PART MIS & DATA

A
1 ANALYSIS
NETWORKS

Introduction

Internet: The term Internet describes the global network of computers

and devices connected with an Internet Protocol (IP) address. It is a
valuable source of information for businesses as it contains competitor
websites, online databases with potential customer data etc.

Intranet: Intranet refers to a subset of the internet that is an

organisation’s private network that only authorised users can access.
It allows the sharing of information, typically to employees throughout
the organisation.

Information Systems
An information system is a combination of hardware, software and
communications capability, where information is collected, processed and
stored.
Information Requirements at Different Levels

Strategic Planning: Information for strategic planning typically

addresses objectives at a high level and is in highly summarised form.
It includes mostly external information covering a long-time horizon.
E.g.: investment appraisal, competitor analysis etc.

Management Control: Contains more detailed information mainly

concerned with effective and efficient use of resources of the
organisation. It contains mainly internal although some external
information may be used and usually covers a period of up to 12
months. E.g.: Annual budgets, cashflow projections etc.

Operational Control: Almost entirely internal information covering a

short period of time and highly detailed. E.g.: Variances, payroll details,
output records etc.

Requirements of Information for Organisations

Record transaction
• Make decisions
• Planning purpose
• Performance management
• Control

Types of Information System

The four main types of information systems that support the different levels
of an organisation may be summarised as follows:
Transaction Processing System (TPS): A TPS (or data processing
system) processes routine business transactions, often in large volumes
and are used by operational level staff. A TPS will include controls to ensure
that the information entered into the system is valid and that the
processes are accurate to ensure reliability.

Types of TPS:

Batch Transaction Processing: Collects and stores transaction data

as a group and processes it later
E.g.: Payroll system (information of joiners and hours works recorded
during the period, payroll calculations done at the end of period).
Real-time systems processing: transactions are processed
immediately as they occur.

1. Management Information System (MIS): Systems which convert data

mainly from internal sources (summary reports, exception reports etc)
and some external sources into information used by tactical level
management across all functions for timely planning, controlling and
decision-making purposes.

2. Decision Support Systems (DSS): Decision support systems assist in

complex decision-making. Such systems typically analyse large
amounts of data and provide information about the likely outcome of
uncertain decisions based on rules and assumptions programmed into
the system.

3. Executive Information Systems (EIS): EIS typically provides senior

management with high-level information about the company’s
performance. It draws data from MIS and may also be linked to external
data sources. Information is presented in a user-friendly, summarised
form so that senior managers are only presented with data relevant to
their concerns.

4. Enterprise Resource Planning Systems (ERP): An Enterprise resource

planning systems (ERP systems) are modular software packages which
are designed to integrate the processes and data from all operations
within the organisation into one single system.
5. Customer Relationship Management System (CRM): Is the approach
used by management to manage customer interactions and data, to
improve customer service, retain customers and drive sales growth.
Most CRM systems are based on a database which stores data about
customers such as their order history and personal information such as
address, age and any marketing feedback they have provided. CRM
systems are often used by customer-facing staff who handle customer
enquiries, orders or complaints.

6. Expert Systems: Holds specialist knowledge, e.g. on law or taxation, and

allow non-experts access to information, advice and recommended
decisions. Can be used at all levels of management.

Sources of Management Information

1. Internal Sources: Internal sources of information may be taken from a
variety of areas such as the sales ledger (e.g., volume of sales), payroll
system (E.g., number of employees) or the fixed asset system (E.g.,
depreciation method and rate)

2. External Sources: In addition to internal information sources, there is

much information to be obtained from external sources such as
suppliers (E.g., product prices), customers (E.g., price sensitivity) and the
government inflation rate.

3. Big Data: 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. Sources of Big Data include social networking
sites, internet search engines, and mobile devices. These extremely
large collections of data that may be analysed to reveal patterns, trends
and associations.

Sources of Management Information

Internal Sources External Sources Big Data

 The following have been adopted as essential characteristics of big
data:
Volume: Refers to the tremendous size of the data which is being
produced.
Velocity: The speed at which new data is generated.
Variety: The types of data being generated such as from internal
sources, external sources, structured, semi structured etc.
Veracity: Refers to the truthfulness of the data. Is the data stored by
the organisation reliable? is there a risk of manipulation?
Value: Value refers to the benefit that big data can provide, and it
relates directly to what the organization can do with the collected
data.

Big Data Analytics

The processing of big data to identify patterns, relationships and other
insights is known as big data analytics. Big data analytics provide several
benefits to an organisation.

Benefits:
Marketing: Gaining insights about customer preferences through
browsing histories of pages visited and purchases made.
Competitive Strength: Through using the information to identify and
respond to changes in customer preferences earlier than competitors
Operational Efficiency: For example, better forecasting of sales volumes
will improve inventory management and reduce wastage (e.g. of
perishable goods).

Risks:
Cost: It is expensive to establish the hardware and analytical software
needed, though these costs are continually falling
Time and Staff Resource: Analysing which data is particularly
important for the organisation, and the impact it may have on the
organisation, may be very time consuming.
Loss And Theft of Data: Companies might find themselves open to civil
legal action if data were stolen and individuals suffered as a
consequence.
Security of Confidential Information
A number of procedures can be used to ensure the security of highly
confidential information.

1. Logical Access Systems: performs three operations when access is

requested;
a. Identification of user
b. Authentication of user identity
c. Check on user identity
2. Passwords:
3. Database Controls:
4. Firewall
a. A combination of hardware and software located between the
company’s intranet (private network) and the public network.
b. A set of control procedures will be established to allow public access
to some parts of the organisation’s computer system.
5. Personnel Security Planning:
6. Anti-Virus and Anti-Spyware Software
7. Software Audit Trail: Is a record of important data about each
transaction. A software audit trail could include, for example, user and
terminal identifications, the time and date of the transaction,
transaction type (e.g. despatch), quantities and values, and cross-
references to related transactions (e.g. invoice). The software audit trail
records information about online transactions so the transaction and its
path (both backward and forward) can be inspected and verified by
third parties.

06
 PART COSTING
B TECHNIQUES
ACTIVITY BASED COSTING (ABC)
Activity based costing is an extension of absorption costing specifically
considering what causes each type of overhead category to occur, i.e., what
the ‘cost drivers’ are. Each type of overhead is absorbed using a different
basis depending on the cost driver.

Absorption Costing
Traditional absorption costing uses a single basis for absorbing all
overheads into cost units. Traditional absorption costing systems:

Under-allocates overhead costs to low-volume products; over-

allocates overheads to higher-volume products.

Under-allocates overhead costs to smaller products; over-allocates

overheads to larger products.
Activity Based Costing
Activity-based costing aims to identify the activities which cause overhead
costs to be incurred and to apportion the overhead costs to each product
based on the use of the activities by each product.

Steps
1. Identify major activities within each department which create costs.
2. Create a cost pool for each activity.
3. Determine what causes the cause of each activity (Cost driver).
4. Calculate the absorption rate for each cost driver.
5. Calculate the total overhead cost for manufacturing each product.
6. Calculate the overhead cost per unit.

Cost Driver
Any factor, reason or base which generates overheads cost.
Reason which increases or decreases overheads.

Cost Pool
Total costs that accumulate for each activity for the company as a whole.

Overhead Costs and Possible Cost Drivers – Examples

Activity Possible cost driver

Ordering costs Number of orders
Materials handling costs Number of production units
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched

ABC VS Absorption Costing - Example

Total budgeted fixed overheads for a company are $712,000. These have
traditionally been absorbed on a machine hour basis. The company makes
two products, A and B.
 A B
Direct material cost $20 $60
Direct labour cost $50 $40
Machine time 3 hrs 4 hrs
Annual output 6000 40000

The company is considering changing to an ABC system and has analysed

the overhead cost into three activities:

Activities Cost pool Cost driver

Machine related 178000 No. of Machine hours
Setup related 230000 No. of setups
Purchasing related 304000 No. of purchase orders
Total overhead 712000

Machine Annual Total machine Number of Number of

hours/unit output hours set-ups purchase
orders
A (3 hours) 6000 18000 16 52
B (4 hours) 40000 160000 30 100
Total 46000 178000 46 152

Required:
A. Calculate the total cost for each product on the assumption that the
company continues to absorb overheads on a machine hour basis.
B. Calculate the cost per unit using the ABC system.
C. Compare the cost per unit of each product using ABC with the cost
per unit using absorption costing, and identify the main reasons for
the difference.
Advantages of Activity Based Costing
Accurate cost calculation (fair distribution of overheads).
Accurate selling price.
ABC recognises the complexity of modern manufacturing by the use
of multiple cost drivers.
ABC can be applied to both production and non-production overheads.
Better cost control.

Disadvantages of Activity Based Costing

Time consuming and expensive.
Selection of cost driver may not be easy.
ABC does not eliminate the need for cost apportionment. Some
arbitrary apportionment may still exist.
The cost of implementing and maintaining an ABC system can exceed
the benefits. (Implementation of ABC is likely to be cost effective when
overheads costs are a high proportion of total costs.)
ABC is a form of absorption costing; an ABC cost is not a variable cost
and therefore not a relevant cost for decision.
ABC will be of limited benefit if the overhead costs are primarily volume
related or if the overhead is a small proportion of the overall cost.

5 MCQ
 TARGET COSTING

Target costing involves setting a target cost by subtracting a desired profit

from a competitive market price. In effect it is the opposite of conventional
‘cost plus pricing’.

Traditional approach Target Costing

Determine Unit cost Arrive at the target cost for Production

Add desired Profit margin Deduct profit margin desired

Determine Selling price Determine selling price

Illustration 1
Exclusive Motors is designing a new version of its luxury car, the Z series. The
vehicle will be launched next year. It is expected to have a lifecycle of 10
years.

The production of the car will require an investment of $3 billion. The

company needs a profit of 20% a year on this investment.

The marketing department believes that the car could be sold for a price of
$40,000 each. 100,000 cars would be manufactured and sold each year.

Required: Calculate the target cost of one Z?

Closing a Target Cost Gap
Possible ways to close a cost gap:

Value analysis can be used to determine which features are adding

value to the product and which will not affect it at all.
Reducing the number of components.
Using cheap labour/staff.
Using standard components wherever possible.
Acquiring new more efficient technology.
Training staff.
Using different materials.

A risk with target costing is that cost reductions may affect the perceived
value of the product.

Illustration 2
A car manufacturer wants to calculate a target cost for a new car, the price
of which will be set at $17,950. The company requires an 8% profit margin on
sales.

Required: Find the target cost?

Target Costing in Service Industries

The target costing approach is a sensible basis for estimating/driving down
costs regardless of the type of business. However, due to the nature of
service industries this process is more difficult in these businesses.

Characteristics of Service Industries

Service industries have the following characteristics which make cost and
performance measurement more difficult:
SHIPO
1. Simultaneity
2. Variability/Heterogeneity
3. Intangibility
4. Perishability
5. No transfer of ownership
Note: From the above ‘Intangibility and Variability/Heterogeneity’ make it
difficult to use target costing in service industry.

Advantages of Target Costing

Target costing encourages the management to continually improve
processes and innovate to gain a competitive cost advantage.
New market opportunities can be converted into real savings to
achieve the best value for money rather than to simply realize the
lowest cost.
The product is created from the expectation of the customer (i.e., cost
approach is more customer centric) and, hence, the cost is also based
on similar lines. Thus, the customer feels more value is delivered.
The company’s approach to designing and manufacturing products
becomes market-driven. Helps in creating economies of scale.

Disadvantages of Target Costing

The development process can be very lengthy as the product has to
go through several alterations to meet the target cost.
Cost reduction process may affect employee morale.

5 MCQ
 LIFECYCLE COSTING

Target costing emphasises cost control through good product design and
production planning. There might also be costs incurred after a product is
sold, such as warranty costs and plant decommissioning.

Therefore, to profit from a product, its total revenue must exceed its total
cost, whether these costs are incurred before, during or after the product is
produced. This is the concept of life-cycle costing.

Aim of Lifecycle Costing

Lifecycle costing aims to cost a product, service, customer or project over
its entire lifecycle with the aim of maximising the return over the total life
while minimising costs.

The product lifecycle describes how demand conditions for a product, a

brand and whole markets change with time.

Phases Of Life Cycle

Development stage: Product is designed and developed;
manufacturing process will also be created. Cashflow will be negative
as there is no revenue.
Introduction (Launch): Special price while launching (skimming,
penetration).
Growth: Competition may rise due to new suppliers entering the
market. This may force lower prices.
Maturity: Most profits are made during this phase. Prices may be
stable.
Decline: Prices may fall with demand unless a specialised market can
be found.
Lifecycle Cost – Examples
Research and development costs
Training costs
Production costs
Distribution costs
Marketing costs
Inventory costs
Retirement and disposal costs

Calculating Lifecycle Cost Per Unit

Total lifecycle costs

Average Lifecycle Cost per unit =
Total lifecycle units

Illustration 1

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 cost per unit 50 40 40 40
Disposal of specialist 300,000
equipment

Required: Calculate lifecycle cost per unit?

Maximising Return Over the Product’s Lifecycle

Careful design of product (can save design and manufacturing costs).
Take the product to market as soon as possible (minimise the time to
market).
Minimize breakeven time.
Maximize the length of the life span.
Minor changes in technology.
Advantages of Lifecycle Costing
It helps management to assess profitability over the full life of a
product, which in turn helps the management to decide whether to
develop the product, or to continue making the product.
It encourages longer-term thinking and forward planning.
The lifecycle concept results in earlier actions to generate more
revenue or to lower costs.
Life cycle costing encourages management to find a suitable balance
between investment costs and operating expenses.

Disadvantages of Lifecycle Costing

It is a time-consuming process.
Collecting data for analysis is a tedious job.

Relevance to Service Industries

Life-cycle costing is relevant to services that require significant upfront
research and development. Like software industries.

5 MCQ
 THROUGHPUT ACCOUNTING

Background
There are two aspects of modern manufacturing that you need to be
familiar with;

Total quality management (TQM)

Just in time (JIT)

Key features of companies operating in a JIT and TQM environment are:

High level of automation.

High level of overheads and low level of direct labour costs.
Low stocks.
Emphasis on high quality and continuous improvement.

Throughput Accounting
Throughput accounting aims to maximise the best use of scarce resource
in a JIT environment.

Throughput Contribution = Sales Revenue – Material Cost

Bottleneck Resource or Binding Constraint

Bottleneck resource or binding constraint is an activity which has a lower
capacity than other activities.

Bottleneck resources may be as follows:

Labour hours
Machine hours

Production is limited to the capacity of the bottleneck resource but this

capacity must be fully utilised. This may result in some idle time in non-
bottleneck resources.
Bottleneck – Example
A factory makes three products, all of which pass through three machines.
The time spent on each machine is the same for all three products. Demand
for the company’s products exceeds the amount that the company can
produce. The maximum daily output of the three machines is as follows:

Machine 1 Machine 2 Machine 3

200 units 180 units 210 units

Machine 2 is the bottleneck, which has the lowest output volume.

Aim of Throughput Accounting

As mentioned earlier, the throughput accounting system aims to maximise
the throughput contribution of the production process (i.e., to make the best
use of a scarce resource (bottleneck) in a JIT environment).

Throughput accounting is an approach to production management which

aims to maximise throughput, while reducing inventory and operational
expenses. It is based on the Theory of Constraints, which focuses on
maximising throughput while keeping the organisation’s bottleneck
resources in view, and trying to minimise the operational costs.

Theory of Constraints (TOC)

Theory of Constraints focuses on bottlenecks in the production process
which act as a barrier to throughput maximisation. The theory of constraints
is applied within an organisation by following ‘the five focusing steps.

Five Steps for Dealing with a Bottleneck Activity

1. IDENTIFY: the bottleneck resource.
2. EXPLOIT: the highest possible output must be achieved from
bottleneck resource. The output must never be delayed and as such a
buffer inventory should be held immediately before bottleneck
resource.
3. SUBORDINATE: operations prior to the binding constraint should
operate at the same speed as it so that WIP does not build up.
 4. ELEVATE the bottleneck: steps should be taken to increase resources or
improve its efficiency.
5. RETURN TO STEP 1: the removal of one bottleneck will create another
elsewhere in the system.

Maximising Throughput and Multiple Products

Optimum Production Plan.
Determine the bottleneck resource.
Calculate the throughput per unit for each product.
Calculate the bottleneck resource per unit. Example: labour hours per
unit or machine hours per unit.
Calculate throughput per unit of bottleneck resource (return per hour).
Rank products.
Allocate resources to arrive at optimum production plan.

Illustration 1

Product A Product B Product C

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

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

machine hours per week.
Operating costs including direct labour costs are $10,880 per week.

Required: Determine the optimum production plan for WR Co and

calculate the weekly profit that would arise from the plan?

Throughput Accounting Ratio (TPAR)

It is the ratio of the throughput per unit of bottleneck r5esource to the
factory cost per unit of bottleneck resource
 Return per factory hour
Throughput accounting ratio =
Cost per factory hour

Throughput per
Return per factory hour = unit
Production time on bottleneck resource

(Throughput generated from one unit of bottleneck resource.)

Total factory costs

Cost per factory hour =
Total time available on bottleneck resource

(The total factory cost is the operational expense [labour plus overhead] of
the organisation.)

In any organisation, you would expect the throughput accounting ratio to

be greater than 1. This means that the rate at which the organisation is
generating cash from sales of this product is greater than the rate at which
it is incurring costs.

Interpretation of TPAR

TPAR > 1 Throughput exceeds operating costs so the product

should make a profit.
TPAR < 1 Throughput is insufficient to cover operating costs,
resulting in a loss.

Criticisms of TPAR
It concentrates on the short-term.
It is more difficult to apply throughput accounting concepts to the
longer-term, when all costs are variable, and vary with the volume of
production and sales or another cost driver.
In the longer-term an ABC approach might be more appropriate for
measuring and controlling performance.
Illustration 2

Product A Product B Product C

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

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

machine hours per week. Operating costs including direct labour costs are
$10,880 per week.

Required: Calculate the Throughput Accounting Ratio for all the products?

Improving Throughput Accounting Ratio

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

5 MCQ
 ENVIRONMENTAL ACCOUNTING

Introduction
Traditional management accounting systems do not provide any analysis
of environmental costs. Management is often unaware of them. The
implication of this is that:
Management cannot do enough to manage environmental activities.
Management accounts underestimate the costs of poor environmental
behaviour and underestimate the benefits of good environmental
behaviour.

Environmental Management Accounting (EMA) aims to overcome this.

Environmental management accounting is the generation and analysis of

both financial and non-financial information in order to support
environment management process.

Importance of Environmental Costs

Society as a whole has become more environmentally aware and
companies can increase their appeal to customers by portraying
themselves as environmentally responsible.
Environmental costs are becoming huge for some companies.
Regulation is increasing worldwide, with penalties for non-compliance
also increasing accordingly.
Identifying environmental costs associated with individual products and
services can assist with pricing decisions.

Environmental Costs – Examples

Consumable and raw materials
Transport and travel
Waste disposal
Water consumption
Energy
Types of Environmental Costs
1. Internal Environmental Costs
These are costs that directly impact on the income statement of a
company.
For example:
Waste disposal costs
Regulatory costs such as taxes

2. External Environmental Costs

These are costs that are imposed on society at large, but not borne by
the company that generates the cost in the first instance.
For example:
Carbon emissions
Usage of energy and water
Forest degradation

Classification of Environmental Costs

1. Environmental prevention costs
The costs of activities undertaken to prevent the production of waste.
For example:
The costs of the design and operation of processes to reduce waste.
Obtaining certification relating to meeting the requirements of
national and international standards.

2. Environmental detection costs

Costs incurred to ensure that the organisation complies with regulations
and voluntary standards.
For example:
Performing pollution tests.
Inspecting products to ensure regulatory compliance.

3. Environmental internal failure costs

Costs incurred from performing activities that have produced
contaminants and waste that have not been discharged into the
environment.
For example:
Recycling scrap.
Disposing of toxic materials.
4. Environmental external failure costs
Costs incurred on activities performed after discharging waste into the
environment.
For example: Costs of cleaning up contaminated soil, or restoring land
to its natural state.

Methods of Environmental Accounting

1. Input/Output Analysis Input/Output analysis
operates on the principle that what comes in must go out. Process flow
charts can help to trace inputs and outputs, particularly waste.
Any difference between the amount input and the eventual output is
'residual', which is called 'waste'.
Input and output quantities are measured and these can be given a
cost.

2. Flow Cost Accounting

Flow cost accounting is a development from input/output analysis. It
divides the material flows into three categories:
Material
System and delivery
Disposal

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

3. Activity Based Costing

Environmental activity-based costing combined elements of
environmental costing with an activity-based costing system. ABC
allocates internal costs to cost centres and cost drivers on the basis of
the activities that give rise to the costs.

4. Lifecycle Costing
Within the context of environmental accounting, lifecycle costing is a
technique which requires the full environmental costs, arising from
production of a product to be taken account across its whole lifecycle.
Under this method of environmental cost accounting, environmental
costs for a product are considered from the design stage of the product
right up to the end-of-life costs, such as decommissioning and removal.
Advantages of Environmental Costing
Better environmental cost control.
Facilitates the quantification of cost savings from "environmentally-
friendly" measures.
Reduces the potential for cross-subsidisation of environmentally
damaging products.
Better/fairer product costs.
Improved pricing so that products that have the biggest environmental
impact reflect this by having higher selling prices.

Disadvantages of Environmental Costing

Time consuming and expensive.
Determining accurate costs and appropriate costs drivers is difficult.
External costs not experienced by the company (e.g., carbon footprint)
may still be ignored/ unmeasured.
Some internal environmental costs are intangible (e.g., impact on
employee health) and these are still ignored.

5 MCQ
 PART DECISION MAKING
C TECHNIQUES

COST VOLUME PROFIT (CVP) ANALYSIS

CVP analysis is the study of the relationship that exists between cost,
volume and the profit of the company. It is based on the concept of
contribution.

Contribution = Sales - Variable Cost

Contribution = Fixed Cost + Profit

CS ratio = (Contribution/Sales * 100)

OR

(Contribution Per Unit/Selling Price* 100)

Breakeven Point
The breakeven point is when total revenue equals total costs.
At breakeven point contribution is equal to fixed costs as there is no profit
or loss made.
 Breakeven Units = Total Fixed Cost/Contribution Per Unit

Breakeven Sales Revenue = Breakeven Units * Selling Price

OR

Breakeven Sales Revenue = Fixed Cost/CS Ratio

Illustration 1
Details of a product are as follows:
Selling price per unit = $15
Variable cost per unit = $12
Total fixed cost = $36,000
Required: Calculate break-even point?

When There is a Target Profit

(fixed cost + target profit)

Units to achieve target profit =
contribution per unit.

(fixed cost + target profit)

Total revenue to generate target profit =
(CS ratio)

Illustration 2
Details of a product are as follows:
Selling price per unit = $15
Variable cost per unit = $12
Total fixed cost = $36,000
Targeted Profit = $21,000
Required: Calculate the sales volume required to achieve the target
profit?
Margin of Safety
Margin of safety is measure of how far away a company is from its break-
even point.

Margin of safety can be computed in terms of units or as a %.

In terms of units = Budgeted sales units – BEP in units

In terms of revenue = Budgeted revenue – BE Revenue

In terms of % = (Budgeted – BE) / Budgeted

Illustration 3
Details of a product are as follows:
Selling price per unit = $15
Variable cost per unit = $12
Total fixed cost = $36,000
Total budgeted units = 20,000 units
Required: Calculate margin of safety?

Graphs
Single Product Analysis

Selling price $50 per unit

Variable cost $30 per unit
Fixed costs $20,000 per month
Forecast sales 1,700 units per month
The completed graph is shown below:

Contribution Breakeven Chart

Profit Volume Chart

Multi Product Environment

Total fixed cost

Breakeven units =
Contribution per mix

Sales volume required to Total fixed cost + Profit

=
achieve a target profit Contribution per mix
1

These mixes should be converted in to units.

Calculations Using CS Ratio

Total fixed cost

Breakeven sales revenue =
Weighted average CS ratio

Sales revenue required to Total fixed cost + Profit

=
achieve a target profit Weighted average CS ratio
1
Illustration 4
PL produces and sells two products, M and N. Product M sells for $7 per
unit and has a total variable cost of $2.94 per unit, while Product N sells for
$15 per unit and has a total variable cost of $4.40 per unit. The marketing
department has estimated that, for every five units of M sold, one unit of N
will be sold. The organization’s fixed costs per period total $123,600.

Required: Calculate the breakeven point for PL?

Illustration 5
TIM produces and sells two products, the MK and the KL. The organization
expects to sell 1 MK for every 2 KLs and have monthly sales revenue of
$150,000. The MK has a C/S ratio of 20% whereas the KL has a C/S ratio of
40%. Budgeted monthly fixed costs are $30,000.

Required: What is the breakeven sales revenue?

Illustration 6
BJS Ltd produces and sells the following three products:

Product X Y Z
Selling price per unit $16 $20 $10
Variable cost per unit $5 $15 $7
Contribution per unit $11 $5 $3
Budgeted sales volume 50,000 units 10,000 units 100,000 units

The company expects the fixed costs to be $450,000 for the coming year.
Assume that sales arise throughout the year in a constant mix.

Required:
a) Calculate the weighted average C/S ratio for the products?
b) Calculate the break-even sales revenue required?
c) Calculate the margin of safety required?
d) Calculate the revenue required to achieve a target profit of $900,000?
e) Draw a multi-product profit-volume chart assuming the budget is
achieved?
Multi Product Profit Volume Chart

Limitations/Assumptions of Cost-Volume-Profit
Analysis
Either a single product is being sold or, if there are multiple
products, these are sold in a constant mix.
Fixed costs remain constant over the 'relevant range'.
Selling price per unit and variable cost per unit constant.
Contribution per unit constant at all levels of activity.
CS ratio remain constant at all levels of activity.
The total cost and total revenue functions are linear.
Multiple Choice Questions
1.
Morava Co produces a product which has a variable cost of $28 and a
selling price of $39. Budgeted sales and production volumes for the next
month are 18,000 units. Budgeted fixed costs are $121,000 per month.

If Morava wishes to generate a profit of $11,000, how many units must be

sold?

A. 1,000

B. 10,000

C. 11,000

D. 12,000

2.
Dilnot Co produces and sells rucksacks and shoulder bags in a standard
mix of 3 rucksacks to 2 shoulder bags.

The following information is available about the two products:

Rucksacks Shoulder bags

$ $
Variable cost 54.00 32.50
Contribution to sales ratio 0.4 0.5

Dilnot Co's annual fixed costs are $1.608.900.

What is the breakeven point in sales revenue (to the nearest $100)?

A. $3,640,500

B. $3,650,300

C. $3,720,000

D. $3,758,000
3.
Cummings Co manufactures a single product, which it sells for $5. Its
annual sales revenue is $80,000 and its annual fixed costs are $25,000. Its
contribution/sales ratio is 40%.

What is Cummings Co's margin of safety to the nearest 0.1%?

A. 21.9%

B. 28.0%

C. 47.9%

D. 92.0%

4.
The following statements have been made about cost-volume-profit (CVP)
analysis.

1. CVP analysis uses an absorption costing approach.

2. CVP analysis assumes that variable cost per unit and selling price per
unit are constant over the full range of production.
3. CVP can be used when multiple products are sold in a varying sales mix.
4. CVP analysis ignores the impact of changes in inventory.

Which of the statements above are correct?

A. 1 and 2

B. 3 and 4

C. 1 and 3

D. 2 and 4
5.
The following profit-volume chart for three products, has been prepared:

Which TWO of the following statements about the above chart are
correct?

A. Point A is the breakeven point if the company's products are sold in

order of their C/S ratio.
B. Point B is the breakeven point if the company's products are sold in the
budgeted sales mix.
C. Changing the product mix in favour of Product 3 would improve the
overall c/s ratio.
D. If all three products are produced, then the company can expect sales
revenues of $350,000.
Constructed Response Questions
The Alka hotel.
The Alka Hotel is situated in a major city close to many theatres and
restaurants. The Alka Hotel has 25 double bedrooms and it charges guests
$180 per room per night, regardless of single or double occupancy. The
hotel's variable cost is $60 per occupied room per night.

The Alka Hotel is open for 365 days a year and has a 70% budgeted
occupancy rate. Fixed costs are budgeted at $600,000 a year and accrue
evenly throughout the year.

During the first quarter (Q1) of the year the room occupancy rates are
significantly below the levels expected at other times of the year with the
Alka Hotel expecting to sell 900 occupied room nights during Q1. Options to
improve profitability are being considered, including closing the hotel for
the duration of Q1 or adopting one of two possible projects as follows:

Project 1 - Theatre Package

For Q1 only the Alka Hotel management would offer guests a 'theatre
package'. Couples who pay for two consecutive nights at a special rate of
$67.50 per room night will also receive a pair of theatre tickets for a
payment of $100. The theatre tickets are very good value and are the result
of long negotiation between the Alka Hotel management and the local
theatre.

The theatre tickets cost the Alka Hotel $95 a pair. The Alka Hotel's fixed costs
specific to this project (marketing and administration) are budgeted at
$20,000.

The hotel's management believes that the 'theatre package' will have no
effect on their usual Q1 customers, who are all business travellers and who
have no interest in theatre tickets, but will still require their usual rooms.
Project 2 – Restaurant
There is scope to extend the Alka Hotel and create enough space to operate
a restaurant for the benefit of its guests. The annual costs, revenues and
volumes for the combined restaurant and hotel are illustrated in the
following graph:

Note: The graph does not include the effect of the 'theatre package' offer.

Required:

a. Using the current annual budgeted figures, and ignoring the two
proposed projects, calculate the breakeven number of occupied
room nights and the margin of safety as a percentage? (4 marks)

b. Ignoring the two proposed projects, calculate the budgeted profit or

loss for Q1 and explain whether the hotel should close for the
duration of Q1? (4 marks)

c. Calculate the breakeven point in sales value of Project 1 and explain

whether the hotel should adopt the project? (4 marks)

d. Using the graph, quantify and comment upon the financial effect of
Project 2 on the Alka Hotel?

Note: There are up to four marks available for calculations.

(8 marks)
(Total: 20 marks)
 LIMITING FACTORS
Limiting Factor
Limiting factor is that resource which is in short supply and which limits the
output of the business.

Examples of limiting factors

Output maybe restricted by a shortage of:

Material

Labour hours

Machine hours

Single Limiting Factor

Key Factor Analysis (Steps for Optimal Production Plan)
Identify limiting factor.

Calculate contribution per unit.

Calculate contribution per unit of the limiting factor.

Rank in order.

Allocate resources in order of the ranking (optimal production plan).

Illustration 1
Product A Product B
Selling price $14 $11
Variable cost per unit $8 $7
Labour hours per unit 2 hours 1 hour
Maximum sales demand 3000 units 5000 units

During July the available direct labour is limited to 8000 hours.

Total fixed cost per month is $20,000.

Required: Determine the profit maximising production budget?

Multiple Limiting Factors
In situations which more than one factor is limited an alternative approach
is used to determine the optimal production plan. This technique is linear
programming.

Linear Programming
If there are multiple limiting factors, linear programming approach is used.
The graphical method can be used when there are just two products (or
service).
The steps involved are as follows.

Define variables
Formulate the objective functions
Formulate the constraint
Draw the graph identifying the feasible region
Find the optimal production plan

Illustration 2
A company produces two products in three departments. Details are shown
below regarding the time per unit required in each department, the
available hours in each department and the contribution per unit of each
product:

Product X: Product Y: Available

hours per unit hours per unit hours
Department A 8 10 11,000
Department B 4 10 9,000
Department C 12 6 12,000
Contribution p.u. $4 $8

There is unlimited demand for Product X, but demand for Product Y is limited
to 600 units per annum.

Required: Determine, using a step-by-step approach, what the optimum

production plan is?
Solution:
Step 1: Define the variables
X = No. of units of X to be produced.
Y = No. of units of Y to be produced.

Step 2: Formulate the objective function

Objective is to maximise contribution C = 4x + 8y

Step 3: Formulate the constraint

In Department A, 8x + 10y ≤ 11,000 hours

In Department B, 4x + 10y ≤ 9,000 hours

In Department C, 12x + 6y ≤ 12,000 hours

Non-negativity constraint: 0 ≤ x, y.

Sales demand for Product Y is also a constraint that can be expressed by

the inequality y ≤ 600.

Step 4: Draw the graph identifying the feasible region

To draw Constraint 1 (Department A)

8x + 10y = 11000
If X = 0, Y = 11,000 + 10 so Y = 1,100
Likewise, if Y = 0, X = 11,000 + 8 so X = 1,375

To draw Constraint 2 (Department B):

If X = 0, Y = 900 and
If Y = 0, X = 2,250

To draw Constraint 3 (Department C):

If X = 0, Y = 2,000 and
If Y = 0, X = 1,000

To draw the final constraint (maximum demand for Product Y), we draw
the line y = 600 for any value of x:

If X = 0, Y = 600 and
If X = 100, Y = 600
Step 5: Finding the optimal production plan

2 point

Point X Y C = 4x + 8y
A 0 0 (4x0) + (8x0) = 0
B 0 600 (4x0) + (8x600) = 4,800
C
D
E
Shadow Price (or Dual Prices)
The additional contribution that would be generated if one more unit of the
resource were to become available.

It is the maximum premium the company could pay for one extra unit of
the binding constraint.

Shadow price of a constraint which is not binding at the optimal solution is

zero.

Steps to Calculate shadow price

Take the equation of the straight line that intersect at the optimal point.
Add one unit to the constraint concerned, while leaving the other
critical constraint unchanged.
Use simultaneous equations to derive a new optimal solution.
Calculate the revised optimal contribution and compare to the original
contribution calculated. The increase is the shadow price.
Illustration 3
Q

Slack
If a resource is not binding at the optimal point, it will have slack.
Maximum capacity is not utilised.
The constraint is a 'less than or equal to' constraint.

Implication of Shadow Prices

High slack: it is an indication of inefficient use of particular resource. If
possible, the resource should be reallocated to another part of the
business.
Low slack: management should be alert to the risk that this resource
could become a binding constraint.

Multiple Choice Question

1.
Q plc makes two products - Quone and Qutwo - from the same raw
material. The selling price and cost details of these products are as shown
below:

Quone Qutwo
$ $
Selling price 20.00 18.00
Direct material ($2.00 per kg) 6.00 5.00
Direct labour 4.00 3.00
Variable overhead 2.00 1.50
12.00 9.50
Contribution per unit 8.00 8.50

The maximum demand for these products is 500 units per week for Quone,
and an unlimited number of units per week for Qutwo.

What is the shadow price of these materials, if material were limited to

2,000 kgs per week?

Pick from list

List options are:

a) $nil
b) $2.00 per kg
c) $2.66 per kg
d) $3.40 per kg

2.
A company has the following production planned for the next four weeks.
The figures reflect the full capacity level of operations. Planned output is
equal to the maximum demand per product.

Product Product Product Product

A B C D
$/unit $/unit $/unit $/unit
Selling price 160 214 100 140
Raw material cost 24 56 22 40
Direct labour cost 66 88 33 22
Variable overhead cost 24 18 24 18
Fixed overhead cost 16 10 8 12
Profit 30 42 13 48
Planned output 300 125 240 400
Direct labour hours per unit 6 8 3 2

The direct labour force is threatening to go on strike for two weeks out of
the coming four. This means that only 2,160 hours will be available for
production, rather than the usual 4,320 hours.

If the strike goes ahead, which product or products should be produced if

profits are to be maximised?

Place a tick in the boxes in the table below as appropriate.

 Should be produced Should not be produced
Product A
Product B
Product C
Product D

3.
A jewellery company makes rings (R) and necklaces (N).

The resources available to the company have been analysed and two
constraints have been identified:

Labour time 3R + 2N ≤ 2,400 hours Machine time 0.5R + 0.4N ≤ 410 hours

The management accountant has used linear programming to determine

that R = 500 and N = 400.

Which of the following is/are slack resources?

1. Labour time available
2. Machine time available

A. (1) only
B. (2) only
C. Both (1) and (2)
D. Neither (1) nor (2)

4.
Cornaur Products uses a scarce material in the manufacture of four
products. Data per unit of each product is shown below:

Y W S E
Selling price $38.72 $29.86 $41.17 $31.25
Variable cost $30.58 $25.56 $34.19 $20.53
Material input (kg) 1.7 1.5 1.9 1.6

In the next period, insufficient material will be available to manufacture all

four products and therefore one product must be discontinued.
In order to maximise short-term profit, which product should be
discontinued?
A. Product Y
B. Product W
C. Product S
D. Product E

5.
Bruno Co manufactures two products, the x and the y. The following
constraints apply:
Materials: 4x + 7y ≤ 7,000 kg
Labour time: 8x + 6y ≤ 10,000 hours
x, y > 0

Using simultaneous equations, what is the profit-maximising output of x?

A. 500 units
B. 875 units
C. 1,250 units
D. 1,750 units

Constructed Response Question.

CSC co.
CSC Co is a health food company producing and selling three types of
high-energy products: cakes, shakes and cookies, to gyms and health food
shops. Shakes are the newest of the three products and were first launched
three months ago. Each of the three products has two special ingredients,
sourced from a remote part the world. The first of these, Singa, is a super-
energising rare type of caffeine. The second, Betta, is derived from an
unusual plant believed to have miraculous health benefits.

CSC Co's projected manufacture costs and selling prices for the three
products are as follows:
 Cokes Cookies Shakes
Per unit $ $ $
Selling price 5.40 4.90 6.00
Costs:
Ingredients: Singa ($1.20 per gram) 0.30 0.60 1.20
Ingredients: Betta ($1.50 per gram) 0.75 0.30 1.50
Other ingredients 0.25 0.45 0.90
Labour ($10 per hour) 1.00 1.20 0.80
Variable overheads 0.50 0.60 0.40
Contributions 2.60 1.75 1.20

For each of the three products, the expected demand for the next month is
11,200 cakes, 9,800 cookies and 2,500 shakes.

The total fixed costs for the next month are $3,000.

CSC Co has just found out that the supply of Betta is going to be limited to
12,000 grams next month. Prior to this, CSC Co had signed a contract with a
leading chain of gyms, Encompass Health, to supply it with 5,000 shakes
each month, at a discounted price of $5.80 per shake, starting immediately.
The order for the 5,000 shakes is not included in the expected demand
levels above.

Required:
a) Assuming that CSC Co keeps to its agreement with Encompass
Health, calculate the shortage of Betta, the resulting optimum
production plan and the total profit for next month? (6 marks)

One month later, the supply of Betta is still limited and CSC Co is considering
whether it should breach its contract with Encompass Health so that it can
optimise its profits.

Required:
b) Discuss whether CSC Co should breach the agreement with
Encompass Health?
Note: No further calculations are required. (4 marks)
Several months later, the demand for both cakes and cookies has increased
significantly to 20,000 and 15,000 units per month respectively. However,
CSC Co has lost the contract with Encompass Health and, after suffering
from further shortages of supply of Betta, Singa and of its labour force, CSC
Co has decided to stop making shakes at all. CSC Co now needs to use
linear programming to work out the optimum production plan for cakes and
cookies for the coming month. The variable 'x' is being used to represent
cakes and the variable 'y' to represent cookies.

The following constraints have been formulated and a graph representing

the new production problem has been drawn:
Singa: 0.25x + 0.5y ≤ 12,000
Betta: 0.5x + 0.2y ≤ 12,500
Labour: 0.1x + 0.12y ≤ 3,000
x ≤ 20,000
y ≤ 15,000
x, y ≥0
Required:

Explain what the line labelled 'C = 2.6x + 1.75y' on the graph is and what the
area represented by the points OABCD means? (4 marks)

Explain how the optimum production plan will be found using the line
labelled 'C = 2.6x + 1.75y' and identify the optimum point from the graph?
(2 marks)

Explain what a slack value is and identify, from the graph, where slack
will occur as a result of the optimum production plan? (4 marks)

Note: No calculations are needed for part (c).

(Total: 20 marks)
 PRICING DECISIONS
Factors Affecting Pricing Decisions

Demand is the quantity of a good or service which

consumers want, and are willing and able to pay for.
Level of Demand
The level of demand will influence pricing; the higher
the demand, the higher the price that can be charged.
The price elasticity of demand (PED) is the degree of
Price Elasticity sensitivity of demand for a good to changes in the
price of that good.
Every product pass through different stages i.e.,
introduction, growth, maturity and decline. Each stage
Product Life
of product life cycle has a great influence on pricing
Cycle
decisions. Prices should be consciously decided during
each stage to achieve marketing objectives.
If a business has one dominant customer, it may find
it difficult to increase prices and might be forced to
offer volume (“bulk buy”) discounts.
Competitors Businesses that offer services sometimes try to attract
"prestige" clients by offering low prices. The hope is to
improve reputation and attract other clients, who will
then pay normal prices.
Buying pattern of consumer has impact on pricing
decision of an organization. If consumers buy the
Customers
product frequently, lower price may be fixed. It will
result in more sales and high overall profit.
The sale and purchase of goods will be at the market
clearing (or equilibrium) price, which is the prevailing
price where supply and demand are equal, with no
Perfect
excess or shortage.
Competition
Individual businesses are not big enough to influence
the total output of the market significantly. They are
"price takers" − they must accept the market price.
Approaches to Pricing
Cost Plus Pricing

Price = Cost Per Unit + Chosen Margin or Mark-Up

A mark-up is the profit expressed as a percentage of cost and margin is

the profit expressed as a percentage of the sales price.

1. Full Cost-Plus Pricing

$/Units
Direct production costs X
Absorption of overheads
Variable production overhead X
Fixed production overhead X
Variable non-production overhead X
Fixed non-production overhead X
Full cost X
Mark-up percentage X
Selling price X

2. Marginal Cost -Plus Pricing

Price = Relevant costs + mark-up

Budgeted Variable Budgeted Variable

+ + Mark-up
Production cost non production cost

Budgeted sales units

3. Return on Investment Pricing
Prices are set to achieve a target percentage return on the capital invested
in production.

4. Opportunity Cost-Plus Pricing

Opportunity cost (relevant cost) pricing is a short-term strategy used to
price:
One-off projects;
Special orders; and
Tenders for contracts

5. Life Cycle Costing

Lifecycle cost pricing will not only consider current fixed and variable costs,
but all the costs over the product’s life.

Demand Based Pricing /Economists Model

In the economist’s model, demand means the total quantity of a product or
service the buyers in a market would wish to buy in a given period.
Demand depends on the price charged by suppliers. For most goods, as the
price falls, demand for the goods rises.

There exists a relationship between the selling price of their product or

service and the demand. By investigating and analyzing this relationship it
is possible, in theory, to establish an optimum price, i.e. a price that will
maximize profits.
Algebraic Approach
Economic theory states that the monopolist maximizes profit when
Marginal cost = Marginal revenue.

Marginal Revenue
The increase in total revenue resulting from selling one additional unit of a
product or service.

Marginal Cost
The increase in total cost from producing and selling one additional unit of
a product or service.

Demand Function
Establish linear relationship between price (P) and quantity demanded (Q).

The equation will take the form:

P = a – bQ

Where:
P = Price
a = Price at which demand would be nil.

Change in Price
b=
Change in Quantity

Q = Quantity demanded
To find the marginal revenue:

MR = a − 2bQ

Establish the marginal cost MC.

To maximize profit, equate MC and MR and solve to find Q.
Substitute Q into the price equation to find the optimum price (P)

Illustration 1
Alex owns the only bakery in a small town and is the only supplier of
doughnuts. Based on an analysis of sales over the past 12 months, Alex has
observed:
If the price of a doughnut is $5.00, demand is zero
For every 50 cents the price of a single doughnut decreases by, the
number of doughnuts Alex sells increases by 20

Based on Alex's observations, a = 500 cents and b = 2.5 (50/20=2.5)

Alex has estimated the daily demand for doughnuts as:

P = 500 - 2.5Q
Where P is the price in cents and Q is daily demand in units.

Alex could use this equation in several ways. For example, if Alex was
considering charging $1.50 (150 cents) per donut the equation could be
used to calculate demand at this price.

150 = (500 - 2.5 x 140)

To solve the equation, Q equals 140. This shows that at a price of $1.50 (150
cents) Alex would expect to sell 140 doughnuts.
Tabular Approach
Price (cents) Quantity demanded Total cost (costs)
460 1 385
420 2 570
380 3 749
360 4 932
325 5 1,100
302 6 1,280
269 7 1,467
244 8 1,656
212 9 1,847
180 10 2,030

Required: Using a tabular approach, calculate the marginal revenue and

marginal cost at each price and output level. Based on this, determine the
price to maximize profit and associated quantity to be produced.

Total Cost Function

Cost equations are derived from historical cost data

y = a + bx

‘a’ is the fixed cost per period (the intercept)

‘b’ is the variable cost per unit (the gradient)
‘x’ is the activity level (the independent variable)
‘y’ is the total cost = fixed cost + variable cost (the dependent
variable)

Production and Sales Level

Consider incremental costs, incremental revenues and other factors.
Incremental costs and revenues are the difference between costs and
revenues for the corresponding items under each alternative being
considered.
Customer Based Pricing - Marketers Approach
Customer-based pricing reflects customers’ perceptions of the benefits
they will enjoy from purchasing the product, e.g., convenience, status. The
product is priced to reflect these benefits.

Competition Based Pricing

Competition-based pricing means setting a price based upon the prices of
competing products.

Different Pricing Strategies

1. Market Skimming Pricing
Market skimming involves charging high prices when a product is first
launched in order to maximize short-term profitability.
Suitable Approach when:

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.
Where the strength of demand and the sensitivity of demand to price
are unknown.
A firm with liquidity problems may use market-skimming in order to
generate high cash flows early on.

2. Penetration Pricing Policy

Penetration pricing is the charging of low prices when a new product is
initially launched in order to gain rapid acceptance of the product.
Once market share is achieved, prices are increased.

It is an alternative to market skimming when launching a new product.

Suitable Approach when:
If the firm wishes to increase market share.
A firm wishes to discourage new entrants from entering the market.
If there are significant economies of scale to be achieved from high
volume output, and so a quick penetration into the market is
desirable.
If demand is highly elastic and so would respond well to low prices.
3. Complementary Product Pricing
A complementary product is one that is normally used with another
product. An example is razors and razor blades – if sales of razors increase
more razor blades will also be bought.

Other examples of complementary products are: game consoles and

associated games printers and printer cartridges.

4. Product Line Pricing

A product line is a range of products that are related to one another.
Product line pricing occurs when setting the price steps between various
products in a product line, based on:
Cost differences between the products
Customer evaluations of different features
Competitors prices. In other words, product line pricing occurs when
a company must decide the price differences between the upgrades
of a product or service.

5. Volume Discounting Pricing Strategy

Volume discounting means offering customers a lower price per unit if they
purchase a particular quantity of a product.
It takes two main forms:

Quantity discounts – for customers that order large quantities.

Cumulative quantity discounts – the discount increases as the
cumulative total ordered increases. This may appeal to those who do
not wish to place large individual orders but who purchase large
quantities over time.

Reason for Using Such Strategy is Two-Fold:

1. To offer a more competitive price overall (as the average price paid
for two items will obviously be lower than the price for one).
2. To acknowledge the law of diminishing marginal utility (i.e., the idea
that the consumer gets most satisfaction from the first unit of a
product or service).
Benefits
Increased Customer Loyalty
Attracting New customers
Lower sales processing costs
Lower purchasing costs
Discounts help to sell items that are bought primarily on price.
Clearance of surplus stock or unpopular item through the use of
discounts.
Discounts can be geared to particular off-peak periods.

Price Discrimination
Price discrimination involves setting different prices for a product or service
in different markets. Customers in some markets may be willing to pay
higher prices than customers in other markets, so price discrimination aims
to achieve the maximum price in each available market.

Loss Leader
A loss leader is a product that is sold at a loss to attract customers who will
then buy other products. Loss leaders may be used in complementary
pricing, where one product (e.g. the printer) is sold at a loss to lock
customers into buying another (e.g. ink cartridges).

Loss leaders are common in supermarket promotions, where products are

advertised at very low, loss-making prices.

Going-Rate Pricing
This simply means charging the prevailing market price. This approach
might be used in competitive markets (i.e., where charging above market
price would lead to a loss of the majority of customers and selling below
market price would not bring additional customers).

Going-rate pricing is common for homogeneous products that have very

little variation (e.g., commodities such as aluminum or beef).

Price Elasticity of Demand

The price elasticity of demand (PED) is the degree of sensitivity of demand
for a good to changes in the price of that good.
Demand for a product can be described as:

Elastic− meaning that demand is very responsive to changes in price.

The change in the quantity of goods demanded will be relatively
greater (i.e. in percentage terms) than the change in price. The PED will
be greater than one.

Inelastic− meaning that a change in price will have little impact on

demand. Demand will change by a relatively small amount (i.e. in
percentage terms) than the change in price. The PED will be less than
one.

Q2 - Q1
% Change in demand (Q) Q1
PED at point 1 =
% Change in Price (P) P2 - P1
P1

PED > 1 (elastic) increasing the price may lead to reduced revenue.

price rises can increase revenue (e.g., necessity

PED < 1 (inelastic)
goods).
Illustration 2
Alex, a baker, has ascertained that the daily demand for doughnuts has the
following demand function:
P= 500 - 0.1Q
Where P is the price in cents, and Q is the daily demand in units.

Required: Calculate the price elasticity of demand based on Alex

increasing the price by 5 cents, assuming that his current price per
doughnut is?
a. $4
b. $2
 RELEVANT COSTING
Introduction
In short term decision should be based on relevant cost. Relevant costs are
those costs that are affected by a specific management decision. Only
those cost and revenue which will be affected by a decision are relevant.
Therefore, relevant costs are:

Future
Sunk cost is not a relevant cost. That have already been incurred.

Incremental
Any cost or benefit that will happen anyway, regardless of the decision
cannot be a relevant cost.

Committed cost cannot be a relevant cost.

Opportunity cost should be included.

Cashflows
It must be a cost (or benefit) that results in cashflow.
Depreciation costs and overhead absorption cost cannot be a relevant
cost.

Relevant Cost Includes:

Variable costs

Incremental fixed costs

Opportunity costs

Opportunity costs
An opportunity cost is the benefit foregone by choosing one opportunity
instead of the next best alternative.
Irrelevant Costs Include:
Depreciation

Sunk costs

Unavoidable costs

Committed costs

Apportioned fixed overheads

Financing cashflows (E.g.; Interest)

Illustration 1
A new project requires the use of an existing machine that would otherwise
be sold.

Information concerning the machine is as follows:

Original purchase price = $20,000

Current net book value (NBV) = $5,000

Estimated current sales value = $4,000

Required: What is the relevant cost (if any) if using the machine in the
project?

Illustration 2
A company which manufactures and sells one single product is currently
operating at 85% of full capacity, producing, 102,000 units per month. The
current total monthly costs of production amount to $330,000, of which
$75,000 are fixed and are expected to remain unchanged for all levels of
activity up to full capacity. A new potential customer has expressed interest
in taking regular monthly delivery of 12,000 units at a price $2.80 per unit. All
existing production is sold each month at a price of $3.25 per unit. If the new
business is accepted, existing sales are expected to fall by 2 units for every
15 units sold to the new customer.

Required: What is the overall increase in monthly profit which would

result from accepting the new business?
Relevant cost can be used in short term decision making.
 a) One off contract
b) Shut down decisions
c) Further Processing decisions
d) Make or buy

One off Contract

Material:
Labour

Shut Down Decision

Look at future incremental cashflow

Closure costs

E.g.; Penalties, Redundancies

Reorganisation costs

Further Processing Decision

Look at future incremental cashflows: Sell at split off v process further
and sell.

Pre separation (joint) costs are not relevant. Only include post split-off
aspects.
Make or Buy Decision
When deciding whether to outsource the manufacture of a particular
component organisation will obviously want to calculate the financial
affect.

Illustration 3
Geranium Co makes a product which requires two sequential operations
on the same machine. Operation 1 takes 15 minutes per unit and Operation
2 takes 30 minutes per unit.

The machine is operating at full capacity. The material cost of the product
is $12 per unit. Instead of carrying out Operation 1, Geranium could buy in
components, for $15 per unit. This would increase production capacity
because the machine has to deal with only Operation 2.

Labour and variable overheads are incurred at a rate of $16 per machine
hour and the finished products sell for $30 per unit.

Make entire product internally or buy in components?

MCQ 5 (Pending)
Constructed Response Questions
The Telephone Co (T Co)
The Telephone Co (T Co) is a company specialising in the provision of
telephone systems for commercial clients. There are two parts to the
business:

Installing telephone systems in businesses, either first time installations

or replacement installations Supporting the telephone systems with
annually renewable maintenance contracts.

T Co has been approached by a potential customer, Push Co, who wants to

install a telephone system in new offices it is opening. Whilst the job is not
a particularly large one, T Co is hopeful of future business in the form of
replacement systems and support contracts for Push Co. T Co is therefore
keen to quote a competitive price for the job. The following information
should be considered:

A. One of the company’s salesmen has already been to visit Push Co, to
give them a demonstration of the new system, together with a
complimentary lunch, the costs of which totalled $400.
B. The installation is expected to take one week to complete and would
require three engineers, each of whom is paid a monthly salary of
$4,000. The engineers have just had their annually renewable contract
renewed with T Co. One of the three engineers has spare capacity to
complete the work, but the other two would have to be moved from
contract X in order to complete this one. Contract X generates a
contribution of $5 per engineer hour. There are no other engineers
available to continue with Contract X if these two engineers are taken
off the job. It would mean that T Co would miss its contractual
completion deadline on Contract X by one week. As a result, T Co would
have to pay a one-off penalty of $500. Since there is no other work
scheduled for their engineers in one week’s time, it will not be a problem
for them to complete Contract X at this point.
C. T Co’s technical advisor would also need to dedicate eight hours of his
time to the job. He is working at full capacity, so he would have to work
overtime in order to do this. He is paid an hourly rate of $40 and is paid
for all overtime at a premium of 50% above his usual hourly rate.
D. Two visits would need to be made by the site inspector to approve the
completed work. He is an independent contractor who is not employed
by T Co, and charges Push Co directly for the work. His cost is $200 for
each visit made.
E. T Co’s system trainer would need to spend one day at Push Co delivering
training. He is paid a monthly salary of $1,500 but also receives
commission of $125 for each day spent delivering training at a client’s
site.
F. 120 telephone handsets would need to be supplied to Push Co. The
current cost of these is $18.20 each, although T Co already has 80
handsets in inventory. These were bought at a price of $16.80 each. The
handsets are the most popular model on the market and frequently
requested by T Co’s customers.
G. Push Co would also need a computerised control system called ‘Swipe
2’. The current market price of Swipe 2 is $10,800, although T Co has an
older version of the system, ‘Swipe 1’, in inventory, which could be
modified at a cost of $4,600. T Co paid $5,400 for Swipe 1 when it ordered
it in error two months ago and has no other use for it. The current market
price of Swipe 1 is $5,450, although if Push Co tried to sell the one, they
have, it would be deemed to be ‘used’ and therefore only worth $3,000.
H. 1,000 metres of cable would be required to wire up the system. The cable
is used frequently by T Co and it has 200 metres in inventory, which cost
$1.20 per metre. The current market price for the cable is $1.30 per metre.

You should assume that there are four weeks in each month and that the
standard working week is 40 hours long.

Required: Prepare a cost statement, using relevant costing principles,

showing the minimum cost that T Co should charge for the contract. Make
detailed notes showing how each cost has been arrived at and explain
why each of the costs above has been included or excluded from your cost
statement.
 RISK AND UNCERTAINITY
Risk
The existence of several possible outcomes, which are known in advance
along with the related probability.

Uncertainty
The potential outcomes of a decision that are not known in advance.
Clearly, associated probability cannot be known either.

Methods of Dealing with Risk in Decision Making

1. Expected Value
The expected value represents the average outcome that would be
achieved if a decision were to be repeated many times.

Expected value = Weighted arithmetic means of possible

(EV) Outcomes
= ∑ (xi p(xi))

This formula represents the sum (Σ) of each possible outcome (Xi)
multiplied by its probability of occurring (p(x i)).

The decision rule would be to choose the outcome with the highest EV.
The sum of the probabilities of all outcomes must equal to 1.

Illustration 1
When an unbiased six-sided die is thrown, each side has an equal chance
(1/6) of being obtained. The expected value of throwing a die many times
is calculated as:
 Value Probability Product
xi p(xi) xi p(xi)
1 1/6 1/6
2 1/6 2/6
3 1/6 3/6
4 1/6 4/6
5 1/6 5/6
6 1/6 6/6
Total Σ (Xi p(Xi)) 21/6

21
The EV is therefore or 3½
6

What this means is that if the dice is thrown many times (many iterations
of the event), the average value of the throws would be 3½.

Since the expected value shows the long run average outcome of a
decision which is repeated time and time again, it is a useful decision rule
for a risk neutral decision maker.

Advantages of Expected Value

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

Disadvantages of Expected Value

The probabilities of the different possible outcomes may be difficult to
estimate.
The average may not correspond to any of the possible outcomes.
Unless the same decision has to be made many times, the average will
not be achieved; it is therefore unsuitable for decision making in “one-
off” situations.
The average gives no indication of the spread of possible results (i.e.,
it ignores risk).
2. Profit Table/Payoff Table
A profit table (pay-off table) can be a useful way to represent and
analyse a scenario where there is a range of possible outcomes and a
variety of possible responses. A pay-off table simply illustrates all
possible profits/losses.

Illustration 2
A baker sells a cake that costs $0.10 to make for $0.30 each. At the end of a
day any cakes not sold must be thrown away. On any particular day the
level of demand follows the following probability distribution:

Number of cakes sold 20 40 60

Probability 0.3 0.5 0.2

The following template may be used:

Order Size
Demand 20 40 60
20 (Pr 0.3)
(Outcomes are computed in this part of
40 (Pr 0.5)
the table)
60 (Pr 0.2)

Required:

a) Construct a profit table to show the possible outcomes?

b) Calculate the daily order the baker should place in order to
maximize the expected value of daily profits?
Value of Perfect Information
Imagine that, in a situation of uncertainty, it is possible to buy an accurate
forecast which predicts with certainty what the uncertain variable is going
to be each time a decision has to be made.
The value of perfect information is the maximum amount a decision-maker
would be willing to pay for advance information to know which outcome will
occur.

Value of Perfect Information = EV with Perfect Information - EV

Without Perfect Information

Illustration 3
The baker in Illustration 2 opts to buy a daily forecast which tells him in
advance of placing the day's order what demand for that day will be with
certainty.

Required: Calculate the value of this perfect information?

Value of Imperfect Information

Imperfect information is when the information is usually correct, but can be
incorrect.

Value of imperfect information = EV with imperfect information - EV

without information

3. Decision Trees
Decision making often involves multi-stage decisions. At each stage in
the decision-making process, the decision maker has to choose
between two or more decisions. The possible outcomes of each decision
will be specified, along with the associated probability.

Having made the first decision, a second decision or possibly even more
decisions may be required.

A "decision" tree helps visualize and evaluate outcomes in the

decision-making process.
Conventions and Process
Decision fork (point) − this is a point at which a decision- maker has to
decide between two or more decisions.

Action a

Action b

Action c

Chance fork (outcome point) − this occurs where there are several possible
outcomes. Normally, for each decision taken, there will be two or more
possible outcomes.

Outcome B
Probability P

Probability Q
Outcome A

The sum of the probabilities of all outcomes (branch) at each chance fork
must equal 1 or 100%.

Having drawn the decision tree, it is necessary to calculate the expected

outcome at each decision fork. To do this process, start at the right-hand
side of the decision tree and work back to each decision fork to identify
which is the best decision at each fork.
Ultimately, the decision tree enables the decision-maker to determine the
best decision to make at the first stage.
Illustration 4
A company is considering investing in a new machine. This would involve
an initial expenditure of $50,000 on patent rights, and profit in the coming
year could be:

$300,000 with probability 0.6

Or $200,000 with probability 0.4

If the company does not invest in the machine, next years' profits will be:

$250,000 with probability 0.7

Or $150,000 with probability 0.3

This can be illustrated as follows:

At chance fork B: Expected profits are $260,000 ((0.6 x 300,000) + (0.4 x

$200,000)).
At chance fork C: Expected profits are $220,000 ((0.7 x 250,000) + (0.3 x
$150,000)).

At decision point A:
Either invest: Expected outcome is $210,000 (260,000 - 50,000).
Or do not invest: Expected profit is $220,000.

Conclusion: The investment should not be made.

Types Of Decision Makers
Not all managers will make the same decision even though they have the
same information; as individuals, they have different attitudes toward risk.

1. Risk seekers are those who seek the maximum possible return
regardless of the probability of it occurring. As optimists, they consider
the best-case scenario.

2. Risk neutral is those who consider the most likely outcome.

3. Risk averse are those who dislike risk and so make decisions based
on the worst possible outcome.

4. Maximax, Maximin and Minimax Regret

Select the alternative with the maximum possible

MAXIMAX payoff (i.e. highest return under the best-case
scenario). The risk seeker's (i.e. optimist's) rule.
Select the alternative with the highest return under the
MAXIMIN worst-case scenario. The pessimist's rule (i.e. risk
averse).
Select the alternative with the lowest maximum regret.
Regret is defined as the opportunity loss from having
MINIMAX REGRET made the wrong decision. Minimax regret is also suited
to investors that are averse to missing out.

Select the option that gives the highest EV. Those who
use EVs may be described as risk neutral (i.e. they are
EXPECTED VALUE
not concerned with the amount of risk associated with
(EV)
each option only the amount of the expected return).
Illustration 5
From the payoff table given below:
State of the market Probability Project 1 Project 2 Project 3
Diminishing 0.4 100 0 180
Static 0.3 200 500 190
Expanding 0.3 1,000 600 200

Required: Determine which project would be chosen, using each of the

following decision rules:
a. Maximax;
b. Maximin;
c. Minimax regret.

5. Sensitivity Analysis
Sensitivity analysis takes each uncertain factor in turn, and calculates
the change that would be necessary in that factor before the original
decision is reversed. Typically, it involves posing 'what-if' questions. By
using this technique, it is possible to establish which estimates
(variables) are more critical than others in affecting a decision.

Sensitivity % = Profit ÷ Variable

Illustration 6
A manager is considering a make v buy decision based on the following
estimates:

If made un-house If buy in and re-badge

$ $
Variable production costs 10 2
External purchase costs - 6
Ultimate selling price 15 14
You are required to assess the sensitivity of the decision to the external
purchase price.

Solution
Step 1: What is the original decision?

Comparing contribution figures, the product should be bought in and

rebadged:

If made in-house If buy in and re-badge

$ $
Contribution 5 6

Step 2: Calculate the sensitivity (to the external purchase price).

For indifference, the contribution from outsourcing needs to fall to $5 per

unit. Thus, the external purchase price only needs to increase by $1 per unit
(or $1/$6 = 17%). If the external purchase price rose by more than 17% the
original decision would be reversed.

Advantages of Sensitivity Analysis

It gives an idea of how sensitive the decision taken is to changes in
any of the original estimates.
It can be readily adapted for use in spreadsheet packages.

Disadvantages of Sensitivity Analysis

Sensitivity is usually only used to examine what happens when one
variable changes and others remain constant.
Without appropriate software, it can be time consuming.

6. Simulation
Simulation is a technique which allows more than one variable to
change at the same time. Most real-life problems are complex as there
is more than one uncertain variable. Models can be generated which
"simulate" the real-world environment within which the decision must
be made.
Advantages:
It overcomes the limitations of sensitivity analysis by examining the
effects of all possible combinations of variables and their realizations.
It therefore provides more information about the possible outcomes
and their relative probabilities. This helps in highlighting implausible
assumptions and detecting bias.
It is useful for problems which cannot be solved analytically by other
means.

Disadvantages:
It is not a technique for making a decision, only for getting more
information about the possible outcomes.
It can be very time consuming without a computer.
It could prove exit relies on reliable estimates of the probability
distributions of the underlying variables.
Pensive in designing and running the simulation on a computer.

Focus Groups
Much of the uncertainty which companies face in the real world relates to
new products and whether they will be successful. To reduce this
uncertainty, focus groups may be used prior to the launch of a product.

A group of people are asked to give their opinion about a new product
or service. The discussion takes place in an interactive environment in
which participants are free to give their opinions and discuss them with
other members of the group.
Prior to the meeting, the members of the group may be screened to
ensure they belong to the target market to which the product is aimed.
Market Research
Market research is the systematic gathering of information about
customers, competitors and the market. The type of information gathered
in market research seeks to answer the following types of question:
Who are the customers?
Where are they located?
What quantity and quality do they want?
What is the best time to sell?
What is the long-term price?
Who are the competitors?

Market research can be used to help companies make decisions about the
development and marketing of new products. The earlier the market
research is conducted in the development of a product, the better, from a
risk point of view.
 PART BUDGETARY SYSTEMS &
D TYPES OF BUDGETS

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

Objectives of Budgeting
Ensure the achievement of the organisation’s objectives.
Helps in planning
Co-ordinate activities
Provides a system of control
Authorising and delegating
Evaluation of performance (provide a framework for responsibility
accounting).
Communicating of ideas and plans
Motivate employees to improve their performance (budgets are
targets).
 The planning and control cycle

Identify objectives Step 1

objective

Planning Identify alternative courses of

process action (strategies) which might
Step 2
contribute towards achieving the
objectives

Evaluate each strategy Step 3

Choose alternative courses of

Step 4
action

--------
Implement the long-term plan in
Step 5
the form of the annual budget
Control
process

Measure actual results and

Step 6
compare with the plan

Respond to divergences from plan Step 7

The Performance Hierarchy

Strategic Planning:
Long term
Prepared by senior managers
It looks at the whole organization and defines resource requirements.

For example, to develop new products in response to changing customer

needs.

Tactical Planning
Tactical planning is medium term.
It looks at the department/divisional level and specifies how to use
resources. For example, to train staff to deal with the challengers that
this new product presents.
It is prepared by lower-level managers within set guidelines of senior
managers.

Operational Planning
Operational planning is very short-term, very detailed and is mainly
concerned with control.
They will be prepared by managers at fairly low-level who have
practical, operational experience.
Approaches to Budgeting
Top down and bottom-up budgeting
Incremental budgeting
Zero-based budgeting (ZBB)
Fixed, Flexed, Flexible budgets
Rolling budget
Activity based budget
Feed-forward control

Top Down and Bottom-Up Budgeting

Top-Down Budgeting (Imposed)
Under this approach to budgeting, top management prepare a budget with
little input from operational level, which is then imposed upon the
employees and lower-level managers.

Top-down approach is effective in new organizations, in small business and

during periods of economic hardship.

Advantages of Top-Down Budgeting

Strategic plans are likely to be incorporated into budgets
Enhanced coordination
Optimum usage of available resources
Experience of senior managers may be used
Quicker process
Avoids budgetary slack

Disadvantages
Dissatisfaction and de-motivation.
Lack of understanding & incorporation of operational issues.
Budget setting exercise may not be adequately supported by lower-
level management.
Lack of initiative and creativity from lower management.
Bottom-Up Budgeting (Participative)
A budget system in which all budget holders are given the opportunity to
participate in setting their own budgets.

Advantages
Overcomes the problem of dissatisfaction and de-motivation by
involving lower-level managers.
Operational experience and knowledge are incorporated into the
budget.
Budget setting exercise may not be more supported by lower-level
management.
Allows for creativity from lower-level management.

Disadvantages
Strategic plans are less likely to be incorporated into budgets.
Reduced coordination.
May not create optimum usage of available resources.
Experience of senior managers may not be used to full potential.
Slower process.
Creates budgetary slack.

Incremental Budgets
An incremental budget starts with the previous period’s budget or actual
results and adds (or subtracts) an incremental amount to cover inflation
and other known changes.
 Advantages of incremental Disadvantages of incremental
budgets budgets
(1) Quickest and easiest method. (1) Builds in previous problems and
inefficiencies.
(2) Suitable if the organisation is (4) Uneconomic activities may be
stable and historic figures are continued. E.g. the firm may
acceptable since only the continue to make a component
increment needs to be in-house when it might be
justified. cheaper to outsource.
(3) Managers may spend
unnecessarily to use up their
budgeted expenditure
allowances this year, thus
ensuring they get the same (or
a larger) budget next year.

Zero Based Budget

Budgeting that requires Each cost element to be specifically justified.

Advantages
Inefficiencies can be identified and avoided.
It responds to changes in business environment.
Resource should be allocated efficiently and economically.

Disadvantages
Management needs to be skilled to implement ZBB
Managers may feel demotivated due to large time spends on
budgeting.

Fixed, Flexible and Flexed budget

Fixed budgets are budgets which are prepared at a fixed level of
activity and do not take into account the possibilities of various levels
of activity.
Flexible budgets are budgets that take into account possible variations
in level of activity and costs. In simple terms, a flexible budget is a
budget which, by recognising different cost behaviour patterns, is
designed to change as volume of activity changes.
 A flexed budget is where the original budget is restated to reflect the
actual level of activity achieved. These are particularly important for
use when calculating variances so that you compare actual
costs/revenue based on actual output with a budget that is also based
on actual output. Without this, variances would not be meaningful.

Rolling Budget
A budget which kept continuously up to date by adding another accounting
period when the earliest accounting period has been expired.

Advantages
There is always a budget that extends into the future
It forces management to reassess the budget regularly and to produce
budgets which are more up to date.

Disadvantages
Costly and time consuming.
Rolling budgets create uncertainty. Staff may feel that the “rules of the
game “keep changing and that targets are constantly changing.

Illustration
A company uses rolling budgeting and has a sales budget as follows:

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

$ $ $ $ $
Sales 125,750 132,038 138,640 145,572 542,000

Actual sales for Quarter 1 were $123,450. The adverse variance is fully
explained by competition being more intense than expected and growth
being lower than anticipated. The budget committee has proposed that the
revised assumption for sales growth should be 3% per quarter.
Update the budget as appropriate.

Q2-127,154
Q3-130,969
Q4-134,898
2.Q1-138,945
Activity Based Budget
Activity based budgets are based on a framework of activities, and cost
drivers are used as a basis for preparing budgets (Like activity-based
costing).

Advantages
It draws attention to the cost of overhead activities which can be large
proportion of total operating costs.
ABB can provide useful information in total quality management (TQM)
environment, by relating the cost of an activity to the level of service
provided.

Disadvantages
A considerable amount of time and effort might be needed to establish
the key activities and their cost drivers.
It may be difficult to identify clear individual responsibilities for
activities.

Feedback Control
Feedback control is defined as the measurement of difference between
planned outputs and actual outputs achieved and modifications to the
plans for the future required results.

Feed-Forward Control
Feed-forward control is control based on forecast results. In other words, if
forecast is bad, control action is taken by difference between budgeted and
forecasted results.

Beyond Budgeting
Beyond Budgeting is a budgeting model which proposes that
traditional budgeting should be abandoned. Adaptive management
processes should be used rather than fixed annual budgets. Traditional
annual plans tie managers to predetermined actions which are not
responsive to current situations.
Performance is monitored against world-class benchmarks and
competitors.
Benefits
Motivation: Rewards are team based which encourages cooperation
and helps achieve corporate goals.
Faster response to threats and opportunities.
Shift of focus: The use of external benchmarks can lead to
management focus on competitive success.

Challenges
Resistance to change
Resource constraints

Setting the Difficulty Level of a Budget

Expectations budget: Budget set at current achievable levels. This is
unlikely to motivate managers to improve but may give more accurate
forecasts for resource planning, control and performance
evaluation.
Aspirations budget: Budget set at a level which exceeds the level
currently achieved. This may motivate managers to improve if it seen
as attainable but may also result in an adverse variance if it is too
difficult to achieve.

Changing Budgetary Systems

An organisation which decides to change its type of budget used, or
budgetary system, will face a number of difficulties.

Resistance by employees
Costs of implementation
Training
Lack of accounting information
Management time
Budget Systems and Uncertainty
Causes of uncertainty in the budgeting process include:

Customers
Inflation
Competitors
Employees
Unrest or disaster
Machine breakdown
Technological advances
Materials

Information for Budgeting

Previous year’s actual results.
Internal sources such as manager’s knowledge concerning state of
repair of fixed assets, training needs of staff.
Estimates of costs of new products.
Statistical techniques may help to forecast sales.
Models, such as the EOQ model.
External sources of information may include suppliers' price lists and
estimates of inflation.

(5 MCQ)
Constructed Response Question.
YUMI CO
Yumi Co owns a number of restaurants. It is a well-established company,
and its restaurants have gained a favourable reputation for the quality of
their meals.

Yumi Co’s restaurants are all set in rural locations, where there is limited
competition and this enabled them to develop a loyal customer base.
Restaurants design their own menus and décor to fit with the requirements
of their local market.

Yumi Co has been consistently profitable, however as is the case across the
restaurant industry, profit margins are quite low and there is still a constant
need for Yumi Co to monitor costs.

One of Yumi Co’s restaurants is located in the small town of Cowly. Cowly
has recently been the location for the filming of a popular television series
and visitor numbers to the town have increased significantly as a result.
Yumi Co’s restaurant in Cowly has noticed a similar increase in customer
numbers.

At the start of the current month a new restaurant opened in Cowly. The
manager of Yumi Co’s restaurant in Cowly has expressed concerns about
the impact this new competitor will have on their ability to achieve profit
targets for the rest of the year.

Budgets for all of Yumi Co’s restaurants are prepared by the head office. At
the start of each year, restaurant managers are given an annual budget,
which is split into months. At the end of each month, the manager receives
a statement comparing actual monthly performance against budget.

The statement for the Cowly restaurant for the most recent completed
month is as follows:
 Actual Budget Variance
Number of customers 1,800 1,500
$ $ $
Revenue 87,300 75,000 12,300 F
Costs:
Food and drink 26,100 22,500 3,600 A
Staff wages 38,250 31,500 6,750 A
Heat, light and power 8,100 7,500 600 A
Rent, rates and other overheads 12,600 12,000 600 A
Profit 2,250 1,500 750 F

Notes:
1. Rent, rates and other overheads are apportioned to its restaurants by
Yumi Co’s head office, based on a fixed annual charge.
2. All other budgeted costs are treated as variable costs, based on the
expected number of customers.

Yumi Co currently adopts an incremental approach to budgeting, with the

annual budget figures for each year being based on the previous year’s
figures. However, a new finance director has recently joined the company,
and he has questioned whether this is suitable for all Yumi Co’s restaurants.
The new finance director has also suggested that the company should
adopt a more participative approach to budgeting.

Required:
a). (i) Prepare a flexed budget for the Cowly restaurant? (3 marks)

(ii) With reference to your answer from part (i), explain the main
weaknesses in the current monthly budget statements issued to the
restaurants as a basis for managing performance? (4 marks)

(b) Discuss whether an incremental approach to budgeting is

appropriate for Yumi Co? (6 marks)

(c) Define a participative approach to budgeting and explain the

potential advantages and disadvantages of introducing this
approach at Yumi Co. (7 marks)
(Total: 20 marks)
 STANDARD COSTING
Standard Cost
The predetermined cost of a unit of a product or service set under specified
working conditions.

The main purposes of standard costs are:

Control: the standard cost can be compared to the actual costs and
any differences (variance) investigated.
Planning: standard costing can help with budgeting.
Performance measurement: any differences between the standard
and the actual cost can be used as a basis for assessing the
performance of cost centre managers.
Assign cost to inventories of raw materials, work in progress and
finished goods – Inventory valuation.
Pricing - provide a cost basis on which to tender for contracts/set
sales prices.
Highlight opportunities for possible cost reductions.

Standard Cost Card

Standard cost card – Product XYZ
$ Per unit
Unit selling price 61
Material (2 kg at $8 per kg) 16
Labour (1.5 hrs at $6 per hr) 9
VOH (1.5 hrs at $5 per hr) 7.5
FOH (1.5 hrs at $3 per hr) 4.5 (37)
Profit 24

Types of Standards
Ideal standards
Ideal standards are benchmarks that can only be met under perfect
operating conditions, without allowances for machine breakdowns,
interruptions to schedules, or idle time. These standards can be
demotivating for managers who realize their impractical achievement.
Evaluating variances becomes challenging, as it's unclear whether the
 adverse variance is due to an unrealistic standard or inefficient
operations.

Attainable standards
Attainable standards are challenging yet realistically attainable under
current operational conditions, considering allowances for normal level
of machine breakdowns and workforce breaks. These standards
demand a high but reasonable level of efficiency. They are preferred
over ideal standards because they are achievable, providing
motivation for managers.

Current standards
Current standards are established based on existing working
conditions. However, a drawback is their limited ability to inspire
employee motivation for improvement in current working conditions,
potentially leaving employees without a sense of challenge or
incentive to enhance performance.

Basic standards
Basic standards, probably set some years ago, stay the same over
time and are often out of date. These standards are used to show
trends over time so that changes in material prices and labour rates,
for example, can be tracked. Since these standards do not change over
time, they are not useful for motivating employees because these
targets are too easy to achieve.
 VARIANCE ANALYSIS
Variance analysis is the study of differences between what was planned or
budgeted and what actually happened. It helps understand why these
differences occurred, providing insights into how well financial plans and
operations are working.

If the actual results are better than expected, the variance is Favourable
(F). If the actual results are worse than expected, the variance is Adverse
(A).

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

Material price variance

The materials price variance arises when the amount paid for materials
differs from the amount budgeted to be paid for materials in a budget
period, due to change in price per unit of raw materials.

(SP – AP) x AQ

SP x AQ – AP x AQ

Material usage variance

The materials usage variance arises when the actual amount of material
used in a budget period differs from the amount budgeted to be used.

(SQ – AQ) x SP
SQ x SP – AQ x SP

SP – Standard price per kg/ltr

SQ – Standard quantity for actual production [SQ for 1 unit x AU]
AP – Actual price per kg/ltr
AQ – Actual quantity
If AQ purchased and AQ used for the production differs
Price variance is calculated using AQ purchased
Usage variance is calculated using AQ used
Material total variance = material price variance + material usage
variance.
Total Materials variance = (SP x SQ) – (AP x AQ)

Example questions
Product X has a standard direct material cost as follows:
10 kilograms of material at $5 per kilogram = $50 per unit

During a period 1000 Units of X were manufactured, using 11,700 kilograms

of material Y which cost $48,600.

Required: Calculate the following variances?

a) The direct material total variance

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

A company manufactures a single product L, for which the standard

material cost is as follows:
$ per
unit
Material 14 kg @ $3 42

During July, 800 units of L were manufactured, 12,000 kg of material were

purchased for $33,600 of which 11,500 kg were issued to production.

SM Co values all inventory at standard cost.

Required: What are the material price and usage variances for July?

Labour Variances
The labour cost total variance is the difference between the actual direct
labour cost and the standard labour cost of the actual production (flexed
budget).
Labour Rate Variance
The labour rate variance arises when the amount paid per labour hour
differs from the amount budgeted to be paid per labour hour in a budget
period.

(SR – AR) x AH

SR x AH – AR x AH

Labour Efficiency Variance

The labour efficiency variance arises when the actual amount of time taken
to produce the actual production volume differs from the amount of time
expected.

(SH – AH) x SR

SH x SR – AH x SR

SR – Standard rate per hour

SH – Standard hour for actual production [SH for 1 unit x AU]
AR – Actual rate per hour
AH – Actual labour hours worked

Total Labour Variance = (SR x SH) – (AR x AH)

Idle time variance (non-productive LHs)

If there are non-productive hours (idle time),
The rate variance is calculated using total AHs for which the wage is
paid.
The efficiency variance is calculated using productive AHs.
A new idle time variance is calculated for the non-productive AHs
(idle time hours).
Idle time x SR

Example questions
The standard direct labour cost of product X is as follows:
2 hours of labour at $5 per hour = $10 per unit of product X

During the period, 1000 Units of products X were made, and the direct labour
cost of labour was $8,900 for 2,300 hours of work.
Required: Calculate the following variances?

a) The direct labour total variance

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

A company expected to produce 200 units of its product in 20X3. In fact, 260
units were produced. The standard labour cost per unit was $70 (10 hours
at a rate of $7 per hour). The actual labour cost was $18,600 and the labour
force worked 2,200 hours although they were paid for 2,300 hours.

Required:

a) What is the direct labour rate variance for the company in 20X3?

b) What is the direct labour efficiency variance for the company in 20X3?

Variable OH Variances
This is the difference between standard variable overheads for actual
production (flexed budget) and the actual variable overheads.

VOH Expenditure Variance

(SR – AR) x AH

VOH Efficiency Variance

(SH – AH) x SR

SR – Standard variable OAR per hr

SH – Standard hour for actual production [SH for 1 unit x AU]
AR – Actual variable OAR per hr
AH – Actual hours (LHs/MHs)

Total Variable OH Variance = (SR x SH) – (AR x AH)

Example questions
The standard variable overhead cost of product X is as follows:

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

During the period, 1,000 units of product X were made, and the total variable
overhead cost was $8,900 for 2,300 hours of work.
Required: Calculate the following variances?

a) Variable overhead total variance

b) Variable overhead expenditure variance

c) Variable overhead efficiency variance

Fixed OH Variances
Two possible FOH variances arise:

The expenditure variance compares the actual fixed cost with the
original budget. If the company uses marginal costing, this is the only
variance which is calculated.
If the company uses absorption costing, a second variance is
calculated, called the volume variance, this is due to making more or
fewer units than was expected.

In marginal costing, only FOH expenditure variance

In absorption costing, both expenditure & volume variance

FOH Total Variance

The fixed production overhead total variance in an absorption costing
system is the amount of under or over-absorbed overhead in a budget
period.

Absorbed FOH – Actual FOH

FOH Expenditure Variance

Budgeted FOH – Actual FOH

FOH Volume Variance

Absorbed FOH – Budgeted FOH or,

(AU – BU) x OAR per unit or,

FOH capacity variance

(AH – BH) x OAR per hour
FOH efficiency variance
(SH – AH) x OAR per hour

FOH volume variance = Capacity variance + Efficiency variance

Example questions
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

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

(AU – BU) x std profit/contribution per unit

In absorption costing – std profit per unit (Sales volume profit

variance).
In marginal costing – std contribution per unit (Sales volume
contribution variance).
Sales price variance
Sales price variance is the measure of change in sales revenue as a result
of variance between actual and standard selling price.

(ASP – SSP) x AU

SSP – Standard selling price per unit

BU – Budgeted units sold

ASP – Actual selling price per unit

AU – Actual units sold

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

Required: Calculate sales price and sales volume variances?

Causes of Variances
Material Variance
Variance Favourable Adverse
Material price Poorer quality materials Higher quality materials
Discounts given for Change to a more
buying in bulk expensive supplier
Change to a cheaper Unexpected price increase
supplier encountered
Incorrect budgeting Incorrect budgeting
Material usage Higher quality materials Poorer quality materials
More efficient use of Less experienced staff using
material more materials
Change is product Change in product
specification Specification
Incorrect budgeting Incorrect budgeting
Labour Variance
Variance Favourable Adverse
Labour rate Lower skilled staff Higher skilled staff
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 Fall in staff motivation
motivation
Incorrect budgeting Incorrect budgeting

Variable OH Variance
Variance Favourable Adverse
Var. o/h Unexpected saving in Unexpected increase
expenditure cost of services in the cost of services
More economic use of Less economic use of
services services
Incorrect budgeting Incorrect budgeting
Var. o/h efficiency As for labour efficiency As for labour efficiency

Fixed OH Variance
Variance Favourable Adverse
Fixed o/h expenditure Decrease in price Increase in price
Seasonal effects Seasonal effects
Fixed o/h volume Increase in production Decrease in
volume production Volume
Increase in demand Decrease in demand
Change is productivity Production lost
of labour through strikes
Fixed o/h capacity Hours worked higher Hours worked lower
than budget than budget
Fixed o/h efficiency As for labour efficiency As for labour efficiency
Interdependence Between Variances
Sometimes a variance in one area will be related to a variance in another.

If Material price variance: Adverse; Usage variance – Favourable.

If Labour rate variance: Adverse; Efficiency variance – Favourable.
If Material price: Adverse; Labour efficiency – Favourable.
If Labour rate variance: Adverse; Usage variance – Favourable.
If Sales price variance: Adverse; Sales volume variance – Favourable.

Operating Statements
An operating statement is a statement or schedule that summarises all the
variances for a budget period and reconciles, or compares, the budgeted
profit with the actual profit for that period.

Proforma operating statement under Absorption costing

Budgeted profit X
Sales volume profit variance X/(X)
Standard profit on actual sales (flexed budget profit) X
Sales price variance X/(X)
Material price variance X/(X)
Material usage variance X/(X)
Labour rate variance X/(X)
Labour efficiency variance X/(X)
Variable OH expenditure variance X/(X)
Variable OH efficiency variance X/(X)
Fixed OH expenditure variance X/(X)
Fixed OH volume variance X/(X)
Actual profit X
 ADVANCED VARIANCES
Material Mix and Yield Variances
In the previous section, we discussed basic variances for materials, focusing
on price and usage. However, real-world products involve multiple
materials input, unlike the assumed scenario of using only one material in
basic variances.

The standard cost of a product predicts the quantity of materials used, but
actual production costs may differ in a few ways.

Firstly, actual material prices may deviate from standard prices,

leading to a price variance calculated separately for each material.
Secondly, the use of materials in different proportions (mix) than the
standard can result in a mix variance, influencing the average cost.
Favourable mix variance means the actual mix is cheaper than the
standard mix.
Lastly, a yield variance which measures the efficiency of turning the
inputs into outputs. It is the difference between what the input should
have been for the output achieved and the actual input.

Material Usage Variance

(SQ - AQ) * SP

Material Mix Variance Material Yield Variance

(AQ in SM - AQ) * SP (SQ- AQ in SM) * SP

Where:

SQ-Standard quantity for actual production (Expected material

usage for actual units).
AQ - Actual quantity used for production (Actual material kg used).
SP - Standard price per unit of material (Standard price/kg).
AQ in SM - Actual quantity in standard mix.
A company manufactures a chemical using two compounds A and B. The
standard materials usage and cost of one unit are as follows:

A: 5 kg at $2 per kg 10

30
B: 10 kg at $3 per kg
40

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

of B.

Required: Calculate the materials usage, mix and yield variances?

Interpreting Mix and Yield Variances

A favourable overall material mix variance means an actual mix cheaper
than standard. Cheaper materials have been substituted for more
expensive ones.

A favourable yield variance means that actual output exceeds output

expected for the given input units. This could be due to:

Less spillage due to production methods; or

Less waste due to quality of materials used as inputs.

A favourable mix variance may lead to an adverse yield variance because

that item is of a lower quality. Also, a favourable mix variance may result in
lower output quality which will eventually result in adverse sales volume
variance.

A manager might get less expensive materials from a different supplier,

leading to favourable price variances. However, if these cheaper materials
are of lower quality, it could increase waste during production, causing an
adverse yield variance.

Alternative Methods of Controlling Production

Processes
In a modern manufacturing environment with an emphasis on quality
management, using mix and yield variances for control purposes may not
be possible or may be inadequate. Other control methods could be more
useful.

Rates of wastage.
Percentage of deliveries on time.
Customer satisfaction ratings.
Average cost of input calculations.
Average cost of outputs.
Detailed timesheets.
Average prices achieved for finished products.
Yield percentage calculations or output to input conversion rates.

The standard material cost of a unit of a product is:

$
Material X 2kg @ $3 6
Material Y 1kg @ $2 2
3kg 8

The actual production was 5,000 units and the materials used were:

Material X 9,900 kg costing $27,000 Material Y 5,300 kg costing $11,000

Calculate the following variances?

a. Total materials cost;

b. Materials price;

c. Materials mix;

d. Materials yield;

e. Materials usage.
Sales Mix and Quantity Variances
Where the company sells more than one product, the budget will include
the budgeted quantity of each product sold. The actual sales can be
compared with the budget, and the sales volume variance calculated. The
overall sales volume variance can be analysed into two further categories:

The sales mix variance compares the actual quantities of goods sold
to the actual quantities sold at the standard mix. It shows the effect on
contribution or profit of selling a different "mix" to the standard. If the
products have different margins, this will affect profits.
The sales quantity variance compares the actual quantity (units) of
goods sold in the standard mix with the budgeted quantity of goods
sold in the standard mix.

Sales Volume Profit Variance

(AU-BU) * Standard profit/unit

Sales Mix Variance Sales Quantity Variance

(AU -AU in SM) * (AU in SM-BU) *
Standard Profit/unit Standard profit/unit

Where:

AU - Actual sales units

BU - Budgeted sales units

AU in SM - Actual units in standard mix

A company sells three related products, Q, P and R. The budgeted sales mix
is 50% for Q and 25% for each of product’s P and R. The current period budget
and actual sales are:
 Products
Budget Q P R
Unit sales 200 100 100
Price $20 $25 $30
Contribution $3 $4 $6
Actual
Unit sales 180 150 170
Price $22 $22 $26

Required: Calculate the sales price, sales mix contribution variance and
sales quantity variances?

Interpreting Mix and Quantity Variances

An adverse mix variance means that customers are buying less of the
higher-margin products and instead buying lower-margin ones. It implies
substitution of one product for another, rather than reducing the overall
quantity of goods acquired.

The sales quantity variance shows the actual quantity of goods sold against
the budget. An adverse variance may be due to poor economic conditions
or a new competitor. This variance identifies factors which affect sales of all
the products.

Inter-relationships
A fall in selling prices for products would lead to an adverse price
variance. However, if it also leads to higher demand for the products,
the volume variance would be favourable.
An adverse sales mix variance may be due to customers switching to
cheaper ranges or brands as these may be considered better value. If
these "better value" products attract customers from other products
too, this will lead to a favourable quantity variance.
 PLANNING AND OPERATIONAL VARIANCES
Revision of Budgets and Standards
At the end of a budget period, before comparing an organization's actual
performance with the budget, revisions may occur to consider unforeseen
changes in the environment. This is because managers are evaluated
based on their performance relative to the budget, and using an inaccurate
budget is deemed unfair.

A budget revision should be allowed if something has happened which is

beyond the control of the organisation or individual manager and which
makes the original budget unsuitable for use in performance management.

Management should consider revising the standards for expected

performance:

If the actual environment differs from what was anticipated when the
original standard was set; or
Even if the environment has not changed, the benefit of hindsight shows
that an unrealistic standard was used (e.g. ideal standard).

Planning and Operational Variances

A planning and operational approach to variance analysis divides the total
variance into those variances which have arisen because of inaccurate
planning or faulty standards (planning variances) and those variances
which have been caused by operational performance, compared with a
standard which has been revised in hindsight (operational variances).

Planning variances are calculated by comparing the original

budget/standard cost with the revised budget/ standard cost.
Operational variances are calculated by comparing actual results and
the revised budget/standard cost. Causes of planning and operational
variances.
Causes of Planning and Operational Variances
Unexpected market changes related to sales demand, material cost,
availability of labour etc.
Unexpected changes in the product specification etc.

Material Price Variance

(SP - AP) * AQ

Planning Variance Operational Variance

(SP - Rs P) * AQ (Rs P - AP) * AQ

Material Usage Variance

(SQ- AQ) * SP

Planning Variance Operational Variance

(SQ- Rs Q) * SP (Rs Q -AQ) * SP

Where:

SP – Standard price per unit of material (standard price/kg).

AP – Actual price per unit of material (actual price/kg).

Rs P – Revised standard price.

SQ – Standard quantity for actual production (expected material

usage for actual units).

AQ – Actual quantity used for production (actual material kg used).

Rs Q – Revised standard quantity for actual production.

 Labour Rate Variance
(SR -AR) * AH

Planning Variance Operational Variance

(SR- Rs R) * AH (Rs R-AR) * AH

Labour Efficiency Variance

(SH - AH) * SR

Planning Variance Operational Variance

(SH-Rs H) * SR (Rs H - AH) * SR

Where:

SH – Standard hours for actual production (Expected hours for actual

units)

AH – Actual hours

Rs H – Revised standard hours for actual production

AR – Actual rate per hour

SR – Standard rate per hour

Rs R – Revised standard rate per hour

Sales Price Variance

(AP-BP) * AU

Planning Variance Operational Variance

(Rs P-BP) * AU (AP- Rs P) * AU
 Sales Volume Profit Variance
(AU -BU) * standard profit/unit

Planning Variance Operational Variance

(Market Size Variance) (Market Share Variance)
(Rs U - BU) * Standard (AU - Rs U) * Standard
profit/unit profit/unit

Where:

BP – Budgeted selling price

AP – Actual selling price per unit

Rs P – Revised selling price

BU – Budgeted sales units

AU – Actual sales units

Rs U – Revised sales units

Illustration 1
KSO budgeted to sell 10,000 units of a new product during 20X0. The
budgeted sales price was $10 per unit, and the variable cost $3 per unit.
Actual sales in 20X0 were 12,000 units and variable costs of sales were
$30,000, but sales were only $5 per unit. With the benefit of hindsight, it is
realised that the budgeted sales price of $10 was hopelessly optimistic, and
a price of $4.50 per unit would have been much more realistic.
Required: Calculate planning and operational variances for sales price?

Illustration 2
PG budgeted sales for 20X8 were 5,000 units. The standard contribution is
$9.60 per unit. A recession in 20X8 means that the market for PG's products
declined by 5%. Actual sales were 4,500 units.
Required: Calculate planning and operational variances for sales
volume?
Illustration 3
Product X had a standard direct material cost in the budget of: 4 kg of
Material M at $5 per kg = $20 per unit. Due to disruption of supply of
materials to the market, the average market price for Material M during the
period was $5.50 per kg, and it was decided to revise the material standard
cost to allow for this. During the period, 6,000 units of Product X were
manufactured. They required 26,300 kg of Material M, which cost $139,390.
Required: Calculate;

a) The material price planning variance?

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

Illustration 4
The standard hours per unit of production for a product is 5 hours. Actual
production for the period was 250 units and actual hours worked were 1,450
hours. The standard rate per hour was $10. Because of a shortage of skilled
labour, it has been necessary to use unskilled labour and it is estimated that
this will increase the time taken by 20%.
Required: Calculate the planning and operational efficiency variances?
Advantages and Disadvantages

ADVANTAGES DISADVANTAGES
Distinguishes between those Extra data requirements (e.g.
variances caused by bad market size).
planning or unavoidable
More time consuming.
factors and those which are
the result of operating factors. Managers may claim that all
Adverse operating variances adverse variances have
provide feedback control on external causes and all
processes which need favourable variances have
correcting. internal causes (i.e.
Planning variances can be manipulation of revised
used to update standards to standards).
current conditions. It is difficult to decide in
Motivation may improve if hindsight what the realistic
managers know they will only standard should have been.
be assessed on variances
under their control.

Revising budgets: Manipulation Issues

Revision to the budget or standard cost may be manipulated in such a way
as to make operating results seem much better than is really the case.
Revision to the budget or standard cost should ideally be based on
independence evidence (verifiable evidence) that operational managers
are not in a position to manipulate.
Relevance of Variances in the Modern Environment of
JIT and TQM
Standard costing and variance analysis may be inappropriate in a
production environment based on Just in Time (JIT) methods or a Total
Quality Management (TQM).

Standard product costs apply to manufacturing environments in which

quantities of an identical product are output from production process.
They are not suitable for manufacturing environments where products
are non-standard or are customised to customer specifications.
Another element of the TQM culture is the idea of trying to achieve
continuous improvement. Traditional variance analysis does not really
accommodate this.
Traditional variance analysis focuses on quantity rather than quality.
This could mean, for example, using lower quality material to save
money. This would contrary to the TQM and JIT culture.
Traditional standard setting is based on a company's own costs and
procedures. This may be too inward looking where the company
operates in a rapidly changing, competitive market.
P.M NOTES
Quantitative Techniques
Forecasting
Management accountants need to use forecasts for many areas of their
work. For example, in budgeting it is useful to be able to forecast sales.

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

Illustration 1 Geometric Mean

The sales of Beta during the last three years were as follows:

Year Sales in $000

20X2 100

20X3 180

20X4 210

20X5 300

The growth rate of sales each year is as follows:

20X3 80% (180 - 100)/100

20X4 16.67% (210-180)/180

20X5 42.9% (300 - 210)/210

The simple average growth rate is 46.5% calculated as

(80% + 16.67% + 42.9%)/3.

However, this overstates the rate of growth:

If the 20X2 sales of $100,000 were to increase by 46.5% each year for three
years, the sales in 20X5 would be $314,000, not $300,000.

The more accurate growth rate is obtained using the geometric mean. This
is used to calculate average growth rates and is most commonly used in
business and finance to calculate growth rates in percentages.

Growing by 80% is the same as multiplying by 1.8, so the geometric mean

3
for the three years is √𝟏. 𝟖𝐱𝟏. 𝟏𝟔𝟔𝟕𝐱𝟏. 𝟒𝟐𝟗 = 𝟏. 𝟒𝟒𝟐 so the average growth rate
is 44.2%.

This can then be used to calculate expected sales in future period.

High Low Method

The high-low method is a technique for estimating the fixed and variable
elements of a semi-variable cost so that more accurate forecasts of costs
can be made.

The method is simple:

Collect a range of data points over a period of time corresponding to

different levels of activity;
Select the costs (y) associated with the highest and lowest levels
of activity (x) and assume a straight-line relationship between these
two points.

Activity 1 Cost Equation

The total cost of output for the last four months is as follows:
Output Costs
$
3,000 3,500
2,400 3,000
3,600 4,350
4,000 4,800

Required:
a. Find the equation y = a + bx, where y is cost, and x is output level?
b. Forecast next month's cost if output is expected to be 4,500 units?
Time Series Analysis
Time series analysis can be applied to any figures that can vary over time,
including sales, production and costs.

The main components of a time series are:

Trend (T)
Seasonal variations (S)
Cyclical variations (C)
Random variations due to non-recurring influences (I)

Random variations are usually due to unforeseen events and situations, and
their degree of impact is difficult to predict. They may be favorable i.e.
positive in nature (e.g. unexpected bankruptcy of a competitor) or adverse
i.e. negative (e.g. damage to business due to freak weather conditions).

A time series (Y) can be summarized in an equation as:

Y = T +S + C+1

Trend
The underlying long-term movement in values over time.

Illustration 2 Trend
Millstream Co manufactures three products - the red, blue and green.
Sales over recent years of the Products have been as follows:

Blue Red Green

Units Units Units
20X0 9,000 4,500 4,850
20X1 8,500 5,000 5,200
20X2 8,200 5,750 4,900
20X3 7,400 5,600 4,800
20X4 7,700 5,900 5,100
20X5 7,300 6,300 4,900
20X6 6,800 6,550 5,000
Sales of the blue show a clear downward trend, even though they rose in
20X4.
Sales of the red show a clear upward trend, even though they fell in 20X3.
Sales of the green show a constant trend around 5,000 units.

Seasonal Variations
Short-term fluctuations in value, resulting from differing circumstances
affecting results at different times of the day, week, month, year, etc.

Factors causing seasonal variations may include:

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

Illustration 3 Seasonal Variations

The sales for one of Leybourne Co's products over each season in the last
three years are as follows.

Each season lasts three months.

Units
Spring 20X0 5,500
Summer 20X0 6,700
Autumn 20X0 5,600
Winter 20X0 4,700
Spring 20X1 5,900
Summer 20X1 7,200
Autumn 20X1 6,300
Winter 20X1 5,100
Spring 20X2 6,500
Summer 20X2 7,900
Autumn 20X2 7,000
Winter 20X2 5,700
The figures for each season in 20X1 and 20X2 are greater than the figures
for the season in the preceding year, showing an upward trend overall.
However, there are significant seasonal variations.
(E.g. Winter 20X2 is lower than Summer 20X0).

Cyclical Variations
Medium-term changes in values resulting from factors that repeat in
cycles. Cyclical variations are longer-term than seasonal variations.

Identifying The Trend

The trend can be found using:
A “line of best fit” drawn on a graph;
The least squares method of linear regression (see s.3).
The calculation of moving averages.

Moving Averages Method

Removes seasonal variations from data by averaging, taking the average
of the results of a fixed number of periods.
The moving average model smooths out data sets to reveal their overall
trend, with little regard for outlying data points. To calculate the trend:

1. Calculate a “moving” total for the number of periods which make up a

normal cycle (usually a year)?
2. Calculate a “moving” average by dividing the moving total by the
number of periods in a normal cycle. This is the trend figure (T)?
3. When the moving average is for an even number of periods (e.g. 4
quarters), the averages in (2) must be averaged again. This is so that
the final computed moving average can be compared directly to a data
point in the actual data.
Illustration 4
Easthowe Co's revenue trend based on the last seven quarters is calculated
as follows:

Year Quarter Revenue (1)4-Quarter (2) 4-Quarter (3)

moving total moving average Average
= (1)/4 = Trend
$000 $000 $000 $000
20X0 1 450
2 520 510
2,040
3 500 526.25
2,170 542.5
4 570 547.5
2,210. 552.5
20X2 1 580 568.75
2,210 585
2 560
3 630

Notes
1. Starting with the first available data calculate the 4-quarter moving
totals.
2. For each moving total in (1) calculate an average.
3. Calculate the average of each pair of averages and position at the
mid-point of its data points. This step is only necessary to take account
of the fact that a 4-quarter average is an even number.

Identifying the Seasonal Variations

Seasonal variations quantify changes in actual data which may be due to
prevailing conditions in a particular season, which is consistent over time
(e.g. summer would have seasonally higher temperatures than winter, and
this would be consistently true every year; or people travel more during
peak holiday seasons).

When forecasting, seasonal variations are added back to the forecast trend,
to account for potential future seasonal conditions.
Additive Model
Having identified the trend, the next stage is to identify the seasonal
variations.
Using the equation:

Y=T+S+C+I

Ignoring C (as we are looking at short-term forecasting) and I (which is

impossible to predict):

Y = T + S, therefore S=Y−T

The additive model assumes that the components of the time series are
independent. Most significantly this means that the trend will not affect the
seasonal variations.

Activity 3 Additive Model

Dewie Co's profits for the last three years have been as follows:

Year Quarter Actual profits

$000
1 1 66
2 90
3 72
4 118
2 1 72
2 96
3 74
4 126
3 1 78
2 102
3 76
4 132
Multiplicative Model
The multiplicative model is based on proportions rather than absolute
values and is expresses as:

Y=T×S×C×I

Or ignoring C and I, Y = T × S and therefore S = Y/T.

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

called a seasonal index.

The other difference between the calculations using the additive and
multiplicative models is that the average seasonal index should sum to the
number of seasons in the time series (e.g. 12 for monthly variations, 4 for
quarterly variations).

Seasonally-Adjusted Data
Seasonally-adjusted (“deseasonalised”) data (i.e. actual data that has
been stripped of seasonal variations) can be used to explore the trend and
any remaining random component.
When actual data is given and seasonally-adjusted figures are required:

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

Activity 5 Seasonally Adjusted Data - Additive Model

Actual production costs and seasonal variations for the four quarters of the
year are as follows:

1 Actual production costs Seasonal adjustments (s)

$ $
1 11,500 -1,000
2 13,500 + 500
3 14,000 + 800
4 13,000 -300

Required: Calculate the seasonally adjusted figures for the four quarters?
*Please use the notes feature in the toolbar to help formulate your answer.
Forecasting Using Time Series Analysis
A trend can be used to predict future values, by extrapolating beyond the
historic values using a graph or an equation that describes the trend (e.g.
using regression as described in the next section).

Once a trend value has been calculated for a future period, it then needs to
be adjusted for seasonal variations using the additive or multiplicative
model.

Illustration 8 Forecasting Using Time Series Analysis

The trend for quarterly profits is described by the equation below:
64,000 + 1000x, where x is the number of quarters and x = 1 represents
20X1 Quarter 1. The seasonal index for Quarter 2 is 0.96.
The profit forecast for 20X4 Quarter 2 (i.e. ((4 x 3) +2)) = Quarter 14) is:
Forecast trend = 64,000 + 1,000(14) = $78,000.
Adjusting for seasonal index, forecast profits = $78,000 x 0.96 = $74,880.

Benefits
It enables future predictions based on past experience.
As compared to the high-low method, it ignores outlying data points.
Analyzing data into component parts facilitates more accurate
forecasting (than using trend alone).

Limitations
Data must be ordered over time (i.e. the point in time at which the
variable is measured must be known) in order to calculate the trend.
The reliability of a forecast depends on the amount of data on which
the trend and seasonal variations are based. The less data that is
available, the less reliable the forecast is likely to be.
Due to the “loss” of data in calculating moving averages, data needs
to be collected over a longer period for a meaningful trend to emerge
using the moving averages method.
Random factors may influence calculations, especially over fewer
data sets. If non-recurring influences are significant, forecasts may
not be reliable.
Extrapolation become less reliable the further into the future the
forecast is made, due to changes in trends, seasonal variations and
other (residual) factors.
Correlation
Correlation - the closeness of the relationship between two or more
variables.

Examples of variables that might be correlated include:

Length of journey on public transport and fare paid;

Hours spent studying and marks in an exam.

Correlation between variables can be shown on a scatter graph.

Illustration 9 Scatter Diagram

If there is no pattern; the points appear to plot "randomly" (as in (d)). In (b),
there appears to be a linear relationship (close to a straight line) but the
relationship is "negative" (i.e. one variable is decreasing as the other is
increasing).

In (c), there is a clear curvilinear relationship. (a) may also be curvilinear

but less obviously so and more data would be needed before taking any
analysis further.
Types of Correlation
Positive correlation − when an increase in one variable is associated
with an increase in the other (e.g. advertising expense and revenue).
Negative correlation − when an increase in one variable is associated
with a decrease in the other (e.g. bicycle traffic and rainfall).
Perfect correlation − when a change in one variable is matched by a
change of equal degree in the other variable. This only exists when all
the points of a scatter graph lie on a straight line.
Zero correlation − when there is no relationship between changes in
the variables.

Correlation Coefficient
Exam Formula
The degree of correlation between two variables can be measured using
the correlation coefficient, r, which is given by the exam formula:

𝑛∑𝑥𝑦 − ∑𝑥∑𝑦
r=
√(𝑛∑𝑥 2 − (∑𝑥 )2 )(𝑛∑𝑦 2 − (∑𝑦)2 )

Where:

n = the number of pairs of values

∑x = the sum of the x values
∑x 2
= the sum of the squares of the x values
(∑x)2 = the square of the sum of the x values
∑y = the sum of the y values
∑y2 = the sum of the squares of the y values
(∑y)2 = the square of the sum of the y values
∑xy = the sum of the products of each pair of x and y values
The value of the correlation coefficient will always lie between −1 and 1:

• r = +1 denotes perfect positive correlation (i.e. all points on an upward

sloping straight line);
• r = −1 denotes perfect negative correlation (i.e. all points on a
downward sloping straight line); and
• r = 0 means that the variables are uncorrelated (i.e. no linear
relationship).
Illustration 10 Correlation Coefficient
Coastway Cafe wants to determine the extent to which the number of ice-
creams sold (y) is correlated to average daily temperature (x).
The correlation coefficient is calculated from pairs of data as follows:

Average daily Number of ice-

temperature creams
(x) (y) Xy x2 y2

14 59 826 196 3.481

27 102 2,754 729 10,404

20 84 1,680 400 7,056

22 85 1,870 484 7,225

17 75 1,275 289 5,625

∑ 100 405 8,405 2,098 33,791

n=5

(Σχ)2 = 1002 = 10,000

(Σy)2 = 4052 = 164,025

(5x8,405) -(100x405)
R= = 0.98
√(5 × 2,098 − 10,000) (5 × 33,791 − 164,025)

There is therefore a high positive correlation between the average daily

temperature and number of ice-creams sold.

Interpretation of r
A high correlation between two variables does not necessarily justify the
conclusion that a causal relationship exists. There may be no direct
connection at all, in which case the correlation is described as "spurious
correlation".
 This can occur for two reasons:

1. There may be an indirect connection (i.e. both x and y depend on a

third variable).
2. The correlation may be a coincidence and due entirely to chance.

Coefficient of Determination (r2)

The coefficient of determination measures how much of the total change
in the amount of one variable can be explained by the change in the other
variable. Unlike the correlation coefficient it is a measure of the cause of the
variation.

It is calculated as the square of the correlation coefficient, r2, and must

therefore always be a positive number.

Illustration 12 Coefficient of Determination

The correlation coefficient between number of quality control tests
undertaken on a line of products and the number of customer complaints
is -0.8.

The coefficient of determination is therefore -0.82 = 0.64. This means that

64% of the changes in the number of customer complaints can be explained
by changes in the number of quality control tests.

Regression
Correlation describes the closeness of a linear relationship between two
variables, but it does not allow forecasting of the value of one variable given
the value of the other.
To forecast variables, it is necessary to assume a linear relationship
between them that can then be described by the equation, y = a + bx,
where a is the point of intersection on the y-axis (i.e. when x = 0) and b is
the gradient of the line.
The values of a and b can be determined by:

Judging “by eye” a line that best fits the data plotted on a scatter
graph;
The least squares method of regression which computes the “line of
best fit” mathematically.
The formulae are provided in the exam as follows:

Illustration 13 Regression
Using the relevant data in Example 10:

n=5

Σx= 100

Σy= 405

Σxy = 8,405

Σx2 = 2,098

(Σx)2 = 10,000

5x8,405-(100x405)
b= = 3.1
5×2,098-10,000

a = 405/5 - (3.1 x 100/5) = 19

So y = 19 + 3.1x

For example, if the temperature is forecast to be 24 degrees, Coastway

Café would expect to sell 19 + (3.1 x 24) = 93.4, rounding to 93 ice creams.

Benefits
Correlation analysis can indicate the existence of associations
between variables.
As least squares regression uses all pairs of data it is much more
accurate than the high-low method and less affected by extreme
values.
Correlation can be used in conjunction with regression analysis to
indicate the strength of the relationship indicated by the equation.
Limitations
A limited amount of data may reduce the reliability of forecasts
made. The reliability of the analysis and forecasts also depends on
the quality of the data.
Correlation is easily misinterpreted as high correlation does not
necessarily indicate a linear relationship and there may be no direct
connection between highly correlated variables.
Linear regression analysis is based on the assumptions of a linear
relationship, which may not be valid, and that the dependent variable
depends solely on the independent variable, whereas it may depend
on a number of variables.
Forecasts that extrapolate values outside the range of data from the
past, may be invalid and must be interpreted with caution.

Learning Effect
If workers specialize, there is a tendency for labour hours per unit to fall as
they become more familiar with the task. During World War II, empirical
evidence from aircraft production found the rate of improvement to be so
regular that it could be reduced to a formula.

The learning effect starts from the production of the first unit/batch. Each
time cumulative production then doubles (i.e. one to two, two to four, four
to eight, etc), the cumulative average time per unit falls to a fixed
percentage of the previous average time. This percentage is the learning
rate.

Wright’s Law
Wright's Law states that as cumulative output doubles, the cumulative
average time per unit falls to a fixed percentage (the 'learning rate') of the
previous average time.
 Average time per
unit for all units
produced to date

Total number of units produced

Learning Curve Formula

Y = axb

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

a = time taken for the first unit of output

x = the cumulative number of units produced

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

LR = the learning rate as a decimal

Activity 11 Learning Curve Formula

It is estimated that it will take 500 hours to produce the first unit of a new
product. Workers have a 95% learning effect.

Required: Calculate how long it will take to produce the seventh unit?
Note: The index of learning b is given as -0.074.
Conditions for a Learning Curve to Appl
The activity is labour intensive.
The units are identical (i.e. a repetitive task).
Low labour turnover.
No prolonged breaks in production.

Applications of Learning Curve Theory

Learning curve theory has applications in many aspects of management
accounting:

Standard setting − the labour standard should be set/revised based

on the expected learning effect.

Budgeting − variable costs are expected to fall with an increase in

production − particularly important to cash budgeting.

Pricing decisions − an accurate labour cost may be predicted into

the future.

Work scheduling − manpower planning (e.g. in systems which

integrate production scheduling, job costing, control of workforce,
performance measurement, etc).

Reservations About the Learning Curve

Knowing what the learning rate will be for new products. The usual
assumption is that it will be similar to products made in the past. This
may not always be a valid assumption.
The learning curve is useful in situations where production of a
product takes place on a continuous basis. If there is a break in
production, however, workers may "forget" the skill and the learning
curve will not be so predictable.
In the modern business world, many products are tailor-made for
customers. The mass production of identical items, on which the
learning effect is based, is not always appropriate.
In some heavily unionized industries, there may be "go slow"
agreements where workers agree not to work to their full capacity in
order to save jobs.
Steady State
With more repetitions, the improvements get smaller until eventually the
learning process stops and reaches a “steady state”. There are no further
improvements to be made.
As cumulative output increases, the effect of the learning curve diminishes.
When cumulative output reaches a certain point, there will be no further
learning. The time taken per unit reaches a steady state and all units
produced beyond this point will take the same amount of time per unit.

Incremental time per unit (steady state)

= Total time (all units at steady state) – Total time (all units before steady
state).

Activity 13 Learning Curve and Steady State

Supercars produces cars on a production line. One of the production line
processes, Process 10, is labour intensive.

A new model, the XY123, will be introduced to production next month. As this
is a new model, the laborers in Process 10 will have to learn how to apply
this process specifically to XY123.

The time taken for the first car is expected to be one hour. A learning rate of
85% is expected. The effect of the learning curve is expected to stop after
30 units have been produced and all subsequent units will take the same
time to produce as the 30th unit.

Supercars has budgeted to manufacture 100 XY123s in the first month of

production.

Required:
1. Calculate the labour time per unit which will apply for the 30th and
subsequent units?
2. Calculate the total labour time to make the first 100 units of the
XY123?
Note: The index of learning b is given as -0.2345.
Tabular Approach
A learning rate for a new product can be estimated using a tabular
approach based on production to date and the time taken, if the
cumulative units are given in exponentials of 2 (e.g. 2, 4, 8, 16, and so on).

When the learning rate stops (i.e. when a "steady state" is reached, as
described above) can also be calculated. This is the point at which the
incremental time per unit becomes constant.

Illustration
Foxy Co makes personal computers. The components for the PCs are
bought from various manufacturers and the factory workers at Foxy Co
assemble these to make a finished PC.
Production of a new type of PC has just begun. The management
accountant has asked one of the workers to keep a record of how much
time he took to make each new computer. The worker provided the
following summary for the first month:

Incremental time taken (minutes)

1st unit 340
2nd unit 204
3rd and 4th units 326
5th to 8th units 522
9th to 16th units 964
17th to 32nd units 1,928
Total 4,284

The time shown within each band is the total for that band, not the average
per computer.

Required:
1. Calculate the learning rate that applied to the new PC?
2. Estimate the point at which the learning period finishes?

Algebraic Approach
An alternative approach to the tabular approach is an algebraic approach.
This has to be used when only information about the cumulative average
time is for two levels of output which are not exponentials of 2.
Illustration 15 Algebraic Approach to Learning Rate
The first unit of a product took 300 minutes; the total time taken for the first
8 units was 2,056 minutes.

The cumulative average time per unit for the first 8 units is therefore 257
minutes (2,056 / 8).

Cumulative output has doubled three times since the production of the first
unit (from 1 to 2, to 4, then to 8) and the cumulative average time per unit
has fallen to 257. If the learning rate is r.

Then, 300 x r3 = 257

257
So, r3 = = 0.8567
300
3
Therefore, r = √0.8567 = 0.9497 i.e. approximately 95%
 PART PERFORMANCE
E MANGEMENT
Performance Analysis in Private Sector Organisations

Financial Measures
Profitability ratios
Liquidity ratios
Gearing ratios

Profitability Ratios
1. Gross profit margin
A high gross profit margin is desirable. It indicates that either sales
prices are high or that production costs are being kept well under
control.
Gross Profit /Sales Revenue ∗ 100

2. Net profit margin

Net Profit /Sales Revenue ∗ 100
3. Asset turnover
Sales Revenue/ Capital Employed ∗ 100

Capital Employed = Equity + Long term liability OR total assets – current

liabilities.
A high asset turnover is desirable. An increase in the asset turnover
could be achieved by:
Increasing turnover, e.g. through the launch of new products or a
successful advertising campaign.
Reducing capital employed,
E.g. through the repayment of long-term debt.

4. Cost to sales ratio

Cost
* 100
Sales Revenue

5. Earnings per share (EPS)

Earnings Attributable to Ordinary Shareholders

Total Number of Ordinary Shares

6. Return on capital employed

Net Profit (PBIT)

* 100
Capital Employed

Net Profit Margin * Asset Turnover

Net Profit Sales Revenue

*
Sales Revenue Capital Employed
A high ROCE is desirable. An increase in ROCE could be achieved by:

Increasing operating profit, e.g. through an increase in sales price or

through better control of costs.
Reducing capital employed, e.g. through the repayment of long-term
debt.

7. Sales growth

Current Year Sales - Previous Year Sales

* 100
Previous Year Sales

Liquidity Ratios
1. Current ratio

Current Assets

Current Liabilities

Current assets = Cash + Receivables + Inventory + Short term investments

Current liabilities = Payables + Overdraft + Short-term loans.

Current ratio measures the company’s ability to meet its short-term

liabilities as they fall due.
A ratio in excess of 1 is desirable but the expected ratio varies between the
type of industry. A decrease in the ratio year on year or a figure that is below
the industry average could indicate that the company has liquidity
problems. The company should take steps to improve liquidity, e.g. by
paying creditors as they fall due or by better management of receivables
in order to reduce the level of bad debts.
 2. Quick ratio

Current assets - Inventory

Current Liabilities

Working Capital Ratios

1. Inventory days

Inventory
* 365
Cost of Sales

2. Receivable days

Trade Receivables
* 365
Credit Sales

3. Payable days

Trade Payables
* 365
Credit Purchase or Cost of Sales

Measuring Risk
Financial Gearing – is the long-term debt as a % of equity.
Gearing = Debt/ Equity × 100 or Debt/ Debt + Equity × 100

A high level of gearing indicates that the company relies heavily on debt to
finance its long-term needs. This increases the level of risk for the business
since interest and capital repayments must be made on debt, where as
there is no obligation to make payments to equity. The ratio could be
improved by reducing the level of long-term debt and raising long term
finance using equity.
Interest Cover

Operating Profit
Interest cover =
Finance Cost

A decrease in the interest cover 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, e.g. through better management of costs, or by reducing finance
costs through reducing the level of debt.

Dividend Cover

Net Profit
Dividend Cover =
Dividend

A decrease in the dividend cover indicates that the company is facing an

increased risk of not being able to make its dividend payments to
shareholders.

Issues Surrounding the Use of Financial Performance

Indicators to Monitor Performance
1. Short-Termism
Short-termism is when there is a bias towards short-term rather
than long-term performance to maximise the remuneration and
bonuses.

2. Manipulation of Results
Accelerating revenue
Delaying cost
Understating a provision or accrual
Manipulation of accounting policies

3. Do Not Convey the Full Picture

It does not convey the full picture regarding the factors that will drive
long-term profitability.
E.g. customer satisfaction, quality.
Decisions Which Involve the Sacrifice of Longer-term
Objectives
Postponing or abandoning capital expenditure projects.
Cutting R&D expenditure
Reducing quality control
Cutting training costs or recruitment

Methods to Encourage Long-term View

Making short term targets realistic (so no manipulation is required).
Link manager’s rewards to share price (long term incentive).
Set quality based and multiple targets.
Providing sufficient management information.
Evaluating manager’s performance in terms of contribution to long
term objectives.

Improving Performance
To enhance performance, it's crucial to pinpoint potential concerns by
comparing current outcomes with targets or past performances. Identifying
disparities between actual and expected results, or detecting a decline in
performance over time, helps in understanding areas that need
improvement. Once these aspects are recognized, control measures can
be implemented to address and enhance overall performance.

Methods of improving performance should be linked to the possible reason

for the poor performance.

Aspects of Measures to Improve

Possible Reasons
Performance Performance
Increase in Reduction in amount of Increase routine
frequency of routine maintenance maintenance of
machine breakdown work machines
Customer Poor website design Redesign the website
dissatisfaction with
online sales service
Declining labour Increase in complexity of Give complex task to
productivity the work specialists
Non-Financial Performance Measures
1. Quality
2. Speed
3. Innovation
4. Pollution
5. Risk
6. Flexibility
7. Capability
8. Customer satisfaction

The Balanced Scorecard

The balanced scorecard approach to performance measurement focuses
on four different perspectives of performance, and uses both financial and
non-financial indicators to set performance targets and monitor
performance.

Identifying Performance
Perspective Basics Question
Targets
How do we create Covers traditional measures
Financial value for our such as growth, profitability.
shareholders?
What do customers Give rise to target that matter
Customer value from us? to customer: cost, Quality,
delivery, inspection and so on.
Can we continue to Considers the business's
improve and create capacity to maintain its
Innovation and future value? competitive position through
learning the acquisition of
new skills and the
development of new products.
What processes must Aims to improve internal
we excel at to achieve processes and
Internal
our financial and decision-making.
customer objectives?
 Goals (CSF) Measures (KPI)
Financial
Increase profit margin Profit margins or percentage increase
in profit margin.
Increase sales revenue or Sales growth (percentage increase in
sales growth sales revenue).
Decrease cost Cost to sales ratios, percentage
decrease in costs.
Customer
Increase customer satisfaction Customer satisfaction ratings, number
of repeats business, customer
complaints.
Reduce customer complaints Customer complaints.
Increase the number of new Percentage increase in customer
and returning customers number.
Innovation and Learning (Growth)
Develop new products Number of new products.
Increase the sales revenue Sales revenue from new products as a
from new products percentage of total sales revenue.
Provide more trainings No. of trainings per employee, no. of
training hours per employee.
Internal (Process Efficiency)
Improve process efficiency Efficiency ratio.
Reduce the time required for a Time taken for the specific task.
specific task
Reduce employee turnover Employee turnover rate.
 Advantages Disadvantages
Provides a holistic view Management may face challenges in
beyond financial metrics. selecting appropriate KPIs, leading to
potential conflicts and analysis overload.
Takes a long-term Identifying suitable measures may be
perspective, aligning with challenging.
organizational goals.
Focuses on a small number Obtaining data for some measures may
of key performance be difficult.
indicators (KPIs).
Links performance Concentrates on the needs of owners and
measurement to customers, neglecting other stakeholder
organizational strategy. needs (employees).

Characteristics of Service Organisations

1. Simultaneity (inseparability) – services are consumed as they are
produced.
2. Heterogeneity also called variability – each service provided could be
unique because people are involved, and the quality of service
cannot be standardised.
3. Intangibility – there is no good with physical presence.
4. Perishability – services cannot be stored.

The Fizgerald & Moon’s Building Block Model

It is an evolution of the Balanced Scorecard, developed to meet the needs
of service organizations.
 Ownership Financial
Achievability performance
Equity Competitiveness
Standard Quality
Innovation
Standard Dimension Flexibility
Resource
utilisation

Reward

Clarity
Controllability
Motivational

Dimensions – are the goals for the business and suitable measures
must be developed to measure each performance dimension.

Dimensions of Performance Possible Measure of Performance

Profit growth Gross profit margin
Financial performance
Net profit margin
Growth in sales Success rate in
Competitiveness
converting enquiries into sales
Number of complaints Customer
Service quality
satisfaction
Number of new services offered within
Innovation
the previous year or two
Mix of different types of work done by
Flexibility employees Speed in responding to
customer requests
Efficiency/productivity measures
Resource utilisation
Capacity utilisation rates
Standards
Individuals need to feel that they 'own' the standards and targets for
which they will be made responsible.
Individuals also need to feel that the targets or standards are realistic
and achievable.
The standards and targets should be seen as 'fair' and equitable for all
the managers in the organisation.

Rewards
The system of setting targets and rewarding individuals for achieving
the targets should be clear. Clarity will improve the motivation to
achieve the targets.
Achievement of performance targets should be suitably rewarded.
Individuals should be made responsible only for aspects of
performance that they are in a position to control.

Difficulties of Target Setting in Qualitative Areas

Difficulty in selecting suitable measure of performance.
Qualitative data is not quantified so it is difficult to target and monitor.
Lack of reliable and comprehensive system for collecting data about
qualitative aspects of performance.

Performance Analysis in Not-for-Profit and

Public Sector Organisations

Problems with Performance Measurement.

1) Multiple objectives

2) Measuring outputs

3) Lack of profit measure

4) Nature of service provided

5) Financial constraints

6) Political, social and legal considerations

Value for Money – providing a service in a way which is economical,
efficient and effective.

1. Economy
Economy is concerned with the cost of inputs, and it is achieved by
obtaining those inputs at the lowest acceptable cost.
*Inputs – Resources (labour, materials, machines, money)

2. Efficiency
Efficiency means maximise the outputs from minimum inputs. It
measures the relationship between inputs and outputs.

3. Effectiveness
ensuring that the outputs of a service or programme have the desired
impacts; that is finding out whether they succeed in achieving
objectives and, if so, to what extent.
*Outputs – Results of an activity.

External Considerations

STAKEHOLDERS (Including
Government & Competitors) ECONOMIC ENVIRONMENT

EXTERNAL
CONSIDERATIONS

EXCHANGE RATE INTEREST RATES INFLATION

 DIVISIONAL PERFORMANCE AND
TRANSFER PRICING
Divisionalisation
Divisionalisation is the division of an organization into divisions. Each
divisional manager is responsible for the performance of the division.

Advantages of Divisionalisation
Decisions should be taken more quickly because information does
not have to pass along the chain of command to and from top
management.
The authority to act to improve performance should motivate
divisional managers. Divisional organization frees top management
from detailed involvement in day-to-day operations and allows
them to devote more time to strategic planning.
Divisions provide valuable training grounds for future members of
top management.

Disadvantages of Divisionalisation
Decisions might be taken by a divisional manager in the best
interests of their own part of the business, but against the best
interest of other divisions.
A task of head office is therefore to try to prevent dysfunctional
decision-making by individual divisional managers.
Top management, by delegating decision-making to divisional
managers, may lose control since they are not aware of what is
going on in the organization as a whole.
Responsibility Centre

Principal
Type of responsibility Manager has control
performance
centre over
measures
Variance analysis
Cost Centre Controllable costs
Efficiency measures
Revenue Centre Revenues only Revenues
Controllable costs, sale
Profit Centre Profit
prices (including TP)
As for profit Centre
except that expenditure
Contribution Centre Contribution
is reported on a marginal
cost basis
Controllable costs, sales
prices (including transfer Return on
Investment centre prices) and investment investment Residual
in non-current assets income
and working capital

Return on Investment (ROI)

Return on investment (ROI) shows how much profit has been made in
relation to the amount of capital Invested.

Controllable (traceable) profit

X 100
Controllable traceable investment

Illustration 1
If investment centre A currently has assets of $1,000,000 and expects to
earn a profit of $400,000, how would the centre's manager view a new
capital investment which would cost $250,000 and yield a profit of $75,000
p.a.?
Required: Calculate ROI?
Residual Income (RI)
Residual Income is a measure of the centre's profits after deducting a
notional or imputed interest cost. Residual Income = Controllable
(traceable) profit — Imputed interest charge on controllable (traceable)
investment.
Imputed interest = Controllable (traceable) investment * Cost of capital %

Illustration 2
A division with capital employed of $400,000 currently earns an ROI of 22%.
It can make an additional investment of $50,000. 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?

The Advantages of RI Compared with ROI

Residual Income will increase when investments earning above the
cost of capital are undertaken and investments earning below the
cost of capital are eliminated.
Residual Income is more flexible since a different cost of capital can
be applied to investments with different risk characteristics.

Transfer Pricing
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.

Transfer Price Calculation

Where there is no external market,
Transfer price is based on cost:
Variable cost
Full cost
Variable cost plus
Full cost plus
Illustration 3
An entity has two divisions, Division A and Division B, Division A makes a
component X which is transferred to Division B. Division B uses component
X to make end-product Y.
Details of budgeted annual sales and costs in each division are as follows:

Division A Division B
Units produced/sold 10,000 10,000
$ $
Sales of final product - 350,000
Costs of production
Variable costs 70,000 30,000
Fixed costs 80,000 90,000
Total costs 150,000 120,000

Required: What would be the budgeted annual profit for each division if
the units of component X are transferred from Division A to Division B?
a) at marginal cost
b) at full cost
Where there is an external market for the component The limits within
which transfer prices should fall are as follows:

Maximum Transfer Price

The maximum price that the buying division will want to pay is the market
price for the product — i.e., whatever they would have to pay an external
supplier for it.

Minimum Transfer Price (for selling division)

The sum of the supplying division's marginal cost and opportunity cost of
the item transferred, less any internal cost savings in packaging and
delivery.

1. Spare Capacity
If there is spare capacity, then, for any transfers that are made by using
that spare capacity, the opportunity cost is zero.
Illustration 4
Details of selling division A
Total production capacity = 6,000 units
Total external demand = 3,000 units
Total internal demand = 2,000 units
Variable cost per unit of the component = $12 External selling price = $20.
Required: Calculate the minimum transfer price for 2,000 units?

2. No Spare Capacity
If the seller doesn't have any spare capacity, opportunity cost represents
contribution foregone. So minimum price will be equal to variable cost-
plus opportunity cost that is the external selling price less any internal
cost savings in packaging and delivery.

Illustration 5
Details of selling division A
Total production capacity = 3,000 units
Total external demand = 3,000 units
Total internal demand units
Variable cost per unit of the component = $12 External selling price = $20
Required: Calculate the minimum transfer price for 2,000 units?

Dual Pricing
In some situations, two divisions may not be able to agree a transfer price.
But the profits of the entity as a whole would be increased if transfers did
occur. These situations are rare. However, when they occur, head office
might find a solution to the problem by agreeing to dual transfer prices.
The selling division sells at one transfer price, and
The buying division buys at a lower transfer price.

Comparing Divisional Performance

ROI and RI are common methods but other method could be used.
Variance analysis.
Ratio analysis — measures such as sales per employee or square
foot as well as industry specific ratios such as transport costs per
mile, brewing costs per barrel, overheads per chargeable hour. Other
information — such as staff turnover, market share.
Problems of Comparing Divisions
• Divisions may operate in different environments.
• The transfer pricing policy may distort divisional performance.
• Divisions may have assets of different ages.
• There may be difficulties comparing divisions with different
accounting policies.
• Evaluating performance on the basis of a few indicators may lead to
manipulation of data.