for a fair appraisal across the company?
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2. Non-financial indicators

2.2 Building block model

2.2.3. Rewards
The last part of the mode looks at the overall reward structure of the organization and is
the link to HR systems. Do compensation packages in the company lead people to achieve
the standards of performance which are set out above?
This part has three (03) aspects:

Clarity Is the system understandable to all employees?

Motivation Will the system drive employees to achieve their objectives?

Controllability Do employees have control over their areas of responsibility?

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2. Non-financial indicators

2.2 Building block model

Example 2 (Question): OSC Co (September 2018)

Exam focus point: Performance analysis using Building Block model

The One Stop Car Co (OSC Co) offers a range of services for car owners at its 55
service centres across the country. The car maintenance business is extremely
competitive in all regions across the country. Each service centre operates
autonomously and managers are able to choose how to package up the services
they offer. OSC Co’s aim is to ‘make the task of car maintenance a pleasure and not
a chore’.
Its national website states the following:
• Range of service packs available, including express service and full valet
• ‘We work whilst you wait’ service, with average wait times of only two hours
• Watch our friendly, experienced mechanics producing high quality work
• Freshly made tea and coffee and free internet in our comfortable lounges
• Monthly free prize draw for all customers completing an online feedback form
Customers initially access the national website, but depending on their location,
they are automatically redirected to the website of their nearest service centrer so
that they can view the offers available at that center. All bookings are made through
the OSC website.
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2. Non-financial indicators

2.2 Building block model

Example 2 (Question): OSC Co (September 2018)

Results for one of the service centres, the Midlands Service Centre (MSC), for the
year which has just ended are given below. The column headed ‘OSC’ shows the
average figures for all of OSC Co’s 55 service centres.

Notes MSC OSC average

Sales revenue ($) 760,500 890,365
Gross profit ($) 304,200 328,146
Number of mechanics: senior 1 7 7.8
Number of mechanics: junior 2 5 5.2
Number of new service pack developed 3 3 2
Number of website hits 14,000 18,260
Total number of jobs booked and completed 9,506 11,870
Number of jobs from repeat customers only 1,500 1,660
Time spent completing jobs (hours) 23,100 24,800
% of customer feedback forms showing score 9 or 10 4 80% 70%
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2. Non-financial indicators

2.2 Building block model

Example 2 (Question): OSC Co (September 2018)

Notes:
(1) mechanics are classified as ‘senior’ if they have been qualified for more than five
years.
(2) ‘Junior’ mechanics includes both trainee mechanics who are unqualified and
mechanics who have been qualified for less than five years.
(3) The MSC introduced three new service packs during the year:
• Free valets for orders over $100
• A safety check costing on $20, instead of the usual $40, for all customers
booking a full service
• A $10 air conditioning efficiency check, which usually costs $20, for all
customers booking an oil change.
These three new service packs produced revenues of $66,000, $58,000 and $54,000
respectively. Two comparable new service packs developed by other centers
produced revenues of $44,000 and $42,000.
(4) The online feedback form asks customers to rate the center from 1 to 10, with
10 being the best.
The CEO of OSC Co has recently attended a business seminar and heard about
Fitzgeral and Moon’s building block model of performance management. The CEO is
interested in how the dimensions block could be applied at OSC Co. The dimensions
of performance identified in the model are: competitiveness, financial performance,
quality of service, flexibility, resource utilisation and innovation.
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2. Non-financial indicators

2.2 Building block model

Example 2 (Question): OSC Co (September 2018)

Required:
For each of the dimensions of the building block model, calculate one performance
indicator for MSC and one for the OSC average using the data available. Briefly
justify your choice of performance indicator and discuss MSC’s performance relative
to the other OSC service centres. (16 marks)
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Overview of solution:
Calculation of Discuss of MSC’s
Justification of choice of
Dimensions performance performance
performance indicator
indicators compared to OSC’s
Competitiveness % of website hits Indicating attractiveness of 2 – 3 sentences of:
converted into orders services provided • Compare MSC’s
Financial Gross profit margin Key performance indicator performance to
performance OSC’s
Quality of service % of jobs from repeat Aim of MSC’s • Provide (potential)
customers (identified by given input: reasons
national website information, • Comment on
range of service packs, MSC’s peformance
average wait times)
Flexibility Time taken per job Shorter time is better
Resource Sales per mechanicsStaff (human) is key resource
allocation in service company
Innovation % revenue from new wide variety of service packs
service packs
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018) Performance

indicator’s
Dimensions (used as heading)
Competitiveness detailed
calculation
MSC OSC average
% of website hits 67.9% 65%
converted into orders (9,506/14,000) x 100 (11,870/18,260) x 100

Justify choice of
performance indicator

This ratio indicates whether MSC’s services are attractive compared to its
competitors, which is important if it is going to survive in such a competitive
market.
It has performed substantially better than other OSC service centres on average,
having converted 67.9% of website hits into jobs, compared to the 65% converted
by other service centres. This is a good result.

Discuss MSC’s performance

2 sentences:
• Compare performance
• Comment
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Financial performance
MSC OSC average
Gross profit margin 40% 36,8%
(304,200/760,500) x 100 (328,146/890,365) x 100

Gross profit margin is the preferred measure for financial performance from the
data presented. It shows the percentage of revenue which exceeds the cost of
goods sold.

MSC’s gross profit margin is almost 3 percentage points higher than the average,
which is a good result. This could be partly because they did relatively well on their
new service pack sales (note 3) but it is also likely to be because their ratio of senior
mechanics to junior mechanics is lower than the average, and junior mechanics will
invariably be paid less than senior ones.
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Time spent completing job/total
Flexibility jobs booked & completed

MSC OSC average

Time taken per job 2.43 hours 2.09 hours
(23,100/9,506) (24,800/11,870)

The time taken to complete each job is important as many customers will use MSC
because they can sit and wait for the work to be done, rather than having to hire a
rental car for the day, for example.

The comparison shows that MSC takes longer to complete a job than the OSC
average. This is not really a good thing and is probably because they have slightly
less experienced staff on the whole, but it could also be that they do a more
thorough job than other service centres. Given the fact that they have a higher level
of return customers than the average and they are graded 9 or 10 by their
customers (10 percentage points higher than the average), this is presumably not
viewed negatively by customers
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Number of jobs from repeated
Quality of service customers/Total number of jobs

MSC OSC average

% of jobs from 15.78% 13.98 %
repeated customers (1,500/9,506) x 100 (1,660/11,870) x 100

Quality is a key element of MSC’s service to customers and if it is poor, customers

will not return.

Again, MSC has outperformed the other service centres on average by 1.8
percentage points. This could be because it has a higher ratio of senior mechanics to
junior mechanics than other service centres, so the quality of work is probably
better, hence the higher level of repeat customers.
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Total sales/ number of mechanics

Resource allocation
MSC OSC average
Sales per mechanics $63,375 $68,490
($760,500/12) ($890,365/13)

The key resource in a service company is its staff and so these indicators measure
how this resource is being utilised.

MSC’s utilisation of its staff is lower than that of the other service centres by $5,115
per mechanic. This clearly ties in with the fact that the average time to complete a
job is longer at MSC than other service centres. However, given that they use a
slightly less experienced staff on average than other centres and the fact that their
gross margin is higher than average, this should not be viewed too negatively.
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2. Non-financial indicators

2.2 Building block model

Example 2 (Solution): OSC Co (September 2018)

Innovation
MSC OSC average
% of revenue from new 23.4% 9.66%
service packs ($66,000+$58,000+$54,000)/ ($44,000+$42,000)/
$760,500 890,365

MSC wants to offer a wide variety of service packs to its customers and needs to be
innovative in packaging services up.

The 23.4% indicates that MSC is indeed innovative in their approach to their
customers’needs, offering an innovative mix of services. MSC has really
outperformed other service centres on this front, generating a far larger part of its
revenue by the introduction of new service packs, which must have attracted
customers. This is a really strong performance
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2. Non-financial indicators

2.3 Target setting in qualitative areas

The balanced scorecard and Fitzgerald and Moon's Building Block model are based on the
assumption that performance targets can be set and measured for non-financial aspects
of performance.
In practice, criticial non-financial aspects of performance may be difficult to quantify in
reliable way, because:

By nature, qualitative data cannot be quantified

Unlikely to have a reliable and comprehensive system for qualitative data

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1. Problems with not-for-profit organisations’ objectives

Major problem with many not-for-profit (NFPOs)’s objectives is that:

It is extremely difficult Multiple objectives make it

to define their objectives impossible to say which is the
overriding objectives
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2.e rPerformance management in not-for-profit organisations

2.1 Value for money

Value for money (VFM) means providing a service in a way which is economical,
efficient and effective.

A common method of assessing public sector performance is to assess VFM which

comprises:

The three Es
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2.e rPerformance management in not-for-profit organisations

2.1 Value for money

3Es represents:

Economy:
Minimising the costs of inputs required to achieve a defined level of output.

Efficiency:
Ratio of outputs to inputs – achieving a high level of output in relation to
the resources put in (input driven) or providing a particular level of service
at reasonable input cost (output driven)

Effectiveness:
Whether outputs achieved met the predetermined objectives.
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2.e rPerformance management in not-for-profit organisations

2.1 Value for money

Example 3:

Value for money in a university would comprise three elements:

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2.e rPerformance management in not-for-profit organisations

2.2 Problems

Public sectors, as well as profit-making organization, also face the same

difficulties in using NFPIs & FPIs:

Target setting in Short-termism Manipulation

qualitative areas
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External consideration
Performance management needs to allow for external considerations including:

Stakeholders Economic environment Competitors

• Internal (employee, • Economic growth • Pricing strategies

management)
• Local economic trends
• Connected
(shareholders, • Inflation
customers, suppliers)
• Interest rate
• External (government,
• Exchange rates
community)
• Governemnt policies