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Performance Management

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Performance Management
Activity Based Costing
Background:
In traditional costing the method to compute Overhead is
Absorption costing where method to compute overheads is
Total Overheads
_______________
Level of activity
Where level of activity is either labor hours or machine hours.
But in modern world there are so many overheads such as
distribution, marketing, setup cost etc. due to which it lead
towards unfair allocation of cost therefore New method of
calculating overhead is introduced which is known as Activity
Based costing
Activity based costing:
Activity based costing is the method of costing which involves
identifying the cost of main support activities and the factors that drive
the cost of each activity.
Support overhead are charged to products by absorbing cost on the
basis of product’s usage of factor deriving the overheads.
Activity based costing needed because:
1. Manufacturing products creates demand for supporting activities
2. Costs are assigned to products on the basis of the product’s
consumption of these activities
3. Activitiees cause cost such as material handling, ordering,
machining, assembly production and dispatching.
Steps of activity based costing:
1. Identify organisation’s major activities
2. Use cost allocation and apportionment methods to charge overhead
costs to each of these activities. The cost that accumlate for each cost
activity cost centre is called cost pool.
3. Identify the factors which determine the size of the cost of activity
4. For each cost pool, calculate an absorption rate per unit of cost driver.
5. Charge overhead cost to product for each activity, on the basis of their
usage of the activity
example
Cost pool
Cost driver
Ordering cost: handling
customer order
Number of orders
Material handling cost
Number of production runs
Machine set up cost
Number of machine setups
Machine operating cost
Number of machine hours
Dispatching cost
Number of orders dispatched
Production schduling cost
Number of production runs
Example:
XoXo company manufacture four products A,B,C,D. output and cost data for
the period ended are as follows:
OutPut Units
A
B
C
D
10
10
100
10
No of production runs
2
2
5
5
Material cost per unit
20
80
20
80
Direct labour cost Per hour: $5
OverHead Costs:
Short run variable cost 3080
Setup cost
10920
Expediting and Scheduling cost 9100
Material Handling cost
7700
Total:
30800
Required: Prepare Unit cost for each product using:
Absorption costing
ABC
Assume, absorption costing absorb overheads on the basis of labour Hours
Direct labour hours per unit
1
3
1
3
Machine Hrs
Per unit
1
3
1
3
A
Absorption costing
A
Direct Material
direct labor
Overhead
unit produced
cost per unit
B
200
50
700
950
10
95
800
150
2100
3050
10
305
C
2000
500
7000
9500
100
95
D
8000
1500
21000
30500
100
305
b) Activity Based Costing
A
Direct material
Direct labour
overhead
B
C
D
200
50
800
150
2000
500
8000
1500
short run variable oh(w1)
set up cost (w2)
70
1560
210
1560
700
3900
2100
3900
expediting scheduling cost
(w3)
1300
1300
3250
3250
1100
4280
10
$428
1100
5120
10
$512
2750
13100
100
$131
2750
21500
100
$215
material handling cost
unit produced
cost per unit
working:
1. 3080/440=7 per machine hour
2.10920/14 prod run= 780 per prod run
3. 9100/14 prod run = 650 per prod run
4. 7700/14 prod run = 550 per prod run
Advantages of ABC:
1. It provides reliable cost estimate
2. It establishes long run product cost
3. It is helpful in developing new products or new ways to do busines because
ABC focus on support activities that would be required for new product or
business
4. ABC is suitable for deriving sale price where sale price is derive by adding mark
up to cost
Disadvantages of ABC:
1.It is costly to implement ABC
2. It is difficult to understand
3. A single cost driver may not explain the cost behaviour of all items in
the pool. An activity may have two or more cost drivers.
4.Implementing ABC is often problematic due to problems with
understanding activities and their costs
Target Costing
Target costing:
In a competitive market, selling price must be competitive in
order to sell at a competitive competitive market and earn a
profit. The production and sales must be kept at a level that
will provide the the required profit at the chosen selling
price.
In many markets new product innovation and improving
existing product is continuous process. Target costing is the
most effective at the product design stage and it is less
effective for established products. That are made in
established processes.
Target costing involves setting a target cost by subtracting desired profit
margin from target selling price
Target is the cost at which product must be produced and sold in order to
get desired profit at the target selling price
Implementing target costing:
Following are the steps to implement target costing:
1. Determine a product specification of which an adequate sales
volume is estimated.
2. Decide a target selling price at which the organisation will be able
to sell the product sucessfully and achieved a desired market
share.
3. Estimate the required profit, based on required profit margin or
return on investment
4. Target cost= target selling price-target profit
5. Prepare the estimated cost for the product, based on the initial
design specification and current cost levels
6. Cost gap= estimated cost – target cost
7. Make efforts to close a gap in such a way that quality of product is
not compromised.
Big B Manufacturer of computer games is in the process of introducing new computer games Big B establish the cost
estimate of the computer game for comparison with competitor games and to get the customer reviews:
Manufacturing Cost
Direct Material
Direct labour
Direct Machinery cost
Ordering and receiving
Quality assurance
$
3.2
24
1.1
0.2
4.6
Non manufacturing cost
Marketing
Distribution
After sales service
Calculate the target cost and cost gap of new product
8.2
3.3
1.3
Solutio
n
$
Target selling price
60
target profir margin 30% of
selling price
18
target cost ( 60-18)
42
estimated cost
46
$3.89 is the cost gap which company need to close but it should be close in such a way that quality of product is
not compromise.
Target costing in service Industries:
Target costing in service Industries:
Target costing is difficult to use in service industries because of the information
required and characteristics, Following are the characteristics of service
industries:
Intangibility:
There are no physical substance of services, as they cant be touch, they cant be
seen or feel.
Inseparability: Many services are bought and consumed at the same time for
Example Haircut.
Variability/hetrogenity:
Many services face the problem of maintaining consistency in the quality of
The product but customer expects it for example quality of fast food.
Perishability: services are innately perishable for example the services
of the beautician can be bought for period of time.
No transfer of ownership:
The customer will get the access to use the facility, there is no transfer
of ownership.
Life Cycle costing
The product life cycle costing can be divided into five phases:





Development
Introduction
Growth
Maturity
Decline
Development:
The product has research or design and development stage. Costs
are incurred but project is not yet in the product and there is no sales
revenue.
Introduction:
The product is introduced in to the market but customer is unaware
about the potential product or service. Heavy need to invest in
Marketing of the product or service to make awareness about the product
to the potential customers or buyers.
Growth:
The product builds up a market and gains market share. Sales revenue
increase and product gains to make a profit
Maturity:
The growth in demand for the product is at its peak and fairly stable at
this stage, it is the most profitable stage of the product, sales will be slow
down now. To sustaining the demand improvements need to be made in
the product
Decline:
It is the staturation point, now product will be loss making here company
need to decide to sell particular product and service and decide to
introduce new product.
Sales and
profits
Sales
revenue
Profit
Time
Life cycle costs:
Life cycle costing estimates the costs and revenues attributable to the
product over its entire expected life cycle
The life cycle costs of product are all the costs attributable to the product
over its entire life product life from product design and concept to
eventual withdrawl from the market.
Following can be the costs of the product during its life cycle:








Design cost
Cost of making prototype
Testing costs
Production process and equipment
Training cost
Production cost
Distribution cost
Marketing and advertising cost
Why to calculate life cycle cost?
In traditional costing it only calculates only periodic profit and loss
from which it was difficult to assess what is the actual profits or loss
has made from particular product.
While by calculating product life cycle costing, now it can be find what
costs has been incurred through out the product life cycle and how
much profit earned through out the life cycle of the product
Moon soft company is the company establishes in the tablets. It is planning
to introduce new line of tablets. Development of new line of tablets is
about to begin shortly and moonsoft is is in the process of determining the
cost of product. It expects new product will have the following cost.
Units produce and sold
Year 1
2000
$
100000
Marketing cost
Research and development
Cost
1900000
Production cost per unit
500
Disposal of specialist equipment
Customer service cost per unit
50
Year 2
15000
$
75000
100000
450
40
Year 3
20000
$
50000
year4
5000
$
10000
400
450
300000
40
40
Marketing director belives customer is ready to pay $500. while finance
director this this is not enough to cover costs through out life cycle.
Require: Compute the cost per unit and comment on sugested selling price
Solution
Life cycle cost
marketing ( 100 +75+50+10)
235
research and development (1900+100) 2000
production ( 1000 +6750+8000+2250) 18000
disposal
300
customer service( 100+600+800+200)
1700
total life cycle cost
22235
total production units
42
cost per unit
529.40476
Since the cost per unit is higher then selling price company should
reduce the cost of produce or increase the selling price.
235
Throughput Accounting
What is throughput?
Throughput is the rate of converting raw material into products sold to
customers, In monetory terms it is extra money which organisation made
from sellinbg its products.
Throughput = Revenue – Raw material cost
What is throughput accounting?
Throughput accounting is an approach to accounting which is big supporter
of Just in time concept. Throughput accounting assumes that manager has
given set of resources available which include builldings, capital, labour force
using these resources purchased material must be used to generate sales.
Given this scenario a financial objective to set for doing this is the
maximisation of throughput which is
Sales - Direct material cost
Throughput accounting main concepts:
1. In short term most costs in the factory are fixed cost including labour cost
and excluding material cost. These fixed costs are called total factory
costs ( operating cost)
2. In JIT environment ideal inventory level is zero, products must not be
produced until or less customers has ordered them.
3. Work in progress should be valued at material cost only so that no value
will be added and no profit is earned until the sales take place.
4. Profitability is determined by the rate at which sales has been made and
JIT environment it all depends on how how quickly customer orders has
been satisfied. As the goal for the profit oriented organisation to make
profits and for that inventory need to be sell in order to achieve the
objective.
Traditional accounting versus throughput accounting ratio
Traditional accounting
Throughput accounting
1. Inventory is an asset
Iventory is not asset, it is
unsyncronised manufacturing
and its barrier to making
profit.
2. Cost can be classified as
Such classification are no
either as direct or indirect cost longer useful.
3. Product costs can be
determined by the selling
price less product cost
Profitibility is determined at
the rate which money is
earned.
4. Profit can be increased by
reducing cost element
Profit is function of material
cost, factory cost and and
throughput.
Marginal costing and throughput accounting both determine a contribuution
by calculating difference between sales – variable cost. In throughput
accounting contribution is much higher because in throughput accounting
contribution is Sales – Material cost where is in marginal costing it is
calculated as Sales – material cost – labour cost – other variable cost.
Throughput costing costs like labour and other variable cost regard as fixed
cost because such costs are not controllable on immediate terms
Illustration 1
A
Sales
30
Material cost
5
Labour cost @ $3/hr
6
Variable OH
2
Fixed Oh
1
Maximum demand
15000
Total labour hours availale are 30000 hours
B
35
7
9
2
4
10000
How do we calculate contribution ?
A
$
Sales
Material cost
Labour cost
Variable cost
5
6
2
____
$
30
13
____
17
______
B
$
$
35
7
9
2
____
18
____
17
_____
How do we calculate throughput?
Sales
Less: Material cost
Throughput /Unit
A
30
(5)
____
25
B
35
(7)
_____
28
Theory of constraints:
Theory of constraints applied within an organisation by focusing on
following Five Steps:
Step 1: Identify the bottleneck process in system
Step 2: Decide how to get benefits from systems bottleneck process:
The production capacity of the bottleneck resource is actively being used
as much as possible and is producing as manay units as possible
Step 3: lower the rank of everything else to the decision made in step 2:
The production capacity of the bottleneck resource should determine the
production schedule for the organisation as whole. Idle time is
unavoidable and therefore need to be accepted if the theory of constraint
is to be successfully applied.
Step 4: Evaluate the system’s Bottleneck:
This will normally require capital expenditure.
Step 5: If new constraint found in Step 4, go back to step 1:
The most likely new constraint into the system is market demand.
Example 1:
Following example is extracted from the student accountant of March 2010
A not for profit organisation hospital performs a medical screening service in
three sequential stages:
1. Take an X- ray
2. Interpret the result
3. Recall patients who need further investigation/tell others all is fine
Process
Time/Patient(hours)
Take an X-ray
Interpret the result
Recall patients who need
Further investigations/tell
Other all is fine
0.25
0.10
0.20
Total hours
Available per
week
40
20
30
Required:
A. Find the Bottleneck process
B. How can we increase the throughput of the process identified in part (a) as
the bottleneck ?
Where there is a bottleneck resource limiting factor performance can be measured
in terms of throughput for each unit of bottleneck resource consumed.
Three Ratios:
Throughput accounting Ratio:
Return per factory hour
_______________________
Cost per factory hour
Cost per factory hour:
Total factory hour
________________
total time available on bottleneck resource
The cost per factory hour is for whole factory and therefore need to calculate
once, Not for each product.
Throughput return per factory hour:
Throughput per unit
____________________
Product’s time on the bottleneck resource
TPAR>1 = It suggests the rate at which organisation is making sales is
greater then rate at which they incurring the cost. So the product will
make the profit
Priority should be given to those products which will provide highest
ratios.
TPAR<1= it suggests that cost is higher then revenue therefore it is loss
making, Hence changes need to make quickly
Illustration 2:
From the information given in Illustration 1
A
throughput/Unit
25
Labour Hour Per unit
2
Throughput per factory hour
25
Which product should be produced first?
B
28
1
15
Cost/Factory Hour:
Factory cost are assumed to be fixed in short term. Take all costs excluding
material cost:
Product A ( 6+2+1)= 9 X15000
Product B ( 9+2+4)=15X10000
Cost/Factory Hour
285000
________
30000
= $9.5/ hr
=
=
135000
150000
__________
285000
___________
TPAR
=
A
25
______
9.5
2.631
B
15
_______
9.5
1.57
Both products have TPAR more then 1, therefore both are worth
producing
Criticism On TPAR:
1.In long term, ABC might be more appropriate for measuring and
controlling performance
2. It is more difficult to apply throughput accounting concepts to the long
term when all costs are variable
3. It focuses on short term
Suggesgt How TPAR could be improved
Management should focus on improving TPAR accounting ratio. If they are
succesfull to do so organisation can achieve higher level of profits.
Following are the ways to improve TPAR:
1.
2.
3.
4.
Increase selling price, this will increase throughput per unit
Reduce material cost, this will also increase the throughput per unit
Reduce total operating cost, this will reduce total factory cost
Immorve the productivity of workforce, this will reduce the production
time and therefore throughput will increase.
Apply throughput to multiproduct decision making:
1. Calculate throughput per unit for each product ( selling pricematerial cost)
2. Identify bottlleneck constraint
3. Calculate throughput per hour of bottleneck resource
4. Rank the products in order of priority which product should be
produced first, starting with the product which producing highest
return per hour first
5. Calculate the optimum production plan, allocating the bottleneck
resource to each one in order, being sure not to exceed the
maximum demand for any of the products.
Example 2
Sona Plc manufactures two types of Cosmetics.
Their cost cards are as follows:
Selling Price
Material cost
Labour cost
Other variable cost
Fix cost
Profit
Machine hours per unit
Maximum demand
Cosmetic 1
$
20
8
3
3
2
_____
(16)
_______
4
________
2 hrs
20000 units
Cosmetic 2
$
38
20
4
6
3
____
( 3)
_____
5
_____
1 hr
10000 units
Total hours available are 40000 hours
a. Calculate the optimum production plan and the maximum profit using key
factor analysis
b. Calculate the optimum production plan using throughput accounting
approach
c. Calculate throughput accounting ratio for both products.
Example 3
BMX LTD is engaged in manufacturing and marketing of bicycles. BMX
produce two types of Bicycles. One is “ ROADY” which is designed to use
on roads and other Is “Mounty” which is designed for use in mountainous
areas. The following information is related to the year ending 31st
December 2005:
Unit selling price and cost data is as follows:
Selling price
Material cost
Variable production costs
ROADY
$
250
100
40
MOUNTY
$
350
120
60
Fixed production overhead attributable to the production of bicycles will
amount to $ 4000000
Expected demand is as follows:
ROADY 150000 units
MOUNTY 70000 units
Each Bicycle is completed in the finishing department. The number of
each bicycle that can be completed in one hour in finishing department is
as follows:
ROADY 6.25
MOUNTY 5.00
There are total of 30000 hours available within the finishing department
BMX ltd operates in JIT manufacturing environment with regard to
manufacture of Bicycles and they do hold very little Work in progress
inventory and nill finish goods whatsoever.
A. Using marginal costing principles,Calculate the mix units of each
bicycle which will maximise the net profit and state the value of that
profit.
B. Calculate the throughput accounting ratio for each type of bicycle
and briefly discuss when it is worth producing a product where
throughput accounting priniciples are in operation. Your answer
should assume that the variable overhead cost are amounting to
4000000 incurred as a result of the chosen product mix in part (a) is
fixed in the short term.
C. Using throughput accounting principles, advice management of the
quantities of each type of the bicycle that should be manufactured
which will maximise profit and prepare projection of the profit that
would be earned by the BMX ltd in the year ending 31st December
2005.
( ACCA paper December 2004 Amended)
Answer Example 1:
Process
Time/Patient (Hours)
Take an X-ray
Interpret the result
Recall patients who
Need further investigation/
Tell others that all is fine
Total Hours
available/week
0.25
0.10
40
20
0.20
30
X rays
40/0.25= 160
Interpret
Results
20/.20= 200
Recall etc
30/.20 = 150
Recall procedure is the bottleneck resource, the organisation performance
Can not be improved untill or less this part of organisation involve with
More people.
Cost Volume profit
( CVP analysis)
Cost volume profit (cvp) breakeven analysis is the study of the interrelationships
between cost, volume and profit at various levels of activity.
Basic formulas:
Contribution per unit = selling price per unit – variable cost per unit
Profit
= ( sales volume X contribution per unit) – fixed cost
Breakeven point
= activity level at which there is neither profit nor loss
total fix cost
__________________
contribution per unit
contribution required to breakeven
___________________________________
contribution per unit
Contribution/sales (C/S) ratio = profit/volume (P/V) ratio = contribution/sales X 100
Sales revenue at breakeven point = Fixed cost / C/S Ratio
Margin of safety in units = budgeted sales units – breakeven sales unit
Margin of safety as %
= budgeted sales – breakeven sales
_______________________________ X 100
budgeted sales
Sales volume to achieve target profit =
fixed cost + target profit
______________________
contribution per unit
Assumptions:
1. Production volume = Sales volume
2. Sales price are constant at all levels of activity
3. CVP analysis can apply to one product only, or to more than one product
only if they are sold in a fixed sales mix ( fixed proportions)
4. Fixed costs per period are same in total and unit variable costs are a
constant amount at all levels of output and sales.
Example:
Simba Co makes and sell single product. The selling price is $12 per unit. The
variable cost of making and selling a product is $9 per unit and fixed costs per
month are $240000.
The company budgets to sell 90000 units of the product a month.
Required:
a. What is the budgeted profit per month and what is the breakeven point
in sales
b. What is the margin of safety
c. What must be sales to achieve a monthly profit of $120000?
Answer:
a. Contribution per unit = $(12-9) = $3 The C/S ratio is 3/12 = 0.25
Budgeted profit
= (90000 X$3) - $240000 = $30000
Breakeven point unit in sale = $240000/$3 = 80000 units per month
Breakeven point in sales revenue = Fixed cost/ C/S ratio= $240000/0.25
= $960000
b. Margin of safety = (90000-80000)/90000 = 11.1%
c. To achieve a profit of $120000, total contribution must be
($240000+120000) =$360000. sales must be $360000/$3 per unit =
120000units or $360000/0.25 = $1440000 in sales revenue)
Breakeven Chart
Sales revenue
$ --------------------------------------|
----------------------------------|
Breakeven
point
----------------------------|
| |
| | |
Fixed Co|st
| |
| | |
| | |
| | | unit
Margin
of
safety
Profit
Variable cost
Contribution breakeven chart
$
fix
cost
---------------------------------------Breakeven point
|
--------------------------------|
|
|
|
|
|
|
|
|
|
|
|
Margin of
safety
Profit
Fix cost
Contribution
Units
Profit
Profit
B’even
Loss
|
|
|
Sales volume
|
or revenue
Fix
|
cost
|
|
| Contribution
|
-----------------------------------------------------
Basic breakeven chart
Example 2:
A new product has the following sales and cost data:
Salling price $70
Variable cost $30
Fixed cost $25000 per annum
Sales forecast 2000 units
Required:
Prepare a breakeven chart using the above data.
Answer:
Step 1: Draw the axes and label them. Your graph should fill as much
space as possible as it will make it clearer and understandable
Step 2: Draw the fixed cost line and label it. This will be straight line
parallel to the horizontal axis at the $25000 level. The $25000 fixed
cost are incurred even at zero activity level.
Step 3: Draw the total cost line and label it. The best way to do this is to
calculate the total costs for the maximum sales level that is 2000 units.
Mark this point on the graph and join it to the cost incurred at zero
activity that is $25000.
Step 4: Draw the revenue line and label it. Once again start by plotting the
revenue at maximum activity level. 2000 units X 70 = 140000. this point
can be joined to the origin, since at zero activity there will be no sales
revenue
Step 5: mark any required information on the chart and read off solutions
as required. Check that your chart is accurate by reading the measures.
Step6: If you have time check your arithmetic calculations.
Breakeven
100
90
80
70
60
50
40
30
20
10
-----------------------------------------------|
|
|
|
|
|
|
|
|
|
Variable cost
Fix cost
Breakeven analysis for Multi product:
The breakeven point for standard sales mix of products is calculated by
dividing the the total fixed costs by the weighted average contribution per
unit , or by weighted average C/S ratio.
Example 3:
Picasso Plc produces and sell two products, product A and B. Product A sells
for $7 per unit and has variable cost of $2.94 while B sells for $15 per unit and
has total variable cost of $4.40 per unit. The marketing department has
estimated that on every five units of A sold one unit of B sells. The
organization's fixed cost per period is $123600.
Required:
Calculate the Picasso breakeven for the year.
Step 1: Calculate the contribution per unit and the weighted average
contribution per unit:
Sales price
variable cost
Contribution
A
$ per unit
7
(2.94)
______
4.06
_______
Contribution from sale of Five units of A = 4.06
contribution from sale of one unit of B
Contribution from sale of 6 units
of standard sales mix
B
$ per unit
15
(4.40)
_______
10.60
_______
$20.30
$10.60
________
30.90
________
Weighted average contribution per unit = 30.90/6 = 5.15 per unit
Step 2: Calculate the breakeven points in units:
Fixed costs/weighted average cost per unit = 123600/5.15 = 24000 units
These are in the ratio 5:1 , therefore breakeven is the point where 20,000 units of
A are sold (24000 X 5/6) and 4000 units of B are sold (24000 X 1/6)
Step 3: Calculate the breakeven point in sales revenue:
20000 units of A at $7 and 4000 units of B at $15
= 140000 + 60000 = $200000
Contribution to Sales ( C/S) ratio for multiple products:
The breakeven points in terms of sales revenue can be calculated by dividing
the fixed cost is equal to required contribution by the weighted average C/S
ratio.
The breakeven point In terms of sales revenue= Fixed cost/average C/S ratio
C/S ratio also known as Profit/volume ratio or P/V ratio.
Example 4:
The date and information is same as example 3
Step 1: Calculate revenue and contribution per mix of 5 units of A and 1 unit
of B.
Product A ( 5units)
Product B ( 1 unit )
per unit
4.06
10.60
Contribution
Revenue
Total
per unit
Total
20.30
7
35
10.60
15
15
________ _____
_____
30.90
50
_________
_____
Weighted average C/S ratio= 30.90/5= 61.8%
Step 2: Fixed Cost/ weighted average C/S ratio
Fixed cost/ weighted average contribution per unit = $123600/.618 =
$200000 in sales revenue
Calculate breakeven sales for each product:
A = $200000 x (35/50) = $140000
Sale price per unit = $7
Therefore breakeven point in units = $140000 /7 = 20000 units.
B = 200000 x (15/50) = $60000
Sales price per unit= $15
Therefore breakeven point in units = $60000/15 = 4000 units
Margin of safety for multi products:
The margin of safety for multi product organisation is equal to the
budgeted sales in the standard mix less the breakeven sales in the
standard mix. It should be expressed as percentage of budgeted sales.
Example:
Picachoo produces and sells two products. The G sells for $8 per unit and
total variable cost of 3.80 per unit, while the H sells for $14 per unit and
has total variable cost of 4.30 for every five units of G are sold, Six units of
H are sold. Pichachoo expected fixed costs are 83160 for the per period.
Budgeted sales revenue for the next period is $150040 in the standard
sales mix.
Required:
Calculate the margin of safety we must first determine the breakeven
point.
Answer:
Step 1: Calculate the weighted average contribution per unit:
Selling Price
variable cost
Contribution
G
$ per unit
H
$ per unit
8
(3.80)
_______
4.20
________
14
(4.30)
________
9.70
_________
Contribution from Sale of Five units of G
Contribution from sale of Six units of H
Contribution from sale of 11 units
Weighted average contribution per unit 79.20/11 = 7.2
$21
$58.20
__________
79.20
____________
Step 2: Calculate the breakeven point in terms of number of shares ( total)
Fixed cost/ weighted average contribution per unit = 83160/7.2 = 11550 units
Step 3: Calculate the breakeven point in terms of number of units of
products
Product G =11550 x (5/11) = 5250 units
Product H = 115550 s (6/11) = 6300 units
Step 4: Calculate the breakeven points in terms of revenue
= (5250 x 8) + (6300 x 14)
= $42000 G revenue + $88200 H revenue = $130200 total revenue
Step 5: Calculate the margin of safety:
Budgeted Sales – Breakeven sales
As a percentage: 19840/150040 = 13.2% of budgeted sales
Targeted profits for multiple Products:
The sales mix required to achieve target profit is the sales mix that will earn a
contribution equal to the fixed costs plus the target profit.
Suppose an organisation wishes to achieve a certain level of profit during a
period. To achieve this profit, contribution must cover fixed cost and leave the
required profit.
Total contribution required = fixed cost + required profit
Once we find out the contribution required we can calculate the sales revenue
of each product needed to achieve target profit. The method is same as used
to calculate breakeven
Formula:
Target profit = (Fixed cost + required profit)/weighted average contribution per
unit
Example:
An organisation makes and sells three products A, B and C. The products
are sold in the proportion A B C= 2:1:3. organisation fixed cost is $80000
per month and details of the product are as follows:
Product
A
B
C
Selling Price
22
15
19
Variable cost
16
12
13
The organisation wishes to earn $52000 next month. Calculate the
required sales value of each product in order to achieve this target profit.
Answer:
Step 1: Calculate the weighted average contribution per unit
A
$ per unit
selling price
22
variable cost
(16)
______
Contribution
6
_______
Contribution from 2 units of A
Contribution from 1 unit of B
Contribution from 3 unit of C
B
$ per unit
15
(12)
_______
3
_______
C
$ per unit
19
(13)
_______
6
________
$12
$3
$18
_____
33
______
Weighted average contribution per unit $33/6 =5.50 = 24000 units
Step 2: Calculate the required number of sales unit:
= (fixed cost + required profit)/weighted average contribution per unit
= ($80000 + $52000)/$5.50
= 24000 units
Step 3: Calculate the required in terms of the number of units of the products
and sales revenue of each product.
Product
A
B
C
Units
24000x2/6
24000x1/6
24000x3/6
8000
4000
12000
Selling Price
$ per unit
22
15
19
Sales revenue
required
176000
60000
228000
___________
464000
___________
The sales revenue of $464000 will generate the profit of $52000 products are
Are sold in the mix of 2:1:3
Example: Using C/S ratio to determine required sales
In this example we will use the Information of above example
Step 1: Calculate revenue per mix i.e. 2 units of A, 1 unit of B and 3 units of C
=(2x$22) + (1x$15) + (3x$19)
=$44 + $15 + $57
= $116
Step 2: Calculate contribution per mix:
$33 same as above example
Step 3: Calculate weighted average C/S ratio:
=($33/116) x 100%
= 28.45%
Step 4: Calculate required total revenue:
= required contribution / C/S ratio
= ($80000+52000)/.2845
=463972
Step 5: Calculate required sales for each product:
Required sales of A= 44/116 x 463972 = $175989
Required sales of B= 15/116 x 463972 = $59996
Required Sales of C =57/116 x 463972 = $227986
Limitations of CVP Analysis:
1. Uncertainty in the estimates of fixed costs and unit variable cost is
often ignored
2. Production and sales are assumed to be same. The consequences
of increase in inventory level are ignored.
3. It is assumed that fixed cost are same in total and variable costs
are same per unit at all level of output.
4. It is assumed that sale price is constant at all levels of activity
level. This may not be true, especially at higher volume of output,
where the price may have to be reduce to get the higher sales.
Advantages:
1. Highlighting the breakeven point and margin of safety give managers
indication of the level of risk
2. Graphical representation of cost and revenue data can be more easily
understood by non- financial managers
3. A breakeven model enables profit or loss at any level of activity within
the range for which the model is valid to be determined, and the C/S
ratio can indicate the relative profitability of different products.
Limiting factor analysis
A limiting factor is any factor that is in scarce supply and that stops
organisation from expanding its activities further, so that there is maximum
level of activity at which organisation can operate.
An organisation might be just faced with one limiting factor other than
maximum sales demand but there might be several other scarce resources
and those might be two or more of them putting an effective limit on the
level of activity that can be achieved.
Example of limiting factor:
 Labour: A limit might be in total quantity of labour or skills labour might be
limited.
 Machine capacity: there may bot be sufficient machine capacity to meet
sales demand
 Material: there may be insufficient material available to meet the sales
sales demand
One Limiting Factor:
If there is one Limiting factor, limiting factor analysis can be used to solve
the problem. Option must be ranked using contribution earned per unit of
the scarce resource.
Limiting factor analysis steps:
Step 1: Determine the Limiting factor (Bottleneck resource)
Step 2: rank the option using the contribution earned per unit of the
scarce resource
Step 3: Allocate the resources
Example:
Mika make two products the Maza and Frooto. Variable costs are as follows:
Direct material
Direct labour ( $3 per hour)
Variable OH
Maza
$
1
6
1
____
8
_____
frooto
$
3
3
1
____
7
_____
The sales price unit of Maza is $14 and $11 per frooto. During the month of july
direct labour hours available is limited to $8000 hours. Sales demand in july is
Expected to be as follows:
Maza
3000 units
Frooto
5000 units
Required:
Determine the production budget that will maximise the profit, assuming
that fixed costs per month are $20000 and there is no opening inventory or
work in progress.
Answer:
Step 1: Confirm that sales demand is something other than sales demand
Maza
Labour hours per unit
Sales demand
Labour hours needed
Labour hours available
Shortfall
2 hrs
3000 units
6000 hrs
Frooto
1 hr
5000 units
5000 hrs
Total
11000
8000
________
3000
_________
Step 2: Identify the contribution earned by each product per unit of scarce
resource; that is per labour hour worked:
Maza
$
Sale price
Variable cost
Contribution/Unit
Labour hour per unit
Contribution per labour hour
( per unit of limiting factor
14
8
____
6
_____
frooto
$
11
7
_____
4
____
2 hrs
1 hr per unit
$3
$4
Step 3: Determine the budgeted production and sales. Sufficient frooto will be
made to meet the full sales demand, and the remaining labour hours will then
be used to make Maza
a. Product
Frooto
Mazaa
Demand
5000
3000
b. Product
units
hours needed
5000
1500
5000
3000
Frooto
Mazaa(bal)
Less: fix costs
Profit
Hours Required
5000
6000
_______
11000
_________
Hours available
5000
3000 (Bal)
_______
8000
________
Contribution
per unit
4
6
priorty
1st
2nd
Total
20000
9000
_____
29000
(20000)
______
9000
Conclusion:
1. Contribution per unit is not the correct way to decide priorties for production and
sales
2. Labour hours are scarce resource in this example, therefore contribution per labour
hour is the correct way to decide priorities for production and sales
3. The frooto earns $4 contribution per labour hour and mazaa earns $3 contribution
per labour hour. Therefore mazaa should be manufacture first as its more profitable
4. Frooto should be manufactured up to sales demand and after that if there is any
resources available then 2nd highest product with contribution per labour hour
should be manufacture
Two or more resources in short supply:
When there are two or more resources are in short supply, Linear programing is
required to find the solution:
Linnear programing is used to:
- Maximise profit or
- Minimise cost
Steps involved in linear programming:
1.
2.
3.
4.
Define the variables
Define and formulate the objective
Formulate the constraints
Draw a graph to identify the feasible region. The constraints are represented
as straight lines on the graph. The feasible region shows those combination
of variables which are possible given the resource constraint
5. Compute the optimal production plan. An iso contribution line ( an objective
function for particular value ) must be drawn. All points on this line represent
An equal contribution. This line must move to and from the origin in parallel
The objective is to get the highest contribution or minimum cost within the the
binding constraint.
A Linnear programing assumption can be solved using simaltinous equations,
however this technique can be used after one has determined graphically the
constraints and the physical region.
Linear Programming Assumptions:
1. Its single quantifiable objective
2. Each product uses the same quantity of the scarce resource per unit
3. The contribution or cost per unit is constant for each product, regardless
the level of activity, therefore the objective function is the straightline
4. Products are independent
5. The focus is short term
6. All costs either vary with a single volume related cost driver or they are
fixed for the production under consideration.
Example 2:
Mama bakery produce two types of cakes. Cake A and Cake B.
Contribution / Cake A = $20
Contribution / Cake B = $45
Cream X and Cream y are used in baking each cake. Each material is in short
supply.
Cream X = 3000 kg available
Cream Y = 2700 kg available
Each Cake A uses 20kg of cream X and 15kg of cream Y.
Each Cake B uses 30kg of cream X and 50kg of cream Y.
The objective of this company is to maximise profits.
Variables:
Let A be the number of cakes of A produced and sold
Let B be the number of cakes of B produced and sold
Objective function:
Maximise = 20A + 45B
Constraints:
Cream X = 20A + 30B < 3000
__
Cream Y = 15A + 50B < 2700
__
Non negativity = A,B > 0
__
Cream X:
20A + 30B = 3000
When A = 0, B= 100
When B=0, A = 150
Cream Y:
15A = 50B = 2700
When A = 0, B= 54
When B = 0, A= 180
200
180
150
p
OPQR = feasible
region
B
Q
100
A
45
Material x
Iso Cont Line
0
O
25
Material Y
50
75
100
Product
B
How can we draw the iso- contribution line ?
20A + 45B = 900 take a number which is multiple of both 20 and 45
both
When A = 0, B = 20
When B = 0, A = 45
Which is the optimal point ?
1. Shift out the objective function
2. We need to maximise profits. Hence the optimal point is the last
point to reach in the feasible region. OPQR
Therefor the optimal point in the above example is B.
How can we find the optimal point using simultaneous equations?
Find the contribution at each point on the feasible region.
At point O, contribution is 0.
At point P, Contribution is 20A + 45B
20(150) + 45(0) = 3000
At point R, contribution is 20A + 45B
20(0) + 45(54) =2430
At point Q, Point of intersaction of cream X and cream Y,
Cream X = 20 A + 30B = 3000 ……………………. X 5
Cream Y = 15 A + 50 B = 2700 ……………………. X 3
100(125.45) + 150 B = 15000
B = 16.36
Contribution = 20A + 45B
= 20(125.45) + 45(16.36)
= 2509 + 736.2
= 3245.2
Slack:
Slack occurs when maximum availability of resource is not used. Slack
is the amount of the unused resource or other constraint. Where the
constraint is less then or equal to constraint
Surplus:
Surplus occurs when more then minimmum requirement is used:
surplus is the excess over the minimum amount of constraint, where
the constraint is more then or equal to constraint.
Shadow Price:
The shadow price or dual price of constraint factor is the amount of change in
the value of objective function for example, the increase in contribution
created by the availability of one extra unit of the limited resource at its
original cost.
For example availability of the material is binding constraint. Suppose that one
extra kilogram becomes available then an alternative production mix becomes
optimal. As a result the contribution increases over the original production mix
contribution by $2. The shadow price of material is therefore $2
Points to remember:
1. The shadow price there represent the maximum premium above the basic
rate that an organisation should be willing to pay for one extra unit of
resource.
2. Since shadow price indicate the effect of a one unit change in a constraint,
they provide measure of the sensitivity of the result.
3. The shadow price of a constraint that is not binding at the optimal solution
is zero.
4. Shadow prices are only valid for small range before the constraint becomes nonbinding or different resources become critical.
Example 3:
This example is from example 2, Find the shadow price of Cream X.
20A + 30B = 3001 ( Add 1 kg to cream X)
15A + 50B = 2700
20A + 30B = 3001 ….. X5
15A + 50B = 2700 ….. X3
100A + 150B = 15005
45A + 150B = 8100
_______________________
55A
/ = 6905
A
= 125.55
100A
100(125.55)
+ 150B = 15005
+ 150B = 15005
B = 16.33
Therefore new contribution is:
20(125.55) + 45(16.33)
= 2511 + 734.85
= 3245.85
Old Contribution = 3245.20
_______________
Shadow price
0.65
_______________
Extra contribution / kg of Cream X
Relevant Costing, Make or Buy and other short term decisions
Organisations are increasingly tended to focus on their core competencies
and turn other functions to other specialist customers. This is known as
outsourcing and sub contracting.
Any short term decisions should be made using relevant costing principles
Relevant costs and revenues are future cash flows and inflows arise due to
the decision which has been made.
1. Relevant cost and revenues are future costs and revenues
2. Relevant costs and revenues are future costs and income
3. Relevant cost and revenues are incremental cost and revenues
Decision making should be based on relevant costs and revenues
1. Relevant costs are future costs. A decision is about future, it can
not change what has been done already in past. The cost which has
occurred in past are known as sunk costs and are tottaly irrelevant
for decision making
2. Relevant costs are cash flows that means only such costs are
relevant which are cash flows non cash expenses such as
depreciation and ammortisation are also known as notional costs
and such costs are tottaly irrelevant
3. Relevant costs are incremental costs. These are the costs which
increase the costs and revenues which incurred due to the decision
which has been made. Common costs can be ignored for the
purpose of decision making.
4. Avoidable costs which can be ignored if decision would have not
been taken.
5. Commited costs are the costs which can not be avoided because of
because of the decisions which has already been made.
Opportunity Cost:
The choice of one course of action requires that alternative course of
action is given up, the financial benefits that sacrificed for the sake of
another one is opportunity cost.
Relevant cost for material:
The relevant cost of the material is generally their current replacement
cost, unless the materials has already been purchased and would not be
purchased once used
In this case relevant cost for using them is the higher of:
- Current resale value
- The value they would obtain if they were put to an alternative use.
If the materials have no alternative use and they also have no opportunity
cost then the relavant cost will zero.
In Stock
Not In stock
Used regularly
No other use
Need to be
replace
Wont be
replace
Scarce
Buy it
Current replacement
cost
Current
replacement cost
Current resale
value
Cant replace
opportunity
cost
Example:
Material
A
B
Qty need for
Contract
200 kg
400 kg
original cost of
qty in inventory
$20/ kg
$10/kg
Current Purchase
Price
$22/kg
Current resale
Price
$15/ kg
$15/kg
Material A is regularly used in business
Material B has no longer use and has no resale value
The relevant cost of material is:
Material A: regular used – Replaced
400kg x $22 = $8800
Material B: 100 kg could have been sold if not used in the contract
100 x 12 = $1200
Other 100 kg would have to be purchase at 100 x $15 = 1500
Therefore 1200 + 1500 = 2700 / original cost is sunk cost therefore irrelevant.
$12/Kg
Relevant Cost For Labour:
Here the question is is there any spare capacity?
If there is any spare capacity with in the department, additional work can be
undertaken at no extra cost, therefore relevant cost of labour is nil.
If department is working in full capacity and additional work can be taken in
only two circumstances.
1. Hire more labour: In this case the relevant cost will be current labour pay
which company has to pay to these labour/employees.
2. Shift work from the other department in this case relevant cost of the
labour will be the lost contribution from not producing the alternative
product and this can be calculated by sales value of the units of the
product which will now be forgone/sacrificed and deduct the cost of the
producing them but exclude the labour cost.
As labour still has to be paid even if they are working on another product.
Spare capacity
Full Capacity
Additional work can
be taken at no extra
cost
Additional work can not
be undertaken
Hire more
labour
Shift work
from another
department
Nil
Current rate of pay
given
Lost contribution
+ variable cost
Example 2:
A contract requires 500 hours of labour. There are 400 hours of spare labour
capacity. The remaining hours can be worked as overtime at time and a half. The
labour rate is $12/hr.
500 hours
400 hrs
Relevant cost = 0
100 hrs
Relevant cost = 100
x 12 x 1.5 = $1800
Make or Buy Decision Making:
When organisation assessing the difference in costs between making product in house
or to outsource, one of the key consideration is whether space capacity does or would
exist.
If there is spare production capacity is available following issues will arise
1. Production resources maybe idle if the component is purchased from outside.
2. The fixed costs of those resources are irrelevant to the decision in the short term
as they will be incurred whether the component is made or purchased.
3. Purchase would be recommended only if the buying price was less then the
variable costs of internal manufacture.
4. In the long term however the business may dispense with or transfer some
of its resources and may purchase from outside if it thereby saves more then
the extra cost of purchasing.
If there is no spare capacity available following issues may arise.
1. A decision to make components in house might displace the
manufacture of other existing products. This could give rise to
opportunity costs of lost contribution or additional costs of buying those
products.
2. In long term management may look to other alternatives such as capital
expenditure of machinery.
Outsourcing:
Matters to consider before deciding to outsource:
1. The quality of the outsider producer must be acceptable
2. Supply continuity must be guranteed
3. If a component is no longer produced by the company the management
should investigate whether the capacity feed up can be used to generate
additional profits from different product.
4. Management should consider that labour should not get de motivated
5. Stability in pricing is also another important factor.
Shutdown decisions:
To decide whether to close part of the business, a cost accountant must consider:
1.
2.
3.
4.
Loss of the contribution from segment
Savings in specific fixed costs from closure
Alternative use of resources released
Extra costs due to closure such as redundancy pay, compensation to customers
etc.
One of Contract:
A business should identify the incremental cash flows associated with a new one
Off contract/project.
Joint product further processing decisions:
Joint products are two or more products which are output from the same
processing operation, but which are indistinguishable from each other up
to their point of separation.
Joint products have substantial sales value. Often they require further
processing before they are ready for sale joint products arise for example,
In the oil refining industry. Where diesel, petrol, lubricants etc are all
produced from same process.
Joint products
Input
Direct mat
Product A
Process
Direct lab
Product B
Variable &
Product C
Fixed OH
By product
Scrap
Waste
What is split of point ?
A specific point at which individual products become identifiable is known as
split of point
Product A
JOINT COST
Product B
Product C
Split of point
Those costs which are incurred before the point of separation must be shared
between joint products i.e. for example for joint products.
After separation products must be sold immediately or may be processed further.
Any costs which incurred after the separation are allocated directly to the product
on which they are incurred.
Should we process product further?
To decide whether to process product we need to consider:
1. Is there any incremental in the revenue ?
2. Is there any extra costs ? Both further processing cost and any differences
in selling costs?
At this stage pre separation cost is sunk cost and therefore it is irrelevant.
Pricing Decisions
The prices which businesses do charge for its products and services determined by the
products of services in which they are operating
perfectly Competitive market:
In competitive market the organizations are price taker. No other market participant can
influence the prices of the product or services it buys or sells.
Perfect competitive market has the following characteristics:
1. there are no barriers to entry to entry into or exit out of the market.
2. Organisations produce homogeneous, identical units of output that are not
branded.
3. Each unit of input, such as units of labour, are homogenous
4. No single organisation can influence the market price or market conditions.
the single organisation is said to be price taker, taking its price from the whole
industry.
106
5. There are large number of organisations in the market.
6.In long term organisations can make normal profits and in short term they
can make abnormal profits.
7.There is no need for government regulations, except to make markets
more competitive.
Imperfect competition:
It refers to the market structure that does not meet the conditions of a
perfect competition.
It has following kinds:
Monopoly:
There is only one provider of good or service. The monopolist sells a product
for which there are no close substitutes. It has control over the market. It
can set the price of the products which sold in the market.
107
Oligopoly:
A few large companies dominate the market and are inter dependent. They
offer the same product and compete for the market dominence for example
dairy/milk products.
Monopolistic competition:
Products are similar but not identical, each firms sells a branded product.
Hence it is a monopolist. For its brand. There is freedom of entry or exit into
the industry.
Factors influence the price of products and service
Cost: the most straightforward approach to arrive at the selling price is to
calculate cost and add on profit margin/markup. Using this cost plus pricing
approach. Cost is calculated on basis of either marginal or this may be termed
as variable cost or total cost.
108
Price perception:
Customer based pricing means setting a price based upon the pricing of
competing products that is taking into consideration both substitutes is an
important aspect of complimentary products.
Innovation: A company may set a high price for an innovative product which
is also known as price skimming.
Competition: Competition based pricing means prices are based on the prices
of competing products which includes complimentary and substitutes
products.
109
Price elasticity of demand:
Generally, it is expected that there will be an inverse relationship between
selling price and sales demand. If the sales price is increased, sales demand
would be expected to fall. If selling price is reduced sales demand would rise.
Here the question is to what extent is demand likely to respond change in price.
The price elasticity of demand ( degree of sensitivity of demand for a product to
changes in the price of that product. Which can be measured as:
%change in sales demand
___________________________
% Change in selling price
If the % change in demand > the % change in price then price elasticity > 1:
It means Demands is elastic that means very responsive. Total revenue increase
when price is reduce and decreases when price is increased.
110
IF the % change in demand < the change in price, then price elasticity < 1:
Demand is inelastic that means it is not very responsive. Total revenue decreases
when price is reduced and increases when price is increased.
Price elasticity of 1 will mean that the % change in demand offsets the % change
in price, leaving total sales revenue unchanged. An increase in selling price will be
offset by decrease in sales demand , a decrease in selling price will be offset by
an increase in sales demand.
Example:
At price of $1.50 annual demand is 100000
If price increased to to $1.75 annual demand is 80000
Price elasticity of demand is ??
% Change in demand = 20000/100000 x 100 = -20%
% change in price = 0.25/1.50 x 100 = 16.67%
111
Price elasticity of demand is 20/16.67 = 1.2 (ignore minus sign)
Straight Line equation:
Straight line equation represented by following equation
Graph of linear function y = a + bx
Y
Y = a + bx
‘a’
Gredient of Line = b
o
X
112
P
The gradient of Line =
________
Q
=-b
Total cost function:
Y = a + bx
graph of cost equation y = 5000 + bx
Y axis
Total
cost
Y(total cost)= 5000 + 10x
Fixed
cost a =
$5000
Variable cost = b = $10
Level of activity
X axis
113
A = is the fixed cost per unit
B = is the variable cost per unit
X= is the activity level
Y = is the total cost = fixed cost + variable cost
Cost equations including volume based discounts:
Suppliers often offer discounts to encourage the purchase of increased volumes.
Where
Example:
Variable cost is $5 up to $10000 units. 10% discount applies on all units
purchased over 10000 units.
Total fixed cost $100000
X < 10000 , TC = 100000 + 5x
_
X > 10001 , TC = 100000 + 4.5x
-
114
Demand based approaches
(The economist View point):
Most organisations recognise that there exist a relationship between the selling
price of the product or service and the demand.
The law of demand explains the inverse relation between quantity and price in
general. It can be stated as follows:
The quantity of a good demand will rise with fall in its price and the quantity of
good demand will fall with increase in its price.
115
200
180
Price per unit
160
140
120
P
D1
100
80
60
40
20
0
50
100
150
200
250 300 350
116
The price demand equation is in the form:
P = a – bq
Where
P is the selling price
Q is the quantity demanded at that price
a = theoritical maximum price ( if price is set at a or above demand will
be zero) , that is from the graph above at a price of $200, demand is zero
B= the change in price required to change demand by 1 unit ( the gradient
of line) =
P
__________
Q
117
Profit maximisation – Algebric Approach:
Economic theorist states that in a perfectly competitive market, the monopolist maximises
profit when:
marginal revenue = marginal cost
Marginal revenue: (MR) is the extra revenue that an additional unit of product will bring.
It is the additional income from selling one more unit of a good. It can also be described as
the change in total revenue divided by the change in the number of units sold.
Note:
The gradient of MR function is twice the gradient of the demand function
MR = a – 2bq
118
Marginal cost is the change in total cost that arises when the quantity
produced changes by one unit means it is the cost of producing one more
unit of good produced.
Example
price
Marginal
revenue
profit
35
35
35
5
25
65
32.5
30
10
25.7
22
93
31
28
16
97
24.2
20
116
29
23
19
5
116
23.2
19
138
27.6
22
22
6
134
22.3
18
156
26
18
22
7
151
21.6
17
170
24.3
14
19
unit
Total
cost
Cost/
unit
Marginal
Total
cost
revenue
1
30
30.0
30
2
55
27.5
3
77
4
119
8
168
21
17
182
22.8
12
14
9
184
20.4
16
193
21.4
11
9
10
200
20
16
203
20.3
10
3
Profits are maximised when MC = MR this scenario when 6 units
are produced mc = mr at $18 and total profit is $22
120
$
MC
B
P
A
Q
Quantity
At this point A, MC = MR i.e. profits are maximised at this point. At output less
then Q, the extra cost of making a unit is less then the extra revenue from
selling it. At output greater then Q, the extra cost of making a unit exceed the
revenue from selling it.
121
Example:
ABC company is considering the price of new product. It has determined the
variable cost of making the item will be $24 per unit. Market research has
indicated that if the selling price were to be $60 per unit then the demand
would be 1000 units per week.
For every $10 per unit increase in selling price, there would be reduction in
demand by 50 units and for every $10 reduction in selling price, there would
be increase in demand of 50 units.
Calculate optimal selling price.
P = a – bq
B= P
---------Q
= 10/50 = 0.2
60 = a – 0.2 (1000)
A =260
P = 260 - 0.2Q
122
MR = 260 – 0.4Q
If MC = MR
24 = 260 – 0.4Q
0.4Q = 236
Q = 590
P = 260 – 0.2(590)
= $142
Pricing strategies:
Cost Plus pricing:
Cost plus pricing includes the unit cost and adding a mark up or sales margin
Full cost plus pricing:
Is method of determing the sales price by by calculating the full cost of the
product and adding a percentage mark up for profit.
123
Advantages of Full cost plus pricing:
1. It is simple annd cheap method of pricing which can be delegated to junior
methods.
2. Since the size of the profit margin can be varied a decision based on a price in
excess of full cost should ensure that a company working at normal capacity
will cover all of its fixed costs and make a profit.
Disadvantages:
1. There is no attempt to establish optimum price.
2. There may be a need to adjust prices to market and demand conditions.
3. Budgeted output volume needs to be established. Out put volume is a key
factor in the overhead absorption rate.
124
Marginal cost plus pricing/ mark up pricing: involves adding a profit margin to
the marginal cost of production/sales.
Advantages:
1. It is a simple and easy method to use.
2. It draw management attention to contribution, and the effects of higher or
lower sales volume on profit.
3. In practice, mark up pricing is used in businesses where there is a readilyidentifiable basic variable cost.
Disadvantages:
1. It ignores fixed overheads in the pricing decision, but the sales price must
be sufficiently high to ensure that profit is made after covering fixed costs.
2. Size of the mark up conditions can be varried in accordance with demand
conditions, competitors , prices and profit maximisation.
125
Price skimming:
This technique use to achieve high profits in the early life cycle of the
product. This is done by charging a high price on entry to the market and
increase the demand throygh advertising and promotion.
Customers are preapare to pay high prices in order to gain the perceived
status of owning the product early. This would enable the company to take
advantage of the unique nature of product. Thus maximizing the sales
through those customers who like to have the latest technology as early as
possible.
The most suitable condition for this strategy are:
 The product is new and different
 The product has short life cycle and high development cost which need to
recover quickly
 The strength and sensitivity of demand is unknown.
At the later stage of the product life cycle the prices of the product reduce to
get the maximum profit from it. The examples are mobile phone.
126
Price penetration:
It is the term use to describe a policy in which the initial price is set at a lower level
to build a strong market share, and is more likely to be successful when demand is
elastic. The price will make the product accessiable to a large number of buyers and
therefore the high volumes will compensate the lower prices being charged.
Product line Pricing:
Product line is a range of products that are intended to meet similar needs of
different target audiences. The products within the product line are related but
May vary in style, colour and quality.
Product line pricing works by:
1. Making the price entry point for the basic product relatively cheap.
2. Pricing other items in the range more highly.
127
An example of this will be a dinner set where serving plates are priced relatively
cheap but other, less essential matching items in the same range example fish
bowls are priced higher.
Customers will be prepared to pay a relatively high price for the less essential
items in order to build up a matching set.
Volume discounting:
Customers are offered a lower price per unit if they purchase a particular
quantity of products. There may be be two types of products:
Quality 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.
128
Volume Discounting:
Volume discounting applied to products with limited life such as fashion products
and also to clear unpopular products.
Price discrimination:
This is occurs when company sells same product at different prices at different
locations.
This is possible when:
1. When seller can determine the price
2. Customer can be segregated to different markets.
3. Customers can not buy at the lower price in one market and sell at higher
price in other market
Relevant costing:
In short term decision making, the incremental cost of accepting an order should
be presented. Bids should then be made at prices that exceed incremental cost
In short term decision making many costs are fixed and irrelevant.
129
In short term decision making company should meet the following conditions:
1. Spare capacity should be available for all of the resources that are required
to fulfill an order.
2. The bid price should represent a one off price that will not be repeatedfor
future orders
3. The order will utilize unused capacity for only short period and capacity will
be released for use on more profitable opportunities.
130
Risk and Uncertainty
Risk:
Risk refers to a situation where probabilities can be assigned to a range of expected outcomes arising from an
investment project and the likelihood of each outcome occurring can therefore be quantified.
For example based on past experience management estimate it has 70% chances to win contract
Uncertainty:
Uncertainty refers to a situation where probabilities can not assigned to expected outcomes. Investment
project risk therefore increases with increasing project life for example it is difficult to assign probabilities to a
new product entering into new market.
Research techniques to reduce uncertainty:
Market research:
Market research assess and reduce uncertainty about the likely responses of customers about new product
which includes advertising campaigns, pricing of product
There are two types of research:
- Desk based research
- Field based research
Desk based research:
It is less costly but it can be lack of focus. It is obtained from secondary sources of information such as magzines, websites,
other published sources and other available sources of information.
Field based research:
It is a approach by direct contact and with a targeted group of potential customers. It targets your potential customers and
product area. However it is much expensive. But internet bringing down costs as companies use to gather information through
emails by offering free gifts etc.
Field based research can be either:
- Motivational
- Measurement
Motivational research:
The objective is to undo the factors why customers do or do not buy particular products. Depth and group interviewing
techniques are involved in motivational research.
Measurement research:
The objective is to build on motivation research by trying to quantify the issues involved. Sample surveys are used to find out
how may people buy the product, in what quantity and from where ?
Focus groups:
Focus group are form of market research. They are small groups( typically eight to ten personal) selected from a broader
population who are interview through informal gathering (environment) they are questioned to gather opinion on particular
subjects or marketing opinion which is also known as test concepts
This focus group can provide researchers much more helpful information, however it is difficult to measure the results objectively
and also its cost is to high for small companies
Simulations:
Simulations is a modeling technique use in capital inesment appraisal decisions. Computer models can be build to to simulate
real life scenarios. This models will predict what range of returns an investor could expect from given decision.
The models use random number tables to generate possible values for the uncertainty the business is subject to. Since the time
and costs involved can be more then benefits gained, Computer technology helping to reduce the costs of such risk anaylsis,
however models can become more complex and probability distributions may be difficult to formulate.
Expected Values:
The expected value rule calculates the average return that will be made if a decision is repeated again and again. It does this
weighting each of these possible outcomes with their relative probability of outcomes
The likelihood that an event will occur is known as its probability. This is normally expressed in decimal form with value
between O and 1.
A value of 0 denotes a nil likelihood of occurrence where as a value of 1 signifies absolute certainty. A probability of 0.5 means
the event is expected to occur 5 times out of 10.
The total of the probabilities for the events that can possibly occur must sum up to 1.0.
An expected value is computed by multiplying the value of each possible outcome by the probability of that outcome and
summing the results.
EV = px
P = probability of outcome
X = the possible outcome
Example:
Economic state
Good
Average
Poor
Probability
0.35
0.50
0.40
Expected Value = Px
Good
Average
Poor
Project A
$175000
$70000
$(15000)
Project B
$85000
$80000
$(5000)
Project A
Project B
(175000 x .35) (85000 x .35)
61250
29750
(70000 x .50)
( 80000 x .50)
35000
40000
( (15000) x .40)
( (5000) x .40)
(6000)
(2000)
_____________ ______________
90250
67750
______________ _______________
Project C should be chosen as its maximize the EV returns
Project C
$75000
$90000
$60000
Project C
(75000 x .35)
26250
( 90000 x .50)
45000
60000 x .40
24000
__________
95250
___________
Advantages and Disadvantages of Expected Values
Advantages:
1. Calculations are simple
2. Its take risk into account by considering the probability of each possible outcome and using this information to calculate an
expected value
Disadvantages:
1. The probabilities used are usually are very subjective
2. The expected value may not correspond to any of the actual outcome.
3. The expected value is weighted average therefore has little meaning for one off project.
Limitations:
1.
2.
3.
4.
The expected value is the weighted average of the probability distribution. Its never actually occur
It ignores the risk and investors attitude towards the risk
Forecasts may be inaccurate and probabilities used are also subjective
Expected values are more valuable as guide to decision making where they refer to outcomes which will occur many times
over. For example how many customers will buy particular product per day.
Sensitivity Analysis:
Sensitivity analysis can be used to assess the range of values that would still give the investor a positive return it is a technique
like what if ? Scenario. The uncertainty may still be there but the effect it has on the investors return will be well understood.
Sensitivity analysis calculates the % change required in individual values before a change of decision results. If only a say 2%
change is required in selling price before losses result, an investor may think twice before proceedings.
Sensitivity Analysis assess how the how the net present value of an project is affected by changes in project variables.
Considering each project variable in turn, the change in the variable required to make the net present value determined is zero,
or alternatively the change in present value arising from a fixed change in the given project variable in this way the key or
critical project variables are determined.
However sensitivity analysis does not assess the probability of changes in project variables and so is often dismissed as a way of
incorporating risk into the investment appraisal process.
Example:
Following are the two possible outcomes for a process:
Probability
0.3
0.7
Outcome
Loss of $10000
Profit of $50000
Answer:
EV = Px
Outcome
(10000)
50000
Probability
0.3
0.7
Should the process be undertaken?
Yes it has positive expected value
Px
(3000)
35000
_______
33000
________
Risk attitude by Individuals:
Different Individuals have different attitudes towards risk. And they respond to Risky situations according to their attitudes.
There are three types of risk attitudes which individuals have.
Which are as follows:
1. Risk seeker
2. Risk neutral
3. Risk averse
Risk Seeker:
A risk seeker is one who will choose more risky option between riskier option and less riskier option.
Risk Averse:
Risk averse is one who will choose less risky option between Riskier option and less risky option.
Risk Neutral:
Risk neutral is indifferent to risk seeker and risk averse, as he will be settle for average that is not too much risky option or not
too less risky option.
Maximax:
The maximax rules applies to risk seeker who seeks to maximize the maximum possible gain of possible outcomes.
Maximin:
The maximin looks at the worst possible outcome at each activity level and then select the highest one of those. The decision
maker therefore chooses the outcome which is guaranteed to minimize his her losses.
Minimax regret rule:
The minimax regret strategy minimizes the maximum regret. Therefore regret means the opportunity loss from having made a
wrong decision.
Value of perfect and Imperfect Competition:
When a decision maker is faced with series of uncertain events that might occur, he or she should consider possibility of
getting additional information about which event is likely to occur.
Perfect information:
Perfect information is available when 100% accurate prediction can be made about the future.
Imperfect Information:
The concept of perfect competition is near to un achievable in real world. For example future is almost 80 to 90% is achievable,
therefore the value of imperfect competition is less then perfect competition is less then perfect competition unless both are
zero.
The approach to calculate the perfect and imperfect information is to compute expected values for the both and then compare
the information. The difference represents the extra amount which is worth paying for the extra information.
Decision tree:
It is a useful analytical tool for clarifying the range of alternative course of action and there possible outcome is decision tree. A
decision tree is a diagram showing several possible courses of action and possible events and the potential outcomes for each
course of action.
For example whether to expand business or not.
There are two stages to make decisions using decision tree:
1. The decision tree is drawn and all probabilities also outcome values are included.
2. All expected values are calculated at all outcome points and these are used to make decisions. A course of action is then
recommended.
Constructing a decision tree:
Draw the tree from left to right, showing appropriate decisions and events or outcomes.
A square is used to represent a decision point that is where a choice between different courses of action must be taken.
A circle is used to represent chance/ outcome point. Outcomes are not within your control. They depend on external
environment for examples economy, suppliers and customers.
Each alternative course of action is represent by branch. The branches have probabilities attached to them
All decision tress must start with a square representing a decision.
There are two branches of decision point. The outcome for one of these choices is known as top branch is certain. However
the lower branch shows that there are two possible outcomes. There are two more sets of outcomes for these essential
outcomes.
Once the tree has been drawn label the tree and relevant cash inflows and outflows and probabilities associated with
outcomes. Probabilities will add up to 1% to 100 %.
Evaluation of decision:
Evaluate the decision from right to left. It means the opposite direction when the tree was made.
- Calculate an EV at each outcome point by applying probabilities to the cashflows
- Choose the best point at each point
Finally a recommendation should be made to management based on the option that gives the highest expected value.
Remember that expected values give us a long run average of the outcome which is expected only if a decision is to be
repeated many times.
Since this is one of decision this technique is not very accurate. Also expected values assume that the investor is risk neural,
there this may not be accurate if the attitude to risk is unknown.
Budgeting and Standard costing
Standard cost:
A standard cost is predetermined estimated unit cost of product or service. The standard cost has number of uses which are
as follows
1. It is used to value inventories and production cost for cost accounting
2. It is useful for planning, control and motivation
3. It acts as control activity by establishing standards management can highlight those activities which are not working to the
plan and then can take corrective action to improve those activities.
Types and methods of standard costs:
A standard cost is based on technical specifications for material, labour and other resources required and the rates for
material and labour
A standard cost shows the full details of each product
Standard cost card
$
Direct material X kgs/ltrs
Direct labour x hrs x $ xx
Direct expenses
Standard direct cost ( prime cost)
Variable production overhead
Standard variable cost of production
Fixed production overhead
Standard full production cost
Administration & marketing overhead
Standard cost of sale
Standard profit
Standard sale price
$
X
X
X
_____
XX
xx
______
X
X
________
X
X
_________
X
x
_________
X
__________
There are four types of cost standards:
Basic Standards:
These are long term standards which remain unchanged for number of years. They are used to show trends over time. With the
passage of time basic standards increasingly becomes easy to achieve and these standards may have negative impact on
employees motivation.
Ideal standards:
These standards are based on perfect operating conditions, therefore these standards does not include any wastage , scrap ,
machine breakdowns etc. they are based on perfect conditions. Such standards are not achievable in any situation therefore
they are not acceptable by the employees as these standards are unlikely to achievable
Attainable standards:
These standards are not based on perfect conditions but they are efficient. These standards includes allownces for wastage,
scrape, machine breakdown etc. As these standards are achievable though these are acceptable for employees
Current standards:
These standards are based on current level of efficiency and incorporate current levels of wastageinefficiency, machine
breakdown etc. here they will not get any incentive to current level of performance. Current standards are usefull during period
of high inflation.
Flexible budget:
Flexible budget is a budget which by recognising different cost behaviour patterns is designed to change as volume of activity
changes.
Flexed budget:
A flexed budget is a budget prepared to show the revenues, costs and profits that should have been expected from the actual
level of production and sales
Budgetary control:
Budgetary control involves drawing up budgets for the areas of responsibility for individual managers and of regularly
comparing actual results against expected results. The difference between actual results and expected results are called
variances and these are used to provide a guideline for control action by individual managers.
Principle of controllability:
A principle of controllability is that managers are held responsible for costs over which they have some influence. Where
budgetary control is based around a system of budget centres. Each budget centre will have its own budget and manager will
be responsible for managing the budget centre and ensuring that the budget is met.
Responsibility accounting:
It is a system of accounting that segregates revenue and income of into areas of personal responsibility in order to monitor
and assess the performance of each part of an organisation.
Responsibility accounting attempts to associate revenue, costs, assets and liabilities with tha managers most capable of them as
a system of accounting it differentiate between controlling and non controllable cost
Some costs are uncontrollable for example expenditures due to inflation while other costs are controllable one but in long term
and not in short term for example production cost might be reduce by bringing new machinery or IT system into the system.
Managers are responsible for those cost on which they have some influence they cant be held responsible for those costs which
are uncontrollable
Example:
Prepare a budget for 2010 for the direct labour cost and overhead expenses of a production department flexed at the activity
levels of 80% 90% and 100% using the information listed below
1. 100% activity represents 60000 direct labour hours.
2. The direct labour hourly rate is expected to be $3.75
3. Variable costs
indirect labour $0.75 per indirect labour hour
consumable supplies $0.375 per direct labour hour
canteen and other welfare services 6% of direct and indirect labour cost
4. Semi variable cost are expected to relate to direct labour hours in the same way as for the last five years
year
2001
2002
2003
2004
2005
5. Fixed costs
Depreciation
Maintenance
Insurance
Rates
Management salaries
direct labour hour
semi variable cost
64000
59000
53000
49000
40000 (estimate)
20800
19800
18600
17800
16000 (estimate)
$
18000
10000
4000
15000
25000
6. Inflation to be ignored.
Calculate the budgeted allowance (expected expenditure) for 2010 assuming 57000 labour hours are worked.
Answer
a.
Direct labour
Other variable cost
Indirect labour
consumable supplies
Canteen etc
Total variable cost
Semi variable costs (w)
Fixed costs
Depreciation
Maintenance
Insurance
Rates
Management salaries
Budgeted costs
80% level
48000 hrs
‘000
180
36
18
12.96
________
246.96
17.60
90% level
54000 hrs
‘000
202.5
100%level
60000 hrs
‘000
225
40.5
20.25
14.58
________
277.83
18.80
18
10
4
15
25
_______
18
10
4
15
25
________
336.56
_________
368.63
____________
45
22.5
16.2
_______
308.7
20.0
18
10
4
15
25
_____
400.7
________
Sing the high low method
Total cost of 64000 hours
Total cost of 40000 hours
20800$
16000
_______
4800
________
Variable cost per hour $4800/24000 = $0.20
Total cost of 64000 hours
Variable cost of 64000 hours
Fixed cost
$
20800
12800
_______
8000
_______
Semi variable cost calculated as follows:
60000 hrs
54000 hrs
48000 hrs
(60000 x $0.20) + 8000 = $20000
(54000 x $0.20) + 8000 = $18800
(48000 x $0.20) + 8000 = $17600
b. The budgeted allowance for 57000 hours would be as follows:
variable cost (57000 x $5.145)
Semi variable cost (8000 + (57000 x $0.20)
Fixed cost
293265
19400
72000
________
384665
__________
Budgeting
Budget is a quantitate detailed plan prepared for a specific time period it is normally prepared in financial terms and prepare for
one year.
Forecast:
Forecasting is the technique to used to arrive at estimate based on judgment and experience
Objectives of budgeting:
Following are the objectives of the budgeting:
Planning:
One of the key purpose of the budgeting is to require planning to occur so that organization achieve its objective
Communication:
The budgeting system help to communicate between the organization both vertically for example between senior and junior
managers and horizontally for example different organization functions
Co ordination:
Budgeting is the method of bringing together the method of activities of all the different departments into one plan. If an
Advertisement is due to take place in a company in few months time, here it is important that production department knows
about the expected increase in sales so that they can increase the production accordingly.
Control:
One of the most important purpose of budgeting system is to control the performance through the budgeted cost and actual
cost. Variances between budgeted and actual cost can be investigated in order to determine the reason why actual
performance has differed from the plan
Motivation:
The budgeting system can influence the behavior of managers and employees, and may motivate them to improve the
performance if the target represented by the budget is reality based.
Appraisal:
Managerial performance is evaluated by the budgetary targets for which individual managers are responsible have been
achieved. Managerial rewards such as bonuses or performance related pay can also be linked to achievement of budgetary
targets.
Below you can see the planning and control cycle diagram:
Set mission
Identify objectives
Identify alternative course of
action
Long term
planning process
Gather data about alternative
Select course of action
Budget process
Implement long term plan in
form of budget
Monitor actual results
Respond to divergence
from plan
Stage 1 Set Mission:
it includes the overall objectives and goals of the organization. The mission of the organization can be both economic and
social. Mostly organization prepares and publish mission in mission statement.
Mission statement include the following information:
 Purpose and aims of the organization
 The information about organisation’s primary stakeholders, clients, customers, shareholders etc
 How organisation provide value to their stakeholders for example by providing various types of products and services
Stage 2 Identify objectives:
It requires company to specify objectives towards which it is working. The objectives chosen must be quantified and have a
time scale attached to them. Objectives should be smart:
o
o
o
o
o
Specific
Measureable
Achievable
Relevant
Timely
Stage 3 Possible courses of action:
A series of specific strategies should be developed. Strategy is the course of the action, including the specification of resources
required, that the company will adopt to achieve its specific objective.
To formulate its strategies, the firm will consider the products it makes and the market it serves. Following are the example of
strategies:
o Developimh new markets for existing products
o Developing new products for existing markets
o Developing new products for new markets.
Stage 4 is gathering data about alternatives and measuring pay offs
Stage 5: Select course of action
Having made decisions, long term plans based on those decisions are created.
Stage 6 implementation of short term plans:
It shows the move from long term plan to short term plan that is annual budget. The budget provides the link between the
strategic plans and their implementation in management decisions.
Stage 7 monitor actual outcome:
Budgets are compared with actual performance which is also known as variance analysis.
Stage 8: Divergences from Plan:
It is control process in the budgeting, responding to divergence from plan either through budget modifications or through
identifying new courses of action.
Budgetary systems within the performance hierarchy:
Budgets provide benchmarks against which to compare actual results. Therefore company needs the variance analysis to
develop correct measures. However budgets need to be flexible to meet the changing needs of the organisation.
The performance hierarchy:
Strategic
planning
Tactical planning
Operational planning
Strategic planning:
Senior management formulate the plan for long term for example 5 to 10 years plans, what products to introduce in the long
term, which markets to target, business capitals etc.
Tactical planning:
Senior management make mid level more detail plans for the upcoming year for example they has to decide how they has to
utilize the resources and to monitor how those resources will be utilized. For example how much units to produce and how
much raw material will be required. How much men source will be required and what skills set will be required etc.
Operational Planning:
All managers are involved in making day to day decisions front line managers such as clerks has to make sure that certain tasks
has been carried out properly within a factory or office.
Operational information mostly gathered from internal sources. It is prepare frequently and it is highly detailed. If managers
meets operational plans it is likely that they will meet tactical plan and strategic plans as well.
How are planning and control inter related?
Control involves measuring actual results and comparing them with the original plan any deviation from the plan require
control action to make the results conform with the plan.
Behavioral aspects in budgeting:
The purpose of the budgetary control system is to assist the management in planning and controlling the resources of their
organization by providing appropriate control information. The information will be valuable if the information is correct and it
is used by the user purposefully. That means the usage of information is equally important as correct information.
Goal congruence:
It means managers are working in their best interest as well as in the best interest of the organization.
Following are the behavioral problems which can arise:
1. The personal who set the budgets are often different then those who are responsible to achieve those budgets
2. The goals of the organization as a whole as expressed in a budget may not concede with the personal aspirations of the
managers. This is known as dysfunctional behavior.
3. At the time of setting the budget there may be budgetary slack or bias. Budget slack is a deliberate over estimation of
expenditure and or under estimation of revenues in the budgeting process. This results in meaning less variances and a
budget which has no use for control purposes. It may also lead to the misallocation of resources.
Participation in settings of budget:
Participation in the process of budget setting will motivate the personal of the organisation and therefore will improve the
quality of the budget as well.
However this may be time consuming and may result in a wide range of targets which may seen as unfair.
There are two ways in which budget can be set:
- top down budget (imposed budget)
- Bottom up budget ( participatory budget)
Top down budget:
This budget is also known as authoritive budget as top management imposed the budget on the management without allowing
them to participate in the process of budget setting.
Advantages:
1.Budgets will be in line with corporate objectives
2. Budgetary slack reduced
3. Decisions taken by experiences managers
4. Top down budgets can set a tone for the organization. They signal expected sale and production activity that the organisation
supposed to reach.
Disadvantages:
1. Such budgets are sometimes ethical challenges, as lower level may find themselves in a position where it seems to achieve
those targets unrealistic.
2. Lower level may find the budgets dictatorial.
Bottom up budget:
This budgets are also known as participative budget as here budget holders have the opportunity to participate in the setting of
their own budgets. All levels of organisations asked to submit their level of expenditure for the upcoming year. Where as senior
level makes the forecast for the income of upcoming year. There may be a negative variance between the forecast of income
and departments budget which will be resolve by them through discussions.
Advantages:
1.
2.
3.
4.
It will increase the employees motivation.
Budgets prepared by those who has better knowledge of their areas
There will be better communication and co ordination between the departments
It increases manager commitment and understanding
Disadvantages:
1. It is more time consuming and expensive to develop and administrate.
2. Budgets may not be in line with corporate objectives
3. Disagreement may occur between the staff involved which may cause dissatisfaction and delays
4. Some managers may try to manipulate their budgets to giving them more roam to for mistakes and inefficiency
5. Decisions made by inexperienced managers.
Budgeting in Public sector vs private organisation:
In public sector organizations the objectives are difficult to define in quantifiable way then the objectives of private sector
organisation for example in private sector the objectives are to maximize profit which can be set out in budgets by increase in
the % of sales and cutting various types of costs.
On the other hand if the public sector organization is school then the objectives may be largely qualitative for example
ensuring mostly students perform well in their academics and other activities or in hospitals patients get appointments with
in few weeks and get cure from deceases. This is difficult to define in quantifiable way.
Just as objectives are define in quantifiable way in same way organizations output. In private sector the out put can be
measured in terms of increase or decrease in sales revenue but in school or difficult it is difficult to define output in a
quantifiable way. What is easier to compare is how much cash is available and how much more cash is needed therefore
budgeting focuses on inputs alone rather then the relationship between input and output.
Also public sector organizations are always under pressure to show that they are offering goods value for money that is
economical, efficient and effective. Therefore, they need to achieve output with the minimum use of resources which makes
budgeting process more difficult.
Types of budgets:
There are various types of budgets which are as follows:
Rolling Budget:
A rolling budget also known as continuous budget, Here portion of budget is replaced on regular basis so that the overall
budget period remains unchanged for example with a budget period of one year at the end of each quarter a new quarter
could be added to the end of the budget period and the elapsed quarter could be deleted, so that the budget will always be
looking at one year ahead.
A cash budget is often a rolling budget because of the need to keep tight control of this area of financial management. A rolling
budget is often supported by affordable and and powerful processing via personal computers and computer networks.
Advantages:
1. Realistic budgets are likely to have better motivational influence on managers
2. Planning and control are based on recent plans which is likely to be far more realistic than a fixed annual budget made
many months ago.
3. There is always a budget which extends for several months ahead. For example if rolling budgets are prepared quarterly
there will budget extending for next 9 to 12 months. This is not the case when fixed annual budgets are used.
4. They force managers to assess budgets regularly and to produce budgets which are upto date in the light of current events
and expectations.
5. It reduce the element of uncertainty in budgeting because they concentrate detailed planning and control on short term
prospects where the degree of uncertainty is much smaller.
Disadvantages:
1. They involve more time, effort and money in budget preparation
2. Revisions in budgets might include revision in standard cost too which in turn would involve revisions to stock valuations.
This could replace a large administrative effort from the accounts department every time a rolling budget is prepared.
3. Frequent budget preparation might have an off putting effect on managers who doubt the value of preparing one budget
after another at regular intervals.
Incremental Budgeting:
Incremental budgeting is a process where current year budget is set by the reference of last year’s actual results after an
adjustment for inflation and other incremental factors.
Advantages:
1.
2.
3.
4.
5.
The impact of change can be seen quickly
Prevents conflict between departmental managers since a consistent approach is adapted throughout the operation
It is easy and quicker to make. Since it is easy to make it can be allocated to junior staff
Less preparation leads to lower preparation cost
It is easy to understand.
Disadvantages:
1. It is not appropriate in rapidly changing environment
2. Assessing the amount of increment can be difficult to assess
3. It builds on wasteful spending. If the actual figures for this year include overspends caused by some form of error then the
budget for next year would potentially include this overspend again.
4. It encourages organizations to spend up to the maximum allowed/encourage slack in the knowledge if they don’t do this
then they will not have as much to spend in the following year’s budget.
5. It can ignore the true activity based drivers of a cost leading to poor budgeting.
Activity based Budget:
Activity based budgeting would need a detailed analysis of costs and cost drivers so as to determine which cost driver and cost
pools were to be used in the activity based costing system. However, where as activity based costing uses activity based
recovery rates to assign costs to cost objects, ABB begins with budgeted cost objects, ABB begins with budgeted cost objects
and works back to the resources needed to achieve the budget.
The budgeted activity levels are determined in the same way as for conventional budgeting that a sales budget and a
production budget are drawn up. ABB then determines the quantity of activity based drivers for example number of purchase
orders , number of set ups, needed to support the planned sales and production. Standard cost data would be compiled that
include the details of activity cost drivers required to produce a product or number of products.
The resources needed to support the budgeted quantity of cost drivers would then be determined for example number of labor
hours to process purchase orders, number of maintenance hours need to complete the set ups. This resource would then be
matched with the available capacity. That is number of purchase clerks to see whether any adjustment were needed
Advantages:
1. It provides useful basis for monitoring and controlling overhead costs by drawing management attention to actual cost of
the activities and comparing actual costs with what the activities were expected to cost
2. It avoid slack that is often linked to incremental budgeting due to its details assessment of the activities and resources
needed to support planed sales and production.
3. In ABB cost of support activities are not seen as fixed to be increased by annual increments but as depending to a large
extent on the planned level of activity.
4. Organizational resources are allocated more efficiently due to the detailed cost and the activity information obtained by
implementing an ABB system.
Disadvantages:
1. ABB might not be appropriate for the organization and its activities and cost structures
2. A budget should be prepared on the basis of responsibility centers, with identifiable budget holders made responsible for
the performance of their budget center. A problem with ABB could be to identify clear individual responsibilities for
activities.
3. A considerable amount of time and effort might be needed to establish an ABB system, for example to identify the key
activities and their cost drivers.
4. It could be argued that in the short term many overhead costs are not controllable and do not vary directly with changes in
the volume of activity for the cost driver. The only cost variance to report would be fixed overhead expenditure
Zero based budgeting:
Zero budgeting requires to make budget for every activity from the scratch as part of budget process so that each activity and
each level of activity can justify its consumption of the economic resource available.
Zero based budgeting prevents the carrying forward of past efficiencies that can be a feature of incremental budgeting and
focus on activities rather than departments or programs.
Each activity is though treated as though it was being undertaken for the first time and is required to justify its inclusion in the
budget in terms of the benefit expected to be derived from its adoption.
Zero based budgeting steps:
Zero based budgeting includes three steps which are as follows:
1.
o
o
o
Activities are identified by managers. These activities are then described in decision package. Decision package includes:
analyses the cost of activity
States its purpose
Identifies the alternative method of achieving the same purpose
o Establishes performance measure for the activity
o Assesses the consequences of not performing the activity at all or of performing it at all or of performing it at different
activity level
This decision package is prepared at the base level, representing the minimum level of service or support needed to achieve
the organization objectives. Further incremental packages may then be prepared to reflect a higher level of service or support
2. Management will then rank all the packages in the order of decreasing benefits to the organization. This will help
management decide what to spend and where to spend it.
3. The resources are then allocated based on priority up to the spending level.
Advantages:
1.
2.
3.
4.
5.
It eliminates the inefficiencies that can arise with incremental budgeting
It raise a questioning attitude towards current activities rather then just accepting the status quo
It leads to more efficient allocation of resources
It focusses attention on the need to obtain value for money from the consumption of organizational resources
All of the organization activities and operations are reviewed in depth.
Disadvantages:
1. In large organizations there are large number of activities, in these circumstances lot of paper work could be um
manageable
2. Since decisions are made at the budget time, managers may feel unable to react to changes that occur during the year. This
could have a detrimental effect on the business if it fails to react to emerging opportunities and threats.
3.The process of identifying decision packages determine their purpose costs and benefits is time consuming and costly
Beyond Budgeting- principles for adaptive management:
Process principles:
Goals:
Set aspirational goals aimed at continuous improvement not fixed annual targets
Rewards:
Reward share success based on relative performance, not on meeting fixed annual targets.
Planning:
Make planning a continuous and inclusive process. It should not be annual event
Controls:
Base controls on relative key performance indicators and performance trends not variance against a plan
Resources:
Make resources available as needed not as per annual budget allocation.
Co ordination:
Co ordinate cross company interactions dynamically not through annual planning cycles
Leadership:
Customer:
Focus everyone on customer outcome not on meeting internal targets
Accountability:
Create a network of team accountable for results not centralized hierarchies
Performance:
Champion success as winning in the market place not on meeting annual targets
Freedom to act:
Give teams freedom and capability to act.
Governance:
Base governance on clear values and boundaries not detailed rules and budgets
Information:
Promote open and shared information don’t restrict it those who need to know.
Advantages:
1. It empowers manager to act by removing resource constraints, key ratios are set, rather than detailed line by line budgets.
2. It motivates people by giving them challenges. Responsibilities and clear value as guidelines. Rewards are team based this
uses the know-how of individual and teams interfering the customer, which in turn enables a far more adaption to
changing market needs
3. It establishes customer oriented teams that are accountable for profitable customer outcomes.
4. Goals are agreed via reference to external benchmarks as opposed to internally negotiated fixed targets. Managerial focus
shift from beating managers for a slice of resources beating the competition.
Problems of adapting beyond budgeting:
1. Managers should be clear what the expectations are and what they have to do they will need to be challenged and
motivated
2. There is no simple method of beyond budgeting it will depend on each company’s culture , structure, IT Infrastructure etc
Master Budget:
The master budget is the summary of all budgets which comprises of budgeted income statement , budgeted statement of
financial position and budgeted cash flow statement
In master budget it is assumed that the level of demand is principal budget factor. The various functional department and
master budgets will be drawn up in following order.
Functional budget:
Functional budget are prepare and consolidate to produce the master budget. This would include raw materials budget, raw
material usage, sales budget, production budget purchase budget.
Fixed budget:
A fixed budget is suitable for those organisations who operates in a stable environment. It is relatively stable and can be
predicted with a reasonable degree of certainity.
It is a budget which prepared in advance not changed or amended as the budget period processes. This budget represents a
periodic approach to budgeting, since a new budget is prepared toward the end of the budget period for the subsequent
budget period. In this way organisation can set a new budget on annual basis.
Flexible Budget:
A flexible budget is a budget which by recognizing different cost behavior patterns, is designed to change as volume of output
change.
Budget systems and sources of information needed:
Past data can be used as a starting point to produce a budget. However, variety of other sources can be used to produce a
budget. Each department of the organisation required to produce the budget
Following are the sources for the information of budgeting are as follows:
1.
2.
3.
4.
5.
Last year actual results
Other internal sources
Long term requirements of customers
External information such as estimate in increase in inflation, changes in exchange rates, suppliers price list etc
Estimate of cost of new product and services.
Difficulties of changing budgetary system:
Management accounting experts argued that traditional accounting budgets are to rigid and prevent fast changes
However organisations intent to change their budgetary systems can face various difficulties while changing the budgetary
system, therefore need to implement changes carefully.
Training:
In order to implement new systems. Training needed to provided to employees which can be time consuming and expensive
Lack of accounting system:
The organization may not have the system in place to obtain and analyze the system in place.
Resistance by employees:
Employees are familiar with old system and also may have built In slack in it therefore they may not accept new system easily.
Cost of implantation:
Any new system or process require careful implementation which will have cost implication
Loss of control:
Senior management may take take time to adapt new system and to understand implication of results.
How budgets can deal with the uncertainty in environment?
Uncertainty arises because of changes in external environment over which a company will will sometimes have little control.
Following are the causes of uncertainty in budgeting process:
1.
2.
3.
4.
5.
6.
Customers may decides less or more than the forecast
There can be natural disasters, transport strikes or terrorism activity which can disturb the productivity.
Employees may not work then expected or they may work more harder then expected
Machines break down un expectedly.
Inflation and movement in interest and exchange rates in inflation
Volatility in cost of materials.
Feedback:
It occurs when output of the a system are used to control it. By adjusting the input or behavior of the system. It is a information
produced from the output from operations which is use to compare actual results with planned results for control purposes..
Negative feedback:
It indicates that results or activities must be brought back on course as they are deviating from the plan.
Positive feedback:
Results in control action continuing the current course
Feed forward control:
It is control based on forecast results in other words , here if forecast is bad , actions will be taken in advance to control the
results.
There are two types of feedback which are as follows:
Single loop feedback:
It is a control which regulates the control of a system for example if sales budget is not reached control action will be taken to
ensure target will be reached soon.
Double Loop Feedback:
It is a information to change for example if target not reach the company would change the plan it self.
Quantitative Analysis in budgeting
This chapter will look at the various quantitative techniques:
- The high low method
- The least square regression
- Learning curves
There are two methods which analyse semi variable cost in fixed and variable element
High low method
Least square regression ( Good news it is not examine directly in f5 from 2013 onwards)
High low method:
1. Review records of costs in previous period
- Select the period with highest activity level
- Select the period with lowest activity level
2. Find the variable cost per unit
Total cost at high activity level – total cost at low activity level
__________________________________________________
Total unit at high activity level – total unit at low activity level
3. Find the fix cost
Total cost at high activity level –( total units at high activity level x variable cost per unit)
Advantages:
1. It is easy to understand
2. It is easy to use
3. It is a quick method
Limitations
1. Bulk discounts may be available at large quantities
2. It assumes activity level is the only factor which influence the costs
3. It uses two values to predict costs. Values between highest and lowest are ignored
4.It relay on historical data. Predictions of future cost may not be reliable.
Example:
Qalandar company is a large organization wishes to develop a method of predicting its total cost in a period and following
costs have been recorded:
Month
January
February
March
April
May
June
activity level
1600
2300
1900
1800
1500
1700
cost
$
28200
29600
28800
28600
28000
28400
Answer:
Highest activity level in February and lowest activity level in may
total cost at highest activity level
Total cost at lowest activity level
Total units at highest activity level
Total units at lowest activity level
29600
28000
2300
1500
Variable cost per unit 29600 – 28000
_____________
2300 – 1500
Fix cost = 29600 – (2300 x 2)= 25000
Total cost = 25000 +2x
Where x is the volume of activity in units.
= 1600
_____
800
= $2
Learning Curve theory:
Learning curved theory is concerned with the idea when new job process or activity processes for the first time the workforce
involved will not do the work effectively and efficiently. However repetition of the task will boost the confident and knowledge
of the people involve in the work and these will help them boost their confidence and knowledge and eventually it will bring
effectiness and efficiency in the work. Though at one stage learning curve will stop at one stage and after that it will be at one
pace known as stady pace. In a result the time to complete the task will decline first and then stablise one once efficient
working is achieved.
The cumulative average time per unit is assumed to decrease by a constant every time that output doubles. Cumlative average
time refers to the average time per unit for all units produced so far and including the first one made,
The following is an example of 80% learning curve the cumulative average time of per unit of output is decrease to 80% of the
previous cumulative average time when output is doubled
When output is low learning curve is really steep but the curve becomes flatter as cumulative output increases with the curve
eventually becoming a straight line when the learning effects end.
40
Average time (hours)
30
20
80% learning curve
10
60
120
Cumulative quantity
180
240
The learning curve can be calculated by:
1. Reducing cumulative average time or average cost per unit or per batch to pproduce c units
2. Use the formula
Y = axb
Where:
Y = cumulative average time or average cost per unit or per batch to produce x units
A = time taken for first unit or first batch
B = log r/ log 2 ( r = index of learning, expressed as decimal)
X = cumulative output in units or in batches
Application of learning curve theory:
1.
2.
3.
4.
The activity is labour intensive
There should be repetitive process of each unit
There should be low turnover rate
There should no long breaks in production
The cessation of learning curve:
The learning curve will apply to certain range and after that there will be no reduction in time of production. This is when
production will reach to steady phase of production and this will become the basis on which budget is produced.
The steady phase will reach when:
1. When labour has reached to their maximum efficiency
2. Some processes can not be speed up any more
3. Machines have reached to the limit of their maximum speed
The importance of learning curve effect:
Learning curve models enables users to predict how long it will take to complete future task. Therefore management
accountant should take into account the learning rate when they are carrying out planning, control or decision making. If they
fail to do so they may has to face serious consequences.
For example company is making new product and they wants to make its price as attractive to customers as much possible and
the same time they want to make profits from it. The first unit of that product will take one hour to complete and labour cost is
$15 per hour and other costs total is $45 and product is introduce into the market for the price of $65. so here we can see that
learning effect of the labour has been ignored and the correct labour time per unit for each product is 0.5 hours and obviously
here the price is too high and it may be possible that product may failed at its launch.
Now the question is why learning curve is important in planning and control? If we have to use standard costing then it is
important that standard cost provide accurate basis for the computation of variances. If standard costs have been calculated
without taking account of learning curve then all the labour usage variance will be favourable because the standard labour
hours on which they are based will be too high. This will make their use for control purpses is pointless.
Example:
Where an 80% learning effect, the cumulative average time required per unit of output is reduced to 80% of the previous
cumulative average time when output is doubled.
The first unit of output of new product requires 100 hours. An 80% learning curve applies. The production time would be as
follows:
Cumulative number of units
1
2
4
8
cumulative avg time per unit
100
80
64
51.2
incremental number of units
1
2
4
incremental
total time (hrs)
60
96
153.6
Out is double each time
Note:
The cost of the additional time can be calculated by applying the labout hour rate to the number of labour hours and variable
overhead rate, where variable overhead vary with the number of labour hours
The learning effect can not effect the material cost
Zalmi sports has designed a new type of cricket bats., for which cost of the new bat to be produced has been calculated as
follows:
Material
Labour( 800 hrs x 5 per hour)
Overhead (150% of labour cost)
Profit markup 20%
Selling price
$
5000
4000
6000
_________
15000
3000
_________
18000
__________
It is plan to sell all the bats at full cost plus 20%. An 80% learning curve is expected to aply to the production work. The
management accountant has been asked to provide cost information so that decision can be made so that decisions can be
made what price to charge.
A. What is the separate cost of second bat
B. What would be the cost per unit of third and fourth bat. If they are ordered separately later on?
C. If they were all order now , could Zalmi sports quote a single unit price for four bats and eight bats?
Answer:
Cumulative number of units
cumulative avg time per unit
1
2
4
8
800
640
512
409.6
Output is being doubled each time
640 x 2 = 1280
512 x 4 = 2048
1. Separate cost of second bat:
Material
Labour (480 hrs X $5)
Overhead (150% of labour cost)
Total cost
$
5000
2400
$3600
_______
11000
________
cumulative total time
800
1280
2048
3276.8
incremental total incremental
time
avg time
480
768
1228.8
480
384
307.2
2. Cost of Third and fourth Bat
Material cost for two bats
Labour(768hrs x $5)
Overhead( 150% of labour cost)
total cost
$
10000
2400
3600
_______
11000
_________
3. A price for the first four bats and first eight bats together
Material
Labour (2048hrs)
Overhead (150% of labour cost)
Total cost
Profit (20%)
Total sale price
Price per boat
/4
first four bats
$
20000
10240
(3276.8hrs)
15360
_______
45600
9120
________
54720
_________
13680
/8
first eight bats
$
40000
16384
24576
________
80960
16192
_________
16192
_________
12144
Example using the formula:
Suppose that an 8-% learning curve apply to the production of new product Meow. To date till the end of june 30 units of
meow have been produced. Budgeted production in july is 5 units, the time to make first unit of meow is 120 hours. The
labour cost is $120 per hour
Required:
a. Calculate the time required to make the 331st unit
b. Calculate the budgeted total labour cost for july
Answer:
Time to produce first 30 units:
Y = a + a xb
B = log 0.8/log2 = - 0.09691/0.30103 = -0.32192181
Y = 120 x (1/31^0.32192181) = 120 x 0.3345594 = 40.147
Total time for 30 units = 30 x 40.147 = 1204.41 hours
Time to produce 31st unit = (1231.51 – 1204.41) = 27.1 hours
Time to produce the first 35 units
Y = 120 x ( 1/35^0.32192181) = 38.203 hours
Total time fot first 35 units = 35 x 38.203 hours = 1337.11 hours
Budgeted labour cost in July = (1337.11 – 1204.41) hours x 10 per hour = 1327
Variance Analysis
Sales variance
Sale price variance
Sales volume variance
The sale price variance show the effect on profit of selling at different price from that expected one
Sale price variance:
Actual units should have sold for
Actual units did sell
Sale price variance
$X
$X
______
$X (F)/A
Sales volume variance:
Budgeted sales volume
Actual sales volume
Sales volume variance in units
x standard profit per unit
Sale volume variance in $
x units
x units
_________
x units (f)/A
$X
____________
$x (F)/A
_____________
Sales volume variance (marginal costing) budgeted sales volume
Actual sales volume
Sales volume variance in units
X standard costing per unit
Sales volume variance in $
x units
x units
__________
x units (f)/A
$x
_____________
$x (F)/A
The sale price variance is the measure of the effect on expected profit of a different selling price to standard selling price.
It is calculated as the difference between what the sales revenue should have been for the actual quantity sold and what it
was
The sales volume profit variance is the difference between the actual units sold and the budgeted planned quantity valued
at the standard profit under absorption costing or at standard contribution under marginal costing per unit. It measures
the increase or decrease in standard profit as a result of the sales volume being higher or lower than the budgeted.
Possible reasons of sales variances
1.
2.
3.
4.
Uneffected fall in demand due to recession
Failure to satisfy demand due to production difficulties
Increase demand due to reduced price
Unplanned price reduction to attract additional business
Material variance:
Material variance can be divided into two sub categories material price variance and material usage variance
Material variance
Material usage variance
Material price variance
Direct material total variance
Actual units should have cost
Actual units did cost
xxx
(xxx)
_______
Direct material total variance
xx (f)/A
Direct material price variance:
Actual kgs should have cost
Actual kgs did cost
Direct material price variance
$ xxx
$ xxx
__________
xxx (F)/A
Direct material usage variance:
Actual units should have used
Actual units did used kgs
xxx kgs
xxkgs
__________
Usage variance in kgs
X standard cost per kg
xx kgs(f)/A
$x
____________
$x (f)/A
Usage variance in $
The direct material total variance is the difference between what the output actually cost and what it should have cost in
terms of material.
The direct material price variance calculates the difference beteen the standard cost and the actual cost for the actual
quantity of material used or purchased, it is difference between what material cost and what it should have cost
The direct material usage variance is the difference between the standard quantity of materials that should have been used for
the number of units actually produced and actual quantity of material used, valued at the standard cost per unit of material.
It is the difference between how much material should have been used and how much material was used valued at standard
cost.
Variance
Favourable
Adverse
Material price
More care taken in
purchasing
Change in material
standard
Unforeseen
discount received
Material usage
Errors in allocating
material to jobs
More effective use
made of material
Material used of
higher quality then
standard
Change in material
standard
Price increases
Careless purchasing
Labour variances:
The total labour variances can be sub divided into labour rate variance and labour efficiency variance
Labour variance
Labour efficiency variance
Labour rate variance
The direct labour total variance
Actual units should have cost
Actual units did cost
Direct labour total variance
$ xxx
$ xxx
__________
$xx(f)/A
Direct labour rate variance:
Actual hrs should have cost
Actual hrs did cost
Direct labour rate variance
$xxx
$ xxx
___________
xxx(f)/A
____________
Direct labour efficiency variance:
Actual units should have taken
Actual units did take
Efficiency variance in hrs
X standard rate per hr
Efficiency variance in S$
XXX
xxx
______
xxhrs (f)/A
$x
__________
xxxx(f)/A
_____________
The direct labour total variance is what output should have cost and what it actually costs in terms of labour
The direct labour rate variance is the difference between the standard cost and the actual number of hours paid for
The direct labour efficiency variance is the difference between the hours that should have been worked for the number of
units actually produced and the actual number of hours worked , valued at standard rate per hour. It is the difference
between how many hours should have been worked and how many hours were worked, valued at the standard rate per
hour.
Variance
Favourable
Adverse
Labour rate variance
Paid lower than standard
rate
Use of less skilled labour
Wage rate increase
Use of more skilled labour
Idle time
It will never be favourable
Stock out
Machine breakdown
Illness or injury to worker
Labour efficiency
Better quality of material
Errors in allocating time to
jobs
Output produced more
quicker then expected
Lower quality material
used
Less skilled labour has
been used
Error in allocating time to
Jobs
Variable overhead variance:
Variable production overhead total variance can be sub divided into the variable overhead expenditure variance and the
variable overhead efficiency variance based on actual hours
Total variable overhead variance
Variable overhead
expenditure variance
Variable overhead efficiency
variance
Varaible overhead total variance:
Actual unit should have cost
Actual units did cost
Variable OH total variance
$XXX
$xxx
_________
xxx (f)/A
Variable overhead expenditure variance:
Actual hrs should cost
Actual hrs did cost
Var OH exp variance
$XXX
$xxx
________
xxx (f)/A
_________
Variable OH efficiency variance:
Actual units should have taken
Actual units did take
Effficiency variance in hrs
x standard rate per hout
Efficiency variance in $
xxx
xxx
______
xx (f)/A
$x
_______
$(f)/A
_________
Thee variable oh efficiency variance is the difference between the amount of variable production oh that should have been
incurred in the actual hours actively worked and the actual amount of variable production oh incurred
The variable production oh is exactly the same in hours as the direct labour efficiency variance but priced at the variable
production overhead rate per hour.
Variance
Favourable
Adverse
Variable overhead
expenditure
More economical use of
overheads
Savings in cost incurred
Increase in costs of
overhead used
Excessive use of overheads
Change in type of
overheads used
Variable overhead
efficiency
Better supervision or staff
training
Labour force working more
efficiently
Lack of supervision or
training
Labour force working less
efficiently
Fixed overhead variances:
Fixed overhead variance can be sub dividied into an expenditure variance and volume
variance. The fixed overhead volume variance can be further divided into capacity and
efficiency variance
Fixed overhead variance
Fixed overhead
expenditure variance
Fived overhead volume variance
Fixed overhead
capacity variance
Fixed overhead variance:
Overhead incurred
Overhead Absorbed
Fix overhead total
Variance
$ xxx
$ xxx
________
$xxx(f)/A
__________
Fixed overhead
efficiency variance
Fixed overhead expenditure variance:
Budgeted overhead expenditure $xxx
Actual overhead expenditure
$xxx
______
fix overhead expenditure
Variance
xxx
_______
Fixed overhead volume variance:
Actual units produced
$xxx
Budgeted units produced $xxx
______
Volume variance in units
xx units (F)/A
x standard rate per unit
$xx
____________
Volume variance in $
$xxx(F)/A
_____________
The fixed overhead volume efficiency variance will be calculated same as volume efficiency variance
Fixed overhead volume efficiency variance:
Actual units should have taken xxx hrs
Actual units did take
xxx hrs
__________
Volume effieciency variance in
Hours
xx hrs (f)/A
x standard OAR per hour
$x
____________
Voliume efficiency variance in
$
$xxx
_____________
The volume capacity variance is the difference between the budgeted hours of work and the actual active hours of work
Excluding idle time
Budgeted hrs of work
Actual hrs of work
xxx hrs
xxx hrs
_________
Volume capacity variance
xx hrs (F)/A
x standard OAR rate per hr
$XX
_________
Volume capacity variance
$xx (f)/A
Fixed overhead variance is the difference between the budgeted fixed overhead expenditure and fixed overhead absorbed
Fixed overhead expenditure variance is the difference between the budgeted fixed overhead expenditure and actual fixed
overhead expenditure
Fixed overhead volume difference is the difference between actual and budgeted volume multiplied by the standard overhead
absorption rate per unit
Fixed overhead efficiency variance is the difference between budgeted hours work and actual hours worked multiplied by the
standard absorption rate per hour
Fixed overhead capacity variance is the difference between budgeted hours of work and actual hours of work multiplied by the
standard absorption rate per hour.
Variance
Favourable
Adverse
Fixed overhead
expenditure
Savings in cost
Changes in price related
fixed overhead
expenditure
Change in type of service
used
Excessive use of service
Change in type of service
used
Fixed overhead volume
efficiency
Labour force working more Labour working
efficiently
inefficiently
Fixed overhead volume
capacity
Labour force working
overtime
Labour shortage, strike,
machine breakdown
A dany manufactures one product and the entire product is sold as soon as it is produced. There are no opening or closing
inventories or or work in progress is negligible. The company operagtes a standard costing system and analysis of variances is
made every month. The standard cost card for the product is as follows :
$
Direct material
2.00
Direct wages
2 hrs at 2 per hour
4.00
Variable overhead
2 hrs at 0.30 per hour
0.60
Fixed overhead
2 hrs at 3.70 per hour
7.40
_______
Standard cost
14.00
Standard profit
6.00
__________
Standard selling price
20.00
____________
Budgeted output for January was 5100 units. Actual results for January were as follow:
Production of 4850 units was sold for $95000. materials consumed in production amounted to 2300 kilos at total cost of
$9800. labour hours paid for 8500 hrs at a cost of $16800. actual operating hrs were 8000 hrs. variable overhead
amounted to $2600 and fixed overhead amounted to 42300.
Required:
Calculate all variances and prepare an operating statement for January.
Answer:
Material price variance
2300kg of material should cost x $4
But did cost
Material price variance
$9200
$9800
_______
600 adverse
Material usage variance
4850 widgets should use x 0.5 kg
But did use
Material usage variance
X standard cost per kg
2425 kg
2300 kg
_________
125 kg
x $4
___________
500 kg favourable
Labour rate variance
8500 hrs of labour should cost x$2
But did cost
Labour rate variance
17000
16800
_______
200 favourable
Labour efficiency variance
4850 widgets should take x 2 hrs
But did take
Labour efficiency variance in hrs
X standard cost per hour
9700 hrs
8000 hrs
___________
1700 favourable
x $2
______________
3400 favourable
________________
Idle time variance 500 hrs (A) x $2
1000 adverse
Variable OH expenditure variance
8000 hours incurring variable OH expenditure should cost X$0.30
But did cost
variable OH expenditure variance
2400
2600
______
200 Adverse
Variable of efficiency variance is same as the labour effieciency variance
1700 (f) hrs x $0.30
510 favourable
Budgeted fixed overhead
Budgeted fixed overhead 5100 units x 2 hrs x 3.70
Actual fix overhead
Fixed overhead expenditure variance
37740
42300
__________
4560 adverse
______________
Fixed OH volume variance
Actual production at standard rate 4850 units x $7.40
Budgeted production at standard rate 5100 units x $7.40
Fixed overhead volume variance
35890
37740
_______
1850 adverse
_____________
Sale price variance:
4850 widgets should have sold for (x$20)
But did sell for
Selling price variance
97000
95600
________
1400 adverse
_____________
Sales volume variance
Budgeted sales volume
Actual sales volume
Sales volume variance in units
X standard profit per unit
Sales volume variance in $
5100 units
4850 unnits
______________
250 units adverse
x $6
1500 adverse
$
Budgeted profit (5100 units x $6 profit)
Sale price variance
Sale volume variance
Actual sales less standard cost of sales
$
30600
1400(A)
1500(A)
(2900) (A)
____________
27700
Cost variance
(F)
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
500
200
3400
1000
200
510
________
4610
Actual profit for January
(A)
600
4560
1850
_________
8210
33600(A)
____________
24100
===============
Check
$
Sales
Material
Labour
Variable Oh
Fixed Oh
$
95600
9800
16800
2600
42300
________
Actual profit
(71500)
_________
24100
___________
Operating statement in marginal cost environment
Example
Using above example date re produce the operating statement in Marginal cost environment
Answer
There is no fixed overhead volume variance
The standard contribution per unit is $20-6.60=$13.40, therefore the sale volume variance of 250 units(A) is valued at x $13.40
$3350 Adverse
The other variances are unchanged, therefore an operating statement might appear as follows
Operating statement for January
$
Budgeted profit
Budgeted fixed production cost
Budgeted contribution
Sales variance:
volume variance
price variance
$
30600
37740
________
68340
$
3350 A
1400 A
4750A
________
63590
(F)
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable OH expenditure
Variable OH efficiency
(A)
600
500
200
3400
1000
200
510
Investigating Variances:
To decide whether to investigate variances or not. Management should need to look at following factors to decide either to
investigate variances or not
1. Only controllable variances should be investigated
2. The cost of investigation should be weighed against the benefits of correcting the cause of the variance
3. Variance might be interrelated with the other variance and much of it might have occurred only because other variance
occurred too for example material price variance favourable is balanced by material usage variance adverse
4. Only significant variances should be investigated and not immaterial as it will be time consuming
Material mix and yield variance:
Material usage variance can be sub divided to material mix and material yield variance when more then one product is used in
the product. However calculating mix and yield variance is only useful for control purposes when management is in a position
to control the mix of material used in production.
Manufacturing processes often require that number of different material are combined to make a unit of finished product.
It is often possible to sub analyse the material usage variance into material mix and yield variance
Adding higher proportion of one material and lower proportion of another material may make the material mix cheaper or
expensive for example standard mix of the material variance is as follows:
(1/3) 1.2 kg of material A at $1 per kg
(2/3) 2.4 kg of material B at $0.50 per kg
$1.20
$1.20
_________
2.40
__________
A mix variance occurs when the materials are not mixed or blended in standard proportions and it is a measure of whether the
actual mix is cheaper or expensive then then the standard mix
A yield variance arises because there is a difference between what the input should have been for the output achieved and the
actual input.
When to calculate mix and yield variance
1. Calculating mix and yield variance is alternate of usage variance when you calculate mix and yield variance then there is no
need to calculate usage variance
2. A mix variance is useless unless management may be able to use cheaper mix of variance
3. A yield variance is the total usage variance for all the materials combined. If a mix variance is calculated then yield variance
is must to calculate.
How to calculate mix and yield variance:
1. Take the total actual quantity of material used
2. Divide total quantity of materials in the standard mix or standard proportions of the different material used in the mix.
3. For each item of materials, the difference between the actual quantity used and the quantity in the standard mix is a mix
variance
4. Convert mix variance for each item of material into a money value by applying the standard price per unit for the material
5. The total of the mix variance for each of the materials in the mix is the total materials mix variance.
The yield variance is calculated as follows:
1. For the actual number of units of product manufactured, calculate the total quantity of materials that should have been
used.
2. compare this standard quantity of materials that should have been used with the actual total quantity of materials that was
used.
3. The difference is the yield variance in material quantities
4. Convert this into a monetory value by applying the weighted average cost per unit of material
Example:
A company manufacture a juice Slash using two components Pina colada and margarita. The standard material usage and cost
of one unit of slash are as follows:
pina colada
5kg at $2 per kg
$10
margarita
10kg at $3 per kg
$30
______
$40
In a particular period 80 units of slash were produced from 600 kg of pina colada and 750 kg of margarita.
Calculate the material usage,mix and yield variance.
Usage variance:
If we do not calculate mix and yield variance we need to calculate usage variance of both materials separately
std usage for
for actual output of 80 units
kg
Pina colada
margarita
400
800
________
1200
actual usage
variance
kg
kg
600
750
_____
1350
200 A
50 F
_________
standard cost per
kg
$
2
3
_____
Usage variance of both materials can be analyse in this way and can be reported instead of mix and yield variance
Variance
$
400 A
150 F
______
250A
Calculate the standard mix of the actual quantity of material used.
Actual usage
actual total usage in standard mix
(5:10 or 1:2)
kg
450
900
_______
1350
________
kg
600
750
______
1350
_______
pina colada
margarita
mix variance kg
kg
150 A
150 F
________
0
_________
the mix variance in quantities are converted into monetory value at the standard price of the materials:
Actual usage/mix
kg
Pina
Colada
magarita
600
750
______
1350
________
standard mix
kg
450
900
_______
1350
________
mix variance
kg
150 A
150 F
__________
0
___________
standard price
$ per kg
mix variance
$
2
300A
3
450 F
______
150 F
_______
Total mix variance is $150 favourable
Yield variance
1350kg of material should produce /15
They did produce
Yield variance in units of output
Standard material cost per unit
Yield variance in $
units
90
10
_____
10 A
_____
$40
$400
Sales mix and quantity variance
Sales mix variance:
The sales mix variance occurs when the proportion of the various products sold are different from those in the budget
Sales quantity variance:
The sales quantity variance shows the difference in contribution/profit because of the change in sales volume from
budgeted volume of sales
When to calculate mix and quantity variances
A sales mix variance and quantity variance are only meaningful where management can control the proportions of the
product sold
Following are the situations where management may be able to control the sales mix are:
1. Where management can control the allocation of the advertising and sales promotion budget between different
products
2. Where the same basic product is sold in different sizes or packaging such as small size or large size
The method of calculation:
Sales mix variance is calculated in a similar way to the material mix variance:
1. Take the total actual quantity of units sold, for all the products combined
2. Divide the toal quantity of sales units into the budgeted standard mix or budgeted proportions of the different products
in the mix
3. For each product the difference between the actual quantity sold and the sales quantity in the budgeted standard mix
is a mix variance
4. Convert the mix variance for each product into a monetory value by applying the standard profit per unit or standard
contribution per unit where the standard marginal costing is used.
5. The total of the mix variance for each of the product in the sales mix is the total sales mix variance.
The sales quantity variance is calculated in a similar way to the material yield variance as follows:
1. Calculate the weighted average standard profit per unit or weighted average contribution per unit. This is calculated
from the budget as the budgeted total profit divided by the budgeted total units of sale
2. Calculate the difference between actual sales units and the budgeted sales units. This difference is the sales quantity in
variance
3. Convert this variance into sales units into a monetory value by applying the weighted average standard profit or
standard contribution per unit of sale.
Example:
Gladiators Company makes and sells two products, Captain America doll and Iron man doll the budgeted sales and profit are as
follows:
sales units
Captain America
Iron man
400
300
revenue
$
8000
1200
costs
$
6000
11100
profit
$
2000
900
_______
2900
________
profit per unit
$
5
3
Actual sales were 280 units of captain America doll and and 630 units of Iron man doll the company management is able to
control the relative sales of each product through the allocation of sales effort, advertising and sales promotion expenses.
Required:
Calculate the sales volume variance, the sales mix variance and the sales quantity variance
Solution:
Sales volume variance
Budgeted sales
Actual sales
Sales volume variance in units
sale volume variance in $
total sale volume in $ 390 F
Captain America
400
280
________
120 A
x$5
_______
600 A
_________
Iron Man
300
630
______
330 units
x$3
___________
990 F
____________
Sales Mix variance
Actual Sales mix
standard sales mix
sales mix variance
standard profit
sales mix
variance
(4:3)
Units
CA 280
IM 630
_____
910
______
units
units
520
390
_____
910
_______
240 A
240 F
_______
0
______
$ per unit
5
3
Sales quantity variance
The standard weighted average profit per unit of sale taken from the budget is $2900/700 = $29/7
units
Budgeted sales in total
700
Actual sales in total
910
_____
210 F
Standard weighted average profit per unit 29/7
Sales quantity variance in $870 F
$
1200 A
720 F
______
480A
______
Planning and operational variances
Revising a budget or standard cost:
Occasionaly organizations has to revise a budget or standard cost, when this happens varainces should be reported in a way
that differentiate between varainces caused by the revision to the budget and varainces that are responsibility of operational
management.
Plannig variance
A planning and operational variances analysis divide the total variances into those variances which have arisen due to
inaccurate planning or faulty standards known as planning variances
Operational variance:
Variances which have been caused by the adverse or favourable operational performance, compared with a standard which has
been revised in hindsight known as operational variance.
Reasons for revising budget or standard cost:
When variances are reported in budgetary control, it is usually assumed that original budget or standard cost is accurate and
reliable and if there is any difference between actual results and the budget or standard it will be measured as variances which
is attributable to the manager who is responsible for that aspect of performance.
Then manager is expected to explain and take actions actions to correct those adverse variances if there is any. However
certain circumstances may occur that make original budget or standard cost invalid or inappropriate.
Following are the reasons to revise budget or standard cost:
1. The sales budget may have been prepared on total market size, however now demand is changed due to economic
changes or due to technological change demand is change now.
2. The standard cost of material of a product decided on what it should be but due to change in market conditions now
prices are much higher or lower.
3. The standard quality of a product is changed significantly due to change in specification.
4. The standard labour rate may become unrealistic because labour rates in market has changed significantly.
5. The standard time to produce a product has changed significantly due to certain reasons.
Example Budget revision
Lampoo company produces Cent and mint which are fairly standardised products. The following
information relates to period 1.
The standard selling price of cent is $50 each and mint $100 each. In period 1, there was a
special promotion on Scent with a 5% discount being offered. All units produced are sold and no
inventory is held.
To produce a Widget they use 5 kg of X and in period 1, their plans were based on a cost of X of $3 per
kg. Due to market movements the actual price changed; if they had purchased efficiently, the cost would
have been $4.50 per kg. Production of Widgets was 2,000 units.
A cent uses raw material Z but again the price of this can change rapidly. It was thought that Z would
cost $30 per tonne but in fact they only paid $25 per tonne and if they had purchased correctly the cost
would have been less, as it was freely available at only $23 per tonne. It usually takes 1.5 tonnes of Z to
produce 1 mint and 500 mint are usually produced.
Each Widget takes three hours to produce and each mint two hours. Labour is paid $5 per hour. At
the start of period 1, management negotiated a job security package with the workforce in exchange for a
promised 5% increase in efficiency – that is, that the workers would increase output per hour by 5%.
Fixed overheads are usually $12,000 every period and variable overheads are $3 per labour hour.
Required
Produce the original budget and a revised budget allowing for controllable factors in a suitable format
Answer
Original budget for Period 1
Sales revenue ((2,000 × $50) + (500 × $100))
Material costs X (2,000 × 5kg × $3)
Material costs Z (500 × $30 × 1.5)
Labour costs ((2,000 × 3 × $5) + ( 500 × 2 × $5))
Variable overheads ((2,000 × 3 × $3) + ( 500 × 2 × $3))
Fixed overheads
Profit
$
150,000
30,000
22,500
35,000
21,000
12,000
_________
29000
__________
Revised budget for Period 1
Sales revenue ((2,000 × $50) + (500 × $100))
Material costs X (2,000 × 5kg × $4.5)
Material costs Z (500 × $23 × 1.5)
Labour costs ((2,000 × 3 × $5 ) + ( 500 × 2 × $5)) × 0.95
Variable overheads ((2,000 × 3 × $3) + ( 500 × 2 × $3)) × 0.95
Fixed overheads
Profit
$
150,000
45,000
17,250
33,250
19,950
12,000
________
22550
_________
When budget revision should be allowed?
A budget revision should be allowed if something happen which is beyond the control of the organisation which makes
budget un suitable for use in performance management.
Any adjustment in the budget should be approved by the senior management who should look at the issues involved
objectively and independent.
Operational issues are the issues that that budget is attempt to control which should not subject to be revision.
The nature of planning and operational variances:
When budget or standard cost is revised variances are still reported as comparison between actual results and the original
budget or standard cost.
However, when variances are reported clear distinction should be made between:
1. Revision that have been made due to revision in budget or standard cost, for which operational managers should not
be made responsible these are called planning variances
2. Varainces that are caused by actual performance and revised budget or standard for which operational manager
should be responsible these are called operational variances.
Planning and operational variances for sales:
When the sales budget is revised it may be assumed that:
The revision to the sales budget was due to reassessment of the total market size for the organisation product.
However, sales management should still be expected to win the same market share as a proportion to the total market
size as in the total budget. On the basis of this assumption, the sales volume variance can be reported as:
Sales volume planning variance: it is the difference between sales volume In the original budget and sales volume revised
budget.
Sales volume operational variance: it is the difference between actual sales volume and the sales volume in the revised
budget.
Example:
Masha budgeted sales for 2010 were 5,000 units. The standard contribution is $9.60 per unit. A recession in
2010 meant that the market for Masha products declined by 5%. Masha’s market share also fell by 3%. Actual
sales were 4,500 units.
Required
Calculate planning and operational variances for sales volume.
Answer
Planning variance
Original budgeted sales
Revised budget sales (–5%)
At contribution per unit of $9.60
Units
5,000
4,750
______
250 A
$2400
========
Operational variance
Revised budget sales
Actual sales
@ contribution per unit of $9.60
Units
4,750
4,500
-----------250 A
$2400
Planning and Operation variance for Sales Price:
There can be a situation where changes has been made to the budgeted or standard selling price when this happens sales
price planning variance and sales price operational variance will be calculated.
Example:
Champa budgeted to sell 10,000 units of a new product during 2005. The budgeted sales price was $10 per
unit, and the variable cost $3 per unit.
Actual sales in 2005 were 12,000 units and variable costs of sales were $30,000, but sales revenue was
only $5 per unit. With the benefit of hindsight, it is realised that the budgeted sales price of $10 was
hopelessly optimistic, and a price of $4.50 per unit would have been much more realistic.
Required
Calculate planning and operational variances for sales price.
Answer:
Planning (selling price) variance
Original budgeted sales price
Revised budgeted sales price
Sales price planning variance
$ per unit
10.00
4.50
5.50 A
The variance is adverse because planning variance is lower then the selling price in the original budget.
Sales price planning variance = $5.50 per unit (A) × 12,000 units sold
= $66,000 (A).
Operational (selling price) variance
The sales price operational variance is calculated in the same way as a 'normal' sales price variance,
except that the sales price in the revised budget is used, not the original budget.
$
12,000 units sold for (12,000 x $5)
60,000
They should have sold for (x $4.5)
54,000
Operational (selling price) variance
6,000 F
Planning and Operational variance for Material:
Example:
Product koko 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
Answer:
Solution
The original standard cost was 4 kg × $5 = $20. The revised standard cost is 4 kg × $5.50 = $22.
Material price planning variance
This is the difference between the original standard price for Material M and the revised standard price.
$ per kg
Original standard price
5.00
Revised standard price
5.50
Material price planning variance
0.50 (A)
The planning variance is adverse because the change in the standard price increases the material cost and
this will result in lower profit.
The material price planning variance is converted into a total monetary amount by multiplying the planning
variance per kg of material by the actual quantity of materials used.
Material price planning variance = 26,300 kg × $0.50 (A) = $13,150 (A).
Material price operational variance
This compares the actual price per kg of material with the revised standard price. It is calculated using the
actual quantity of materials used.
$
26,300 kg of Material M should cost (revised standard $5.50)
144,650
They did cost
139,390
Material price operational variance
5,260 (F)
Material usage operational variance
This variance is calculated by comparing the actual material usage with the standard usage in the revised
standard, but it is then converted into a monetary value by applying the original standard price for the
materials, not the revised standard price. This is an important rule.
6,000 units of Product X should use (x 4kg)
They did use
Material usage (operational) variance in kg of M
Original standard price per kg of Material M
Material usage (operational) variance in $
kg of M
24,000
26,300
2,300 (A)
$5
$11,500 (A)
The variances may be summarised as follows.
$
6,000 units of Product X at original std cost ($20)
Actual material cost
Total material cost variance
Material price planning variance
Material price operational variance
Material usage operational variance
Total of variances
$
120,000
139,390
19,390 (A)
13,150 (A)
5,260 (F)
11,500 (A)
19,390 (A)
Example:
Xander company makes a single product. At the beginning of the budget year, the standard labour cost was
established as $8 per unit, and each unit should take 0.5 hours to make.
However, during the year, the standard labour cost was revised. A new quality control procedure was
introduced to the production process, adding 20% to the expected time to complete a unit. In addition,
due to severe financial difficulties facing the company, the workforce reluctantly agreed to reduce the rate
of pay to $15 per hour.
In the first month after revision of the standard cost, budgeted production was 15,000 units but only
14,000 units were actually produced. These took 8,700 hours of labour time, which cost $130,500.
Required
Calculate the labour planning and operational variances in as much detail as possible
Answer:
Original standard cost = 0.5 hours × $16 per hour = $8 per unit
Revised standard = 0.6 hours × $15 per hour = $9 per unit
Planning and operational variances for labour are calculated in a similar way to planning and operational
variances for materials. We need to look at planning and operational variances for labour rate and labour
efficiency.
Labour rate planning variance
This is the difference between the original standard rate per hour and the revised standard rate per hour.
$ per hour
Original standard rate
16
Revised standard rate
15
Labour rate planning variance
1F
The planning variance for labour rate is favourable, because the revised hourly rate is lower than in the
original standard. The variance is converted into a total monetary amount by multiplying the planning
variance per hour by the actual number of hours worked.
Hours
7,000
8,400
1,400 A
$16
$22,400 A
14,000 units of product should take: original standard (× 0.5)
14,000 units of product should take: revised standard (× 0.6)
Labour efficiency planning variance in hours
Original standard rate per hour
Labour efficiency planning variance in $
The planning variance is adverse because the revised standard is for a longer time per unit (so higher cost
and lower profit).
Labour rate operational variance
This is calculated using the actual number of hours worked and paid for.
8,700 hours should cost (revised standard $15)
They did cost
Labour rate operational variance
$
130,500
130,500
0
the workforce was paid exactly the revised rate of pay per hour.
Labour efficiency operational variance
This variance is calculated by comparing the actual time to make the output units with the standard time in
the revised standard. It is then converted into a monetary value by applying the original standard rate
per hour.
14,000 units of product should take (× 0.6 hours)
They did take
Labour efficiency (operational variance in hours)
Original standard rate per hour
Labour efficiency (operational variance in $)
Hours
8,400
8,700
300 A
$16
$4,800 A
The variances may be summarised as follows.
$
14,000 units of product at original standard cost ($8)
Actual material cost
Total material cost variance
Labour rate planning variance
Labour efficiency planning variance
Labour rate operational variance
Labour efficiency operational variance
Total of variances
$
112,000
130,500
18,500 A
8,700 F
22,400 A
0
4,800 A
18,500 A
Divisional Performance Measurement
Divisionalisation:
It is a situation where managers of a company given a degree of autonomy over decision making that means they are given the
authority to make decisions without asking senior managers in short they are allowed to run there part of business as it is their
own business.
Advantages:
1. Managers will get more motivated
2. Decisions will be taken in short period of time
3. Managers are more aware about the problems about their area they can make better decisions.
Disadvantages:
1. They may manipulate the results for bonuses
2. Managers may work for their own interest rather then company Interest.
3. Their may be conflicts of interests between different division managers
The Use of Performance measures to control divisional managers:
If managers are to be given authority in decision making it becomes imposibble for senior management to watch over them on
day to day basis which can remove the benefit of divisionalization.
The way to control the performance is to establish a measures in advance a set of measures that will be used to evaluate
their performance normally at the end of each year.
These measures provide a way to determine whether they are doing well or not in their part of the business and also to
communicate to managers how they are expected to perform.
It is equally important that performance measures are designed well. For example suppose a manager was given only one
performance measure to increase profits, this may seems sensible that in normal situation the company will want division to
be more profitable. However, if managers expects to be rewarded on the basis of how much division is profitable then all of
managers actions will be focused on increasing profit. To the exclusion of everything else and this would not be beneficial for
the organization if the manager were to achieve it by reducing the quality of the output from the division. It may not
beneficial for the manager as well in the long term but manager may tend to focus on short term rather then long term.
It is therefore necessary to have series of performance measures for the managers may be one relate to the profitability and
at the same time other should be related to quality and manager should be assessed on the basis of how well he has
achieved all of his measures.
The company may wish performance measures to be goal congruent that is to encourage managers to make decisions that
are not only good for the manager but end being good for the company as a whole as well.
Controllable Profits:
One of the most important financial performance measure is profitability. However, if the measure is to be used to assess the
performance of the divisional manager. It is important that any cost which is out side the control of manager should be
exclude.
For example , it may be decided that pay increase in all divisions should be fixed centrally by Head office. In this scenario it
would be unfair to penalise or reward the manager on the division profits in respect of this cost and for this purpose income
statement need to be prepared ignoring wages and it would be on resulting controllable profit that manager would be
assessed.
Investment Centres and problem with measuring profitability:
As stated earlier, divisionalisation implies that the divisional manager has some degree of autonomy in case of investment
centre the manager is given decision making authority not only over costs and revenues but additionally over capital
investment decision.
In this situation, it is important that any measure of profitability is related to the level of capital expenditure simple to assess
on the absolute level of profits would be dangerous. The manager might increase profits by 10000 and got reward for it but its
hardly beneficial for the company if it had required capital investment of 1000000 to achieve.
The most common way to relating profitability to capital investment is to use return on investment as a measure, however this
can lead to loss of goal congruence and measure known as residual income is theoretically better.
Return On Investment:
Controllable division profit expressed as a percentage of divisional investment. It is equivalent to Return on capital employed
and this is one of the reasons it is famous as an divisional performance measure.
Example 1
Badri Co has divisions throughout the Carribean.
The Koka Balls division is currently making a profit of $82,000 p.a. on investment of $500,000.
Badri Co has a target return of 15%
The manager Koka Balls is considering a new investment which will require additional investment
of $100,000 and will generate additional profit of $17,000 p.a..
(a) Calculate whether or not the new investment is attractive to the company as a whole.
(b) Calculate the ROI of the division, with and without the new investment and hence
determine whether or not the manager would decide to accept the new investment.
Answer:
Return from new project 17000
_______
100000
= 17%
a. For company 17% is > 15% therefore company wants to accept it.
b. For devision
ROI without project 82000
_______ =16.4%
500000
ROI with project
82000 + 17000
______________
500000 + 100000
= 16.5% ROI for division increases therefore manager wants to accept it.
In above example manager is motivated to accepted an investment which is better for the company as a whole. He has been
motivated to make a goal congruent decision.
in this illustration we have used the opening Statement of Financial Position value for capital invested. In practice it may be
more likely that we would use closing Statement of Financial Position value (which would be lower because of depreciation).
There is no rule about this. in practice we could do whichever we thought more suitable. However, in examinations always use
opening Statement of Financial Position value unless, of course, you are told to do differently. However, there can be problems
with a ROI approach as is illustrated by the following example
Example:
The circumstances are the same as in example 1, except that this time the manager of the KoKa balls division is considering an
investment that has a cost of $100, 000 and will give additional profit of $16,000 p.a.
(a) Calculate whether or not the new investment is attractive to the company as a whole.
(b) Calculate the ROI of the division, with and without the new investment and hence
determine whether or not the manager would decide to accept the new investment
Answer:
Return from new project
16000
________
100000
= 16%
For company 16% is greater then 15% therefore company wants to accept it
B. For division
ROI with project
ROI without project 16.4%
82000 + 16000
______________ = 16.3%
500000 + 100000
Here manager is not motivated to make goal congruent decision for this purpose it is better to assess manager performance
on the basis of residual income
Residual Income:
Instead of using a percentage measure as with ROI the residual income assess the manager on absoulute profi. However in
order to take account of the capital investment, notional interest is deducted from the P&L profit figure. The balance
remaining known as the residual income.
Example 3
Repeat examples 1 and 2, but in each case assume that the manager is assessed on his
Residual Income, and that therefore it is this that determines how he makes decisions.
Answer:
RI without project 82000
Profit
Less interest
(75000)
15% x 500000
7000
RI with project
Less Interest
15% x 600000
99000
90000
9000
9000 > 7000 manager motivated to accept
2. RI without project
7000
__________
ROI with project profit
Less Interest
98000
90000
15% x
8000
600000
8000 > 7000 manager motivated to accept in both cases decisions are goal congruent.
Financial Performance Measurement
Financial statements are prepared to assist users of the financial statements. Therefore they need to interpret to take the
decisions. The calculation of different ratios make it easier to compare information with the prior year information or with
other companies
To analyse the performance of the company there are various areas which we should look at which are as follows:
o Profitability
o Liquidity
o Gearing
The importance of area depends on whose behalf that we are analysing the statements.
Ratios
Profitability ratios
Net profit margin
Profit before interest and tax
_________________________
Revenue
Gross profit Margin:
Return on Capital employed:
Gross profit
___________
Revenue
profit before interest and tax
___________________________
total long term capital
(capital + reserves + long term liabilities)
Asset turnover:
Revenue
_____________
total long term capital
Liquidity ratios:
Current Assets
_______________
Current Liabilities
Quick Ratio:
Current Asset – Inventory
________________________
Current Liabilities
Inventory Days
Inventory
__________________ x 365 days
Cost of sales
Recievable days
Payable days
Gearing:
trade Recievable
_________________ x 365 days
revenue
Trade payables
______________ x 365 days
Purchases
Long term liabilities
_________________
shareholders funds
%
Limitations:
1. Mostly ratios are useful when they are compare with other information
2. At the time of Inflation the ratio comparison could be misleading
3. Ratios are easy to manipulate due to availability of different formula of same ratio.
Example
Statements of Financial Position as at 31 December
2010
$
ASSETS
Non-current assets
Tangible assets
Current assets
Inventory
Trade receivables
Cash
2009
$
$
1,341
1,006
948
360
_____
826
871
708
100
_____
2314
________
3655
_________
LIABILITIES AND CAPITAL
Capital and reserves
$1 ordinary shares
Retained earning
$
1,200
990
_______
1679
_____2505
______
720
681
_______
2190
1401
2010
$
Non-current liabilities
10% loan 2015
Current liabilities
Trade payables
Tax payable
Dividends payable
Total Liabilities and Capital
2009
$
$
500
653
228
84
$
400
516
140
48
965
_______
3655
________
704
_____
2505
_____
Income statement for the year ended 31 December
Revenue
Cost of sales
Gross Profit
Distribution costs
Administrative expenses
Profit from operations
Finance costs
Profit before taxation
Tax expense
Profit after taxation
Dividends
Retained profit for the period
Required: Compute the profitability, Liquidity and Gearing Ratios
2009
$
7,180
(5,385)
________
1795
(335)
(670)
(790)
(50)
_______
740
(262)
________
478
169
______
309
_______
2010
$
5,435
(4,212)
________
1223
(254)
(507)
(462)
(52)
______
410
(144)
_______
266
95
______
171
______
Answer
2010
Net profit margin
Gross Profit Margin
Return on capital employed
Asset Turnover
Current Ratio
790
_____
7180
1795
_____
7180
790
_____
2690
7180
______
2690
2134
_____
965
2009
11%
8.5%
25%
29.4%
22.5%
25.7%
2.67
3.02
2.4
2.4
Quick Ratio
Inventory Days
Receiveable days
Payable Days
Gearing Ratio
2010
2009
1.36
1.15
1308
______
965
1006
_____ x365
5385
948
_____ x 365
7180
653
____ x 365
5385
500
____
2190
68.2 days
48.2 days
75.5 days
47.5 days
44.3 days
44.7 days
22.8%
28.6%
Non Financial Performance Measurement
It is important have range of performance measures considering both Financial and non financial matters. In the case of
service industries it is very important where things such as quality is important for the growth of the business.
There are various areas where performance measurement are likely to be needed. However you need to be aware about
Fitzgerald and Moon building Blocks and Kaplan and Norton and Balanced Score Card
Fitzgerald and Moon
Fitzgerald and Moon focused on performance measurement in service industry. According to them following areas needed the
performance measurement:






Quality
Competitive performance
Flexibility
Financial performance
Innovation
Resource utilisation
Kaplan and Norton’s Balanced Scorecard:
The balanced and Score card developed by Kaplan and Norton views the business from four perspective and aims to
establish goals for each with measures which can be used to evaluate whether these goals have been achieved.
Measures
Perspective
Question
Measures
Customer Perspective
What do existing and
potential customer value
from us
% sales from new
customers
% orders from enquires
%on time deliveries
Customer survey analysis
Internal Business
perspective
What process we must
excel to achieve our
customer and financial
objective
Value analysis
Efficiency
Unit cost analysis
Process/Cycle time
Learning and growth
perspective
How can we grow in future Time to market for new
and create value
product
Number of new products
introduced
Financial perspective
How do we create value
for our shareholders
Profitability, ROI, Sales
growth, cash flow, liquidity
Performance in the not for profit organization
Not for profit organizations are those which primary goal is not profit making so there performance can not assessed by
economic means example such as police , Charities, schools , hospitals. For such organisations it is not appropriate to use
standard profit measures, Instead in case of the health service the objective is to ensure that the best service is provided
against best cost.
Problems with performance measurement of Not for profit organization:
Multiple Objectives:
If all objectives can be clearly identified, it may be impossible to identify an over riding objective or to choose between
competing objectives.
Financial constraints:
Public sector organizations have limited control over the level of funding that they receive and the objectives that they can
achieve.
Political , legal and social considerations:
The public have higher expectations from public sector organizations than from commercial organizations are subject to
greater scrutiny and more onerous legal requirements.
The difficulty of measuring outputs:
For example in hospitals the objective is to make ill people better. However, how can we in practice measure how much
better they are?
Value for money:
Non profit organizations such as the health service are expected to provide value for money, which can be defined as
providing a service in a way which is economical, efficient and effective.
Therefore performance should be assessed under each of these 3 E’s
Economy: Attaining the appropriate quantity and quality of the inputs at lowest cost
Efficiency: Maximising the output for a given input
Effectiveness: Determine how well the organization has achieved its objectives.
Performance Management Information System
The purpose of the information system in the business is to provide management with the information which they need to
make good decisions for the company and to monitor the progress of the company.
Levels of management and information requirements:
Strategic Planning:
Strategic planning is to take decisions for the company usually for five to ten years which includes directions for the business
and making decisions on how to follow this strategy. The type of decisions which may be considered are for example, which
new products to produce, which new market to enter etc.
The information is required mainly from external and internal sources as well for example information about competitors,
information about government, company’s profitiablity forecasts and capital spending requirements
Management control:
Management control which is also known as tactical control is managing the implementation of strategic plan in short term
mostly for 12 months short term budgets will be prepared and operations measured against the budgets.
Information will be required from both external and internal sources and its include things such as variance analysis reports
as well as productivity measurements.
Operational control:
Operational control is concerned with monitoring and controlling the day to day performance of the business. The
information required is internal to the business. Information required example include, hours worked by the employees, raw
material usage and wastage reports and quality control reports.
Information systems used by management:
In order to make decisions at various levels. Management need information system to supply information at various levels
they require and to present information in a way that is useful for them. You should aware be aware of the following types of
information processing systems, and the level of management that benefits from them.
Transaction processing system:
Transaction processing is the recording of the daily routine transactions of the business, this includes recording all the
financial transactions, keeping records of inventory, the processing of orders etc. the information provided mainly used for
operational control.
Management information system:
The purpose of the management information system is to convert data into information that is useful for managers at all
levels but is particularly useful at the level of management control. For example transaction processing system will provide list
of receivables but management information system will process the information can process the transaction and provide
information as sales per customer
Also it is management information system that can process the transaction information and produce reports of variances.
Executive Information System:
Tradition management information system can produce reports as described above, these reports tend to be standard reports
and need planning in advance for example it may be programmed to produce variance report each month.
An executive information system enable the user to access the data and produce flexible non standard reports, its designed to
easy to use. The user can request a report without any programming knowledge, also there is an emphasis on presenting the
information graphically and it has the ability to drill down(initially information is presented in summary, but clicking on the
graph it is possible to get more and more detail as required). This systems are for top level management and for strategic level
of decision making.
Enterprise resource planning systems:
Well buddies these systems nothing to do directly with the planning. What this systems to do actually is integrate all
departments and functions of organizations into single computer system for example system used by the warehouse, there is
a single system serving all the departments.
The system runs off a single database so that the various departments can more easily share information.
An example of its usefulness an order received from customer will be entered in to the system and its status will be update by
the relevant department as it progresses the warehouse will update when it is dispatched the accounts department will
update when its invoiced and so on.
Open and closed systems:
Open systems are systems that respond to changes external to the company, whereas closed systems follow a fixed set of
rules and do not change. For example basic accounting system is a closed system in that it follows fixed rules. However,
businesses do need to change in response to changes in external factors such as the actions of competitor and changes in the
economic environment , As a result there may be a sub systems that are closed, the overall information system need to be an
open system in that information requirements will change as the business it self changes.
Closed systems are easier to control and maintain because do not change. Open systems provide more flexibility and can
provide better information, but are harder to control and maintain because of the changes made.
Performance management systems, Measurement And control
In order to manage performance managers need information. In this topic we will consider the type of information is needed,
the different program available to help manage the information and type of controls needed.
Information requirements:
Different information is required for different types of decisions. There are three levels of decision making and control.
Strategic:
These are long term decisions. Usually for five to ten years regarding long term direction of the company. For example which
product to make or which new market to enter.
Tactical:
These are for short term decision making mainly for upcoming year planning to achieve the strategic objectives for examples
how many units to sell in coming year
Operational:
These are day to day decisions implementing short term plans for example how many units to produce in month.
At strategic level, the information needed will tend to be more external, be more long term forecasts and less detailed
example include information about forecast of the economy, information about competitors
At operational level, the information needed will be internal, be immediate and it will be detailed for example aged list
of customer balances
At tactical level information will be combination of internal and external and will be medium term for example
information about productivity of customers so that decision can be made for pay rises in coming year.
Sources of Information:
External sources of information include:




Government statistics
Internet
Competitors financial statements
Industry publications
Internal sources of information include:
 Receivable ledgers
 Payroll system
 Payables ledger
Types of information software:
Following are the type of software that are available to provide/assist with information.
Transaction processing system:
It is a software that produce day to day transaction of the business for example software which produce and record day to
day sale invoices
Management information system:
It is a software that convert information from transaction processing system into information for the benefit of managers for
examples monthly summaries of the product by sale.
Executive Information system:
It is software that enables the user to obtain information on ad hoc basis as opposed to the standard reports that will be
produced by the MIS. For example MIS may be programmed to produce monthly report on sales by region. However,
Manager may require instant information analysing the sales in one particular region. An executive information system
enables the manager to access the data bases directly and access the information required immediately. The software is easy
to use. Questions may be entered using normal language as opposed to programming languages. The information generated
is produced in an easy to use format.
Enterprise resource planning system:
It is a system that integrates all the applications into a business and uses a common database. The same system is used for
processing transactions and providing management information.
Direct Data capture:
Traditionally data was entered into systems using keyboards manually. However, in this scenario there was high chances of
making errors
Examples of direct data capture methods include:
Barcode:
It can be read directly using scanner.
RFID ( Radio frequency identification)
A chip embedded in a product that can be read electronically. Similar in use to a barcode, but can be read simply by being close
to a reader as opposed to having to be closed to be correctly positioned under scanner
OCR (optical character recognition)
Scanning machine can read the characters as opposed to simply marks. It needs pre printed forms.
OMR ( Optical mark reader)
Bubbles that are filled in on a pre printed form that can be read automatically by a machine. Famous example it is used by
ACCA on the front sheet of their exams
ICR ( Intelligent character recognition)
It is similar to OCR but it does not require pre printed forms for example it can be trained to find and input that VAT numbers
on invoices received from suppliers.
Direct User Input:
Here input is made using the keyboard , but instead of operator copying in the data, the supplier of the data inputs it directly.
For example if employees required to fill the timesheets instead of employees filling forms and than operator entering it into
the systems, the employees enter the data directly into the systems themselves.
Another example is customer entering the order into the systems directly instead of filling the forms
Controls:
It is important that controls exist on:
Input:
to prevent so far as possible input errors and to prevent wrong people entering data
Processing and Storage: to prevent data being changed without authorization and comply with legislation
Output:
to ensure only authorized people are allowed to access information
Types of control that should be considered include:
Input
Passwords:
to only allow authorized users to input and also to keep a record of who has entered data
Range tests: to help ensure input is accurate for example only allow hours per week within the range of to 0 to 50
Format checks: to help ensure input is correct for example employees name include only characters not numbers.
Processing and storage:
Passwords:
only authorised users are able to change data
Audit trial:
a record is kept within the software of all changes made to data and by whom
Data protection officer: an employee with the responsibility of making sure that data protection laws are complied with
Output:
Passwords:
only authorised users are allowed to access data
Transfer pricing
What is Transfer pricing ?
Transfer price is the price that one division of the same company charges for the goods and services provided to another
division of the same company, Its internal company activity, the sale of the one devision is the purchase of the another
division. There is no effect in the accounts of the company as a whole.
Example:
Division A produces goods and transfers them to devision B which packs and sell them to outside customers.
Division A has cost of $10 per unit and additional cost of $4 per unit Devision B sells the goods to external customer for $20
per unit
Required:
Assume a transfer price between the devisions of $12 per unit, calcultate:
a) The total profit per unit made by the company over all
b) Profit per unit made by each devision
Solution:
a) Selling price
Costs
A
B
20
10
4
Profit
b)
Total profit
Cost
Profit
(14)
______
6
______
A
12
10
_______
$2
________
Selling price
Total profit 12
Costs
4
B
20
(16)
______
4
_______
Why companies have transfer price?
The reason for having transfer pricing in the organisation to make each division profit accountable, for example in the
previous example there would be no transfer price than division A would only be reporting only costs and division B would
be reporting only profits. Problem would be incurred when division A selling goods to outside customer as well as to
division B.
Cost plus transfer pricing:
The very common in practice to determine the transfer price for the company is to have a policy that all goods are
transferred at the cost to the supplying divisions plus fixed percentage.
Example:
Bezoo company devision A has cost of $15 per unit and transfer goods to division B which has additional cost of $ 5 per unit
Devision B sells externally at $30 per unit
The company has policy to set transfer price at cost + 20%
Required:
a) Transfer price
b) Profit made by company overall
c) Profit made by each devision separately
Solution:
a) Transfer price 15 X 1.2 = 18
b) Selling Price
Costs:
A
15
B
5
C) A
Total profit
Cost
Profit
30
(20)
______
$10
_______
B
18 Selling price
30
(15)
Total profit 18
______ Costs
5
(23)
$3
________
_______
7
_________
Goal Congruence:
If company is properly devisionalised, than each division manager will have autonomy over decision making, It will be
therefore decision of each division manager which product is worth developing in their division , For this purpose here we
assume that each devision producing many products and stopping production of a product will not create the problem
In this scenario Cost plus approach, can be problematic in goal congruence, As in some situations a manager may be
motivateeed not to produce a product which is beneficial for the company as a whole.
Example:
Masha company Division A has cost of $20 per unit and transfer goods to division B which has additional cost of $8 per unit.
Division B sells externally at $30 per unit
The company has policy of setting transfer price at cost plus 20%
Required:
a) Transfer price
b) Profit made by company overall
c) Profit made by each division separately
Determine decisions made by the managers and comment on whether or not goal congruent decisions will be made
Solutiion:
a) Transfer price: 20 X 1.2 = 24
b) Selling price
30
Costs
A: 20
B: 8
(28)
_____
Profit
2
______
C
A
total profit
24
cost
(20)
_____
Profit
$4
______
Selling price
total profit
Costs
Profit/loss
B
30
24
8
(32)
_____
($2)
______
Transfer pricing to achieve goals:
So folks in the examination you may asked to state the transfer price which is goal congruent and not loss making for the
company, there is a rule to state the transfer price, But its not ok to straight way telling you the rules with out understanding
the logic right. So let us do some examples and than in the I will tell you the rules related to it
Example:
Niba Company Division A has cost of $ 20 per unit and transfer goods to division B which has additional cost of $8 per unit.
Devision B sells externally at $30 Per unit
Required:
Determine Sensible range of transfer price to achieve goal congruence.
Solution:
For Division A transfer price should be greater than $20 and for devision B it should be $30-$8 = $ 22 so transfer price should
be between $20 and $22
Example
Tom company division A has cost of $ 15 per unit and transfer goods to devision B which has additional cost of $10 per unit
Division B externally sells at $35 per unit.
Division A can sell partly finished goods externally at $20 per unit. There is limited demand externally from devision A and
Devision A has unlimited production capacity.
Required:
Determine sensible range of transfer price in order to achieve goal congruence
Solution:
For devision A transfer price should be greater than $15 and for B it should be 35 – 10 = $25… sensible range of transfer
price should be between 15 and 25
Example:
Sara Co Division A has cost of $8 per unit and transfer goods to division B which has additional cost of $4 per unit. Division
B sells externally at $20 per unit.
Determine a sensible range for the transfer price in order to achieve goal congruence, If division B can buy partly finished
goods from outside for:
a) $14 per unit and b) $18 per unit.
Solution
a) For division A transfer price should be greater than 8 and for B transfer price should be less than 14
b) For Division A transfer price is greater than 8
For Division B transfer should be 20 – 4 = 16………. So transfer price should be between 8 and 16.
So after dealing with the above examples… we determine that minimum transfer price should be that which is not loss
making for the division which is selling the product and maximum transfer price should be less than the external seller.
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