1
WELCOME TO
PERFORMANCE MANAGEMENT
(F5)
2
CHAPTER 1: COSTING
3
OVERVIEW
What will you learn?
COSTING
I.
Absorption costing
II.
Marginal costing
III.
Compare absorption costing and marginal costing
4
I. ABSORPTION COSTING
1. Overview on Absorption costing
Absorption costing is a method of product costing which aims to include in the total
cost of a product (unit, job, and so on) an appropriate share of an organisation's total
overhead, which is generally taken to mean an amount which reflects the amount of
time and effort that has gone into producing the product.
Under absorption costing, costs can be divided into 2 types:
A direct cost is a cost that can be traced in full to the product, service or department
that is being costed.
An indirect cost (overhead) is a cost that is incurred in the course of making a product,
providing a service or running a department, but which cannot be traced directly and in
full to the product, service or department.
5
I. ABSORPTION COSTING
1. Overview on Absorption costing
The cost classification is illustrated as follow:
Total costs
Direct costs
Indirect costs/Overheads
Non-production
overheads
Production overhead
Absorbed
overheads
Production costs
Over/Under
absorbed overheads
Other costs
6
I. ABSORPTION COSTING
2. Stages of Absorption costing
The aim of traditional absorption costing is to determine the full production cost per unit
Absorption costing is carried out through a 3-stage process:
Allocation
Apportionment
01
02
Overhead absorption
03
Cost
items 1
Production
cost center 1
Production
cost center 1
Production
cost center 1
Unit
cost 1
Cost
items 2
Production
cost center 2
Production
cost center 2
Production
cost center 2
Unit
cost 2
Cost
items 3
…
Service cost
center 1
Service cost
center 1
Cost
items n
General cost
center
Unit
cost 3
7
I. ABSORPTION COSTING
2. Stages of Absorption costing
2.1
Allocation
Allocation is the process by which whole cost items are charged directly to a cost unit or
cost center.
Rule to allocate is as follow:
Cost item
Overheads
Direct cost
Cost units
Clearly identifiable
with cost centers
NOT Clearly identifiable
with cost centers
Cost centers
General cost centers
8
I. ABSORPTION COSTING
2. Stages of Absorption costing
2.1
Allocation
There are some types of cost center:
Type of cost center
Type of overheads charged
Production department
Production overheads
Production area service department
Administrative department
Administration overheads
Selling or distribution department
Sales and Distribution overheads
Overhead cost center
(General cost center)
Items of expense are shared by several
departments (rent and rates, heat and light,
canteen)
9
I. ABSORPTION COSTING
2. Stages of Absorption costing
2.2
Apportionment
There are 2 steps of overhead apportionment:
Step 1: Apportion general cost centers to cost centers using a fair basis of apportionment
Step 2: Apportion service cost centers to production cost centers
Some basis for apportioning general cost centers to cost centers:
Overhead to which the basis applies
Basis
Rent, rates, heating and light, repairs and
depreciation of buildings
Floor area occupied by each cost center
Depreciation, insurance of equipment
Cost or book value of equipment
Personnel office, canteen, welfare, wages
and cost offices, first aid
Number of employees, or labor hours
worked in each cost center
The basis of apportioning service cost centers must also be fair. Different apportionment basis may
be applied for each service cost center.
Service center to be apportioned
Possible basis of apportionment
Stores
Number or cost of material requisitions
Maintenance
Hours of maintenance done per cost center
Direct labor hours worked in each production
center.
Production planning
10
I. ABSORPTION COSTING
2. Stages of Absorption costing
2.3
Overhead absorption
Overhead absorption is the process whereby overhead costs allocated and apportioned
to production cost centers are added to unit, job or batch costs based on Overhead
Absorption Rates (OAR).
4 steps to absorb the overhead:
Step 1: Estimate overhead likely to be incurred during the coming period
Step 2: Estimate activity level for the period (upon which the OAR are to be based)
Step 3: Calculate OAR = Estimated overhead/Budgeted activity level
Step 4: Absorb the overhead into the cost unit by applying calculated absorption rate
However, OAR is based on estimates in the budget, it could be not the same actually
occurs. So, there are 2 cases:
•
Over-absorption: overheads charged to the cost of production or sales are greater
than overheads actually incurred
•
Under-absorption: insufficient overheads have been included in the cost of
production or sales.
11
I. ABSORPTION COSTING
3. Example
Example 1 (Question):
A company is preparing its production overhead budgets and determining the
apportionment of those overheads to products. Cost center expenses and related
information have been budgeted as follows:
Machine
shop A
$
Machine
shop B
$
Assembly
$
Canteen
$
Maintenance Total
$
$
Indirect wages
8,586
9,190
15,674
29,650
15,460
78,560
Consumable
materials
6,400
8,700
1,200
600
-
16,900
Rent
16,700
Power
8,600
Depreciation
(machinery)
40,200
Maintenance Total
$
Machine
shop A
Machine
shop B
Assembly
Canteen
Power usage
(%)
55
40
3
-
2
100
Area (sq ft)
10,000
12,000
15,000
6,000
2,000
45,000
Machine
usage (hours)
7,200
18,000
Direct labor
(hours)
8,000
6,200
25,200
20,800
35,000
12
I. ABSORPTION COSTING
3. Example
Example 1 (Question):
The total production overhead expenditure of the company was $176,533 and its
actual activity was as follows:
Direct labour
hours
Machine usage
hours
Machine
shop A
Machine
shop B
Assembly
8,200
6,500
21,900
7,300
18,700
-
Total
36,600
26,000
Required: Calculate the under- or over-absorption of overheads and comment on
the implications of the figures calculated.
13
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Stage 1: Allocation
There is only overheads under cost items here.
•
Overheads clearly identifiable with cost centers: Indirect wages and
Consumable materials
•
Overheads NOT clearly identifiable with cost centers: Rent, Power and
Depreciation. They are allocated to general cost centers.
Stage 2: Apportionment
Step 1: Apportion general cost to cost centers using a fair basis of
apportionment
There are 5 cost centers namely machine shop A, machine shop B, assembly,
canteen and maintenance.
At this step, we need apportioning rent, power and depreciation costs for these
cost centers.
Using a fair basis of apportionment:
•
Rent is apportioned based on area
•
Power is apportioned based on power usage
•
Depreciation is apportioned based on machine usage
14
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Stage 2: Apportionment
Step 1: Apportion general cost to cost centers using a fair basis of apportionment
Indirect wages
Consumable
materials
Rent (W1)
Power
Depreciation
Total
Shop A
Shop B
Assembly
Canteen
Maintenance
$
8,586
$
9,190
$
15,674
$
29,650
$
15,460
Total
$
78,560
6,400
3,711
4,730
11,486
34,913
8,700
4,453
3,440
28,714
54,497
1,200
5,567
258
600
2,227
-
742
172
22,699
32,477
16,374
16,900
16,700
8,600
40,200
160,960
Working
Calculation of rent overheads apportionment for Machine shop A is set out below.
Calculations of power, depreciation overheads apportioned for other departments
could be solved using the same mindset.
(W1) Overhead apportioned by area
Area occupied by department
x Budgeted overhead
Total area
10,000
= 45,000 x 16,700 = 3,711
Rents overheads in shop A =
15
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Step 2: Apportion service cost centers to production cost centers
There are 2 service cost centers namely canteen and maintenance and 3
production cost centers namely machine shop A, machine shop B and assembly.
Using a fair basis of apportionment:
•
Canteen is apportion based on direct labor as labor uses mainly this service
•
Maintenance is apportion based on machine usage
Shop A ($)
Shop B ($)
54,497
Assembly
($)
22,699
Canteen
($)
32,477
General costs
from step 1
34,913
Apportion
canteen (*)
Apportion
maintenance
(**)
Total
7,423
5,753
19,301
(32,477)
4,678
11,696
47,014
71,946
Maintenance
($)
16,374
Total
($)
160,960
(16,374)
42,000
-
-
160,960
(*) Apportion canteen = $32,477/35,000 x Budgeted direct labor hours
(**) Apportion maintenance = $16,374/25,200 x Budgeted machine usage hours
16
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Stage 3: Overhead absorption
Budgeted overhead absorption rates for each of the production departments
Shop A
Shop B
Assembly
Step 1: Estimate overhead likely to be incurred during the coming period
Estimated overheads
47,014
71,946
42,000
Step 2: Estimate activity level for the period (upon which the OAR are to be
based)
Budgeted activity level (*)
7,200
18,000
20,800
Step 3: Calculate OAR = Estimated overheads/ Budgeted activity level
OAR
6.53
4
2.02
(*) Budgeted activity level of shop A and B are based on the machine usage, of
assembly is based on the direct labor.
17
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Stage 3: Overhead absorption
Under-or over-absorption of overheads is as follows:
Actual activity
$
Actual overheads
$
176,533
Absorbed amount using OAR:
Machine shop A [6.5 x 7,300]
Actual activity
47,669
Machine shop B [4 x 18,700]
74,800
Assembly [2.02 x 21,900]
44,238
166,707
Under-absorption overheads
9,826
18
I. ABSORPTION COSTING
3. Example
Example 1 (Answer):
Comment on the implications of the figures calculated
The budgeted overheads is much lower than actually incurred, so the company
should consider to make adjustments to budgeted process, if needed.
It is obvious that the main reason of the under-absorption overheads is that more
machine hours and direct labour were used than expected. Further investigation
needs to be conducted to determine whether budget is too low or actual
production is inefficient. The under-absorption overheads is not good as in many
case, the company does not have enough resource to compensate for the cost
increase, which causes serious consequences such as not be able to fulfill orders,
loss customer goodwill.
In this case, the adjustment should be debit overheads of $9,826.
19
II. MARGINAL COSTING
1. Overview on Marginal costing
Marginal cost is the cost of one unit of a product/service which could be avoided if that
unit were not produced/provided.
Contribution is the difference between sales revenue and variable (marginal) cost of
sales.
Marginal costing is a method of product costing which focus on variable costs for
consideration and making decision.
Rules of marginal costing:
Total costs
Production costs
Variable costs
(Variable production
overheads)
Cost of goods sold
(Marginal
production costs)
Unit cost
Fixed costs
Non-production costs
Variable costs
(direct materials, direct
labour, direct expenses)
Fixed costs
Other variable costs
Period cost (deduct profits)
20
II. MARGINAL COSTING
2. Example
Example 2 (Question):
SAP Co makes and sells a single product. At the beginning of period 1, there are no
opening inventories of the product, for which the variable production cost is $4 and the
sales price $6 per unit. There are no variable selling costs. Fixed costs are $2,000 per
period, of which $1,500 are fixed production costs. Normal output is 1,500 units per
period.
In period 1, sales were 1,200 units, production was 1,500 units.
In period 2, sales were 1,700 units, production was 1,400 units.
Required: Calculated profit for each period and for the two periods using marginal
costing.
Guidance:
The question requires to determine profit:
• Profit (Step 5) = Contribution (Step 4) – Period costs
• Contribution (Step 4) = Sales revenue (Step 1) - All variable costs (Step 3)
• All variable costs (Step 3) = COGS (Step 2) + Other variable costs
Step 1: Calculate Sales revenue = Sales volume x Selling price
Step 2: Calculate COGS (Marginal production costs)
COGS = Opening inventory + Variable production overheads – Closing inventory
Step 3: Calculate all variable costs
Step 4: Calculate contribution
Step 5: Calculate profit
21
II. MARGINAL COSTING
2. Example
Example 2 (Question):
Step 1: Calculate Sales revenue = Sales volume x Selling price
Period 1
Period 2
Total
1,200
6
7,200
1,700
6
10,200
2,900
6
17,400
Sales volume (units)
Selling price ($/unit)
Sales revenue ($)
Step 2: Calculate COGS (Marginal production costs)
COGS = Opening inventory + Purchase - Closing inventory
Under marginal costing, only variable costs of $4/unit are charged to cost of
sales.
Period 1
Period 2
Total
4×1,400
Opening inventory
0
Add: Variable
production overheads
6,000
Less: Closing inventory
1,200
COGS
4,800
4×1,500
1,200
5,600
11,600
0
4×(1,5001,200)
6,800
4×(300+
1,4001,700)
11,600
22
II. MARGINAL COSTING
2. Example
Example 2 (Question):
Step 3: Calculate all variable cost
All variable costs = COGS (Step 2) + Other variable costs
There is no other variable costs. Therefore, all variable costs = COGS (Step 2)
Step 4: Calculate contribution
Sales revenue
COGS
Contribution
Period 1
$
7,200
4,800
2,400
Period 2
$
10,200
6,800
3,400
Total
$
17,400
11,600
5,800
Period 1
$
2,400
2,000
Period 2
$
3,400
2,000
Total
$
5,800
4,000
400
1,400
1,800
Step 5: Calculate profit
Contribution
Period costs (Fixed costs)
Profit
23
III. COMPARE ABSORPTION
COSTING AND MARGINAL COSTING
1. Example
Example 3 (Question):
SAP Co makes and sells a single product. At the beginning of period 1, there are no
opening inventories of the product, for which the variable production cost is $4 and
the sales price $6 per unit. There are no variable selling costs. Fixed costs are $2,000
per period, of which $1,500 are fixed production costs. Normal output is 1,500 units
per period.
In period 1, sales were 1,200 units, production was 1,500 units.
In period 2, sales were 1,700 units, production was 1,400 units.
Required: Calculated profit for each period and for the two periods using absorption
costing.
Guidance:
The question still requires determining profit for each period, so the basic calculation
process is the same in example 2 above. However, under absorption costing, as full
costs are charged to the cost of sales, not only variable costs  a difference in the
determination of COGS.
Unit fixed cost is determined through OAR of fixed production costs = Estimated
overhead/ Budgeted activity level.
As budgeted activity level (normal output) is 1,500 units per period but production
was 1,400 units in period 2, which means there is an under-absorption overhead here.
Therefore: Profit = Sales revenue - (COGS + Under-absorption overhead + Other
expenses)
24
III. COMPARE ABSORPTION
COSTING AND MARGINAL COSTING
1. Example
Example 3 (Answer):
Step 1: Determine sales revenue  Same as example 2.
Step 2: Determine COGS
Under absorption costing, fixed production cost are charged to COS.
$/unit
Direct cost
4
Overhead
(Estimated overhead/Budgeted activity level)
Full cost
1
1,500/1,500
5
Period 1
Period 2
Opening inventory
Purchase
7,500
1,500
7,000
Closing inventory
1,500
COGS
6,000
5x(1,500
- 1,200)
Total
5x1,400
14,500
-
-
8,500
14,500
25
III. COMPARE ABSORPTION
COSTING AND MARGINAL COSTING
1. Example
Example 3 (Answer):
Step 3: Calculate profit.
Period 1
$
Period 2
$
Sales revenue
7,200
10,200
17,400
Less: COGS
6,000
8,500
14,500
-
100
100
1,200
1,600
2,800
Less: Under-absorption overhead (*)
Gross profit
Total
$
Other expenses [2,000-1,500]
500
500
1,000
Profit
700
1,100
1,800
(*) As production in the period 2 was only 1,400 units, which is lower than normal
output, thus there is under-absorption overhead
(1,500 - 1,400) x $1 = $100
26
III. COMPARE ABSORPTION
COSTING AND MARGINAL COSTING
1. Example
Example 3 (Answer):
Compare the answers
Thus, profit for 2 periods are $1,800 for both absorption costing and marginal
costing methods. But there is a difference of profit of each period. Details are as
follows:
Period 1
$
Period 2
$
Total
$
Absorption costing (Example 2)
700
1,100
1,800
Marginal costing (Example 3)
400
1,400
1,800
Difference
300
300
0
27
III. COMPARE ABSORPTION
COSTING AND MARGINAL COSTING
2. Comparative table
Absorption costing
Marginal costing
Similarity
Used to determine production costs; In the long run, total profit will be the same
Differences
COGS calculation
Full production costs
Only variable costs
Fixed production
costs
Traced in to cost unit
Treated as period costs
Inventory levels
increase
Profit higher
Profit lower
Gross profit or
contribution?
Gross profit
Contribution
Reporting to
management
Needed for financial reporting
purposes
Useful for decision-making
purposes
Notes: Explanation of profit figures when inventory levels increase between absorption
costing and marginal costing:
•
COGS = Opening inventory + Purchase - Closing inventory
•
Profit = Sales revenue - COGS - Other expenses
•
If inventory levels increase between in the period, under absorption costing, some
of the fixed production overhead incurred during the period will be carried forward
in closing inventory, so closing inventory will increase, leading to COGS will reduce.
Finally, profit under absorption costing is higher.
28
CHAPTER 2A:
ACTIVITY BASED COSTING
29
OVERVIEW
What will you learn?
ACTIVITY BASED COSTING (ABC)
I.
Overview of ABC
II.
Compare absorption costing and ABC
III.
Discussion about ABC
30
I. OVERVIEW OF ABC
1. Definition
Activity based costing (ABC) is a method of costing which involves identifying the costs
of the main support activities and the factors that 'drive' the costs of each activity.
Support overheads are charged to products by absorbing cost based on the product's
usage of the factor driving the overheads.
A cost driver is a factor which has most influence on the cost of an activity.
Below is some cost drivers for overheads:
Overheads
Cost driver
Production set-up costs
Number of production set ups
Machine oil and machine repairs
Number of machine hours
Supervisor salary
Number of labor hours
Ordering costs: handling customer orders
Number of orders
Materials handling costs
Number of production runs
It is obvious that ABC is an extension of traditional absorption costing specifically
considering what causes each type of overhead category to occur. Each type of overhead
is absorbed using a different basis depending on the cost driver.
31
I. OVERVIEW OF ABC
1. Definition
Example 1:
SAP Co manufactures 2 products X and Y. Total incurred overheads costs is
$31,000 which includes 2 categories namely supervisor salary costs and
materials handling costs. In order to unit cost for each product, it is necessary to
absorb overheads.
Under the traditional absorption costing, both supervisor salary and materials
handling costs are likely to be absorbed based on number of the labor hours.
However, under ABC, cost driver attached to the activities which causes
overheads is considered carefully. Thus, supervisor salary costs are absorbed
based on number of the labor hours, but materials handling costs are absorbed
based on number of production runs as production runs is factor which has most
influence on these cost, not labor hours is.
32
I. OVERVIEW OF ABC
2. Steps in ABC
ABC is carried out through 5 steps:
Step 1: Identify an organisation's major supporting activities
Step 2: Identify overheads to each activities
Step 3: Identify cost driver of each activity
Step 4: Calculate a cost per unit of cost driver
Cost per unit of cost driver = Overheads (Step 2)/ Total units of cost drivers (Step 3)
Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
33
I. OVERVIEW OF ABC
2. Steps in ABC
Example 2 (Question):
Suppose that SAP Co manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows.
Output
units
W
X
Y
Z
10
10
100
100
Number of
Material
production runs cost per unit
in the period
$
2
20
2
80
5
20
5
80
14
Direct labor
hours per
unit
1
3
1
3
Direct labor cost per hour: $5.
Overhead costs
Short-run variable costs
Set-up costs
10,920
Expediting and scheduling costs
Materials handling costs
9,100
7,700
$
3,080
30,800
Required: Prepare unit costs for each product using ABC.
Machine
hours per
unit
1
3
1
3
34
I. OVERVIEW OF ABC
2. Steps in ABC
Example 2 (Answer):
Step 1: Identify an organisation's major support activities
There are 4 major supporting activities namely short-run variable, set-up,
expediting and scheduling and material handling.
Step 2: Identify overheads to each activities
Overheads are allocated for 4 support activities as follows:
Short-run variable
Set-up
Expediting and scheduling
Materials handling
$
3,080
10,920
9,100
7,700
Step 3: Identify cost driver of each activity
Activity
Cost driver
Short-run variable
Machine hours
Set-up
Number of production runs
Expediting and scheduling
Number of production runs
Materials handling
Number of production runs
35
I. OVERVIEW OF ABC
2. Steps in ABC
Example 2 (Answer):
Step 4: Calculate a cost per unit of cost driver
($)
Total of cost
driver
(units)
Cost per unit
of cost driver
($)
3,080
440 (*)
7
Number of
production runs
10,920
14
780
Expediting and Number of
scheduling
production runs
9,100
14
650
Materials
handling
7,700
14
550
Activity
Cost driver
Overheads
Short-run
variable
Machine hours
Set-up
Number of
production runs
(*) Total machine hours = Machine hour per unit x Output units
= 1x10 + 3x10 + 1x100 + 3x100 = 440 hours
36
I. OVERVIEW OF ABC
2. Steps in ABC
Example 2 (Answer):
Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
Activity
Short-run variable
Set-up
Expediting and
scheduling
Materials handling
W
$
70
1,560
X
$
210
1,560
Y
$
700
3,900
Z
$
2,100
3,900
1,300
1,100
4,030
1,300
1,100
4,170
3,250
2,750
10,600
3,250
2,750
12,000
Thus, product costs per unit are as follows:
Direct material costs (**)
Direct labour costs (***)
Overheads
Total costs
Units produced
Cost per unit
W
$
200
50
4,030
4,280
10
428
X
$
800
150
4,170
5,120
10
512
Y
$
2,000
500
10,600
13,100
100
131
(**) Direct material costs = Material cost per unit x Output
(***) Direct labor costs = Direct labor hours per unit x Output
Z
$
8,000
1,500
12,000
21,500
100
215
37
II. COMPARE ABSORPTION COSTING AND ABC
1. Example
Example 3 (Question):
Suppose that SAP Co manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows.
Output
units
W
X
Y
Z
10
10
100
100
Number of
Material
production runs cost per unit
in the period
$
2
20
2
80
5
20
5
80
14
Direct labor
hours per
unit
1
3
1
3
Machine
hours per
unit
1
3
1
3
Direct labor cost per hour: $5.
Overhead costs
Short-run variable costs
Set-up costs
Expediting and scheduling costs
Materials handling costs
$
3,080
10,920
9,100
7,700
30,800
Required: Prepare unit costs for each product using absorption costing
38
II. COMPARE ABSORPTION COSTING AND ABC
1. Example
Example 3 (Answer):
Absorption costing is a method of product costing, which is mentioned in chapter
1 Costing. Accordingly, the absorption rate for overheads based on direct labor
hours or machine hours.
Total direct labor hours = Total machine hours = 440 hours
OAR = $30,800/ 440 hours = $70/hour
So, product costs per unit are as follows:
Direct material costs
Direct labour costs
Overheads
[OAR x Machine hours]
Total costs
Units produced
Cost per unit
W
$
200
50
X
$
800
150
Y
$
2,000
500
Z
$
8,000
1,500
700
950
10
95
2,100
3,050
10
305
7,000
9,500
100
95
21,000
30,500
100
305
39
II. COMPARE ABSORPTION COSTING AND ABC
1. Example
Example 3 (Answer):
See that production costs per unit is significant difference between 2 methods.
Details are as follows:
Product
Absorption costing
ABC
Difference per unit
$
$
$
Difference in total
$
W
95
428
+333
+3,330
X
305
512
+207
+2,070
Y
95
131
+36
+3,600
Z
305
215
-90
-9,000
The difference is because of overheads absorbed to each product.
Product
Output
units
Direct labor/
Machine hours
per unit
W
X
Y
Z
10
10
100
100
1
3
1
3
Overheads
under
absorption
costing
Overheads
under ABC
Difference
$
700
2,100
7,000
21,000
$
4,030
4,170
10,600
12,000
$
+3,330
+2,070
+3,600
-9,000
40
II. COMPARE ABSORPTION COSTING AND ABC
1. Example
Example 3 (Answer):
There are 2 main reasons for the distinction in overheads:
Overheads = Allocated criteria (1) x Cost per unit of allocated criteria (2)
(1) Allocated criteria: It is obvious that under absorption costing, there is only
allocated criteria namely machine hours but under ABC, there are 2 allocated
criteria for overheads activities namely machine hours and number of production
runs.
(2) Cost per unit of allocated criteria: each product uses criteria.
• Overheads will be lower for low-volume products (here, W and X) and
reverse, for Y and Z, overheads will be higher
• Overheads will be lower for smaller products (here W and Y, with just
one hour of work needed per unit) and reverse, for X and Z, overheads
will be higher.
Due to which, production cost per unit is not accurate. When making pricing
decision for products W, X and Y, there is a risk that there is a loss as production
cost is determined too low.
41
II. COMPARE ABSORPTION COSTING AND ABC
2. Comparative table
Thus, there are some differences between ABC and absorption costing:
Absorption costing
ABC
•
Allocate overheads based on the
unique criterion, always labor hours
or machine hours
•
Allocate overheads based on the
number of cost driver that activity
uses
•
Easy to understand and calculate
•
•
Overheads are allocated
unreasonably
Complicated, take time to
calculate. Sometimes, costs could
outweigh benefits
42
III. DISCUSSION ABOUT ABC
Benefits and limitations of ABC
Using ABC has some following benefits and limitations:
• Cost control and reduction by
the efficient management of
cost drivers
• Better costing information
used to assist pricing decisions
• Facilitate a good
understanding of what drives
overhead costs
• A more realistic estimate of
costs and profits which can be
used in a performance
appraisal
Benefits
Limitations
• It is time consuming and
expensive
• It will be of limited benefit if
overhead costs are primarily
volume related
• The benefit is reduced if the
company is producing only
one product or a range of
products with similar costs
• Complex situations may have
multiple cost drivers
Therefore, ABC is suitable for larger organisations and the service sector. Details are as
follows:
•
When production overheads are high relative to prime costs such as service sector
•
When production overheads are high relative to prime costs
•
When there are considerable differences in the use of resources by products
•
Where consumption of resources is not driven by volume.
43
CHAPTER 2B: TARGET COSTING
44
OVERVIEW
What will you learn?
TARGET COSTING
I.
Overview of target costing
II.
Closing a target cost gap
III.
Target costing in service industry
45
I. OVERVIEW OF TARGET COSTING
1. What is target costing?
But this method is no longer suitable in
competitive market.
To sell product or service, target costing
method is used. Under this method:
1. Firstly, selling price is set based on
market price
2. Secondly, identify required profit
margin
3. Finally, target cost is formed
Traditionally
Target costing
Under traditional costing method:
1. Firstly, cost is always determined
2. Secondly, expected profit is set
3. Finally, selling price is formed
Step 1:
Identify cost
Step 1: Identify
selling price
Step 3:
Determine
selling price
Step 2:
Set expected profit
(% mark-up cost)
Step 3:
Determine
target cost
Step 2: Set
expected profit
(% mark-up cost)
Note: There is a difference between a mark-up and a margin
• A mark-up is the profit expressed as a percentage of cost (cost is 100%)
• A margin is the profit expressed as a percentage of the sales price (sales is 100%)
46
I. OVERVIEW OF TARGET COSTING
1. What is target costing?
Thus, target costing was born.
Target costing involves setting a target cost by subtracting a desired profit margin
from a target selling price.
Target cost is the cost at which a product must be produced and sold in order to
achieve the required amount of profit at the target selling price.
When a product is first planned, its estimated cost will often be higher than its target
cost.
The aim of target costing is then to find ways of closing this target cost gap and
producing and selling the product at the target cost.
Achieving a target cost will usually require some redesigning of the product and the
removal of unnecessary costs. Target costing therefore encourages a business to
examine its processes and costs carefully.
47
I. OVERVIEW OF TARGET COSTING
2. Implementing target costing
Target costing is carried out through 7 steps:
1
Define product specification and estimate sales volume (if any)
2
Decide a target selling price
3
Estimate required profit based on profit margins or return on investment
4
Calculate target cost = Target selling price (step 2) - Target profit (step 3)
5
Estimate cost for the product based on the product specification and
current cost levels
6
Calculate target cost gap = Estimated cost (step 5) - Target cost (step 4)
7
Make efforts to close the cost gap (see section II)
48
I. OVERVIEW OF TARGET COSTING
2. Implementing target costing
Example 1 (Question)
SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.
Cost information for the new hutch is as follows:
•
Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
•
Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
•
Wire: 1m of wire is needed at a cost of $1.50 per metre
•
Labour: 2 hours are required. Labour is paid at a rate of $7/hour
•
Variable overhead: These will be incurred at a rate of $1.50 per labour hour.
Required: Calculate the target cost gap of the new product.
49
I. OVERVIEW OF TARGET COSTING
2. Implementing target costing
Example 1 (Answer)
Step 1: Define product specification and estimate sales volume (if any)
Product is rabbit hutch, which is made from timber, felt and wire.
Sales volume: no information is mentioned in the question.
Step 2: Decide a target selling price
Target selling price is $125
Step 3: Estimate required profit based on profit margins or return on investment
Profit is required at a margin 25% on sales.
So, target profit = 25% x $125 = $31.25
Step 4: Calculate target cost
Target cost = Target selling price (step 2) - Target profit (step 3)
= $125 - $31.25 = $93.75
50
I. OVERVIEW OF TARGET COSTING
2. Implementing target costing
Example 1 (Answer)
Step 5: Estimate cost for the product based on the product specification and
current cost levels
Estimated costs
$
Timber
48.0
Felt roofing material [17.5 x $2]
35.0
Wire [1 x $1.5]
1.5
Labour [2 x $7]
14.0
Variable overhead [2 x $1.5]
Total
Step 6: Calculate target cost gap
Target cost gap = Estimated cost (step 5) - Target cost (step 4)
= $101.5 - $93.75 = $7.75
3.0
101.5
51
II. CLOSING A TARGET COST GAP
Value analysis
To close a target cost gap, it is important to understand which features of the product
are essential for customers and to maintain product quality. This is known as value
analysis.
Value analysis involves examining the factors which affect the cost of a product or
service, so as to come up with ways of achieving the intended purpose most
economically at the required standards of quality and reliability.
Value can be viewed from a number of different perspectives:
Cost value
The cost of
producing and
selling an item
Exchange value
The market value
of the product or
service
Use value
The purposes it
fulfils (performance,
reliability)
Esteem value
The prestige the
customer attaches
to the product
Value analysis seeks
•
to refine the design of the product to reduce unit cost
•
to provide the same use value at the lowest cost
•
to maintain or enhance the esteem value of a product at the lowest cost
The aim of value analysis is to reduce cost without compromising other aspects of value.
52
II. CLOSING A TARGET COST GAP
Techniques can be used to improve production processes
Management can then set benchmarks for improvement towards the target cost, by
improving production technologies and processes, such as:
Reduce the number of components
Use cheaper staff (where this does not affect quality)
Use standard components wherever possible
Acquire new, more efficient technology
Training staff in more efficient techniques
Cut out non-value added activities
Use different materials (identified through activity analysis that is an analysis of
how much is being spent on particular activities)
53
II. CLOSING A TARGET COST GAP
Techniques can be used to improve production processes
Example 2 (Question)
SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.
Cost information for the new hutch is as follows:
•
Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
•
Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
•
Wire: 1m of wire is needed at a cost of $1.50 per metre
•
Labour: 2 hours are required. Labour is paid at a rate of $7/hour
•
Variable overhead: These will be incurred at a rate of $1.50 per labour hour.
Required:
From Example 1 result, target cost gap = $7.75
Recommend appropriate strategies for House Co to close the cost gap.
54
II. CLOSING A TARGET COST GAP
Techniques can be used to improve production processes
Example 2 (Answer)
As above mention, raising the selling price is not an appropriate strategy for
closing the cost gap.
As rabbit hutch is a top new product, its quality depends on main material and
skill labour. Thus, there is a risk that using lower quality timber and labour would
be likely to reduce the quality of the finished product and so would not be
suitable strategies here.
SAP Co could consider some following strategies:
•
Make the hutch smaller
•
Make the window bigger which helps to increase the proportion of wire and
reduce the proportion of wood
55
III. TARGET COSTING IN SERVICE INDUSTRIES
Services industries and problems with target costing
Services are any activity or benefit that one party can offer to another that is essentially
intangible and does not result in the ownership of anything. Its production may or may not be
tied to a physical product.
Unlike manufacturing, service industries have the following characteristics which make cost and
performance measurement more difficult:
Characteristic
Explanation
Problem with target costing
Intangibility
Unlike goods, there are no
substantial material or physical
aspects to a service: no taste,
feel, visible presence, and so on
Some of the features of service cannot be
properly specified, so it is difficult to know
what a customer receive exactly
When services do not have any material
content, it is not possible to reduce costs
to a target level by reducing material costs
Inseparability
Services are created at the same
time as they are consumed
Variability
It is difficult to maintain
consistency in the standard of
service offered
Perishability
Services are innately perishable
No transfer of
ownership
As service has no physical
aspects, it cannot transfer
ownership as goods or property
When services are variable, it is possible
to calculate an estimated average cost,
but this is not specific and so not ideal for
target costing
56
CHAPTER 2C:
LIFE CYCLE COSTING
57
OVERVIEW
What will you learn?
LIFE CYCLE COSTING
I.
Product life cycle
II.
Life cycle costs
III.
Discussion about life cycle costing
58
I. Product life cycle
The product life cycle
The product life cycle (PLC) can be divided into five stages:
(1) Development
(2) Introduction
(3) Growth
(4) Maturity
(5) Decline
(1)
(2)
(3)
(4)
(5)
59
I. Product life cycle
The product life cycle
Details of 5 stages in PLC are as follows:
Stage
Explanation
Sales volume
Costs
(1)
Development
The product is
researched or designed
and developed
None
(2)
Introduction
The product is
launched to the
market
Very low levels
Very high fixed costs such
as non-current assets,
advertising
(3)
Growth
The product gains a
bigger market
Rapid increase
Increase in variable costs
Some fixed costs increase
such as increased number
of factories
(4)
Maturity
Sales of product have
reached a peak and are
fairly stable
Stable and high
volume
Primarily variable costs
(5)
Decline
The product is decided
to stop selling
Falling demand
Primarily variable costs
decreased
Some fixed costs such as
decommissioning costs
Research and
development (R&D)
60
II. Life cycle costs
Costs over the product life cycle
Life cycle costs of a product are all the costs attributable to the product over its entire
life, from product concept and design to eventual withdrawal from the market.
The elements of a product's cost over its life cycle could include the followings:
R&D costs
• Design costs
• Cost of making a prototype
Cost of purchasing any
technical data required
Purchasing the right from another
organization to use a patent
Training costs
Initial operator training and
skills updating
Production costs
• Direct material
• Labour costs
Distribution costs
Transportation and handling
costs
Marketing and advertising
• Customer service
• Field maintenance
Inventory costs
• Holding spare parts
• Warehousing
Retirement and disposal costs
• Decommissioning costs
• Costs of cleaning up a
contaminated site
61
III. Discussion about life cycle costing
1. What is life cycle costing?
Under traditional costing techniques:
Costs of a product could be determined from incurred costs which is based on the
financial accounting year.
The profitability of a product could be assessed wrongly as:
• Some products have a very long development phase, possibly more than a financial
year.
• At development phase, it does not generate revenue but requires a huge cost.
So, it is reasonable to tracks and accumulates costs and revenues attributable to each
product over its entire product lifecycle.
Thus, life cycle costing was born.
Life cycle costing is the accumulation of costs over a product's entire life.
Life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be
generated from selling this product at different target prices throughout the product’s
life.
62
III. Discussion about life cycle costing
1. What is life cycle costing?
Example 1 (Question)
Solaris specializes in the manufacture of solar panels. It is planning to introduce a new
slimline solar panel specially designed for small houses. Development of the new panel
is to begin shortly, and Solaris is in the process of determining the price of the panel. It
expects the new product to have the following costs:
Units manufactured and sold
R&D costs
Year 1
Year 2
Year 3
Year 4
2,000
15,000
20,000
5,000
$
$
$
$
1,900,000
100,000
-
-
100,000
75,000
50,000
10,000
Production cost per unit
500
450
400
450
Customer service costs per unit
50
40
40
Marketing costs
Disposal of specialist equipment
40
300,000
The Marketing Director believes that customers will be prepared to pay $500 for a
solar panel but the Financial Director believes this will not cover all the costs
throughout the life cycle.
Required: Calculate the cost per unit looking at the whole life cycle and comment on
the suggested price.
63
III. Discussion about life cycle costing
1. What is life cycle costing?
Example 1 (Answer)
Cost per unit is determined as follows:
R&D costs
Year 1
Year 2
Year 3
Year 4
Total
$’000
$’000
$’000
$’000
$’000
1,900
100
-
-
Marketing costs
100
75
50
10
235
Production cost (*)
1,000
6,750
8,000
2,250
18,000
100
600
800
200
1,700
Customer service costs (**)
Disposal costs
300
Total life cycle costs
Total production
(‘000 units)
Cost per unit
2,000
300
22,235
2
15
20
5
42
529.4
(*) Production cost = Units manufactured and sold x Production cost per unit
(**) Customer service costs = Units manufactured and sold x Customer service costs
per unit
64
III. Discussion about life cycle costing
2. Benefits of life cycle costing
Life cycle costing has some following benefits:
Help management to assess profitability
over the full life of a product, thanks to
which, they decide whether to develop the
product, or to continue making the product
Be useful for developing products with a
relatively short life as management may be
possible to estimate sales volumes and
prices with reasonable accuracy
Help management to decide earlier actions
to generate more revenue or cut more
costs
Help management to make better
decisions as they are able to assess
revenues and costs more accurately and
realistically, at least within a particular life
cycle stage
Provide more useful information for
enterprises to prepare long-term business
plan
65
III. Discussion about life cycle costing
3. Maximising return over the product life cycle
There are a number of ways that return can be increased over the life cycle.
Details are as follows:
Design
costs out of
products
Approximately 70%–90% of a product’s life cycle costs are
determined at the design and development stage. Thus,
design and production teams must work together to ensure
costs are minimised
Minimise
the time to
market
When a new product launched, it is vital to get it into the
marketplace as quickly as possible to increase market
share, cut more incurred extra costs and extend the life
span of product
Minimise
breakeven
time (BET)
BET is time that revenue from the product has covered all
life cycle costs, so BET is very important for liquidity
purposes
Extend the
length of
the life
cycle itself
The longer the life cycle, the greater the profit that will be
generated. The life cycle could be maximized through finding
other uses for a product or staggering the launch of the
product in different markets.
66
CHAPTER 2D: THROUGHPUT
ACCOUNTING
67
OVERVIEW
What will you learn?
I.
Theory of constraints
II.
Throughput accounting
68
I. THEORY OF CONSTRAINTS
1. Terminology
There are some terminologies needed to remember:
Definition
Theory of
constraints (TOC)
Throughput
An approach to production management which aims
to maximize sales revenue less material cost. It
focuses on bottlenecks which act as constraints to
the maximization of throughput.
The money generated from sales minus the cost of
the materials used in making the items sold.
Throughput = Sales – Material costs
Bottleneck
resources
(Binding
constraints)
An activity which has a lower capacity than
preceding or subsequent activities, thereby limiting
throughput.
69
I. THEORY OF CONSTRAINTS
2. Production scheduling and the bottleneck resource
Bottleneck resource should be considered in production scheduling in some following
ways:
There is always bottleneck
resource during normal production
process; therefore, idle time of
other resources are inevitable and
should be accepted.
Production must be
fully utilized to the limit
of bottleneck resource’s
capacity to avoid workin-progress which brings
back no profit.
Buffer inventory should be
maintained as in Just-in-time
(JIT) system.
70
I. THEORY OF CONSTRAINTS
2. Production scheduling and the bottleneck resource
Example 1:
Machine X can process 600 kg of raw material per hour, machine Y can process
only 400 kg per hour. With an input of 600 kg, 200 kg of processed material must
wait on the bottleneck machine (machine Y) at the end of an hour of processing
because machine Y does not have enough capacity.
Input
600 kg
Machine X
(1000kg/hour)
600 kg
Machine Y
(400kg/hour)
400 kg
in capacity
out of capacity
200 kg
wait Machine Y to be processed
 incur additional costs but
earn no money
71
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Goldratt devised a five-step approach to summarise the key stages of TOC.
Step 1: Identify
Identify the binding
constraint/ bottleneck
1
5 stages to
deal with
bottleneck
activity
5
4
2
3
72
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Question):
Demand for a product made by P Ltd is 500 units per week. The product is made in
three consecutive processes – A, B and C. Process capacities are:
Process
A
B
C
Capacity per week
400
300
250
The long-run benefit to P Ltd of increasing sales of its product is a present value of
$25,000 per additional unit sold per week.
Investigations have revealed the following possibilities:
(1) Invest in a new machine for process A, which will increase its capacity to 550
units per week. This will cost $1m.
(2) Replace the machine in process with an upgraded machine, costing $1.5m. This
will double the capacity of process B.
(3) Buy an additional machine for process C, costing $2m. this will increase capacity
in C by 300 per week.
Required: What is P Ltd.’s best course of action?
73
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
Actions
Process
Demand
Production
250 units
500 units
250 units
250 units
250 units
500 units
250 units
300 units
+ 300 units
500 units
300 units
Step 1: Identify
Process A
Process B
Process C is constraint
with lowest capacity
400 units
300 units
250 units
400 units
300 units
250 units
Choose option (3):
• Buy additional
machine costing
$2,000,000
400 units
• Capacity increases in
C by 300 units/week
Apply option (3) to increase
process C’s capacity by 300 units
Process C
Step 2: Exploit
Highest possible output
must be achieved from
process C – 250 units
Step 3: Subordinate
Process A, B operate at
the same speed as
process C – 250
units/week
Step 4: Elevate
Elevate process C
250 units
550 units
74
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
After elevating process C, the lowest of the capacities is 300 on process B now so we
will be able to produce and sell this amount hence this is the production figure.
The production & sales have gone from 250 to 300 so a 50 increase.
Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 50 =
1,250,000.
With the cost of machine of $2,000,000, this doesn’t give us a benefit.
 It is worth investigating further. Process B is bottleneck now so we can attempt
to resolve this. Let’s consider the following slide.
75
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
Actions
Process
Demand
Production
Step 1: Identify
Process A
Process B is constraint
now after elevating
process C
400 units
300 units
550 units
400 units
300 units
550 units
500 units
300 units
300 units
300 units
300 units
500 units
300 units
550 units
500 units
400 units
Process B
Process C
Step 2: Exploit
Highest possible output
must be achieved from
process B – 300 units
Step 3: Subordinate
Process A, C operate at
the same speed as
process B – 300
units/week
Step 4: Elevate
Elevate process B
Choose option (2):
• Upgrade machine
costing $1.5m
• Capacity doubled per
week
300 units
400 units
x2
600 units
Apply option (2) to
double process B’s capacity
76
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
After elevating process B, the lowest of the capacities is 400 on process A now so we
will be able to produce and sell this amount hence this is the production figure.
The production & sales have gone from 250 to 400 so a 150 increase.
Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 150 =
3,750,000.
With the cost of machine of $2,000,000 (Process C’s machine) & $1,500,00 (Process
B’s machine), it give a net benefit of $250,000.
 Whilst this is good, it could be better so it is worth seeing whether we should do
all three options. Let’s consider the following slide.
77
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
Actions
Step 1: Identify
Process A is constraint
now after elevating
process C & B
Process
Demand
Production
550 units
500 units
400 units
400 units
400 units
500 units
400 units
600 units
550 units
500 units
550 units
Process A
Process B
Process C
400 units
600 units
550 units
400 units
600 units
400 units
Step 2: Exploit
Highest possible output
must be achieved from
process A – 400 units
Step 3: Subordinate
Process B, C operate at
the same speed as
process A – 300
units/week
Step 4: Elevate
Elevate process A
Choose option (1):
• Invest new machine
costing $1,000,000
• Capacity increases in
A to 550 units/week
400 units
+ 150 units
550 units
Apply option (1) to increase process A’s
capacity to 550 units
78
I. THEORY OF CONSTRAINTS
3. Dealing with bottleneck activities
Example 2 (Answer):
After elevating process A, the lowest of the capacities is 550 on process A & C now.
We can produce this amount but there is no point as we only have demand of 500
so that becomes our production level.
Sales demand is our bottleneck.
The production & sales have gone from 250 to 500 so a 250 increase.
Each of these units has a benefit of $25,000 so this is a benefit of $25,000 x 250 =
6,250,000.
With the cost of machine of $2,000,000 (Process C’s machine) & $1,500,00 (Process
B’s machine) & $1,000,000 (Process A’s machine), it give a net benefit of $1,750,000.
79
II. THROUGHPUT ACCOUNTING
1. Concepts in throughput accounting
Throughput accounting (TA) is an approach to production management which aims to
maximize sales revenue less material cost, while also reducing inventory and
operational expense.
TA is based on the following concepts, all derived from the TOC:
In the short run, all cost in the factory (except for material
costs) are fixed costs and called Total Factory Costs (TFC)
Ideal inventory level is zero. WIP should be valued at material
cost only, so no profit earned until the sale takes place.
Profitability is determined based on how quickly goods can be
produced to sell.
80
II. THROUGHPUT ACCOUNTING
2. Comparison between throughput accounting and conventional
cost accounting
Throughput accounting
Conventional cost accounting
Inventory
Inventory is not an asset.
It is result of unsynchronized
manufacturing and is barrier to
making profit.
Inventory
Inventory is an asset
Cost classification
Such classifications are no longer
useful
Cost classification
Costs can be classified either as
direct or indirect.
Labour cost
All labor costs are part of TFC, which
are fixed costs
Labour cost
Direct labor is a variable cost
Profitability
Profitability is determined by the rate
at which money and throughput is
earned
Profitability
Product profitability can be determined
by deducting a product cost from
selling price
Profit
Profit can be increased by reducing
cost elements
Profit
Profit is a function of material cost, TFC
and throughput.
Profit = Throughput – TFC
81
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
Throughput accounting will be tested mostly on application to production industry using
be guidance below, service industry will apply the same mindset.
The following guidance should be followed:
Step 1
Determine the bottleneck resource
Step 2
Calculate the throughput per unit for
each product
Step 3
Calculate throughput per bottleneck resource
(*)
Step 4
Rank product
Step 5
Allocate resources to arrive at
optimum production plan
(*) In Step 3, there are 2 ways to produce optimum production plan (throughput
maximized):
• Calculate throughput per unit per bottleneck resource
• Calculate throughput accounting ratio (TPAR)
82
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.1
Use throughput ranking
Example 3 (Question):
WR Co manufactures three (03) products. A, B, and C. Product details are as follow:
Sales price
Materials cost
Direct labor cost
Weekly sales demand
Product A
$
2.8
1.2
1.0
4,000 units
Product B
$
1.6
0.6
0.8
4,000 units
Product C
$
2.4
1.2
0.8
5,000 units
Machine hours per unit
0.5 hours
0.2 hours
0.3 hours
Machine time is a bottleneck resource and maximum capacity is 4,000 machine
hours per week. Operating costs including direct labor costs are $10,880 per week.
Direct labor workers are not paid overtime and work a standard 38-hour week.
Required: Determine the optimum production plan for WR Co and calculate the
weekly profit that would arise from the plan.
83
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.1
Use throughput ranking
Example 3 (Answer):
Step 1: Determine the bottleneck resource
The bottleneck resource is machine time (4,000 machine hours available each week).
Step 2: Calculate the throughput per unit for each product
Sale price
Less: Materials cost
Throughput per unit
Product A
$
2.8
(1.2)
1.6
Product B
$
1.6
(0.6)
1.0
Product C
$
2.4
(1.2)
1.2
Step 3: Calculate throughput per unit of limiting factor (machine hours)
Machine hours per unit
Throughput per machine hour
Product A
$
0.5 hours
$3.2
Product B
$
0.2 hours
$5
$1.6 throughput per
unit/0.5 hours
Product C
$
0.3 hours
$4
84
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.1
Use throughput ranking
Example 3 (Answer):
Step 4: Rank product
Product A
Product B
Product C
3rd
1st
2nd
Step 5: Allocate resources to arrive at optimum production plan
The profit-maximizing weekly output and sales volumes are as follow:
B
C
4,000
5,000
Bottlenecks
resource
hours/unit
0.2 hours
0.3 hours
A (balancing -β)
3,400
0.5 hours
Product
Units
1,700/0.5
Total
hours
800
1,500
2,300
1,700
4,000
Throughput
per hour
($)
5.0
4.0
3.2
Total
throughput ($)
4,000
6,000
5,440
15,440
Less: operating expenses
(10,880)
Profit per week
4,560
85
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.1
Use throughput ranking
The throughput accounting ratio (TPAR ratio) is the ratio of the throughput per unit of
bottleneck resource to the factory per unit of bottleneck resource. This ratio should be
as high as possible, and certainly more than 1.
The formula of TPAR ratio:
Throughput per unit of bottleneck resource
TPAR ratio = Factory cost per unit of bottleneck resource
Note:
•
‘Per unit of bottleneck resource’ means the same with ‘per factory hour’ in this
context
•
‘Total factory costs’ (TFC) are also described as ‘Total operating costs’. (These are
cost other than material cost, and regarded as fixed cost per period)
86
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
Interpretation of TPAR ratio:
•
TPAR ratio should exceed 1.0. This means total throughput should exceed total
factory costs otherwise the organization will make a loss.
•
In terms of performance measurement, products can be ranked in order of priority
for manufacture and sale in order of their TPAR ratios. (Higher TPAR ratios should
be given priority over lower TPAR ratios).
However, ranking products in order of priority according to their TPAR ratio will always
give the same ranking as putting them in order of throughput per unit of bottleneck
resource.
87
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
Example 4 (Question):
Corrie Company produces three (03) products, X, Y and Z. The capacity of Corrie’s
plant is restricted by process Alpha. Process Alpha is expected to operate for 8 hours
per day and can produce 1,200 units of X per hour; 1,500 units of Y per hour and 600
units of Z per hour.
Selling prices and material costs for each product are as follow.
Product
X
Y
Z
Selling price
$ per unit
150
130
300
Material cost
$ per unit
80
40
100
Operating costs are $720,000 per day.
Required:
(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,5000
units of Y and 1,200 units of Z.
(b) Calculate the TPAR for each product.
(c) In the absence of demand restrictions for the three products, advise Corrie’s
management on the optimal production plan.
88
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
Example 4 (Answer):
(a)
Profit = Throughput (W) – TFC = Sales – Material cost – TFC (or operating costs)
= 1,065,000 – 720,000 = 345,000
(W)
Product
units
Selling price
$ per unit
Material cost
$ per unit
Throughput
$ per unit
Total
throughput
X = 6,000
150
80
70
420,000
Y = 4,500
Z = 1,200
130
300
40
100
90
200
405,000
240,000
1,065,000
150-80
89
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
Example 4 (Answer):
(b)
TPAR ratio =
Throughput per unit of bottleneck resource (i)
Factory cost per unit of bottleneck resource(ii)
(ii) Factory cost per unit of bottleneck resource = Operating cost per factory hour =
$720,000/8 hours = $90,000
Throughput per unit * total unit per
factory hour = 90 * 1,500
(i)
Product
X
Y
Z
Throughput per factory hour
84,000
135,000
120,000
Cost per factory hour
$90,000
$90,000
$90,000
0.93
1.50
1.33
1
2
TPAR
Ranking
90
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
Example 4 (Answer):
(c)
Since Product Y is ranked 1st, highest TPAR, it should be prioritized to be made
and sold first. If only Product Y is made and sold (no limit on sales demand):
$
1,500 units
Total output per day (units)
12,000
per hour
Total throughput ($90/unit)
1,080,000
× 8 hours
Operating costs
(720,000)
Total profit per day
360,000
This is $15,000 ($360,000 - $345,000) per day more than the profit from the
production mix in part (a).
TPAR ratio of Product X is 0.93, below 1. This means it makes less throughput per
hour than its factory cost per hour. Corrie should stop production for X.
91
II. THROUGHPUT ACCOUNTING
3. Application of throughput accounting in performance measurement
3.2
Use throughput accounting ratio (TPAR) ranking
How to improve TPAR ratio?
The ratio is increased by either:
Detail actions
Increase selling price of product
Increase throughput per
bottleneck hour
Reduce material costs
Improve efficiency, and increase the number of units or
product that are made in each bottleneck hour
Reduce expenditure on operating costs/ factory costs
Reduce the operating
cost per bottleneck hour
Elevate the bottleneck, so there are more hours
available of the bottleneck resource
Note:
Throughput accounting approach is similar to approach of maximizing contribution per
unit of scarce resource which you will see later in Chapter 6: Limiting factor analysis.
92
CHAPTER 3:
RELEVANT COST ANALYSIS
93
OVERVIEW
What will you learn?
RELEVANT COST ANALYSIS
I.
Apply relevant cost analysis for specific situations
II.
Opportunity costs
94
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
1. Definition of relevant costs
Relevant costs are future cash flows arising as a direct consequence of a decision
3 conditions for costs to be recognized as relevant costs:
Cost must be a cost that will
occur in the future
Cost must be a cost (or benefit)
that results in cash flow
Cost is an incremental cost,
arising as a direct consequence
of the decision
Tuf Co decides to produce tofu to serve
foreign customers, which require
soybeans for raw material. It is obvious
that cost of soybeans purchase is a
relevant cost as:
•
•
•
It arising directly from decision of
producing tofu or it occur in the
future
Cash flow of Tuf Co is affected
It is an incremental cost of Tuf Co
arising directly from decision of
producing tofu
95
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
1. Definition of relevant costs
Therefore, the followings are non-relevant costs:
1
SUNK COSTS
Sunk costs are costs already incurred. They are not relevant in decisionmaking and are therefore ignored.
2
COMMITTED COSTS
Committed costs have already been committed to and so are not relevant to
the decision. Example is the cost of materials under a long-term contract.
3
NOTIONAL COSTS
Notional costs are non-cash items or accountancy entries
4
FIXED COSTS
Fixed costs are allocated, and general fixed costs are not specific to a
decision. Avoidable fixed costs would be relevant.
96
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.1
Relevant cost of materials
There are several questions to consider when identifying relevant cost of material: “in
stock, regularly used or any alternative use?”
How to determine relevant cost of materials:
Note: At each step, when relevant cost is determined in full, the calculation should be
stopped.
97
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.1
Relevant cost of materials
Example 1 (Question)
A company is considering making a new product which requires several types of raw
material:
Units in
inventory
Units
required
A
Nil
40
Current purchase price is $7/unit.
B
100
purchased
for $10/unit
150
Current purchase price is $14/unit. The material
has no use in the company other than for the
project under consideration. Units in inventory
can be sold for $12/unit.
C
50
purchased
for $20/unit
120
Current purchase price is $22/unit. The material
is regularly used in current manufacturing
operations.
Material
Additional information
Required: What is the relvant cost of the materials required for manufacturing the
new product?
98
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.1
Relevant cost of materials
Example 1 (Answer)
A.
40 needed in
total
B.
150 needed in
total
C.
120 needed in
total
Step 1:
in stock?
Step 2:
regularly used?
Step 3:
alternative use?
Relevant cost
No.
40
-
-
Purchase cost.
= 40x7 = $280
Yes.
100
No.
50 needed
more
Yes.
50
No.
70 needed
more
No.
100
Disposal cost.
=100x12=$1,200
Purchase cost.
=50x14=$700
Yes.
50
Purchase cost.
=50x22=$1,100
Purchase cost.
=70x22=$1,540
99
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.2
Relevant cost of labor
How to determine relevant cost of labour:
Note: At each step, when relevant cost is determined in full, the calculation should be
stopped.
100
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.2
Relevant cost of labor
Example 2 (Question)
A company has a new project which requires the following three types of labor:
Hours required
Unskilled
12,000
Semi-skilled
2,000
Skilled
8,000
Additional information
Paid at $8 per hour and existing staff are fully
utilised. The company will hire new staff to meet
this additional demand.
Paid at $12 per hour. These employees are
difficult to recruit and the company retains a
number of permanently employed staff, even if
there is no work to do. There is currently 800
hours of idle time available and any additional
hours would be fulfilled by temporary staff that
would be paid at $14/hour.
Paid at $15 per hour. There is a severe shortage
of employees with these skills and the only way
that this labor can be provided for the new
project would be for the company to move
employees away from making Product X. A unit
of Product X takes 4 hours to make and makes a
contribution of $24/unit.
Required: What is the relevant cost of the labor hours required for the new project?
101
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.2
Relevant cost of labor
Example 2 (Answer)
Unskilled
12,000 hours
required in total
Step 1:
Spare capacity?
Step 2:
Hire staff?
No.
Yes.
12,000
Semi-skilled
2,000 hours
required in total
Yes.
800
No.
1,200 needed
more
Skilled
8,000 hours
required in total
No.
8,000
Yes.
1,200
No.
8,000
Relevant cost
Current rate of pay.
= $12,000 × 8 =
$96,000
Relevant cost.
=0
Current rate of pay.
= $1,200 × 14 =
$16,800
Variable costs.
= $8,000 ×
15=$120,000
Lost contribution.
= $8,000 × (24/4)
= $48,000
102
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.3
Relevant cost of machine use
Once a machine has been bought its purchase cost is a sunk cost.
As mentioned above, depreciation is not a relevant cost. However, using machinery may
involve some incremental costs such as:
Repair costs
arising from use
Hire charges
Fall in resale value
arising from use
103
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.3
Relevant cost of machine use
Example 3 (Question)
Co is considering whether to undertake some contract work for a customer. A special
cutting machine will have to be hired for three months for the work (the length of the
contract). Hire charges for this machine are $75 per month, with a minimum hire
charge of $300.
Required: What are the relevant costs?
104
I. APPLY RELEVANT COST ANALYSIS
FOR SPECIFIC SITUATIONS
2. Identification relevant costs in specific situations
2.3
Relevant cost of machine use
Example 3 (Answer)
In order to undertake the contract, Co must hire further a cutting machine for 3
months (incremental costs).
•
•
Rent cost = 3x75 = $225
Minimum hire charge = $300
Thus, relevant costs = $300.
Note: Process to calculate relevant costs
•
Identify correctly types of relevant costs (material, labour or machine use)
•
Follow step by step as mentioned.
105
II. OPPORTUNITY COST
Definition
Opportunity cost may also be a type of relevant cost.
Opportunity cost is the value of a benefit sacrificed when one course of action is
chosen, in preference to an alternative.
The opportunity cost is represented by the forgone potential benefit from the best
rejected course of action.
106
II. OPPORTUNITY COST
Definition
Example 4 (Question)
A company has a new project which requires the following three types of labor:
Hours required
Unskilled
12,000
Semi-skilled
2,000
Skilled
8,000
Additional information
Paid at $8 per hour and existing staff are fully
utilised. The company will hire new staff to meet
this additional demand.
Paid at $12 per hour. These employees are
difficult to recruit and the company retains a
number of permanently employed staff, even if
there is no work to do. There is currently 800
hours of idle time available and any additional
hours would be fulfilled by temporary staff that
would be paid at $14/hour.
Paid at $15 per hour. There is a severe shortage
of employees with these skills and the only way
that this labor can be provided for the new
project would be for the company to move
employees away from making Product X. A unit
of Product X takes 4 hours to make and makes a
contribution of $24/unit.
Required: What are the opportunity costs in this scenario?
107
II. OPPORTUNITY COST
Definition
Example 4 (Answer)
If the skilled labor does not undertake the new project, they could do product X to get
a contribution of $6 per hour. Thus, opportunity cost = 8,000 hours x $6 = $48,000.
The opportunity cost is the contribution forgone from not being able to put it to its
alternative use. Therefore, opportunity cost is a relevant cost but not versa.
108
CHAPTER 4:
SHORT TERM DECISIONS
109
OVERVIEW
What will you learn?
TARGET COSTING
I.
Minimum price decisions
II.
Make or buy decisions
III.
Outsourcing
IV.
Further processing decisions
V.
Shutdown decisions
110
I. MINIMUM PRICE DECISIONS
How to carry out minimum price decisions ?
The minimum price for a one-off decision is its total relevant costs. This is the price at
which the business would break-even.
Three steps to determine the minimum price is presented below:
Step 1
Identify relevant cost factors
Step 2
Calculate relevant costs for cost
factors determined at Step 1
Step 3
Determine the minimum price
111
I. MINIMUM PRICE DECISIONS
How to carry out minimum price decisions ?
Example 1 (Question)
JAPP Co has been approached by a customer to manufacture a specialized
machine. This would be a one-off order which JAPP Co would undertake in
addition to its normal budgeted production.
The assistant accountant has prepared the following quotation:
Direct materials:
Aluminum plating (20 m2 @ $10 per m2 )
Rivets (100 @ $1 each)
Direct labor:
Skilled (50 hours @ $16 per hour)
Semi-skilled (20 hours @ $10 per hour)
Overheads
Notes
$
1
2
200
100
3
4
5
800
200
100
1,400
140
1,540
308
1,848
Administration overhead @ 10% of production cost
6
Profit 20% of total cost
Selling price
7
112
I. MINIMUM PRICE DECISIONS
How to carry out minimum price decisions ?
Example 1 (Question)
Notes:
(1) The aluminum plating is regularly used on other work within the business.
It has an inventory value of $10 per m2 although the current purchase
price has recently risen to $12 per m2 . There are 20 m2 of aluminum
plating in stock and these are used regularly.
(2) Rivets are currently held in inventory and cost $1 each although the
company has no further use for them. They could be sold to a scrap
merchant for $0.50 each.
(3)
(4)
(5)
(6)
(7)
Skilled laborer are paid $16 per hour and are currently fully utilized on
other work. If the job was undertaken it would be necessary to work a
maximum of 40 hours of overtime (paid at time and a half) and/or reduce
the production of another product which earns contribution of $20 per
hour.
There is currently 100 hours of idle semi-skilled labor time available.
Overheads represent an apportionment to cover factory fixed costs.
It is policy to add 10% to the production cost of each job to cover the
administration cost of orders accepted.
Profit of 20% of total cost is added to each job as part of the standard
pricing policy.
Required: On a relevant cost basis, determine the minimum price which should
be quoted for the job.
113
I. MINIMUM PRICE DECISIONS
How to carry out minimum price decisions ?
Example 1 (Answer)
Step 1: Identify relevant cost factors
Cost factor
Aluminum plating
Rivets
Skilled labor
Semi-skilled labor
Overheads
Administration cost
Relevant
cost?
Explanation
Yes
They are future cash flows arising as a direct
consequence of undertaking the order
No
They will be incurred regardless of whether or not
the order is accepted
Step 2: Calculate relevant costs for cost factors determined at Step 1
Cost factors include 2 groups namely material and labour.
(1) Relevant costs of material
Step 1:
in stock?
Aluminum plating
20 m2 needed in
total
Rivets
100 needed in total
Total
Yes.
10
No.
10
Yes.
100
Step 2:
Step 3:
regularly used? alternative use?
Yes.
10
No.
100
Relevant cost
Purchase cost.
= 10x12 = $120
Purchase cost.
= 10x12 = $120
Disposal cost.
=100x0.5=$50
$290
114
I. MINIMUM PRICE DECISIONS
How to carry out minimum price decisions ?
Example 1 (Answer)
Step 2: Calculate relevant costs for cost factors determined at Step 1
(2) Relevant costs of labor
Step 1:
Spare capacity?
Step 2:
Hire staff?
Relevant cost
No.
Yes.
40
Current rate of pay.
= 40x24=$960
No.
No.
Skilled labor
50 hours required in total
Semi-skilled
20 hours required in total
Yes.
20
Total
Step 3: Determine minimum price decision
The minimum price is total relevant costs = 290 + 1,320 = $1,610.
Variable costs.
= 10x16=$160
Lost contribution.
= 10x20 = $200
Relevant cost = 0
$1,320
115
II. MAKE OR BUY DECISIONS
Overview
In reality, enterprise always face the decision to choose between making items in-house
or purchasing them from an external supplier.
MAKE
BUY
Making items in-house
VS.
Purchasing from external supplier
Example:
Example:
Manufacture its own components
Buy the components from outsiders
Accounting service is carried out
by an internal department
Accounting service is carried out
by a hiring external organization
Some following factors need to be considered:
Direct control
over the work
Quality of
achieved work
Time to complete
the work
Costs incurred
from make or buy
decisions
116
II. MAKE OR BUY DECISIONS
How to conclude make or buy decisions ?
There are two types of make or buy decisions:
1
•
•
Without limiting factors
This type will be covered in this
chapter
The relevant costs for this type
are the mainly differential costs
between the two options.
2
With limiting factors
This type will be covered in
Chapter 6: Limiting factors analysis
Three steps to determine make or buy decisions is presented below:
Step 1
Identify relevant
cost factors
Step 2
Calculate extra
relevant costs of
buying
Step 3
Conclude make
or buy decision
117
II. MAKE OR BUY DECISIONS
How to conclude make or buy decisions ?
Example 2 (Question)
Mars Co makes units Pluto (P) and Jupiter (J), for which costs in the forthcoming
year are expected to be as follows:
P
J
Production (units)
1,000
1,500
Direct materials
Direct labour
Variable production overheads
Total
$
3
6
2
11
$
5
9
3
17
Directly attributable fixed costs per annum and committed fixed costs:
Incurred as a direct consequence of making P
Incurred as a direct consequence of making J
Other fixed costs (committed)
Total
A sub-contractor has offered to supply units of P for $12 and J for $21.
Required: Should Mars make or buy the components?
$
1,500
3,000
10,000
14,500
118
II. MAKE OR BUY DECISIONS
How to conclude make or buy decisions ?
Example 2 (Answer)
Step 1: Identify relevant cost factors
Cost
Relevant
cost?
Explanation
Variable costs
Yes
Directly attributable fixed costs
Committed fixed costs
Yes
They are future cash flows arising as a
direct consequence of making P and J
No
They are not incremental costs
Reference: Chapter 3 Relevant cost analysis.
Step 2: Calculate extra relevant costs of buying
Unit variable cost of making
Unit variable cost of buying
Extra costs of buying per unit
Production volume (units)
Extra variable cost of buying
Fixed costs saved by buying
Extra relevant costs of buying
P ($)
11
12
1
1,000
1,000
(1,500)
(500)
J ($)
17
21
4
1,500
6,000
(3,000)
3,000
Step 3: Conclude make or buy decision
Mars Co should make J as extra cost of buying is obvious. In the case of P, the company
should consider further as some followings:
•
Fixed costs incurred from making P is just estimated, so the saved total costs of
buying of $500 may be incorrect.
•
Other factors such as control, time and quality should be reviewed.
119
III. OUTSOURCING
How to conclude outsourcing decisions ?
Outsourcing is the use of external suppliers for finished products, components or services.
Considering whether to outsource, in fact, involves comparing the costs of making ‘inhouse’ products and the costs to buy products from outside, which is the same mindset of
‘make-or-buy’
3-step process as in make-or-buy could be applied.
However, when considering outsourcing, non-financial factors below should be preferred:
Advantages
Cost savings
Access to expertise
Disadvantages
Loss of control
Impact on quality
Releases capital
Flexibility & reliance of supplier
Frees up capacity
Potential loss of confidential information
Loss of in-house skill
Impact on employees’ morale
120
III. OUTSOURCING
How to conclude outsourcing decisions ?
Example 3 (Question)
Stunnaz is considering a proposal to use the services of a press cuttings agency.
At the moment, press cuttings are collected by a junior member of the marketing
department, who is also responsible for office administration, travel bookings, a
small amount of proofreading and making the tea. The total annual cost of
employing this person is $15,000 pa.
There is concern that the ability of this person to produce a comprehensive file
of cuttings is limited by the time available. They have calculated that they need
to spend about two hours of their seven-and-a-half-hour day simply reading the
national and trade press, but usually only have about five hours a week for this
job.
Press subscriptions currently cost $850 pa and are paid annually in advance.
The assistant makes use of a small micro-fiche device for storing cuttings. The
cuttings are sent to a specialist firm once a month to be put onto fiche. Stunnaz
pays $45 each month for this service. The micro-fiche reader is leased at a cost of
$76 per calendar month. This lease has another 27 months to run.
The cuttings service bureau has proposed an annual contract at a cost of $1,250.
Several existing users have confirmed their satisfaction with the service they
receive.
Required: Should Stunnaz outsource its press cuttings work?
121
III. OUTSOURCING
How to conclude outsourcing decisions ?
Example 3 (Answer)
Step 1: Identify relevant cost factors
Cost
Relevant cost?
Explanation
Salary for junior member
No
This person will still be paid even if we
outsource (because she does other
things as well)
Current subscriptions
Yes
Fee of specialist firm service
Yes
Micro-fiche reader leasing
charge of $76 per month
No
They are future cash flows arising as a
direct consequence of outsourcing
It is a committed cost that must be paid
whatever the decision.
Reference: Chapter 3 Relevant cost analysis.
Step 2: Calculate extra relevant cost of outsourcing
$
Cost of in - house option:
Subscriptions
Specialist firm service [$45 x 12]
Total costs of in- house option
Cost of outsourcing
Extra relevant cost of outsourcing
850
540
1,390
1,250
(140)
122
III. OUTSOURCING
How to conclude outsourcing decisions ?
Example 3 (Answer)
Step 3: Conclusion
It is obvious that if outsourcing is chosen, Stunnaz has potential to save $140 pa.
However, they should have further considerations:
•
The in-house option should give management more direct control over the work,
but the outsource option often has the benefit that the external organization has a
specialist skill and expertise in the work.
•
Will outsourcing create spare capacity? If exist, Stunnaz should do what to get more
benefit.
•
Would the subcontractor be reliable with delivery times and quality?
123
IV. FURTHER PROCESSING DECISIONS
Definition
This decision often involves joint products from a common manufacturing process.
Joint products are two or more outputs from the same process, but which are
indistinguishable from each other up to their split-off point.
Split-off point: The point at which joint products become separately.
Input
Split-off point
At the split-off point, enterprise decides whether they should sell immediately joint
products or whether they should be processed further before selling them.
Product A
Product B
Further process
+ input 2
Process 1
Product
(Further processed)
Joint – product C
By – product C
Sell immediately
Profit 1
Profit 2
124
IV. FURTHER PROCESSING DECISIONS
How to conclude further processing decisions ?
Rules to make further processing decision:
Profit created from selling products processed further is greater than profit created
from selling products immediately.
Profit (for each process) = Revenue created - Relevant costs incurred.
Three steps to determine further processing decisions is presented below:
Step 1
Identify relevant
cost factors
Step 2
Calculate
incremental revenue
and incremental cost
between 2 option
Step 3
Make decision based
on the net profit of
processing further
125
IV. FURTHER PROCESSING DECISIONS
How to conclude further processing decisions?
Example 4 (Question)
The Poison Chemical Company produces two joint products, Alash and Pottum
from the same process.
Joint processing costs of $150,000 are incurred up to the split-off point, when
100,000 units of Alash and 50,000 units of Pottum are produced. The selling
prices at the split-off point are $1.25 per unit for Alash and $2.00 per unit for
Pottum.
The units of Alash could be processed further to produce 60,000 units of a new
chemical, Alashplus, but at an extra fixed cost of $20,000 and variable cost of 30c
per unit of input. The selling price of Alashplus would be $3.25 per unit.
Required: Decide whether the company should sell Alash or Alashplus?
126
IV. FURTHER PROCESSING DECISIONS
How to conclude further processing decisions?
Example 4 (Answer)
Step 1: Identify relevant cost factors
Cost
Relevant
cost?
Extra fixed incurred from
processing Alash further
Yes
Variable costs incurred
from processing Alash
further
Yes
Joint processing costs of
$150,000
No
Explanation
They are future cash flows arising as
a direct consequence of further
processing
They will be incurred regardless of
what the decision is.
Step 2: Calculate incremental revenue and incremental cost between 2 options
Revenue of Alash: $1.25 x 100,000 = $125,000
Revenue of Alashplus: $3.25 x 60,000 = $195,000
Incremental revenue = $195,000 – $125,000 = $70,000
Incremental revenue
$
70,000
Incremental costs:
Fixed costs:
(20,000)
Variable costs
(30,000)
Net profit
20,000
127
IV. FURTHER PROCESSING DECISIONS
How to conclude further processing decisions?
Example 4 (Answer)
Step 3: Make decision based on the net profit of processing further
The net profit of processing further is positive of $20,000.
 Alashplus gives a higher profit of $20,000, thus the company should process
further Alash into Alashplus and sell Alashplus.
Note: There is another approach for step 2 and step 3:
Step 2: Compare profit created from selling immediately and processed further
Alash
$
125,000
Alashplus
(Further process)
$
195,000
0
0
0
125,000
20,000
30,000
50,000
145,000
1.25x100,000
Sales revenue
Relevant costs:
Fixed costs
Variable costs
Total costs
Profit
3.25x60,000
0.3x100,000
Step 3: Make decision based on the more beneficial figures from Step 2
Alashplus gives a higher profit of $20,000 ($145,000 - $125,000), thus the company should
process further Alash into Alashplus and sell Alashplus.
128
V. SHUTDOWN DECISIONS
How to conclude shutdown decisions ?
The consideration of a shutdown decision involves 2 things:
Why?
Make losses or too expensive to run?
Time?
Permanent or temporary
To make decision, 3 aspects need to be considered:
Factors
Financial factor
Explanation
Relevant costs incurred from the decision should be considered.
Timing of
shutdown
Enterprise needs to consider most appropriate timing for a shutdown.
Some costs may be avoidable in long run but not in short run.
Others
• What impact will a shutdown decision have on the morale of
employees who remain?
• What signal will decision give to competitors? How will they react?
• How will customers react? Will they lose confidence in the
company's products?
• How will suppliers be affected? If one supplier suffers
disproportionately there may be a loss of goodwill and damage to
future relations.
129
V. SHUTDOWN DECISIONS
How to conclude shutdown decisions ?
Example 5:
Elen Co manufactures product X. Related information is as follows:
$
Sales revenue
40,000
Variable costs
(25,000)
Contribution
15,000
Fixed costs
(18,000)
Profit/ (Loss)
(3,000)
Because of the loss result, Elen Co is considering whether they should stop
manufacturing X. They find that the total fixed costs of $18,000 includes direct
fixed costs of $5,000. Thus, if product X stopped, $5,000 is saved obviously. The
remained amount of $13,000 is fixed overhead is allocated for X, so it is clearly
they incurred regardless X is.
However, if product X is stopped, the profit will be reduced by $10,000 which
includes $15,000 of contribution and $5,000 of saved direct fixed costs.
Here is the financial aspect. Elen Co needs consider further other factors before
making decision.
130
CHAPTER 5:
COST VOLUME PROFIT ANALYSIS
131
OVERVIEW
What will you learn?
CVP ANALYSIS
I.
Revision of CVP analysis
II.
Application of CVP analysis
III.
Breakeven chart
IV.
Limitation of CVP analysis
132
I. REVISION OF CVP ANALYSIS
1. Rationale of CVP Analysis
The aim of CVP analysis is to consider the effects of differing levels of activity on the profit
target of an enterprise by studying the relationship between costs, sale volume and
profit.
In particular, the enterprise needs to determine the break-even point to set prices and
output levels. If sales exceed the breakeven point the company will make a profit.
The breakeven point is the level of sales at which there is neither profit nor loss.
133
I. REVISION OF CVP ANALYSIS
2. Formulas
Contribution/sale ratio (C/S ratio)
C/S ratio gives the amount of contribution earned per dollar of sales.
Contribution per unit = Unit selling price - Unit variable costs
C/S ratio =
Contribution
x 100%
Sales
Profit = (Sales volume × Contribution per unit) – Fixed costs
Breakeven point (BEP)
Breakeven point is the level of sales at which there is neither profit nor loss.
Breakeven point in units (*) =
Total fixed costs
Contribution per unit
Sales revenue at breakeven point =
Fixed costs
x 100%
C/S ratio
(*) To understand this formular, please read the explanation of breakeven point in
units in the next slide.
134
I. REVISION OF CVP ANALYSIS
2. Formulas
Margin safety
A measure of the amount by which sales must fall before enterprise starts
making a loss. A loss is made if sales volume is less than the BEP.
Margin of safety in units = Budgeted sales - Breakeven sales
Margin of safety in % =
Budgeted sales−Breakeven sales
x 100%
Budgeted sales
Target profit
Enterprise could use CVP analysis to find the volume needed to attain a
required profit level.
Fixed costs +Target cost
Sales volume to achieve target profit = Contribution per unit
Note: Explanation for breakeven point in units:
• Profit = Total sales revenue - Total variable costs - Total fixed costs
• 0 = (Selling price x Sales volume) - (Variable cost per unit x Sales volume) - Total fixed costs
• Total fixed costs = (Selling price - Variable cost per unit) x Sales volume
• Total fixed costs = Contribution per unit x Sales volume
Total fixed costs
• Thus, sales volume (BEP in units) = Contribution per unit
135
II. APPLICATION OF CVP ANALYSIS
1. Single product breakeven analysis
CVP analysis is undertaken through following 5 steps:
Step 1
Determine contribution per unit
Step 2
Determine C/S ratio
Step 3
Determine breakeven point
Step 4
Determine margin of safety
Step 5
Determine sales or sales volume to
achieve target profit
136
II. APPLICATION OF CVP ANALYSIS
1. Single product breakeven analysis
Example 1 (Question):
A company makes and sells a single product. The selling price is $12 per unit. The
variable cost of making and selling the product is $9 per unit and fixed costs per
month are $240,000.
The company budgets to sell 90,000 units of the product a month.
(a) What is the breakeven point?
(b) What is the margin of safety?
(c) What must sales be to achieve a monthly profit of $120,000?
137
II. APPLICATION OF CVP ANALYSIS
1. Single product breakeven analysis
Example 1 (Answer):
(a) Breakeven point
Step 1: Determine contribution per unit
Contribution per unit = Unit selling price - Unit variable costs = $12 - $9 =$3
Step 2: Determine C/S ratio
C/S ratio = Contribution/ Sales x 100% = 3/12 x 100% = 25%
Step 3: Determine breakeven point
Breakeven point in units =
Total fixed costs
$240,000
=
= 80,000 units
3
Contribution per unit
Sales revenue at breakeven point =
$960,000
Fixed costs
$240,000
x 100% = 0.25 x 100% =
C/S ratio
138
II. APPLICATION OF CVP ANALYSIS
1. Single product breakeven analysis
Example 1 (Answer):
(b) Margin of safety
Step 4: Determine margin of safety
Margin of safety in units = Budgeted sales - Breakeven sales
= 90,000 unit – 80,000 unit = 10,000 units
Margin of safety in %
=
Budgeted sales−Breakeven sales
x 100%
Budgeted sales
10,000
= 90,000 x 100% = 11.1%
(c) Target profit of $120,000
Step 5: Determine sales or sales volume to achieve target profit
Sales volume =
Fixed costs +Target cost 240,000 + 120,000
= 120,000 units
Contribution per unit =
3
Sales = Sales volume x Selling price = 120,000 x $12 = $1,440,000
139
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
To perform breakeven analysis for a multi-product organization, assume that a constant
sales mix for the products in order to calculate a weighted average contribution per unit
sold or a weighted average C/S ratio.
A constant sales mix for the products is whenever x units of product A are sold, y units
of product B and z units of product C are also sold.
Steps for multi - product breakeven analysis are as follows:
Step
1
Determine weighted average of the breakeven, margin or target profit
(It is the same 5 steps of single product case)
Step
2
Determine the breakeven, margin or target profit for each product
(Corresponding weighted average x Corresponding ratio of the product
in the mix)
140
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
Example 2 (Question):
PL produces and sells two products, M and N. Product M sells for $8 per unit and
has a total variable cost of $3.8 per unit, while Product N sells for $14 per unit
and has a total variable cost of $4.3 per unit. The marketing department has
estimated that, for every five units of M sold, six units of N will be sold. The fixed
costs per period total $83,160. PL is planning to achieve sales revenue of
$150,040 and another plan to get profit of $39,960.
Required:
(a) What is the breakeven point in sales?
(b) What must sales be to achieve the target profit?
141
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
Example 2 (Answer):
(a) Breakeven point
Step 1: Determine contribution per unit
M
$/unit
8
3.8
4.2
N
$/unit
Selling price
14
Variable cost
4.3
Contribution
9.7
2
• Weighted average contribution per unit
$
Contribution from sale of 5 units of M [5 x $4.2]
21
Contribution from sale of 6 units of N [6 x $9.7]
58.2
Contribution from sale of 11 units
79.2
79.2
Thus, weighted average contribution per unit = 11 = $7.2 (per unit)
142
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
Example 2 (Answer):
(a) Breakeven point
Step 2: Determine C/S ratio
•
Weighted average sales revenue per unit
$
•
Sales revenue of 5 units of M [5 × $8] 2
Sales revenue of 6 units of N [6 × $14]
40
Sales revenue of 11 units
124
84
Weighted average C/S ratio
Weighted average C/S ratio = Contribution/ Sales x 100% = 79.2/124 x100% =
63.87%
143
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
Example 2 (Answer):
(a) Breakeven point
Step 3: Determine breakeven point
•
Weighted average breakeven point
Breakeven point in units = Total fixed costs/ Contribution per unit
= $83,160/7.2 = 11,550 units
Sales revenue at breakeven point = Fixed
2 costs/ C/S ratio = $83,160/ 0.6387 =
$130,200
•
Breakeven point for each product
Sales volume of M = 11,550 x 5/11 = 5,250 units
Sales volume of N = 11,550 x 6/11 = 6,300 units
Sales revenue of M = 40/124 x $130,200 = $42,000
Sales revenue of N = 84/124 x $130,200 = $88,200
144
II. APPLICATION OF CVP ANALYSIS
2. Multi product breakeven analysis
Example 2 (Answer):
(b) Target profit of $39,960
Step 5: Determine sales or sales volume to achieve target profit
Weighted average sales volume =
=
Fixed costs +Target cost
Contribution per unit
83,160 + 39,960
= 17,100 units
7.2
For each product:
2
Product
Sales volume
(units)
Selling price
($/unit)
Sales revenue
($)
M
7,773
(5/11*17,100)
8
62,184
N
9,327
(6/11*17,100)
14
130,578
Total
17,100
192,762
Exam focus point: Determine breakeven point, target profit, margin safety for
specific situations from given data
145
III. BREAKEVEN CHART
1. Single product breakeven chart
A single product breakeven chart records costs and revenues on the vertical axis (y) and
the level of activity on the horizontal axis (x). Lines are drawn on the chart to represent
costs and sales revenue.
Following the step-by-step guidance below can help you to produce your own chart:
Step 1
Step 2
Draw the axes Oxy
Horizontal axis (Ox): level of activity
Vertical axis (Oy): revenue and costs
Determine and draw Fixed cost line
This will be a straight line parallel to the horizontal axis at fixed cost level.
Step 3
Determine and draw Total cost line
• Calculate the total costs for the maximum sales level.
• Join it to the cost incurred at zero activity.
Step 4
Determine and draw Revenue line
• Calculate the revenue at maximum activity.
• Join it to the origin.
Step 5
Determine breakeven point
BEP can be read off where the total sales revenue line cuts the total cost line.
146
III. BREAKEVEN CHART
1. Single product breakeven chart
After drawing single product breakeven chart, the area of margin of safety is also read off.
The margin of safety can be seen as the area to the right of the breakeven point up to the
forecast sales level.
It is the difference the budgeted level of activity and the breakeven level of activity.
y
$'000
360
x
x
320
280
BEP
240
Variable
costs
200
160
120
80
40
Fixed
costs
Margin of safety
x
2,000
4,000
6,000
8,000
10,000
12,000
14,000
Units
147
III. BREAKEVEN CHART
1. Single product breakeven chart
Example 3 (Question):
A new product has the following data:
Selling price $60/unit, Variable cost $40/unit, Fixed costs $25,000 per month.
Forecast sales is 1,800 units per month.
Required: Determine the breakeven point through the breakeven chart.
148
III. BREAKEVEN CHART
1. Single product breakeven chart
Example 3 (Answer):
Step 1: Draw the axes Oxy, whereas:
•
Ox is monthly sales volume. The value is illustrated to 1,800 units
•
Oy is monthly sales revenue. The highest value is 1,800 x $60 = $108,000
Step 2: Determine the Fixed cost line
This line will be a straight line parallel to the Ox axis at the $25,000 level
Step 3: Determine the Total cost line
This line will pass through 2 following points:
•
Total costs at zero of sales volume is $25,000
•
Total costs at sales volume of 1,800 units is $97,000 (25,000 + 40 x 1,800)
Step 4: Determine sales revenue line
This line will pass through 2 following points:
•
Revenue at zero of sales volume is 0
•
Revenue at sales volume of 1,800 units is $108,000
149
III. BREAKEVEN CHART
1. Single product breakeven chart
Example 3 (Answer):
Step 5: Determine the breakeven point
The breakeven point is the intersection of the total cost line and revenue line.
This is illustrated by the below chart:
Align the perpendicular lines to the axes Ox and Oy, we determine the value of
breakeven sales volume of 1,250 units and revenue of $75,000.
$'000
y
x
x
Breakeven
Point
80
75
Variable
costs
50
Fixed
costs
30
20
Margin of safety
400
800
1250
1600
1800
x
150
III. BREAKEVEN CHART
2. Single product contribution breakeven chart
One of the problems with the single product breakeven chart (basic breakeven chart) is
that it is not possible to read contribution directly from the chart.
A contribution breakeven chart is based on the same principles but it shows the
variable cost line instead of the fixed cost line.
y
$'000
360
x
x
320
280
Fixed
costs
BEP
Contribution
240
200
160
120
80
40
Margin of safety
x
2,000
4,000
6,000
8,000
10,000
12,000
14,000
Units
151
III. BREAKEVEN CHART
3. Multi-product breakeven chart
As well as being able to carry out CVP calculations we may draw a breakeven chart in a
multiple product situation if a constant product sales mix is assumed.
We treat the whole mix as a single product and follow steps mentioned in case of single
product breakeven chart to draw multi-product breakeven chart.
Example 4 (Question):
SAPP Co sells three products, X, Y and Z, which have variable unit costs of $3, $4 and
$5 respectively. The sales price of X is $8, the price of Y is $6, and the price of Z is $6.
Fixed costs per annum are $10,000.
Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z.
A breakeven chart would make the assumption that output, and sales of X, Y and Z
are in the proportions 2,000: 4,000: 3,000 at all levels of activity.
Required: Determine the breakeven point through the breakeven chart.
152
III. BREAKEVEN CHART
3. Multi-product breakeven chart
Example 4 (Answer):
We treat the whole mix is as a single product:
Sales
volume
(units)
Variable unit
costs
($/unit)
Variable
costs
($)
Unit price
($/unit)
Sales
($)
X
2,000
Y
4,000
3
6,000
8
16,000
4
16,000
6
Z
3,000
24,000
5
15,000
6
Total
9,000
18,000
37,000
Fixed
costs
10,000
Total
47,000
Step 1: Draw the axes Oxy, whereas:
•
Ox is monthly sales volume. The value is illustrated to 9,000 units
•
Oy is monthly sales revenue. The highest value is $58,000
58,000
153
III. BREAKEVEN CHART
3. Multi-product breakeven chart
Example 4 (Answer):
Step 2: Determine the Fixed cost line
This line will be a straight line parallel to the Ox axis at the $10,000 level
Step 3: Determine the Total cost line
This line will pass through 2 following points:
•
Total costs at zero of sales volume is $10,000
•
Total costs at sales volume of 9,000 units is $47,000
Step 4: Determine sales revenue line
This line will pass through 2 following points:
•
Revenue at zero of sales volume is 0
•
Revenue at sales volume of 9,000 units is $58,000
154
III. BREAKEVEN CHART
3. Multi-product breakeven chart
Example 4 (Answer):
Step 5: Determine the breakeven point
The breakeven point is the intersection of the total cost line and revenue line.
The breakeven point is approximately $27,500 of sales revenue and 4,500 units of
sales volume. This is illustrated by the below chart:
Costs and
revenue
($'000)
60
Profit
($11,000 at
budget)
breakeven
point
30
fixed costs
10
1000
5000
9000
Sale units
155
III. BREAKEVEN CHART
4. The profit-volume chart
The profit-volume chart (P/V chart) is another form of the breakeven chart, showing
a single line of profit or loss at each level of activity.
In a multi-product environment, two lines must be shown in P/V chart:
•
One straight line: assumed constant mix of products
•
One bow-shaped line: show how individual products contribute to profit rather than
a constant mix. The most profitable product is assumed to be sold first and so on.
The following steps should be followed:
Step 1: Calculate the C/S ratio of each product being sold, and rank the products in
decreasing order of profitability
Step 2: Calculate the cumulative sales and profit.
Step 3: Draw the graph, showing cumulative sales on the x-axis, profit earned on the
y-axis. The products are shown individually on a graph from left to right following
ranking (Step 1).
Step 4: Draw the straight line showing average profit earned by those products and
locate the breakeven point.
156
III. BREAKEVEN CHART
4. The profit-volume chart
Example 4 (Cont.):
The breakeven point of $27,500 as above could be shown as follow:
Profit/loss
($'000)
10
Profit
Budgeted
profit
5
Breakeven
20
40
Loss
-10
breakeven
point
appr = $27,500
58
Sale
revenue
($'000)
157
III. BREAKEVEN CHART
4. The profit-volume chart
Example 4 (Cont.):
Step 1: Calculate the C/S ratio of each product being sold, and rank the products
in decreasing order of profitability
Product
Contribution
Sales
C/S ratio
$
$
%
Ranking
X
10,000
16,000
62.50
1
Y
8,000
24,000
33.33
2
Z
3,000
18,000
16.67
3
21,000
58,000
36.21
Step 2: Calculate the cumulative sales and profit.
Cumulative profit
$
Cumulative sales
$
($10,000 contribution - $10,000 fixed costs)
16,000
X and Y
8,000
40,000
X, Y and Z
11,000
58,000
Product
X
158
III. BREAKEVEN CHART
4. The profit-volume chart
Example 4 (Cont.):
Step 3: Draw the graph, showing cumulative sales on the x-axis, profit earned
on the y-axis. The products are shown individually on a graph from left to right
following ranking from step 1.
•
At output (sales) = 0, profit earned = fixed costs
•
Plot the graph with (cumulative sales; cumulative profit) for each product
identified in step 2.
Profit
earned
($'000)
Z
11
8
Y
4
X
-10
16 20
40
58
Sale
revenue
($'000)
159
III. BREAKEVEN CHART
4. The profit-volume chart
Example 4 (Cont.):
Step 4: Draw the straight line showing average profit earned by those products
and locate the breakeven point.
Profit
earned
($'000)
Z
11
8
Y
4
X
-10
16 20
40
breakeven
point
appr = $27,500
58
Sale
revenue
($'000)
160
III. BREAKEVEN CHART
4. Advantage & Limitations of breakeven analysis
4.1
Advantages
The using of CVP analysis have some following advantages:
Easy to understand
Be easily understood for non-financial managers as it is illustrated
by breakeven chart
Determine profit or loss
Be able to determine profit or loss at any level of activity
Focus
Focus on breakeven point and safety margin, so help managers to
assess risk better
161
III. BREAKEVEN CHART
4. Advantage & Limitations
4.2
Limitations
Assumption
Limitation
CVP analysis can apply to one
product only, or to more than one
product only if they are sold in a
fixed sales mix.
CVP analysis is valueless in an organisation that
they sell more than one product, and a fixed sales
mix is not exist.
Fixed costs per period are same in
total, and unit variable costs are a
constant amount at all levels of
output and sales.
This assumption may not hold true as:
•
Fixed costs will change if output falls or
increases substantially
•
The variable cost per unit will decrease
where economies of scale are made at
higher output volumes, but the variable cost
per unit will also eventually rise when
diseconomies of scale begin to appear at
even higher volumes of output.
Sales prices are constant at all
levels of activity.
This assumption may not hold true as if sales
volumes are to increase, sales price must fall.
Production volume = sales volume.
This assumption may not hold true as inventory
levels are constant.
162
CHAPTER 6:
LIMITING FACTORS ANALYSIS
163
OVERVIEW
What will you learn?
LIMITING FACTORS ANALYSIS
I.
Limiting factors
II.
Apply limiting factors analysis to decide optimum production plan
III.
Apply limiting factor analysis to choose make or buy decisions
IV
Slack, surplus and shadow price
164
I. LIMITING FACTORS
1. Definition
A limiting factor is any factor that is in scarce supply and that stops the organization
from expanding its activities further, so that there is a maximum level of activity at
which the organization can operate.
Example:
•
•
•
Labor: limit of the total quantity of labor or employees with particular skills
Material: be insufficient materials to produce
Machine capacity: be insufficient machine capacity for the production required
Note:
An organization might be faced with just one or several limiting factors.
165
I. LIMITING FACTORS
2. Limiting factor analysis
Limiting factor analysis are techniques to analyze limiting factors in order to maximize
contribution:
Contribution = Sales - Variable costs
Distinguish limiting factor and bottleneck resource
Bottleneck resource
Limiting factor
Analyze limiting factors to
maximize contribution
Contribution = Sales - Variable costs
VS.
Analyze binding constraints to
maximize throughput
Throughput = Sales - Materials
166
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
1. One limiting factor
Rule:
Identify contribution per unit of the limiting factor for each product, then choose
product with the highest of contribution per unit to produce.
3 steps to carry out:
Step 1
Identify limiting factor
Step 2
Calculate contribution per limiting factor for each product, compare and
rank for these figures
Step 3
Decide optimum production plan
167
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
1. One limiting factor
Example 1 (Question)
Sausage makes two products, the Mash and the Sauce. Unit variable costs are as
follows.
Mash
Sauce
$
$
Direct materials
1
3
Direct labour ($3 per hour)
6
3
Variable overhead
1
1
8
7
The sales price per unit is $14 per Mash and $11 per Sauce. During July the
available direct labor is limited to 8,000 hours. Sales demand in July is expected to
be as follows.
Mash
Sauce
3,000 units
5,000 units
Required: Determine the maximized profit of the production, assuming that fixed
costs per month are $20,000 and that there is no opening inventory of finished
goods or work in progress.
168
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
1. One limiting factor
Example 1 (Answer)
Step 1: Identify limiting factor
Mash
Sauce
Total
Labour hours per unit (hour)
6/3 = 2
3/3 = 1
Sales demand (unit)
3,000
5,000
Labour hours required (hour)
6,000
5,000
11,000
Labour hours available (hour)
8,000
Shortfall (hour)
3,000
Thus, labour hour is limiting factor.
Step 2: Calculate contribution per limiting factor for each product, compare and rank for
these figures
Mash
Sauce
$
$
Sales price
14
11
Variable cost
8
7
Unit contribution
6
4
Labour hours per unit
2
1
Contribution per labour hour
3
4
Ranking
2
Step 3: Decide optimum production plan
st
As the above ranking result, Sauce is prioritized 1 to produce.
Unit
Labour hours
Hours
Contribution per
produced
per unit
available
labour hour
Sauce
5,000
1
5,000
4
Mash
1,500
2
3,000 (β)
3
8,000
Therefore, profit = 29,000 - 20,000 = $9,000.
1
Contribution
20,000
9,000
29,000
169
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
When there are at least 2 limiting factors, linear programming technique is used to
determine the maximum contribution or the minimum costs.
Linear programming technique includes 2 following methods:
•
Graphical method
•
Simultaneous equations
2.1
Graphical method
Step 1: Define the problem
•
Define variable
•
Establish constraints
•
Construct objective function
Step 2:
Draw the constraints on a graph
Step 3:
Establish the feasible region for the optimal production
Step 4:
Determine the optimal solution using an iso-contribution line
170
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.1
Graphical method
Example 2 (Question)
SAP Co manufactures two products, M and N. Both products pass through two
production departments, mixing and shaping. The organization’s objective is to
maximize contribution to fixed costs.
Product M is sold for $1.50 whereas product N is priced at $2.00. There is unlimited
demand for product M but demand for N is limited to 13,000 units per annum. The
machine hours available in each department are restricted to 2,400 per annum. Other
relevant data are as follows.
Machine hours required
Product M
Product N
Mixing hours
0.06
0.08
Shaping hours
0.04
0.12
Variable cost per unit for M is $1.3/unit and for N is $1.7/unit.
Required: Determine the feasible region for the optimal production.
171
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.1
Graphical method
Example 2 (Answer)
Step 1: Define the problem
•
Define variables
There are 2 variables are 2 products that SAP can make and sell
Let x = number of units of product MA produced and sold
Let y = number of units of product NB produced and sold
•
Establish constraints
The number of units of product N is less than or equal to 13,000, so y ≤ 13,000
The number of machine hours cannot be greater in total than 2,400 hours, so:
0.06x + 0.08y ≤ 2,400 and 0.04x + 0.12y ≤ 2,400
•
Construct objective function (maximise contribution)
Contribution on each type of product is as follows:
Product M: 1.5 - 1.3 = $0.2/unit
Product N: 2.0 - 1.7 = $0.3/unit
Therefore, in order to maximise contribution, it is needed to determine x and y for theto
value of (0.2x + 0.3y) is maximized and satisfied following constraints:
x, y ≥ 0
y ≤ 13,000
0.06x + 0.08y ≤ 2,400
0.04x + 0.12y ≤ 2,400
Step 2: Draw the constraints on a graph
Draw the following graphs:
y = 13,000
0.06x + 0.08y = 2,400
0.04x + 0.12y = 2,400
172
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.1
Graphical method
Example 2 (Answer)
Step 3: Establish the feasible region
The feasible region is the area contained within all of the constraint lines.
Step 4: Determine the optimal solution using an iso-contribution line
We do not know the maximum value of the objective function but we can draw an isocontribution line (iso means ‘equal’) that shows all the combinations of x and y that provide
the same total value for the objective function.
Suppose that SAP wishes to earn contribution of $3,000 (0.2x + 0.3y = 3,000), so:
•
y = 0, x = 15,000 or SAP produce and sell 15,000 units of M and no N
•
x = 0, y = 10,000 or SAP produce and sell no M and 10,000 units of N
Thus, the possible combinations required to earn contribution of $3,000 could be shown by
the straight line 0.2x + 0.3y = 3,000.
The contribution lines are all parallel to each
other. We were to move the contribution
line out any further, it would cease to lie in
the feasible region and greater contribution
could not be achieved.
In this case, the contribution line just passes
through the intersection of 0.06x + 0.08y =
2,400 and 0.04x + 0.12y = 2,400.
So x = 24,000 and y = 12,000.
The point (24,000; 12,000) will therefore give us the optimal allocation of resources (to
produce 24,000 units of M and 12,000 units of N)
173
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.2
Simultaneous equations
It is conducted as Graphical method, except step 4. According to Simultaneous
Equations, enterprise will calculate contribution at some special points that they are
intersection of the constraint lines and within the feasible region, then choose the point
of the highest contribution.
Step 1: Define the problem
•
Define variable
•
Establish constraints
•
Construct objective function
Step 2:
Draw the constraints on a graph
Step 3:
Establish the feasible region for the optimal production
Step 4:
Determine the optimal solution through calculating contribution of points
at which the constraint lines intersect and within the feasible region
174
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.2
Simultaneous equations
Example 3 (Example 2 - Question)
SAP Co manufactures two products, M and N. Both products pass through two
production departments, mixing and shaping. The organization’s objective is to
maximize contribution to fixed costs.
Product M is sold for $1.50 whereas product N is priced at $2.00. There is unlimited
demand for product M but demand for N is limited to 13,000 units per annum. The
machine hours available in each department are restricted to 2,400 per annum. Other
relevant data are as follows.
Machine hours required
Product M
Product N
Mixing hours
0.06
0.08
Shaping hours
0.04
0.12
Variable cost per unit for M is $1.3/unit and for N is $1.7/unit.
Required: Determine the optimal production using simultaneous equations.
175
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.2
Simultaneous equations
Example 3 (Answer)
Step 1, 2, 3: They are stated as example 2 above. The feasible region is as follows:
Step 4: Determine the optimal solution through calculating contribution of points at which the
constraint lines intersect and within the feasible region
These points are A, B, C and D.
•
Point A (x = 0, y = 13,000)
Contribution A = 0.2x + 0.3y = 0.2 x 0 + 0.3 x 13,000 = $3,900
•
Point B
B is the intersection of line y = 13,000 and line 0.04x + 0.12y = 2,400
0.04x + 0.12 x 13,000 = 2,400, so x = 21,000
Contribution B = 0.2x + 0.3y = 0.2 x 21,000 + 0.3 x 13,000 = $8,100
176
II. APPLY LIMITING FACTOR
ANALYSIS TO DECIDE OPTIMUM PRODUCTION PLAN
2. Multiple limiting factors
2.2
Simultaneous equations
Example 3 (Answer)
•
Point C
C is the intersection of line 0.06x + 0.08y = 2,400 and line 0.04x + 0.12y = 2,400
So x = 24,000 and y = 12,000
Contribution C = 0.2x + 0.3y = 0.2 x 24,000 + 0.3 x 12,000 = $8,400
•
Point D (x = 40,000 and y = 0)
Contribution D = 0.2x + 0.3y = 0.2 x 40,000 + 0.3 x 0 = $8,000
Contribution A < Contribution D < Contribution B < Contribution C, so the optimal solution is at
point C. SAP Co should produce 24,000 units of M and 12,000 units of N to get the maximized
contribution of $8,400.
177
III. APPLY LIMITING FACTOR
ANALYSIS TO CHOOSE MAKE OR BUY DECISION
How to apply limiting factor analysis in choosing make or buy?
Rule:
Make the decision to buy products which have the lowest variable costs per unit of
limiting factor.
Note: In case of make or buy decision related to relevant costing principles, we studied in
chapter 4 Short-term decisions.
3 steps to carry out:
Step 1
Identify limiting factor
Step 2
Calculate extra costs per limiting factor of buying for each product, compare
and rank these extra cost
Step 3
Determine the optimum production plan
178
III. APPLY LIMITING FACTOR
ANALYSIS TO CHOOSE MAKE OR BUY DECISION
How to apply limiting factor analysis in choosing make or buy?
Example 4 (Question)
SAP manufactures three components, S, A and T, using the same machines for
each. The budget for the next year calls for the production and assembly of 4,000
of each component. The variable production cost per unit of the final product is
as follows.
Product
S
A
T
Machine hours
3
2
4
Variable cost
20
36
24
Only 24,000 hours of machine time will be available during the year, and a
subcontractor has quoted the following unit prices for supplying components: S
$29; A $40; T $34 per unit.
Required: Advise the optimum production plan for SAP.
179
III. APPLY LIMITING FACTOR
ANALYSIS TO CHOOSE MAKE OR BUY DECISION
How to apply limiting factor analysis in choosing make or buy?
Example 4 (Answer)
Step 1: Identify limiting factor
If produce all products as required, machine hours need is 4,000 x (3+2+4) = 36,000
hours, which is higher than machine hour limited at 24,000 hours.
Thus, machine hour is limiting factor.
Step 2: Calculate extra costs per limiting factor of buying for each product, compare
and rank these extra costs
S
A
T
Variable cost of making
20
36
24
Variable cost of buying
29
40
34
Extra variable cost of buying
9
4
10
Machine hours saved by buying
3
2
4
Extra variable cost of buying per hour saved
3
2
2.5
Ranking
3
1
2
Step 3: Compare extra costs per unit of step 2 and determine the optimum production
plan
As the above ranking result, SAP should make on priority in order S, T and A.
Product
Units
Machine
hours/unit
Total
Variable
machine
costs/unit
hours
S
4,000
3
12,000
20
Make
T
3,000
4
12,000
24
Total
24,000
The machine hour is full, additional amount of T and A must be bought:
T
1,000
34
Buy
A
4,000
40
Total
Total
costs
80,000
72,000
34,000
160,000
346,000
180
IV. SLACK, SURPLUS AND SHADOW PRICE
1. Slack and surplus
Surplus occurs when more than a minimum requirement of a resource or other
constraining factor is used.
Slack occurs when maximum availability of a resource or other constraining factor is not
used.
Slack is used to evaluate whether the use of the limiting factor is effective or not. In
particularly, at the optimal solution:
•
Resource used = resource available
no spare capacity of a resource and no slack => effective
•
Resource used < resource available
there is spare capacity of a resource and there is slack => ineffective
181
IV. SLACK, SURPLUS AND SHADOW PRICE
1. Slack and surplus
Example 5 (Question)
A company had the following limiting factors for Period 3:
Test time: 12,000 hours
Program time: 28,000 hours
The following information was established:
Product X
Product Y
Test per unit
18
4
Program minutes per unit
36
14
Optimum production plan
(unit)
20,000
66,000
Required: What were the slack resources for test time and program time?
Example 5 (Answer)
Test time used: (20,000 x 18)/60 + (66,000 x 4)/60 = 10,400 hours
Therefore, slack hours = 12,000 – 10,400 = 1,600 hours
Program time used: (20,000 x 36)/60 + (66,000 x 14)/60 = 27,400 hours
Therefore, slack hours = 28,000 – 27,400 = 600 hours
182
IV. SLACK, SURPLUS AND SHADOW PRICE
2. Shadow price
Shadow price: This is the ‘increase in value which would be created by having available
one additional unit of a limiting resource at the original cost’.
Thus, a shadow price is:
The additional contribution generated from one additional unit
of limiting factor
Shadow price
The opportunity cost of not having the use of one extra unit of
limiting factor
The maximum extra amount that should be paid for one
additional unit of scarce resource
Example 6
Material is a limiting factor. If one extra kilogram becomes available then an
alternative production mix becomes optimal.
As a result, the contribution increases over the original production mix by $2.
Thus, the shadow price of a kilogram of material is $2
183
CHAPTER 7:
PRICING DECISIONS
184
OVERVIEW
What will you learn?
PRICING DECISIONS
I.
Factors influencing price
II.
Relationship between demand and price
III.
Determine optimum selling price to maximize profit
IV.
Decisions to increase production and sales
V.
8 price strategies
185
I. FACTORS INFLUENCING PRICE
Factors and explanation
Factors
Price sensitivity
Explanation
Price sensitivity is the degree to which the price of a
product affects consumers' purchasing behaviors. Or, it's
how demand changes with the change in the cost of
products.
Price perception is the way customers react to prices.
Price perception
Example: Customers may react to a price increase by
buying more. This could be because they hear information
from experts that selling price of the commodity will
continue to increase in the future, so they expect further
price increases to follow.
Quality
This is an aspect of price perception. In the absence of
other information, customers tend to judge quality by
price. Thus, a price rise may indicate improvements in
quality and a price reduction may signal reduced quality.
Intermediaries
Products or services could be distributed to the market
through independent intermediaries. They have private
price policies, so the products or services could be bought
at different price from different supplies.
186
I. FACTORS INFLUENCING PRICE
Factors and explanation
Factors
Explanation
Competitors
To attract customers, every competitor has a private price
policy
Suppliers
Price of input risen, there is a price rise of product or
service produced from these inputs.
Inflation
In periods of inflation, the price of products or service
could be changed.
Newness
When a new product is introduced for the first time, it is
difficult to set a suitable price
Incomes
If incomes are rising, price may be a less important than
product quality and convenience of access. However,
income levels are falling and/or unemployment levels
rising, price will be more important.
Ethics
When existing scarcity of goods, price of product or service
could be push too high to take profit.
187
I. FACTORS INFLUENCING PRICE
Factors and explanation
However, the price of a product or service will be determined based on the market in
which it operates. There are 4 types of market:
Perfect competition
market
Many buyers and sellers deal an
identical product. Neither
producer nor user has any
market power, and both must
accept the prevailing market
price.
Monopolistic
competition market
Many suppliers offer similar, but
not identical, products. The
similarities ensure elastic demand
whereas the slight differences give
some monopolistic power to the
supplier.
Monopoly market
One seller who dominates many
buyers. The monopolist can use
their market power to set a
profit-maximizing price.
Oligopoly market
Where relatively few competitive
companies dominate the market.
While each large firm can
influence market prices, the
unpredictable reaction from the
other giants makes the final
industry price indeterminate.
Cartels are often formed.
188
II. RELATIONSHIP BETWEEN DEMAND AND PRICE
1. Price elasticity of demand
In general, a buyer will be willing to buy more at a lower price.
Price elasticity of demand (PED)
Price elasticity of demand (PED) is a measure of the extent of change in market
demand for a good in response to a change in its price. It is measured as:
% change in demand
PED = % change in price
PED has an important role to help enterprises to choose suitable price policies. Details are
as follows:
PED
Explanation
Price policy
PED >1
(Demand is
elastic)
When
price
increase/
decrease 1%, demand will
decrease/ increase more
than 1%
Price increase, revenue will decrease and
reverse. Thus, enterprise must consider
whether the increase level in cost is less
or more than the increase in revenue to
decide increase price
PED < 1
(Demand is
inelastic)
When
price
increase/
decrease 1%, demand will
decrease/ increase less than
1%
Enterprise should increase price of the
product as the price increase level is
more than the decrease level of output.
Thus, revenue increase, costs decrease
leading to profit increase
PED = 1
(Demand is unit
elastic)
Changes in price yield
equivalent (percentage)
changes in demand
189
II. RELATIONSHIP BETWEEN DEMAND AND PRICE
1. Price elasticity of demand
PED
Explanation
Price policy
PED = 0
(Demand is
perfectly inelastic)
There is no change in quantity
demanded, regardless of
change in prices
Customers are not sensitive to the
prices. Therefore, enterprise should
focus more on quality, service,
production mix and location
PED = ∞
(Demand is
perfectly elastic)
Customers will want to buy an
infinite amount, but only up
to a particular price. Any price
increase above this level will
reduce demand to 0
Enterprise should reduce elasticity by
creating a customer preference which
is unrelated to the price (through
advertising and promotional activities)
The below graph illustrates price elasticity of demand:
190
II. RELATIONSHIP BETWEEN DEMAND AND PRICE
1. Price elasticity of demand
Example 1:
The price of a good is $15 per unit and annual demand is 60 units. Market
research indicates that an increase in price of $3 per unit will result in a fall in
annual demand of 15 units.
Required: What is the price elasticity of demand?
Solution:
Annual demand at $15 per unit is 60 units.
Annual demand at $18 per unit is 45 units.
% change in demand = (15/60) × 100% = 25%
% change in price = ($3/$15) × 100% = 20%
% change in demand −25%
PED = % change in price = 20 % = -1.25
It means that the price increase/ decrease 1%, demand for the good will
decrease/ increase 1.25%. Demand is elastic.
Notes: The minus sign of PED is ignored as PED is expected to be negative since
demand will fall if price rises and vice versa.
191
II. RELATIONSHIP BETWEEN DEMAND AND PRICE
2. Demand equation
The demand equation shows the relationship between the price charged for a product
and the subsequent demand for that product.
Demand equation
When demand is linear the equation for the demand curve is P = a – bQ
where:
•
P = the price
•
Q = the quantity demanded
•
b = change in price/change in quantity
•
a = the price at which demand would be nil, a is constant and calculated as
follow:
a = $(current price) +
Current quantity at current price
x $b
Change in quantity when the price is changed by $b
3 steps to determine demand curve:
Step 1:
Calculate b
Step 2:
Substitute the known value for b at Step 1
into the demand function to find a
Step 3:
Check the
equation
192
II. RELATIONSHIP BETWEEN DEMAND AND PRICE
2. Demand equation
Example 2:
Using example 1 again.
Required: Determine the demand equation.
Solution:
Step 1: Calculate b (*)
b = change in price/change in quantity = 3/15 = 0.2
Step 2: Substitute the known value for b at Step 1 into the demand function to
find a
P = a - bQ
Or 15 = a - 0.2 x 60, so a = 27
Step 3: Check your equation
The demand equation is therefore P = 27 - 0.2Q
We can check this equation when P is $18
18 = 27 - 0.2Q, so Q = 45 units.
(*) Alternative approach to find b:
We substitute each price and demand level into the equation: P = a – bQ
Annual demand at $15 per unit is 60 units  15 = a – 60b (1)
Annual demand at $18 per unit is 45 units  18 = a – 45b (2)
Then we have (2) – (1):
3 = 15b  b = 3/15 = 0.2
193
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
1. Algebraic method
In accordance economic theory:
•
Marginal revenue (MR) – revenue generated by selling another unit - will
continually fall as output rises whenever the firm is faced with downward-sloping
curve
•
While marginal cost (MC) - the variables cost per unit for each additional unit that is
made or sold – may rise due to the law of diminishing return.
As you sell more, profit will grow as long as the extra revenue obtained is greater than the
extra cost incurred (extra revenue = MR, extra cost = MC) - see the graph below
D
It will continue to maximise only up to the output level where marginal cost has risen to
be exactly equal to the marginal revenue.
Therefore, profits are maximised at the point where MC = MR.
194
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
1. Algebraic method
3 steps to determine the optimal price to maximise profit:
Step 1: Determine a and b in the demand equation P = a - bQ
Step 2: Determine quantity (Q) at maximized profit through the equation MC = MR
Step 3: Determine selling price (P) at maximized profit by substituting Q at Step 2 into
the demand function at Step 1
Example 3 (Question):
SAP Co has used market research to determine that if a price of $250 is charged
for product G, demand will be 12,000 units. It has also been established that
demand will rise or fall by 5 units for every $1 fall/rise in the selling price. The
marginal cost of product G is $80
Required: If MR = a – 2bQ when the selling price (P) = a - bQ, calculate the profit
maximising selling price for product G.
195
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
1. Algebraic method
Example 3 (Answer):
Solution:
Step 1: Determine a and b in the demand equation P = a – bQ
b = change in price/change in quantity = 1/5 = 0.2
Substitute b in the demand equation to find a:
250 = a – 0.2 * 12,000  a = 2,650
Step 2: Determine quantity (Q) at maximized profit through the equation
MC = MR
MR = 2,650 - 2x0.2xQ = 2,650 - 0.4Q
MC = 80
MC = MR or 80 = 2,650 - 0.4Q, so Q = 6,425
Step 3: Determine selling price (P) at maximized profit by substituting Q at step
2 into the demand function at step 1
P = a - bQ = 2,650 - 0.2x6,425 = $1,365
Therefore, SAP Co should sell 6,425 units at selling price unit of $1,365 to
maximise profit.
196
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
1. Algebraic method
Notes: Formula MR = a - 2bQ and MC = variable cost per unit are always provided in
the exam. However, it is very easy to determine them. Details are as follows:
•
MR = a - 2bQ
From the demand equation P = a - bQ, total revenue (TR) = PQ = aQ - bQ2
MR = TR’(Q) = a - 2bQ
•
MC = variable cost per unit
Total costs = Fixed cost + Variable cost = Fixed cost + Variable cost per unit x
Quantity
Or TC = Fixed cost + Variable cost per unit x Q
MC = TC’(Q) = Variable cost per unit
Exam focus point: Determine marginal cost and marginal revenue equations in order
to calculate optimum price and quantity.
197
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
2. Tabular method (self-reading)
The optimum selling price can also be determined using tabulation. Whereby, it is needed
to calculate the marginal costs, revenues and profit at different combinations of output
and selling price.
Example 4 (Question):
The following data is available for prices and costs.
Output
(Units)
0
1
2
3
4
5
6
7
8
9
10
Sales price per unit
($/unit)
504
471
439
407
377
346
317
288
259
232
Average cost of output
($/unit)
720
402
288
231
201
189
182
180
186
198
Required: Complete the table below to determine the output level and price at
which the organisation would maximise its profits.
198
III. DETERMINE OPTIMUM SELLING PRICE TO
MAXIMISE PROFIT
2. Tabular method (self-reading)
Example 4 (Answer):
Output
(Units)
Unit
price
($)
Total
revenue
($)
MR
($)
Total
costs
($)
MC
($)
Profit
($)
0
1
2
3
4
5
6
7
8
9
10
504
471
439
407
377
346
317
288
259
232
504
942
1,317
1,628
1,885
2,076
2,219
2,304
2,331
2,320
504
438
375
311
257
191
143
85
27
(11)
600
720
804
864
924
1,005
1,134
1,274
1,440
1,674
1,980
120
84
60
60
81
129
140
166
234
306
(600)
(216)
138
453
704
880
942
945
864
657
340
Therefore, profit is maximised at 7 units of output and a price of $317, when MR is
most nearly equal to MC.
199
IV. DECISIONS TO INCREASE PRODUCTION AND SALES
1. Steps to make decision
It is necessary to consider incremental costs, incremental revenues and other factors
before deciding to increase production and sales.
Incremental costs and revenues are the difference between costs and revenues for
the corresponding items under each alternative being considered.
4 steps to decide production and sales increase:
Step 1: Determine incremental revenue
Step 2: Determine incremental costs
Step 3: Calculate incremental profit
Step 4: Make decision to increase production and sales
(This could be considered through incremental profit at step 3 and further factors)
200
IV. DECISIONS TO INCREASE PRODUCTION AND SALES
2. Example
Example 5 (Question):
SAP Co manufactures a product which uses two types of material: A and B. Each
unit of production currently sells for $10. A local trader has expressed an interest
in buying 5,000 units but is only prepared to pay $9 per unit. Current costs and
revenues are as follows:
$’000
Sales
Less: production costs
Material A – 1 kg per unit
Material B – 1 litre per unit
Labour - 1 hour per unit
Fixed overhead
Non-production costs
Total cost
Budgeted profit
$’000
350
25
50
75
76
25
250
100
201
IV. DECISIONS TO INCREASE PRODUCTION AND SALES
2. Example
Example 5 (Question):
The following additional information has also been made available:
(a) There is minimal inventory of material available and prices for new material
are expected to be 5% higher for Material A and 3% higher for Material B.
(b) SAP Co has been having problems with his workforce and is short of labour
hours. He currently has the capacity to produce 36,000 units but would have to
employ contract labour at $3.50 per hour to make any additional units.
(c) Included in the fixed production overhead is the salary of the production
manager. He is stressed and exhausted and has threatened to leave unless he
receives a pay rise of $5,000. SAP Co would not be able to fulfil any new orders
without him.
Required: Evaluate whether SAP Co should accept the new order.
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IV. DECISIONS TO INCREASE PRODUCTION AND SALES
2. Example
Example 5 (Answer):
Solution:
Step 1: Determine incremental revenues
Incremental revenues = 5,000 x $9 = $45,000
Step 2: Determine incremental costs
Current production = $350,000/ $10 = 35,000 units
Therefore:
Current cost per unit of material A [$25,000/35,000]
Curret cost per unit of material B [$50,000/35,000]
Current cost of labour [$75,000/35,000]
$
0.71
1.43
$2.14
Thus, incremental costs when accepting order of 5,000 units are as follows:
Material A [$0.71 x 105% x 5,000]
Material B [$1.43 x 103% x 5,000]
Labour [$2.14 x 1,000 + 4,000 *$3.50]
(Labour spare capacity of 1,000 units (36,000 units – 35,000 units) at
$2.14 and additional hiring costs to produce 4,000 units at $3.50)
Fixed overhead
(addition salary for production managers)
Total
$
3,728
7,365
16,140
5,000
32,233
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IV. DECISIONS TO INCREASE PRODUCTION AND SALES
2. Example
Example 5 (Answer):
Solution:
Step 3: Determine incremental profit
Incremental profit = Incremental revenues - Incremental costs = $45,000 $32,233 = $12,767
Step 4: Make decision to increase production and sales
It is obvious that if accepting this order to increase production, SAP Co could gain
more profit of $12,767. However, SAP Co should consider further followings:
•
The current workforce and production manager will be able to fulfil the new
order with the same labour efficiency
•
Whether it is happy for existing customers that they still buy product with
the unit selling price of $10 instead of $9.
204
V. 8 PRICE STRATEGIES
Overview
An enterprise could use one or more pricing strategies when selling their products to
maximize profits. Every period, they could apply different strategies. However, there are 8
below popular price strategies:
1. All forms of cost-plus
5. Product line
2. Skimming
6. Volume discounting
3. Penetration
7. Discrimination
4. Complementary
product
8. Relevant cost
205
V. 8 PRICE STRATEGIES
1. All forms of cost-plus
There are 2 types:
Full cost-plus pricing
Marginal cost-plus pricing
Definition
This is a method of deciding the
sales price by adding a
percentage mark-up for profit
to the full cost of the product.
This is a method of deciding
the sales price by adding a
profit margin to the marginal
cost of the product.
Calculation
Selling price = Total unit costs +
Profit mark-up
Selling price = Marginal costs +
Profit margin
Advantages
Quick, simple and cheap
Cover all of its costs and ensure
to make a profit.
Simple and easy to use
Help management focus to
contribution
Disadvantages
Price may need to be adjusted
to reflect market conditions
Quantity of product must be
estimated accurately, otherwise
the selling price could be too
high or too low.
Ignore fixed overheads so the
sales price must be sufficiently
high to ensure that a profit is
made
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V. 8 PRICE STRATEGIES
1. All forms of cost-plus
Example 6:
A company budgets to make 20,000 units which have a variable cost of
production of $4 per unit. Fixed production costs are $60,000 per annum.
Required: If the selling price is to be 40% higher than full cost, what is the selling
price of the product using the full cost-plus method?
Solution:
Variable unit costs
Fixed unit costs [$60,000/ 20,000]
Total unit costs
Profit mark-up [40% x $7]
Selling price
$
4
3
7
2.8
9.8
20
7
V. 8 PRICE STRATEGIES
2. Skimming
Price skimming involves charging high prices when a new product is first launched on
the market, in order to maximise short-term profitability.
The aim of market skimming is to gain high unit profits early in the product's life, in the
hope of recovering the costs of investment quickly. This is useful for some followings:
The product is new and different, so that early adopters are prepared to pay
high prices to be seen to own the latest products.
High prices in the early stages of a product’s life might generate high initial
cash outflows, therefore, a firm with liquidity problems may prefer this.
The product has a short life cycle and needs to recover development costs
and make a profit quickly.
Example 7
Market skimming is often used for technological product, or “breakthrough” product.
In 2020 Samsung released Samsung Galaxy S20 with high original price of $999.
However, one year later, this price dropped to just $600.
208
V. 8 PRICE STRATEGIES
3. Penetration
Penetration pricing is a policy of low prices when a product is first launched in order
to obtain strong demand for the product as soon as it is launched on the market. Low
prices should encourage bigger demand.
The aim is to entice customer to try a new product and build market share with the hope
of keeping new customers once price rises back to the normal levels. This is useful for
some followings:
The firm wants to
discourage new entrants
into the market
The firm wishes to
shorten the initial period
of the product’s life cycle
Demand is highly elastic
and so would respond
well to low prices
However, to implement this strategy, enterprises need a certain capital source, especially
for small and medium enterprises because the possibility of loss is quite high.
Example 8
Netflix is the perfect example of penetration pricing done right. Subscription fees of
Netflix starts at $9.99 then go up to $13.99 and maximum of $15 and one month of
free of subscription ending. However, people are completely fine with paying the
higher subscriptions for the unending flow of good media content.
209
V. 8 PRICE STRATEGIES
4. Complementary product
Complementary products are goods that tend to be bought and used together. If an
organisation makes and sells complementary products, it may wish to decide the
selling prices for the products in a single pricing policy decision.
Example 9
An electric toothbrush and replacement toothbrush heads are complementary
products. The electric toothbrush may be priced competitively to attract demand but
the replacement heads can be relatively expensive.
210
V. 8 PRICE STRATEGIES
5. Product line
A product line is a group of products that are related to one another. A product line
may be a range of branded products, and a consistent pricing policy should be applied
to all the products in the range.
Example 10
Common example can be seen in fast-food restaurants (e.g "meal deals" containing a
burger, soft drink and french fries for less than the total price of the individual items)
211
V. 8 PRICE STRATEGIES
6. Volume discounting
A volume discount is a reduction in price given for larger than average purchases.
The aim of a volume discount is to increase sales from large customers.
However, when applying this strategy, it is important to consider carefully between the
reduced costs of a large order and the loss of revenue from offering the discount.
Example 11:
SAP Co sells a product X with a selling price is $10/ unit. A customer approaches
SAP Co and suggests that he would buy 500 units X in case unit selling price is
down to $7.
See that the loss of revenue from offering the discount = ($10-$7) x 500 units =
$1,500
SAP Co detects that total fixed costs will decrease $1,000 when production
reaches 450 units.
Thus, it is obvious that the reduced costs of $1,000 is smaller than the loss of
revenue of $1,500, it means that SAP Co makes a loss of $500 if accepting the
orders. SAP Co should consider further. In case, this is a key customer and SAP Co
doesn’t want to affect goodwill with customer. They could agree this deal.
212
V. 8 PRICE STRATEGIES
7. Discrimination
Price discrimination is the practice of charging different prices for the same product to
different groups of buyers when these prices are not reflective of cost differences.
This is useful for some followings:
The market must be segmentable in price terms, and different sectors must
show different intensities of demand.
There must be little or no chance of a black market developing (this would
allow those in the lower priced segment to resell to those in the higher one)
There must be little or no chance that competitors can or will undercut the
firms’ prices in the higher priced (and/or most profitable) market segment.
The cost of segmenting and administering the arrangement should not exceed
the extra revenue derived from the price discrimination strategy.
213
V. 8 PRICE STRATEGIES
7. Discrimination
Example 12
Pricing discrimation can be used in the different number of cases:
•
By market segment: Items such as cinema tickets and hairdressing services
are often available at lower prices to over 60s, students or juveniles
•
By product version: For example, some car models have added on extras
•
By place: Theatre seats are usually sold according to the type of seat and
its location in the theatre auditorium
•
By time: This is perhaps the most popular type of price discrimination. For
example, off-peak travel bargains, hotel prices.
214
V. 8 PRICE STRATEGIES
8. Relevant cost
A relevant cost approach is to identify a price at which the organization will be no
better off, but no worse off, if it sells the item at that price. Any price in excess of this
minimum price will add to net profit.
Thus, this is useful for special orders which may require a relevant cost approach to the
calculation. For example, a company might have a capacity of 500,000 units per month
but only be producing and selling 300,000 units per month. It could therefore consider
special orders to use up some of its spare capacity.
Relevant costs can be used to arrive at a minimum tender price for a one-off tender or
contract. The minimum price should be equal to the relevant costs.
Notes: The principles to determine relevant costs were mentioned in Chapter 3
Relevant cost analysis.
215
V. 8 PRICE STRATEGIES
9. Condition summary to apply price strategies
Price strategy
Cost-plus pricing
Marginal costplus pricing
Conditions
•
There is no market price to compare, and enterprise wants
that profit is guaranteed
•
Enterprise wants to focus on contribution in short-term
decisions concerning the use of excess capacity or one off
contracts
•
Where the product is new and different and has little direct
competition
Where products have a short life cycle, and there is a need to
recover their development costs quickly and make a profit
Where the strength of demand and the sensitivity of demand
to price are unknown
A firm with liquidity problems and hope to generate high cash
flows early on
•
Skimming
•
•
•
•
Penetration
•
Complementary
product
•
A firm wishes to increase market share
A firm wishes to discourage new entrants from entering the
market
If demand is highly elastic and so would respond well to low
prices
The main product will be priced at a low price, the profit that
the business earns mainly from the high price in
supplementary products.
216
V. 8 PRICE STRATEGIES
9. Condition summary to apply price strategies
Price strategy
Product line
Volume
discounting
Conditions
•
Company must decide the price differences between the
upgrades of a product or service
•
Sales margin is substantial allowing profits to be made even
after discounting
Products with a limited shelf life such as fashion items may
be discounted to shift them
•
•
•
Discrimination
•
•
Relevant cost
•
The market must be segmentable in price terms, and
different sectors must show different intensities of demand
Customers cannot buy at the lower price in one market and
sell at the higher price in the other market
There must be little or no chance that competitors can and
will undercut the firm’s prices in the higher priced market
segments
The cost of segmenting and administering should not exceed
the extra revenue derived from the price discrimination
strategy
When there are special orders which are one-off revenueearning opportunity
21
7
CHAPTER 8:
RISK AND UNCERTAINTY
21
8
OVERVIEW
What will you learn?
RISK AND UNCERTAINTY
I.
Definition of risk and uncertainty
II.
Techniques to reduce uncertainty
III.
Rules to make decisions
IV
Means of decisions
V.
Value of information
219
I. DEFINITION OF RISK AND UNCERTAINTY
Definition
Uncertain events are events where the outcome cannot be estimated with a statistical
probability.
Risk involves situations or events which may or may not occur, but whose probability of
occurrence can be estimated statistically.
Example 1
Uncertainty
The same oil company may dig for oil in a previously unexplored area. The company
knows that it is possible for them to either find or not find oil but it does not know the
probabilities of each of these outcomes.
Risk
Based on past experience of digging for oil in a particular area, an oil company may
estimate that they have a 60% chance of finding oil and a 40% chance of not finding oil.
220
I. DEFINITION OF RISK AND UNCERTAINTY
Risk attitudes
A person's attitude to risk and uncertainty may affect the decision that is taken.
There are 3 following attitude groups:
Risk seeker
This is a decision-maker who is interested in the best outcomes, no matter
how small the chance that they may occur.
Risk neutral
This is a decision-maker who balances risk and return. They are willing take
on more risk, but only if the expected profit or return is higher. They will also
accept a lower return for lower risk.
Risk adverse
This is a decision-maker who acts on the assumption that the worst outcome
might occur and will make a decision that limits or minimises the risk
221
II. TECHNIQUES TO REDUCE UNCERTAINTY
1. Market research
There are two techniques to reduce uncertainty:
•
Market research
•
Outcome estimates
Market research is the systematic process of gathering, analysing and reporting data
about markets to investigate, describe, measure, understand or explain a situation or
problem facing a company or organisation.
Data can be either quantitative or qualitative:
QUANTITATIVE DATA
in the form of numbers and
measurements
QUALITATIVE DATA
tells us why consumers think, buy or
act the way they do
Example, they do statistics how
many people buy Adidas shoes and
how many people buy Nike shoes
Example, consumers buy Adidas
shoes instead of Nike shoes
222
II. TECHNIQUES TO REDUCE UNCERTAINTY
2. Outcome estimates
This technique is constructed based on a pay-off table.
Pay-off tables identify and record all possible outcomes (or pay-offs) in situations where
there are two or more decision options and the outcome from each decision depends
on the eventual circumstances that arise ('worst possible', 'most likely' or 'best
possible').
A pay-off table is a table or matrix where:
•
One side of the table has a different row (or column) for each decision option
•
The other side of the table has a column (or row) for the eventual circumstances
that may arise
Then, based on the stated rules or attitude of the decision-maker, they will choose a
specific decision.
Note:
The stated rules are clearly explained in the following section III. Rules to make decision.
223
II. TECHNIQUES TO REDUCE UNCERTAINTY
2. Outcome estimates
Example 2 (Question)
SAP Co is trying to set the sales price for one of its products. Three prices are
under consideration, and expected sales volumes as table follows.
Pricing
$4
$4.3
$4.4
Best possible
16,000
14,000
12,500
Most likely
14,000
12,500
12,000
Worst possible
10,0000
8,000
6,000
Circumstances
(expected sales demand):
Fixed costs are $20,000 and variable costs of sales are $2 per unit.
Required: Prepare a pay-off table and what is decision for a risk averse?
224
II. TECHNIQUES TO REDUCE UNCERTAINTY
2. Outcome estimates
Example 2 (Answer)
Here we need to prepare a pay-off table showing pay- off (profit), dependent on:
•
Different selling price options
•
Different levels of sales demands based on eventual circumstances (best
possible, most likely & worst possible)
The table is completed by entering the total profit for each different selling price,
given 3 possible circumstances.
Working to prepare pay-off table:
Unit price
Unit variable cost
Unit contribution
Contribution (*)
Best possible
Most likely
Worst possible
Fixed cost
Profit (**)
Best possible
Most likely
Worst possible
$4
($2)
$2
$
32,000
28,000
20,000
(20,000)
$
12,000
8,000
0
$4.3
($2)
$2.3
$
32,200
28,750
18,400
(20,000)
$
12,200
8,750
(1,600)
(*) Contribution = Unit contribution x Sales demand
(**) Profit = Contribution - Fixed costs
$4.4
($2)
$2.4
$
30,000
28,800
14,400
(20,000)
$
10,000
8,800
(5,600)
225
II. TECHNIQUES TO REDUCE UNCERTAINTY
2. Outcome estimates
Example 2 (Answer)
We have pay-off table as follows:
Pricing
$4
$4.3
$4.4
Best possible
12,000
12,200
10,000
Most likely
8,000
8,750
8,800
0
(1,600)
(5,600)
Circumstances
(expected profit)
Worst possible
It is obvious that only when selling price of $4 guarantees that SAP Co would not
make a loss, even if the worst possible outcome occurs.
Therefore, a risk averse might prefer a price of $4.
226
III. RULES TO MAKE DECISIONS
1. Expected value
In order to make a decision, a decision-maker might base on 4 below rules:
(1) Expected value
(2) Maximin rule
(3) Maximax rule
(4) Minimax regret rule
The expected value (EV) of the outcome can be calculated simply by multiplying the
value associated with each potential outcome by its probability.
Rule to make decision: The decision option with the highest EV of benefit or the lowest
EV of cost should be selected.
BENEFITS
• Easy to understand and calculate
• Takes uncertainty into account by
considering the probability of each
possible outcome and using this
information to calculate an expected
value
LIMITATIONS
• EV is a weighted average outcome,
so it could never occur
• EV is an average value, it ignores the
extreme outcomes, so this might be
suitable for risk neutral
• EV is a long-term average, so will
not be reached in the short term
and is therefore not suitable for one
off decisions
227
III. RULES TO MAKE DECISIONS
1. Expected value
Example 3 (Question)
Suppose a manager has to choose between mutually exclusive options A and B,
and the probable outcomes of each option are as follows.
Project A
Probability
0.8
0.2
Project B
Profit
($)
5,000
6,000
Probability
0.1
0.2
0.6
0.1
Profit
($)
(2,000)
5,000
7,000
8,000
Required: Which of the project is chosen under expected value?
Example 3 (Answer)
EV of each project is calculated as follows:
•
•
EV(A) = 0.8 x 5,000 + 0.2 x 6,000 = $5,200
EV(B) = 0.1 x (2,000) + 0.2 x 5,000 + 0.6 x 7,000 + 0.1 x 8,000 = $5,800
As EV is based on the profit and EV(B) > EV(A), so project B should be chosen.
228
III. RULES TO MAKE DECISIONS
2. Maximin rule
Maximin means maximise the minimum achievable profit.
Rule to make decision: Decision-maker should select offer that maximises the minimum
profits.
Three steps to carry out:
Step 1
Draw the payoff table
Step 2
Choose minimum payoffs of all decisions
Step 3
Choose the maximum of all the payoffs chosen in Step 2
229
III. RULES TO MAKE DECISIONS
2. Maximin rule
Example 4 (Question)
Suppose that a manager is trying to decide which of three mutually exclusive
projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Project
A
B
C
Probability
Net profit if outcome turns out to be
I
II
III
$50,000
$65,000
$80,000
$70,000
$60,000
$75,000
$90,000
$80,000
$55,000
0.2
0.6
0.2
Required: Which project would be chosen under maximin rule?
230
III. RULES TO MAKE DECISIONS
2. Maximin rule
Example 4 (Answer)
Step 1: Draw the payoff table (per question)
Project A
Project B
Project C
I
$50,000
$70,000
$90,000
II
$65,000
$60,000
$80,000
III
$80,000
$75,000
$55,000
Step 2: Choose minimum payoffs of all decisions
For each project (each decision), we need choose minimum outcome
Project A
Project B
Project C
I
$50,000
$70,000
$90,000
II
$65,000
$60,000
$80,000
III
$80,000
$75,000
$55,000
Step 3: Choose the maximum of all the payoffs chosen in Step 2
The maximum of minimum profit is $60,000. Thus, project B should be chosen.
Note: Assess maximin rule
•
This rule does not consider the probability of each outcome occurring
•
This rule is conservative but does not try to maximise profit, so it is suitable
for risk averse
231
III. RULES TO MAKE DECISIONS
3. Maximax rule
Maximax means maximise the maximum achievable profit.
Rule to make decision: Decision-maker should select offer that maximises the
maximum profits.
Three steps to carry out:
Step 1
Draw the payoff table
Step 2
Choose maximum payoffs of all decisions
Step 3
Choose the maximum of all the payoffs chosen in Step 2
232
III. RULES TO MAKE DECISIONS
3. Maximax rule
Example 5 (Example 4 - Question)
Suppose that a manager is trying to decide which of three mutually exclusive
projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Project
A
B
C
Probability
Net profit if outcome turns out to be
I
II
III
$50,000
$65,000
$80,000
$70,000
$60,000
$75,000
$90,000
$80,000
$55,000
0.2
0.6
0.2
Required: Which project would be chosen under maximax rule?
233
III. RULES TO MAKE DECISIONS
3. Maximax rule
Example 5 (Answer)
Step 1: Draw the payoff table
It is the same as step 1 of maximin rule
I
Project A
$50,000
Project B
$70,000
Project C
$90,000
II
$65,000
$60,000
$80,000
III
$80,000
$75,000
$55,000
Step 2: Choose maximum payoffs of all decisions
For each project (each decision), we need choose maximum outcome
I
II
III
Project A
$50,000
$65,000
$80,000
Project B
$70,000
$60,000
$75,000
Project C
$90,000
$80,000
$55,000
Step 3: Choose the maximum of all the payoffs chosen in Step 2
The maximum of maximum profit is $90,000. Thus, project C should be chosen.
Note: Assess maximax rule
•
This rule does not consider the probability of each outcome occurring
•
This rule is overly optimistic but does not care for risk, so it is suitable for
risk seeker
234
III. RULES TO MAKE DECISIONS
4. Minimax regret rule
Minimax regret means minimise the maximum potential regret.
Rule to make decision:
•
This approach attempts to minimise the regret from making the wrong decision.
•
Regret is the opportunity lost through making the wrong decision.
Three steps to carry out:
Step 1
Draw the regret payoff table
Regret for the decision option = Profit from the best decision option - Profit
from the decision option, given the outcome circumstances or situation
Step 2
Choose the maximum payoffs of all decisions
Step 3
Choose the minimum of all the payoffs chosen in Step 2
235
III. RULES TO MAKE DECISIONS
4. Minimax regret rule
Example 6 (Example 4 - Question)
Suppose that a manager is trying to decide which of three mutually exclusive
projects to undertake. Each of the projects could lead to varying net profits which
are classified as outcomes I, II and III. The manager has constructed the following
payoff table or matrix:
Project
A
B
C
Probability
Net profit if outcome turns out to be
I
II
III
$50,000
$65,000
$80,000
$70,000
$60,000
$75,000
$90,000
$80,000
$55,000
0.2
0.6
0.2
Required: Which project would be chosen under minimax regret rule?
236
III. RULES TO MAKE DECISIONS
4. Minimax regret rule
Example 6 (Answer)
Step 1: Draw the regret payoff table
Regret = Profit from the best decision option - Profit from the decision option
Steps to identify regret payoff as below:
1.1 Draw a payoff table (per question)
Project A
Project B
Project C
I
$50,000
$70,000
$90,000
II
$65,000
$60,000
$80,000
III
$80,000
$75,000
$55,000
1.2 Identify profit from the best decision option, given each circumstance
Project A
Project B
Project C
I
$50,000
$70,000
$90,000
II
$65,000
$60,000
$80,000
III
$80,000
$75,000
$55,000
1.3 Calculate regret
If outcome 1 arises, the best profit ($90,000) is obtained from project C:
Regret if company choose project C = 0
Regret if company choose project B = 90,000 – 70,000 = $20,000
Regret if company choose project A = 90,000 – 50,000 = $40,000
237
III. RULES TO MAKE DECISIONS
4. Minimax regret rule
Example 6 (Answer)
Step 1: Draw the regret payoff table
We then apply the same approach if outcome II & III arise, which results in this
regret table below:
Project A
Project B
Project C
I
$40,000
$20,000
$0
II
$15,000
$20,000
$0
III
$0
$5,000
$25,000
Step 2: Choose the maximum regret payoffs of all decisions
For each project (each decision), we need choose maximum outcome
Project A
Project B
Project C
I
$40,000
$20,000
$0
II
$15,000
$20,000
$0
III
$0
$5,000
$25,000
Step 3: Choose the minimum of all the payoffs chosen in Step 2
The minimum of maximum regret is $20,000. Thus, project B should be chosen as
it leads to lowest regret in the worst circumstances.
238
IV. MEANS OF DECISIONS
1. Decision trees
In many cases, in order to make a final decision, the manager needs to go through several
stages. Each stage will have corresponding possibilities and outputs to choose.
Therefore, decision trees were born.
Decision trees are diagrams which illustrate the choices and possible outcomes of a
decision.
A decision tree is drawn from left to right. Guidance to draw a decision tree:
•
Start with a square which is the decision point
•
Draw subsidiary branches which are decision options
•
Draw circles which are outcome points
Then, decision maker considers possible outcomes illustrated in the decision tree and use
rules mentioned in part III Rules to make decisions to make final decision.
239
IV. MEANS OF DECISIONS
1. Decision trees
Example 7 (Question)
SAP Co considers launching a new product to the market. The information related
to the new product is as follows:
•
•
•
Unit selling price could be $14 or $18
In case, unit selling price is $18, SAP Co could sell 8,000 units. Unit cost is
either $10 or $11 with probabilities of 0.4 and 0.6.
If selling price $14/unit, either 10,000 units or 15,000 units could be sold
with probabilities of 0.8 and 0.2. Unit cost is $6 or $8 with probabilities of 0.7
and 0.3.
Required: Draw a decision tree and what is the decision under EV rule?
240
IV. MEANS OF DECISIONS
1. Decision trees
Example 7 (Answer)
Cost $6/unit
0.7
Decision tree could be prepared as follows:
Sell 10.000 units
0.8
Sell
$14/unit
Launch
to market
Decision
Do not
launch
D
Cost $8/unit
0.3
B
Sell 15.000 units
0.2
Cost $6/unit
0.7
D
Cost $8/unit
0.3
A
Sell
$18/unit
C
Sell 8.000 units
Cost $10/unit
0.4
E
Expected value outcome at each point:
•
Cost at point D: $6 x 0.7 + $8 x 0.3 = $6.6
•
Cost at point E: $10 x 0.4 + $11 x 0.6 = $10.6
•
Profit at point B: (10,000 x 0.8 + 15,000 x 0.2) x ($14 - $6.6) = $81,400
•
Profit at point C: 8,000 x ($18 - $10.6) = $59,200
Therefore, there are 3 possible outcomes which needs to be considered:
•
Launch the new product and sell at $14/unit to make a profit of $81,400
•
Launch the new product and sell at $18/unit to make a profit of $59,200
•
Do not launch the new product to not care about profit or loss
Under EV rule, SAP Co should select option that maximises the profits.
Thus, SAP Co should launch the new product and sell at $14/unit.
Cost $11/unit
0.6
241
IV. MEANS OF DECISIONS
2. Sensitivity analysis
Sensitivity analysis is a term used to describe any technique whereby decision options
are tested for their vulnerability to changes in any ‘variable’, such as expected sales
volume, sales price per unit, material costs and labour costs.
There are 2 approaches to sensitivity analysis:
•
Calculating the maximum percentage change in a variable before the decision would
change
•
Assessing if the decision would change if a variable changed by x% of estimate
Thanks to which, sensitivity analysis concentrates management attention on variables
that are the most important for the decision under review.
242
IV. MEANS OF DECISIONS
2. Sensitivity analysis
Example 8 (Question)
SAP Co has estimated the following sales and profits for a new product which it
may launch on to the market.
$
Sales (2,000 units)
Variable costs:
Contribution
Incremental fixed costs
Profit
Materials
Labour
$
4,000
2,000
1,000
(3,000)
1,000
(800)
200
Required: Analyse the sensitivity of the project to changes in key variables.
243
IV. MEANS OF DECISIONS
2. Sensitivity analysis
Example 8 (Answer)
•
Sensitivity of the project to the fixed costs: 200/800x100% = 25%
It means that if fixed costs increase more than 25% estimate, the project would
be loss
•
Sensitivity of the project to materials: 200/2,000x100% = 10%
It means that if material costs increase more than 10% estimate, the project
would be loss
•
Sensitivity of the project to labour costs: 200/1,000x100% = 20%
It means that if labour costs increase more than 20% estimate, the project would
be loss
•
Sensitivity of the project to selling price, assuming that there is no change in
sales volume: 200/4,000x100% = 5%
It means that if selling price decreases more 5% estimate, the project would be
loss.
It is obvious that profitability is most sensitive in this example are the selling price
(5%) and material costs (10%). SAP Co shoud concentrate on these factors.
244
IV. MEANS OF DECISIONS
2. Sensitivity analysis
Therefore, using sensitivity analysis has the following benefits and limitations:
Easy to understand
BENEFITS
Highlight key variables which are crucial to the success of
the project, once identified these can be closely
monitored
It is unrealistic to assume that all changes are independent
LIMITATIONS
Does not offer a clear decision rule, so appropriate
management judgement is still required
245
V. VALUE OF INFORMATION
1. Perfect information
Perfect information is information that predicts with 100% accuracy what the outcome
situation will be.
Having perfect information removes all doubt and uncertainty from a decision, and
enables managers to make decisions with complete confidence that they have selected
the best decision option.
Value of perfect information is the difference between the EV of profit with perfect
information and the EV of profit with the information.
Three steps to determine value of perfect information:
Step 1
Determine expected value when having no perfect information (EV1)
Choose maximum EV if profit and minimum EV if costs
Step 2
Determine expected value when having perfect information (EV2)
The best decision option will be always selected
Step 3
Determine value of perfect information (EV)
EV = EV2 - EV1
246
V. VALUE OF INFORMATION
1. Perfect information
Example 9 (Question)
The management of SAP Co must choose whether to go ahead with either of two
mutually exclusive projects, A and B. The expected profits are as follows.
A
B
Probability of
demand
Profit if there is
strong demand
$4,000
$1,500
Profit if there is
moderate demand
$1,200
$1,000
Profit/(loss) if there
is weak demand
$(1,000)
$500
0.2
0.3
0.5
Required: Calculate the value of perfect information about demand
247
V. VALUE OF INFORMATION
1. Perfect information
Example 9 (Answer)
Step 1: Determine expected value when having no perfect information (EV1)
As no information to check, the project with the higher EV of profit would be
selected
Demand
Probability
Strong
Moderate
Weak
EV
0.2
0.3
0.5
Project A
Profit ($)
EV ($)
4,000
800
1,200
360
(1,000)
(500)
660
Project B
Profit ($)
EV ($)
1,500
300
1,000
300
500
250
850
Thus, project B with EV1 of $850 would be selected.
Step 2: Determine expected value when having perfect information (EV2)
Perfect information will indicate for certain whether demand will be weak,
moderate or strong. If demand is forecast 'weak', project B would be selected. If
demand is forecast as 'moderate' or ’strong’, project A would be selected.
Demand
Probability
Project chosen
Profit ($)
EV ($)
Strong
0.2
A
4,000
800
Moderate
0.3
A
1,200
360
Weak
0.5
B
500
EV2
Step 3: Determine value of perfect information (EV)
EV = EV2 - EV1 = 1,410 - 850 = $560
250
1,410
248
V. VALUE OF INFORMATION
2. Imperfect information
Imperfect information helps to predict partial outcomes.
The value of imperfect information is the difference between the EV of profit with
imperfect information and the EV of profit without the information.
Three steps to determine value of imperfect information:
Step 1
Determine expected value without information (EV1)
Choose maximum EV if profit and minimum EV if costs
Step 2
Determine expected value when having imperfect information (EV2)
Step 3
Determine value of imperfect information (EV)
EV = EV2 - EV1
249
V. VALUE OF INFORMATION
2. Imperfect information
Example 10 (Question)
SAP Co wants to make a decision between two mutually exclusive options, Option
A and Option B. The profits from each option will depend on the state of the
economy in the next 12 months. Current estimates are that there is a 60%
probability that the economy will be weak and a 40% probability that the
economy will be strong.
The profitability with each decision option would be as follows:
Option A
Option B
Weak economy
$50,000
$20,000
Strong economy
$60,000
$100,000
Research could be carried out into the state of the economy in the next 12
months. It has been estimated that if the true state of the economy will be weak,
there is an 80% probability that the research would predict this correctly. It is also
estimated that if the true state of the economy will be strong, there is an 90%
probability that the research would predict this correctly.
Required: Calculate the value of imperfect information about demand
250
V. VALUE OF INFORMATION
2. Imperfect information
Example 10 (Answer)
Step 1: Determine expected value without information (EV1)
State of
economy
Weak
Strong
EV
Probability
0.6
0.4
Option A
Profit ($)
EV ($)
50,000
30,000
60,000
24,000
54,000
Option B
Profit ($)
EV ($)
20,000
12,000
100,000
40,000
52,000
As no information to check, the option with the higher EV of profit would be
selected. Thus, option A with EV1 of $54,000 would be selected.
Step 2: Determine expected value when having imperfect information (EV2)
If research information is obtained, the decision will be to select Option A if the
research indicates a weak economy and to select Option B if the research
indicates a strong economy.
Actual state
of economy
Weak
Weak
Strong
Strong
EV2
Research
prediction
Weak
Strong
Strong
Weak
Option
chosen
A
B
B
A
Profit ($)
Probability
EV ($)
50,000
20,000
100,000
60,000
0.6x0.8 = 0.48
0.6x0.2 = 0.12
0.4x0.9 = 0.36
0.4x0.1 = 0.04
24,000
2,400
36,000
2,400
64,800
Step 3: Determine value of imperfect information (EV)
EV = EV2 - EV1 = 64,800 - 54,000 = $10,800
251
V. VALUE OF INFORMATION
2. Imperfect information
Example 10 (Answer)
Step 1: Determine expected value without information (EV1)
State of
economy
Weak
Strong
EV
Probability
0.6
0.4
Option A
Profit ($)
EV ($)
50,000
30,000
60,000
24,000
54,000
Option B
Profit ($)
EV ($)
20,000
12,000
100,000
40,000
52,000
As no information to check, the option with the higher EV of profit would be
selected. Thus, option A with EV1 of $54,000 would be selected.
Step 2: Determine expected value when having imperfect information (EV2)
If research information is obtained, the decision will be to select Option A if the
research indicates a weak economy and to select Option B if the research
indicates a strong economy.
Research
prediction
Weak
Weak
Strong
Strong
EV2
Option
chosen
A
A
B
B
Actual state of
economy
Weak
Strong
Strong
Weak
Profit
($)
50,000
60,000
100,000
20,000
Step 3: Determine value of imperfect information (EV)
EV = EV2 - EV1 = 68,000 - 54,000 = $14,000
Probability
EV ($)
0.6x0.8 = 0.48
0.6x0.2 = 0.12
0.4x0.9 = 0.36
0.4x0.1 = 0.04
24,000
7,200
36,000
800
68,000
252
CHAPTER 9:
BUDGETARY SYSTEMS
253
OVERVIEW
What will you learn?
Budgetary systems
I.
Objectives of budgeting systems
II.
The planning and control cycle
III.
Planning and control in performance hierarchy
IV.
Other aspects of budget preparation
254
I. OBJECTIVES OF BUDGETING SYSTEMS
Overview
A budget is a quantified plan of action for a forthcoming accounting period.
7 objectives of budgeting systems:
Objectives of budgeting systems
Ensure the achievement of the organisation's objectives
Compel planning
Communicate ideas and plans
Co-ordinate activities
Provide a framework for responsibility accounting
Establish a system of control
Motivate employees to improve their performance
Notes: Distinguish a budget and a forecast:
•
A budget is a plan of what to achieve and what it has set as a target
•
A forecast is an estimate of what is likely to occur in the future
255
II. THE PLANNING AND CONTROL CYCLE
Steps of the planning and control cycle
7 steps of budgeting systems:
Step 1
Identify objectives
•
Step 2
Determine strategies to achieve the objectives
•
•
Step 3
Gather information internally to find out what resources it
possesses (strengths & weakness).
Gather information externally to assess its position in the
environment (threats & opportunities).
Evaluate strategies
•
Step 4
Objectives should be met 5 factors 'SMART’.
(Specific, Measurable, Attainable, Relevant and Time limit)
The strategies must then be evaluated in terms of suitability,
feasibility and acceptability.
Choose alternative courses of action
•
Collect the chosen strategies together and co-ordinate them into
a long-term financial plan.
256
II. THE PLANNING AND CONTROL CYCLE
Steps of the planning and control cycle
7 objectives of budgeting systems:
Step 5
Implement the long-term plan
•
Step 6
Measure actual results and compare with plan
•
Step 7
Break the plan into smaller parts which is short-term plan or
budget.
Actual results are recorded and analyzed and information about
actual results is fed back to management.
Respond to divergences from plan
•
•
•
Take control action if identifying anything has gone wrong, find
out why and correct.
Do nothing if actual results are going better than planned.
Alter the plan if actual results are different from the target and
nothing management can do.
257
III. PLANNING AND CONTROL IN THE
PERFORMANCE HIERARCHY
1. Planning
Planning is prepared at every performance hierarchy.
The plans made at the higher levels of the performance hierarchy provide a
framework within which the plans at the lower levels must be achieved.
The plans at the lower levels are the means by which the plans at the higher levels
are achieved.
258
III. PLANNING AND CONTROL IN THE
PERFORMANCE HIERARCHY
1. Planning
3 planning levels:
Strategic
plans
Tactical
plans
•
•
•
•
Prepared at a strategic level by senior management.
Focused on overall corporate performance.
Environmental influence.
Set overall plans and targets for units and departments.
•
Prepared at lower management level, within guidelines set by
senior management.
Time horizon typically 12 months.
Plans for individual departments or activities.
Provides a link between strategic plans at senior level and
operational planning.
Budget targets should be consistent with strategic objectives.
•
•
•
•
•
•
Operational
plans
•
•
•
Prepared by managers at a fairly junior level.
Based on objectives about 'what' to achieve in operational terms
and 'how’ something is achieved.
Short time horizons.
Detailed specifications of targets and standards.
Operational plans should be prepared that enable budget targets
to be achieved.
259
III. PLANNING AND CONTROL IN THE
PERFORMANCE HIERARCHY
1. Planning
Example 1:
SAP Co is an exporter of Vietnamese agricultural products. They plan for next 5year. Details are as follows:
•
Strategic plan: Become the 3rd exporter in Vietnam, annual revenue growth
rate must be at least 6%;
•
Tactical plan: New promotion campaign will be launched through online
channel;
•
Operational plan: Each sales staff planned training development to improve
selling and communication skills
260
III. PLANNING AND CONTROL IN THE
PERFORMANCE HIERARCHY
2. Control
If the plan stage is to set targets, the control stage is to measure actual results against the
plan and take action to adjust actual performance to achieve the plan or to change the plan
altogether.
Feedback occurs when the results of a system are used to control it, by adjusting the
input or behaviour of the system.
Feedback is information produced as output from operations; it is used to compare
actual results with planned results for control purposes.
261
III. PLANNING AND CONTROL IN THE
PERFORMANCE HIERARCHY
2. Control
Details are as follows:
Therefore, control is impossible without planning.
262
IV. OTHER ASPECTS OF BUDGET PREPARATION
1. Information used in budget systems
Information used in budgeting comes from a wide variety of sources. There are 2 main
sources of budget information:
Sales budget information
Production budget information
Sales budget is often the primary
budget from which the majority of
the other budgets are derived. They
include:
This information will come from the
production department and a large
part of the traditional work of cost
accounting. They include:
•
•
•
•
•
•
•
•
•
•
Past sales patterns
The economic environment
Results of market research
Pricing policies and discounts
offered
Competition
Anticipated advertising
Changing consumer taste
Distribution
Legislation
•
•
Labour costs: idle time, overtime
and standard output rates per
hour
Raw material costs: allowances
for losses during production
Machine hours: expected idle
time and expected output rates
per machine hour
263
IV. OTHER ASPECTS OF BUDGET PREPARATION
1. Information used in budget systems
Example 2:
Below is production and material budgets for the month of February of a
production company:
Product Trophies is made from 2 draw materials namely Mersey and Gatt. Each
unit of Trophy contains 5 kilos of Mersey and 3 kilos of Gatt.
264
IV. OTHER ASPECTS OF BUDGET PREPARATION
2. Change budgetary systems
An organisation wishing to change its budgetary practices will face a number of
difficulties. Details are as follows:
Difficulties
Explanations
Resistance by
employees
Employees will be familiar with the current system and may have
built in slack so will not easily accept new targets
Loss of control
Management may take time to adapt to the new system and
understand the implications of results
Costs of
implementation
Any new system or process requires careful implementation
which will have cost implications namely timing, labour, capital…
Training
In order to prepare and implement budgets under the new
system, managers will need to be fully trained, which requires
time consuming and expensive costs
Lack of
accounting
information
Information could be not available for preparing the new style
budget
265
IV. OTHER ASPECTS OF BUDGET PREPARATION
3. Budgeting and uncertainty
Budgets are estimated, so preparing a budget involves uncertainty. Detailed causes are as
follows:
Difficulties
Explanations
Customers
They may decide to buy less or more than forecast
Products/
services
In the modern business environment, requirements of customers
to products or services could be changed rapidly
Inflation
Exchange rate fluctuations can affect the cost of imported
materials, and the price that foreign customers will have to pay,
which is likely to affect demand
Materials
Cost of raw materials may change unexpectedly
Competitors
They may steal some of an organisation’s expected customers, or
somecompetitors’ customers may change their buying allegiance
Employees
They may not work as hard as was hoped
Machines
They may break down unexpectedly
Unrest or
disaster
There may be political unrest, social unrest or minor or major
natural disasters
266
CHAPTER 10: TYPES OF BUDGET
267
OVERVIEW
What will you learn?
Types of budget
I.
Top-down and bottom-up
II.
Fixed and flexible budgets
III.
Rolling Budget
IV.
Incremental Budget
V.
Zero Based Budgeting
VI.
Activity based budget
VII.
Beyond Budgeting
268
I. TOP-DOWN AND BOTTOM-UP
Details of top-down and bottom-up
Top-down and bottom-up are two reverse approaches to budget preparation. Details are as follows:
Definition
Advantages
Disadvantages
Top-down budgeting
Bottom-up budgeting
Budget targets are set at senior
management level for organization as a
whole and for each major department
or activity within organization
This is when the budgeting process
starts at a relatively low level of
management
Senior management level set
a whole budget
Lowest managers draft
specific budgets
Departmental managers set
departmental budgets
Supervisor managers combine
lower-level budgets
Managers lower down to set
specific budget
Senior management co-ordinates
to a whole budget
• Take much less time and planning
effort
• Created based on real operation,
so be attainable
• Senior management could bring a
strategic budget for organization
• Promote motivational advantages
as all management levels join to
prepare budget
• Budget could be not achievable
• Take more time and planning effort
• This does not bring properly co-ordination • Specific budgets submitted could
between levels of employee
be easy to reach
269
II. FIXED AND FLEXIBLE BUDGETS
1. Fixed budget
A fixed budget is a budget which remains unchanged throughout the budget period,
regardless of differences between the actual and the original planned volume of output
or sales.
Fixed budget is based on budgeted volumes and
costs/revenues and as such is often unrealistic
Major purpose of a fixed budget is for planning
and is the master budget prepared before the
beginning of the budget period
270
II. FIXED AND FLEXIBLE BUDGETS
2. Flexible budget
A flexible budget is a budget which, by recognising different cost behavior patterns, is changed
as the volume of output and sales changes. It recognises cost behavior patterns such as changes
in sales revenue and variable costs as sales volumes change, and step changes in fixed costs as
activity levels rise or fall by more than a certain amount.
Example 1:
SAP Co prepared a budgeted sales revenue of $10m during the next year. Budgeted fixed and
variable costs are correspondingly $3m and $1m. At the end of the first quarter next year,
actual revenue is just $8m, fixed and variable costs are $4m and $2m respectively.
Required: What is the flexible budget?
Answer:
SAP Co could prepare flexible budget based on the comparing the rate between actual and
original fixed budget.
Sales
revenue
Fixed costs
Fixed budget
($m)
(a)
Actual
($m)
(b)
Flexible budget
($m)
(c)
Budget variance
($m)
(d) = (c)-(b)
10
8
8
0
(3)
(4)
1x8/10
1
(1)
(2)
(0.8)
1.2
6
2
4.2
2.2
A
(3)
Variable
costs
Profit
A
A
271
II. FIXED AND FLEXIBLE BUDGETS
2. Flexible budget
A flexible budget has the following advantages and disadvantages:
Advantages
Disadvantages
Show different results from
possible activity levels
Take more time, money and
effort to prepare
Have a higher value
Difficult to prepare exactly
in advance
272
III. ROLLING BUDGET
Definition and example
A rolling budget is a budget which is continuously updated by adding a further
accounting period (a month or quarter) to the end of the budget when the
corresponding period in the current budget has ended.
As a result, a number of rolling budgets are prepared each year and each rolling budget
covers the next 12-month period.
Example 2 (Question):
A company uses a system of rolling budgets. The sales budget is displayed below
Sales
Jan - Mar
$
78,480
Apr - Jun
$
86,120
Jul - Sep
$
91,800
Oct - Dec
$
97,462
Total
$
353,862
Actual sales for January - March were $74,640. The adverse variance is explained by
growth being lower than anticipated and the market being more competitive than
predicted.
Senior management has proposed that the revised assumption for sales growth
should be 2.5% per quarter.
Required: Update the budget using rolling budget.
273
III. ROLLING BUDGET
Definition and example
Example 2 (Solution):
Actual sales for January - March were $74,640 and sales growth per quarter
should be 2.5%. Thus, sales revenue for next quarters are as follows:
Apr - Jun
$
Sales
Jul - Sep
$
Oct - Dec
$
Jan - Mar
$
Total
$
317,692
76,506
78,419
80,379
82,389
[74,640x102.5%]
[76,506x102.5%]
[78,419x102.5%]
[80,379x102.5%]
274
III. ROLLING BUDGET
Advantages and disadvantages
A rolling budget has the following advantages and disadvantages:
Advantages
Disadvantages
Reduce uncertainty
Take more time, money and
effort to prepare
More realistic
May demotivate managers
There is always a budget
that extends into the future
Put additional pressure on the
accounts department
Encourage managers to
think about the future
Notes: Rolling budget is suitable in case:
•
Accurate forecasts cannot be made
•
Any area of business that needs tight control.
275
IV. INCREMENTAL BUDGET
Definition and example
Incremental budget is a method of budgeting in which next year's budget is prepared by
using the current year's actual results as a starting point, and making adjustments for
expected inflation, sales growth or decline and other known changes.
Example 3 (Question):
SAP Co produces two products, A and C. In the last year (20X4) it produced 640
units of A and 350 units of C incurring costs of $672,000. Analysis of the costs has
shown that 75% of the total costs are variable. 60% of these variable costs vary in
line with the number of A produced and the remainder with the number of C.
The budget for the year 20X5 is now being prepared using an incremental
budgeting approach. The following additional information is available for 20X5:
•
All costs will be 4% higher than the average paid in 20X4.
•
Efficiency levels will remain unchanged.
•
Expected output of A is 750 units and of C is 340 units
Required: What is the budgeted total variable cost of products A and C for the full
year 20X5?
276
IV. INCREMENTAL BUDGET
Definition and example
Example 3 (Solution):
In the year 20X4
Total variable costs =75% x $672,000 = $504,000
Variable costs
($)
Product
Sales volume
(Units)
Unit variable cost
($)
A
[504,000x60%]
302,400
640
472.5
C
[504,000x40%]
201,600
350
576
In the year 20X5
Product
Unit variable cost
($)
Increase rate of cost
(%)
Sales volume
(Units)
Variable costs
($)
A
472.5
4
750
368,550
C
576
4
340
203,674
277
IV. INCREMENTAL BUDGET
Advantages and disadvantages
An incremental budgeting has the following advantages and disadvantages:
Advantages
Disadvantages
Be simple, cheap and easy
to understand
inefficiencies continue
Be relatively quick to
administer
not suitable for changing
environments
not produce challenging
performance targets
not encourage finding ways
of improving
Notes: Incremental budget is suitable for stable businesses, where costs are not expected
to change significantly.
278
V. ZERO BASED BUDGETING
Definition
Zero based budgeting (ZBB) involves preparing a budget for each cost centre or activity
from a zero base. Every item of expenditure has then to be justified in its entirety in
order to be included in the next year's budget.
Thus, ZBB rejects the assumption inherent in incremental budget that next year's budget
should be based on the current financial year results and based on the followings:
The current year's results
may include wasteful
spending and inefficiencies
Budget activities should be
reviewed and assessed
to consider whether
they are still suitable
279
V. ZERO BASED BUDGETING
How to prepare a ZBB
3 steps to prepare a ZBB:
Step 1: Define decision packages
There are 2 types of decision packages:
•
Mutually exclusive packages: contain alternative methods of
getting the same job done
•
Incremental packages: divide one aspect of an activity into
different levels of effort
Step 2: Evaluate and rank each decision package
•
Based on its benefit to the organisation
•
Minimum work requirements and work that meets legal
obligations will be given high priority
Step 3: Allocate resources to decision packages
•
According to funds available and the evaluation in Step 2
280
V. ZERO BASED BUDGETING
How to prepare a ZBB
Example 4
The head teacher of a school considers using a ZBB for the provision or facilitation
of school lunches.
Step 1: Define decision packages
•
The catering manages will have the following incremental packages:
Level 1: providing an area where students can bring their own cold food to,
with some sandwiches and other cold food and drinks being prepared and sold by
catering staff
Level 2: providing a self-service cafeteria with hot and cold food and drinks
available
Level 3: providing a full, hot food, catered service for pupils
•
The school head, on the other hand, consider 2 mutually exclusive packages:
providing a service internally or outsourcing the whole catering activity to an
external provider
Step 2: Evaluate and rank each decision package
The catering manager will rank the numerous decision packages that he prepares.
Then, the headmaster will rank the catering packages amongst all the packages
prepared for the rest of the school.
Step 3: Allocate resources to decision packages
The resources are then allocated based on order of priority up to the spending
level.
281
V. ZERO BASED BUDGETING
Advantages and disadvantages of a ZBB
Using of a ZBB has following benefits and limitations:
Advantages
Disadvantages
Identify/remove inefficient
or obsolete operations
Time-consuming
Force employees to avoid
wasteful expenditure
Difficult to define decision
packages and ranking
Increase motivation of staff
Detriment of long-term
benefits
Respond to changes in the
business environment
Notes: ZBB is suitable in case:
•
Allocating resources in areas where spend is discretionary
•
Public sector organisations such as local authorities
282
VI. ACTIVITY BASED BUDGET
Definition and example
Activity based budgeting (ABB) involves defining the activities that underlie the financial
figures in each function and using the level of activity to decide how much resource
should be allocated and how well it is being managed and to explain variances from
budget.
ABB focuses on 4 following principles:
Activities drive costs is managed, thanks to which, plan and control of
long-term costs will be better
Not all activities add value, so activities must be examined and split up
according to their ability to add value
Demand and decisions beyond the control of a department’s manager
drive many departmental activities
Traditional financial measures of performance are unable to fulfil the
objective of continuous improvement, so should add more measures
which focus on drivers of costs, the quality of activities undertaken and
the responsiveness to change
Notes: ABB can only be used in organisations which use Activity based costing (ABC)
•
ABC is mentioned in chapter 2a Activity based costing
•
A cost driver is a factor which has most influence on the cost of an activity
283
VII. BEYOND BUDGETING
Definition and example
Beyond budgeting is a budgeting model which proposes that traditional budgeting
should be abandoned and focus on adaptive management processes.
Beyond budgeting is based on 2 principles:
Use adaptive management processes rather than
the more rigid annual budget
•
•
Managers should plan on a more adaptive,
rolling basis, but with the focus on cash
forecasting, rather than purely on cost control.
Performance is monitored against world-class
benchmarks, competitors and previous periods.
Move towards devolved networks rather than
centralised hierarchies:
•
The emphasis is on encouraging a culture of
personal responsibility by delegating decisionmaking and performance accountability to
line managers.
284
VII. BEYOND BUDGETING
Advantages and disadvantages
Using of beyond budgeting has following benefits and limitations:
Advantages
Disadvantages
Encourages innovation
May be resistance to
change in adopting
Increases motivation
Need to plan, even if there
are lots of uncertainties
Allows faster responses to
threats and opportunities
285
CHAPTER 11: QUANTITATIVE
ANALYSIS IN BUDGETING
286
OVERVIEW
What will you learn?
Types of budget
I.
High-low method
II.
Learning curves
287
I. HIGH LOW METHOD
Definition
The high-low method is a quantitative technique for analysing total costs at the highest
and lowest activity levels to determine fixed cost and variable cost elements.
5 steps to conduct:
Step 1: Review records of costs in previous periods
•
Select the period with the highest activity level
•
Select the period with the lowest activity level
Step 2: Adjust inflation factor (if any)
Step 3: Determine variables for activity levels:
Total costs
at highest
activity level
Total costs
at lowest
activity level
Total units
at highest
activity level
Total units
at lowest
activity level
288
I. HIGH LOW METHOD
Definition
The high-low method is a quantitative technique for analysing total costs at the highest
and lowest activity levels to determine fixed cost and variable cost elements.
5 steps to conduct:
Step 4: Calculate the variable cost/unit
Total costs at highest activity level −Total costs at lowest activity level
Total units at highest activity level −Total units at lowest activity level
Step 5: Calculate the fixed cost
Total cost at highest
activity level
Total units at highest
activity level
Variable cost
per unit
289
I. HIGH LOW METHOD
Example
Example 1 (Question):
SAP Co wishes to develop a method of predicting its total costs in a period. The
following data have been recorded.
Month
Activity level
(Units)
Cost
($)
Jan
1,600
28,200
Feb
2,300
29,600
Mar
1,900
28,800
Apr
1,800
28,600
May
1,500
28,000
Jun
1,700
28,400
Required: The total cost model for a period could be represented by what equation?
290
I. HIGH LOW METHOD
Example
Example 1 (Solution):
Step 1: Review records of costs in previous periods
Period with highest activity level: Feb (2,300 units)
Period with lowest activity level: May (1,500 units)
Step 2: Adjust inflation factor (if any)
The question does not mention inflation factor, so transfer step 3.
Step 3: Determine variables for activity levels:
Total costs at highest activity level: $29,600
Total costs at lowest activity level: $28,000
Total units at highest activity level: 2,300 units
Total units at lowest activity level: 1,500 units
Step 4: Calculate the variable cost/unit
Total costs at highest activity level −Total costs at lowest activity level
Total units at highest activity level −Total units at lowest activity level =
(29,600−28,000)
= $2
(2,300−1,500)
Step 5: Calculate the fixed cost
Total cost at highest activity level - (Total units at highest activity level × Variable
cost per unit) = $29,600 - (2,300x$2) = $25,000
Total costs (y) = fixed costs + Variable costs = 25,000 + 2x where x is the volume of
activity in units.
291
I. HIGH LOW METHOD
Benefits and limitations
Therefore, using the high low method has some following benefits and limitations:
Benefits
Limitations
Separate total costs into
fixed and variable costs
Result could be not suitable
to current conditions
Easy to understand and use
Results may be distorted
due to random variations
292
II. LEARNING CURVES
1. Definition
In practice, it is often found that the resources required to make a
product decrease as production volumes increase.
The 100th unit
of a product
The first unit
of a product
Economies of scale
Costs usually fall when
products are made on a
larger scale, such as bulk
quantity discounts received
from suppliers
Reasons
The workers are likely to
become more efficient
Workers feel confident and
knowledgeable about the
work
as
they
gain
experience. This means that
it takes them less time to
complete the work
293
II. LEARNING CURVES
1. Definition
Learning curve theory applies to situations where the workforce as a whole improves in
efficiency with experience.
The learning effect or learning curve effect describes the speeding up of a job with
repeated performance.
Where a learning curve applies, there is a learning rate and a learning effect.
•
Learning rate is expressed as a percentage value. For example: 70% learning curve
•
Learning effect is that, as the workforce learns from experience how to make the
new product, there is a big reduction in the time taken to make additional units.
The learning process starts as soon as the first unit/batch comes off the production line
The cumulative output
of the product doubles
The average time to produce a
unit falls buy a learning rate
The learning effect
294
II. LEARNING CURVES
1. Definition
The below diagram shows that
When output is low,
the learning curve
is really steep
The curve becomes
flatter as cumulative
output increases
The curve becomes a
straight line when the
learning effect ends
Steep
Becoming flatter
Straight line
295
II. LEARNING CURVES
2. Conditions to apply
The theory of learning curves will be applied if any or all of the following conditions satisfy:
Made largely by labour effort (rather than by a highly
mechanised process) or where labour skill is an
important factor in the production process
Brand new or relatively short lived (the learning process
does not continue indefinitely)
Complex and made in small quantities for special orders
296
II. LEARNING CURVES
3. APPROACH
There are two methods that can be used to deal with a learning curve scenario:
Approaches to
learning curve
The tabular
approach
The algebraic
approach
297
II. LEARNING CURVES
3. APPROACH
3.1
The tabular approach
The tabular approach can only be used to calculate average times when cumulative output
doubles.
Rule: Every time that cumulative output doubles the average production time is x% of
what is was before, where x is the learning rate.
Example 1 (Question):
Where an 80% learning effect occurs, the cumulative average time required per
unit of output is reduced to 80% of the previous cumulative average time when
output is doubled.
The first unit of output of a new product requires 100 hours. An 80% learning
curve applies.
Required: What is the total time to produce 8 units in total?
298
II. LEARNING CURVES
3. APPROACH
The tabular approach
3.1
Example 1 (Solution):
The production times would be as follows:
Cumulative
number of
units
Cumulative
avg time per
unit (hours)
Cumulative
total time
(hours)
Incremental
number of
units
Incremental
total time
(hours)
Time per
incremental unit
(hours)
1
2*
4*
8*
100
100x80% = 80
80x80% = 64
64x80% = 51.2
100
80x2 = 160
64x4 = 256
51.2x8 = 409.6
1
2
4
60
96
153.6
60
48
38.4
(*) Output is being doubled each time.
Therefore, total time to produce 8 units is 409.6 hours
Notes: The value of b should not be rounded less than 3 decimal places.
299
II. LEARNING CURVES
3. APPROACH
3.2
The algebraic approach
The learning curve formula can be used to solve all learning curve scenarios.
Learning curve formula: Y = aXb
where:
Y is the cumulative average time per unit taken to produce X units
a is the time taken to produce the first unit
X is the cumulative number of units
b is the index of learning (log LR/log 2)
LR = the learning rate as a decimal
300
II. LEARNING CURVES
3. APPROACH
The algebraic approach
3.2
5 steps to determine timing/ cost of the Xth unit
01
Calculate the cumulative average time per unit to
produce x units
02
Multiply the result in Step 1 by x resulting in total
time to produce x units
03
Calculate the cumulative average time per unit to
produce (x-1) units
04
Multiply the result in Step 3 by (x-1) resulting in total
time to produce (x-1) units
05
Subtract result in step 4 by step 2 to determine time
consumed to produce the Xth unit
301
II. LEARNING CURVES
3. APPROACH
3.2
The algebraic approach
Example 3 (Question):
Suppose that an 80% learning curve applies to production of a new product item
ABC. Up to now, 30 units of ABC have been produced. The time to make the very
first unit of ABC in January was 120 hours.
Required: Calculate the time required to make the 31st unit?
302
II. LEARNING CURVES
3. APPROACH
3.2
The algebraic approach
Example 3 (Solution):
Step 1: Calculate the cumulative average time per unit to produce 31 units
Apply learning curve formula: Y = aXb
Where: a = 120
X = 31
b = log 0.8/ log 2 = - 0.3219281
So, Y (31) = 120 x 31-0.3219281 = 39.726 hours
Step 2: Multiply the result in Step 1 by 31 resulting in total time to produce 31 units
31 x 39.726 = 1,231.51 hours
Step 3: Calculate the cumulative average time per unit to produce 30 units
Y (30) = 120 x 30-0.3219281 = 40.147 hours
Step 4: Multiply the result in Step 3 by 30 resulting in total time to produce 30 units
30 x 40.147 = 1,204.41 hours
Step 5: Subtract result in step 4 by step 2 to determine time consumed to produce the 31st unit
1,231.51 - 1,204.41 = 27.1 hours
Notes:
The labour costs could be calculated by applying the labour hour rate to the number of
labour hours
Material costs is not affected by the learning effect.
303
II. LEARNING CURVES
3. APPROACH
3.2
The algebraic approach
Example 4 (Solution):
Using example 3 again
Assuming that the budgeted production unit is five units next month and the labour cost is $10
per hour
Required: Calculate the budgeted total labour cost next month
Answer:
Cummulative average time per unit to produce 35 units:
Y (35) = 120 x 35-0.3219281
= 38.203 hours
Time to produce the first 35 units = 35 * 38.203 = 1,337.10 hours
Time to produce 5 units next month = 1,337.10 – 1,204.41 = 132.69 hours
Budgeted labour costs next month = 132.69 * $10 = $1,326.90
304
III. ASSESS LEARNING CURVES
Advantages and disadvantages
Using learning curves has some following benefits and limitations:
Advantages
Help management has a
comprehensive view in
budget preparation
Disadvantages
Learning curve phenomenon
is not always present
Stable conditions at work is
not always practicable
Difficult to determine
learning rate
Takes long time to emerge
305
CHAPTER 12: BUDGETING
AND STANDARD COSTING
306
OVERVIEW
What will you learn?
Budgeting and standard costing
I.
Standard cost
II.
Flexible budgets
III.
Principles of controllability
307
I. STANDARD COST
1. What is a standard cost?
A standard cost is an estimated unit cost.
Example
$/unit
Direct costs:
Direct materials
Direct labour
Indirect costs:
Variable overheads
Fixed overheads
Full production costs
[5 kg @ $3/kg]
[3 hrs @ $6/hr]
15
18
33
2
3
38
Standard costing involves the establishment of predetermined estimates of the costs of
products or services, the collection of actual costs and the comparison of the actual
costs with the predetermined estimates.
The predetermined costs are known as standard costs and the difference between
standard and actual cost is known as a variance.
The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
308
I. STANDARD COST
1. What is a standard cost?
Standard costing has 3 main uses:
Uses of standard costing
Explanations
To value inventories
It is an alternative to FIFO and average cost
To budget production costs
When a standard per unit of product has
been established, budgeting production costs
becomes a fairly straightforward process
To control budget
Compare actual costs with the expected
costs to understand existed variances and
find out solutions to proceed on time
Suited to mass production and repetitive assembly work, where large
quantities of a standard product are manufactured
Notes:
The concept of variance analysis will be mentioned in Chapter 13 Variance analysis.
309
I. STANDARD COST
2. Deriving standards
When preparing a standard cost, it is necessary to involve some aspects:
Aspect
Explanations
Material cost
Costs of direct materials per unit of raw material will be
estimated by the purchasing department based on:
•
Purchase contracts already agreed
•
Pricing discussions with regular suppliers
•
The forecast movement of prices in the market
•
The availability of bulk purchase discounts
•
The quality of material required by the production
departments
Labour cost
Direct labour rates per hour will be set based on:
•
Payroll
•
Any agreements on pay rises with trade union
representatives of the employees
Material usage
and labour
efficiency
Technical specifications must be prepared for each
product by production experts (either in the production
department or the work study department)
310
I. STANDARD COST
2. Deriving standards
When preparing a standard cost, it is necessary to involve some aspects:
Aspect
Explanations
Sale price
and margin
Standard selling price will depend on several factors:
•
Anticipated market demand
•
Competing products
•
Manufacturing costs
•
Inflation estimates
Standard sales margin is the difference between the
standard cost and the standard selling price.
Overheads
The absorption rate of fixed production overheads will
be predetermined and based on budgeted fixed
production overhead and planned production volume
311
I. STANDARD COST
3. Types of standard
There are 4 types of standards:
Definition
Advantage
Ideal standard
A standard which can be
attained under perfect
operating conditions: no
wastage, no inefficiency,
no idle time, no
breakdowns
Be high standard
and perfect goal
to toward
Be not able to
achieve
Employees may feel
that the goals are
unattainable and so
they will not work so
hard
Attainable standard
Disadvantage
Impact on
behavior of
employees
Type
A standard which can be
attained if production is
carried out efficiently,
machines are properly
operated and/or
materials are properly
used. Some allowance is
made for wastage and
inefficiencies
Can be used for
many purposes
namely
production, cost
and budget
setting, so it is
most often used
in practice
Take more time
and resources
Be an incentive to
work harder as
they provide a
realistic but
challenging target
of efficiency
312
I. STANDARD COST
3. Types of standard
There are 4 types of standards:
Basic standard
Current
standard
Type
Definition
Advantage
Disadvantage
Impact on
behavior of
employees
A standard based on
current working
conditions (current
wastage, current
inefficiencies)
A good standard
to budget as
reflects current
capacity
Will not create
motivation to
develop
Will not motivate
employees to do
anything more
than they are
currently doing
A long-term standard
which remains
unchanged over the
years and is used to
show trends.
Be suitable to
evaluate
performance for a
long-term period
Be rarely used as
standards are too
low
Be easy to achieve
the standards, so
they become
bored and lose
interest in what
they are doing if
they have nothing
to aim for.
Notes:
It is obvious that conditions to undertake each standard decreased from ideal standard
(under perfect operating conditions) to basic standard (basic conditions). Therefore, the
target results would be reduced respectively.
313
I. STANDARD COST
4. Budgets and standards compared
Similarity between budgets and standards costing
Both budgets and standards involve looking to the future and forecasting what is
likely to happen given a certain set of circumstances and used for control purposes.
3 important differences are as follows:
Budgets costing
Standard costing
Gives planned total
aggregate costs for a
function or cost centre
Shows the unit resource
usage for a single task
Can be prepared for all
functions, even where
output cannot be measured
Limited to situations
where repetitive actions
are performed and
output can be measured
Financial targets
Financial and
non-financial targets
314
II. FLEXIBLE BUDGETS
What is a flexible budgets?
A flexible budget is a budget which, by recognising different cost behaviour patterns,
changes as volume of activity (output and sales) changes.
2 steps to prepare a flexible budget:
01
02
Identify fixed and
variable costs
Produce a flexible
budget using
marginal costing
techniques
315
II. FLEXIBLE BUDGETS
What is a flexible budgets?
Example 1 (Question):
SAP has prepared a below budget for next month:
Revenue
Costs:
Fixed costs
Variable costs
Profit
$m
10
3
1
6
Up to the year end, actual revenue is just $8m, fixed and variable costs are $4m and
$2m respectively.
Required: Prepare a flexible budget and budgetary control analysis.
316
II. FLEXIBLE BUDGETS
What is a flexible budgets?
Example 1 (Solution):
Step 1: Identify fixed and variable costs
Fixed costs: not affected by revenue fluctuation, so it is the same fixed budget
and is $3m
Variable costs: change based on revenue fluctuation as a rate of $1 variable costs
and $10 revenue
Step 2: Produce a flexible budget using marginal costing techniques
As mentioned in step 1, flexible budget is as follows:
$m
Revenue
8
Costs:
Fixed costs
Variable costs
Profit
3
[1/10x8]
0.8
4.2
317
II. FLEXIBLE BUDGETS
What is a flexible budgets?
Example 1 (Solution):
Budgetary control analysis is as follows:
Revenue
Fixed costs
Variable costs
Profit
Fixed budget
$m
(a)
10
3
1
6
Actual results
$m
(b)
8
4
2
2
Flexible budget Budget variance
$m
$m
(c)
(d) = (c)-(b)
8
0
3
1
0.8
1.2
4.2
2.2
A
A
A
A is an adverse or unfavourable variance.
See that in order to create $8m of revenue, the expected profit should not have
been the fixed budget profit of $6m, but the flexible budget profit of $4.2m.
Instead, actual profit was $2m that is lower $2.2m than we should have
expected. The main reason is that fixed and variable costs were higher than
expected $1m and $1.2m respectively.
Notes:
We studied the basic content of flexible budget in Chapter 10 Types of budget. In this
chapter, how to prepare and use a flexible budget are mentioned. The comparison of a
fixed budget with the actual results for a different level of activity is rarely used for
control purposes. Flexible budgets should be used to show what cost and revenues
should have been for the actual level of activity.
318
III. PRINCIPLE OF CONTROLLABILITY
1. Budget centres
Budgetary control is based around a system of budget centres. Each budget centre will
have its own budget and a manager will be responsible for managing the budget centre
and ensuring that the budget is met.
Thus, the selection of budget centres in an organisation is a key first step in setting up a
control system.
In order to ensure effectively, the control system needs 3 following features:
There is a
clear hierarchy of
budget centres
Identify clearly
responsibilities
for achieving
budget targets
Identify clearly
responsibilities for
revenues, costs and
capital employed
Therefore, budgetary control and budget centres are part of the overall system of
responsibility accounting within an organization.
Responsibility accounting is a system of accounting that segregates revenue and costs
into areas of personal responsibility in order to monitor and assess the performance of
each part of an organization.
319
III. PRINCIPLE OF CONTROLLABILITY
2. Controllable costs
Controllable costs are items of expenditure which can be directly influenced by a given
manager within a given time span.
Manager should distinguish between controllable costs and uncontrollable costs to aim
controls because of the followings:
A cost which is not
controllable by a junior
manager might be controllable
by a senior manager
A cost which is not
controllable by a manager in
one department may be
controllable by a manager in
another department
320
III. PRINCIPLE OF CONTROLLABILITY
2. Controllable costs
Some costs should be specially cared:
Fixed costs
Apportioned costs
It is not correct that all fixed costs are
non-controllable in the short run
Managers should be held accountable
for costs which they can control.
Committed fixed costs are costs
to support the long-term needs
of the business and committed
to by longer-term decisions
affecting longer-term needs.
Managers have no control.
Example, apportioned rent and
rates costs would not be
controllable by the production
department manager
Discretionary fixed costs are
costs incurred as a result of a top
management decision but could
be raised or lowered at fairly
short notice.
Managers have some influence.
Example, costs of raw materials
might be the responsibility of the
purchasing manager (prices) and
the production manager (usage)
Notes:
There is no clear rules to determine controllable and uncontrollable costs. In the exam, it
is important to consider carefully the given information and its behavioural impact.
321
CHAPTER 13:
VARIANCE ANALYSIS
322
OVERVIEW
What will you learn?
Budgeting and standard costing
Sales variance
Material variances
Basic variances
Labour variances
Overhead variances
Operating
statements
Variance analysis
Investigating
variances
Materials mix
and yield
variances
Sales mix and
quantity
variances
Under absorption costing
Under marginal costing
Indicating factors
Investigation models
Materials mix variance
Material yield variance
Sales mix variance
Sales quantity variance
323
I. BASIC VARIANCES
1. Terminologies
In order to understand basic variances, you need to understand the basic variances
brought forward from your earlier studies.
Terminologies
Definitions
Variance
is the difference between an actual result and an
expected result. In standard costing, cost variances
are the difference between the standard costs and
actual costs of units produced.
Variance analysis
is the process by which the total difference between
standard and actual results is analysed.
Favourable variance (F)
when actual results are better than expected results
Adverse variance (A)
when actual results are worse than expected results
324
I. BASIC VARIANCES
2. Revision of basic variance analysis
Basic variances can be calculated for:
Sales
variances
Material variances
Basic
variances
Costs
variances
Labor variances
Overhead
variances
Variable overheads
Fixed overheads
325
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.1
Sales variances
The sales variance is the monetary difference between actual and budgeted sales.
The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what the
sales revenue should have been for the actual quantity sold, and what it was.
The sales volume variance is the difference between the actual units sold and the
budgeted (planned) quantity, valued at the standard profit per unit. In other words, it
measures the increase or decrease in standard profit as a result of the sales volume
being higher or lower than budgeted.
Sales
revenue
Selling price
Sales volume
Sales
variance
Selling price
variance
Sales volume
variance
326
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.1
Sales variances
Sales
variance
Selling price variance
Sale volume variance
Actual sales
volume
Actual sale
volume
Actual sales
volume
Budgeted sales
volume
Actual sales
price
Standard sales
price
Standard
Margin (*)
Standard
Margin (*)
(*) In which:
Contribution per unit (marginal costing)
Margin
Profit per unit (absorption costing)
327
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.1
Sales variances
Example 1 (Question):
Jasper Co has the following budget and actual figures for 20X4.
Budget/standard
Actual
Sales volume
600
620
Selling price per unit
$30
$29
Standard full cost of production = $28 per unit.
Required:
Calculate the selling price variance and the sales volume profit variance.
328
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.1
Sales variances
Example 1 (Solution):
Selling price variance
Sales volume variance
Actual sales price
$29
Actual sales volume
620 units
Standard sales price
$30
Budgeted sales volume
600 units
Actual sale volume
620 units
Standard profit margin ($30 – $28)
Selling price variance
$620 (A)
Sales volume profit variance
$1 (A)
Sales volume variance in units
Sales variance in this case = 620 (A) + 40 (F) = 580 ($) (A)
20 units (F)
$2
$40 (F)
329
I. BASIC VARIANCES
2. Revision of basic variance analysis
Favorable
Adverse
Sales price
Unexpected price increase due to:
•
higher
than
anticipated
customer demand
•
lower than anticipated demand
for competitor's products
•
an improvement in quality or
performance
Unexpected price decrease due to:
•
lower
than
anticipated
customer demand
•
higher than anticipated demand
for competitor's products
•
a reduction in quality or
performance
Sales volume
Causes of sales variances
Unexpected increase in demand
due to:
•
a lower price
•
improved
quality
or
performance
•
a fall in quality or performance
of competitor's products
•
a
successful
marketing
campaign
Unexpected fall in demand due to:
•
a higher price
•
lower quality or performance of
the product
•
an increase in quality or
performance of competitor's
products
•
an unsuccessful marketing
campaign
Notes:
The sales price and volume variance may be linked. For example, an increase in the price
of a product will result in a favourable sales price variance but may also result in an
adverse sales volume variance, due to a fall in demand.
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2.2
Material variances
The material total variance is the difference between what the output actually cost and
what it should have cost, in terms of material. It can be subdivided into the direct
material price variance and the direct material usage variance.
The material price variance is the difference between what the material did cost and
what it should have cost.
The material usage variance is the difference between the standard cost of the material
that should have been used and the standard cost of the material that was used.
Material cost
Material price
Material usage
Material
variance
Material price
variance
Material usage
variance
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2.2
Material variances
Price variance
Usage variance
Actual quantity
usage
Actual quantity
usage
Actual quantity
usage
Standard
quantity usage
Actual price
Standard price
Standard price
Standard price
Material total variance
Actual quantity usage
Standard quantity usage
Actual price
Standard price
Actual
material costs
Standard
material cost
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2.2
Material variances
Example 2 (Question):
Product X has a standard direct material cost as follows.
10 kilograms of material Y at $10 per kilogram = $100 per unit of X.
During period 4, 1,000 units of X were manufactured, using 11,700 kilograms of
material Y which cost $98,600.
Required:
Calculate the following variances.
(a) The material total variance
(b) The material price variance
(c) The material usage variance
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2.2
Material variances
Example 2 (Solution):
(a) The direct material total variance
This is the difference between what 1,000 units should have cost and what they
did cost.
Actual material cost
Standard material cost
$98,600
1,000 units × $100
$100,000
$1,400 (F)
The variance is favourable because the units cost less than they should have cost.
(b) The material price variance
This is the difference between what 11,700 kg should have cost and what 11,700
kg did cost.
Actual price
Standard price
$98,600/11,700kg
Actual quantity usage
Material price variance
1,000 units × 10kg
$1.57 × 11,700kg
$8.42
$10
$1.58 (F)
11,700 kg
$18,400 (F)
The variance is favourable because the material cost less than it should have.
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2.2
Material variances
Example 2 (Solution):
(c) The direct material usage variance
This is the difference between how many kilograms of Y should have been used
to produce 1,000 units of X and how many kilograms were used, valued at the
standard cost per kilogram.
Actual quantity usage
Standard quantity usage
1,000 units × 10kg
Standard price per kilogram
Material price variance
$10 × 1,700kg
11,700 kg
10,000 kg
1,700 kg (A)
$10
$17,000 (A)
The variance is adverse because more material was used than should have been.
Summary
Price variance
$18,400 (F)
Usage variance
$17,000 (A)
Total variance
$1,400 (F)
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2. Revision of basic variance analysis
2.2
Material variances
Causes of material variances
Material usage
Material price
Favorable
•
•
•
•
Poorer quality materials
Discounts given for buying in
bulk
Change to a cheaper supplier
Incorrect budgeting
Adverse
•
•
•
•
•
•
•
•
Higher quality materials
More efficient use of material
Change in product specification
Incorrect budgeting
•
•
•
•
Higher quality materials
Change to a more expensive
supplier
Unexpected price increase
encountered
Incorrect budgeting
Poorer quality materials
Less experienced staff using
more materials
Change in product specification
Incorrect budgeting
Notes:
The material price variance and the material usage variance may be linked. For example,
the purchase of poorer quality materials may result in a favourable price variance but an
adverse usage variance.
336
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.3
Labour variances
The labour total variance is the difference between what the output should have cost
and what it did cost, in terms of labour. It can be subdivided into the labour rate
variance and the labour efficiency variance.
The labour rate variance is the difference between what the labour did cost and what it
should have cost.
The labour efficiency variance is the difference between the standard cost of the hours
that should have been worked and the standard cost of the hours that were worked.
Labour cost
Labour rate
Labour hour
Total labour
variance
Labour rate
variance
Labour effiency
variance
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2.3
Labour variances
Labour rate variance
Labour efficiency variance
Actual hour
Actual hour
Actual hour
Standard hour
Actual rate
Standard rate
Standard rate
Standard rate
Total labour variance
Actual hour
Standard hour
Actual rate
Standard rate
Actual
labour cost
Standard
labour costs
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2. Revision of basic variance analysis
2.3
Labour variances
Example 3 (Question):
The standard direct labour cost of product X is as follows.
2 hours of grade Z labour at $5 per hour = $10 per unit of product X.
During period 4, 1,000 units of product X were made, and the direct labour cost
of grade Z labour was $8,900 for 2,300 hours of work.
Required: Calculate the following variances.
(a) The direct labour total variance
(b) The direct labour rate variance
(c) The direct labour efficiency (productivity) variance
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2. Revision of basic variance analysis
2.3
Labour variances
Example 3 (Solution):
(a) The direct labour total variance
This is the difference between what 1,000 units should have cost and what they
did cost.
Actual labour cost
$8,900
Standard labour cost
$10,000
$1,100 (F)
The variance is favourable because the units cost less than they should have done.
(b) The labour rate variance
This is the difference between what 2,300 hours should have cost and what 2,300
hours did cost.
Actual rate
Standard rate
Actual labour hours
Labour rate variance
$8,900/2,300 hours
$1.13 × 2,300 hours
$3.87
$5
$1.13 (F)
2,300 hours
$2,600 (F)
The variance is favourable because the labour cost less than it should have.
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2. Revision of basic variance analysis
2.3
Labour variances
Example 3 (Solution):
(c) The labour efficiency variance
Standard labour hours
1,000 units × 2 hours
Actual labour hours
2,000 hours
2,300 hours
300 hours (A)
Standard rate per hours
$5
Labour efficiency variance
$5 × 300 hours
$1,500 (A)
The variance is adverse because more hours were worked than should have been
worked.
Summary
Labour rate variance
$2,600 (F)
Labour efficiency variance
$1,500 (A)
Total labour variance
$1,100 (F)
341
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2. Revision of basic variance analysis
2.3
Labour variances
Causes of labour variances
Labour efficiency
Labour rate
Favorable
Adverse
•
Lower skilled staff
•
Higher skilled staff
•
Cut in overtime/ bonus
•
Increase in overtime/bonus
•
Incorrect budgeting
•
Incorrect budgeting
•
Unforeseen wage increase
•
Higher skilled staff
•
Lower skilled staff
•
Improved staff motivation
•
Fall in staff motivation
•
Incorrect budgeting
•
Incorrect budgeting
Notes:
The labour rate variance and the labour efficiency variance may be linked. For example,
employing more highly skilled labour may result in an adverse rate variance but a
favourable efficiency variance.
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2. Revision of basic variance analysis
2.4
Overhead variances
Overhead
variance
Variable overhead variances
Fixed overhead variances
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I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.1
Variable overhead variances
The variable production overhead total variance is the difference between what the
output should have cost and what it did cost, in terms of variable production overhead.
It can be subdivided into the variable production overhead expenditure variance and the
variable production overhead efficiency variance (based on actual hours).
The variable production overhead expenditure variance is the difference between the
amount of variable production overhead that should have been incurred in the actual
hours actively worked and the actual amount of variable production overhead incurred.
The variable production overhead efficiency variance is the difference between the
standard cost of the hours that should have been worked for the number of units
actually produced and the standard cost of the actual number of hours worked.
Notes:
Variable overhead variances is closely similar to material/labour cost variances.
344
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.1
Variable overhead variances
Expenditure variance
Efficiency variance
Actual hour
worked
Actual hour
worked
Actual hour
worked
Standard hour
worked
Actual rate
Standard rate
Standard rate
Standard rate
Total variable overhead variance
Actual hour worked
Standard hour worked
Actual rate
Standard rate
Actual variable
overhead cost
Standard variable
overhead cost
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2. Revision of basic variance analysis
2.4.1
Variable overhead variances
Example 3 (Question):
Suppose that the variable overhead cost of product X is as follows.
2 hours at $1.50 = $3 per unit
During period 6, 1,000 units of product X were made. The labour force worked
2,020 hours, of which 60 hours were recorded as idle time. The variable overhead
cost was $3,075.
Required:
Calculate the following variances.
(a) The variable overhead total variance
(b) The variable overhead expenditure variance
(c) The variable overhead efficiency variance
346
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2. Revision of basic variance analysis
2.4.1
Variable overhead variances
Example 3 (Solution):
(a) The variable overhead total variance
Actual variable overhead cost
$3,075
Standard variable overhead cost
$3,000
$75 (A)
The variance is adverse because actual variable overhead incurs more than
budgeted one.
(b) The variable overhead expenditure variance
Actual rate
$3,075/(2,020 – 60) hours
Standard rate
$1.57
$1.5
Eliminate idle time
Actual hours worked
Variable overhead expenditure
variance
$0.07 (A)
(2020 – 60) hours
1,960 hours
$0.07 × 1,960 hours
$135 (A)
The variance is adverse because variable overhead incurred more than it should
have for the actual hour worked.
347
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2. Revision of basic variance analysis
2.4.1
Variable overhead variances
Example 3 (Solution):
(c) The variable overhead efficiency variance
Standard hours worked
Actual hours worked
1,000 units × 2 hours
(2020 hours – 60 idle hours)
2,000 hours
1,960 hours
40 hours (F)
Standard rate per hours
Labour efficiency variance
$1.5
$5 × 300 hours
$60 (F)
The variance is adverse because more hours were worked than should have been
Summary
The variable overhead expenditure variance
$135 (A)
The variable overhead efficiency variance
$60 (F)
The variable overhead total variance
$75 (A)
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2. Revision of basic variance analysis
2.4.1
Variable overhead variances
Causes of variable overhead variances
Variable overhead
efficiency variance
Variable overhead
expenditure variance
Favorable
•
Unexpected saving in cost of services
•
More economic use of services
•
Incorrect budgeting
•
As for labour efficiency
Adverse
•
Unexpected increase in the cost of
services
•
Less economic use of services
•
Incorrect budgeting
•
As for labour efficiency
349
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Fixed overhead total variance is the difference between fixed production overhead
incurred and fixed production overhead absorbed. In other words, it is the under- or
over-absorbed fixed production overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed
production overhead expenditure and actual fixed production overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted
production/volume multiplied by the standard absorption rate per unit.
Fixed overhead volume efficiency variance is the difference between the number of
hours that actual production should have taken and the number of hours actually taken
multiplied by the standard absorption rate per hour.
Fixed overhead volume capacity variance is the difference between budgeted hours of
work and the actual hours worked, multiplied by the standard absorption rate per hour.
350
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Using other overhead costing methods, fixed overhead variance is calculated by other
ways
Marginal costing system
Absorption costing system
With a marginal costing profit
and loss, no overheads are
absorbed, the amount spent is
simply written off to the income
statement.
Under absorption costing we
use an overhead absorption rate
to absorb overheads. Variances
will occur if this absorption rate
is incorrect.
The fixed overhead variance is
the difference between what
was budgeted to be spent and
what was actually spent.
The fixed overhead variance can be
subdivided into the fixed overhead
expenditure variance and the fixed
overhead volume variance.
Fixed overhead variance
Actual cost
Budgeted cost
Fixed overhead variance
Expenditure variance
Volume variance
Volume Volume
capacity efficiency
variance variance
351
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Volume efficiency
variance
Volume capacity
variance
Expenditure variance
Budgeted hour
Actual hour
Actual hour
Standard hour
Standard rate
Standard rate
Standard rate
Standard rate
Volume variance
Actual hour
Budgeted hour
Budgeted hour
Standard hour
Actual rate
Standard rate
Standard rate
Standard rate
Total fixed overhead variance
Actual hour
Standard hour
Actual rate
Standard rate
Actual fixed overhead cost
Standard fixed overhead cost
Notes: Standard hours are absorbed hours of work, that means it is calculated by actual
produced units multiply standard rate (overhead absorption rate).
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2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
These above variances can by determined by the following diagram:
Cost
$
Expenditure
variance
Total
variance
Actual fixed overhead
Volume
variance
Budgeted fixed overhead
Budgeted Actual
units
units
Number of units produced
Rule:
Fixed overhead expenditure variance = the gap between Budgeted fixed overheads and
actual fixed overheads.
Fixed overhead volume variance = the gap between Point cost and budgeted fixed
overheads.
Total fixed overhead variance = the gap between Actual fixed overheads and Point cost.
353
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Question):
Suppose that a company plans to produce 1,000 units of product E during August
20X3. The expected time to produce a unit of E is five hours, and the budgeted fixed
overhead is $20,000. The standard fixed overhead cost per unit of product E will
therefore be as follows.
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20,450. The
labour force manages to produce 1,100 units of product E in 5,400 hours of work.
Required:
Calculate the following variances.
(a) The fixed overhead total variance
(b) The fixed overhead expenditure variance
(c) The fixed overhead volume variance
(d) The fixed overhead volume efficiency variance
(e) The fixed overhead volume capacity variance
354
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Solution):
(a) Fixed overhead total variance
Actual hours × standard cost per unit
Actual fixed overhead cost
Fixed overhead absorbed
$20,450
1,100 units × $20
Fixed overhead total variance
(= over absorbed overhead)
$22,000
$1,550 (F)
The variance is favourable because less overheads incurred than budgeted.
(b) Fixed overhead expenditure variance
Budgeted units × standard cost per unit
Actual fixed overhead cost
Budgeted fixed overhead at standard rate
Fixed overhead expenditure variance
$20,450
1,000 units × $20
$20,000
$450 (A)
The variance is adverse because actual expenditure was greater than budgeted
expenditure.
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I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Solution):
(c) Fixed overhead volume variance
The production volume achieved was greater than expected. The fixed overhead
volume variance measures the difference at the standard rate.
Budgeted fixed overhead at standard rate
Fixed overhead absorbed
$20,000
1,100 units × $20
Fixed overhead volume variance
The variance is favourable because output was greater than expected.
$22,000
$2,000 (F)
356
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Solution):
(d) Fixed overhead volume capacity variance
The volume capacity variance is the difference between the initial budgeted hours
of work and the actual active hours of work (excluding any idle time).
Budgeted units × standard rate
Budgeted hours of work
1,000 units × 5 hours
5,000 hours
Actual hours of work
5,400 hours
Fixed overhead volume capacity variance
in hour
400 hours (F)
Standard fixed overhead absorption rate
per hour
$4
Fixed overhead volume capacity variance
$4 × 400 hours
$1,600 (F)
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2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Solution):
(e) Fixed overhead volume efficiency variance
The volume capacity variance is the difference between the budgeted hours of work
for the actual production volume and the actual active hours of work (excluding any
idle time).
Actual hours of work
Actual units × standard rate
Standard hours of work
1,100 units × 5 hours
Fixed overhead volume efficiency
variance in hour
5,500 hours
100 hours (F)
Standard fixed overhead absorption
rate per hour
Fixed overhead volume efficiency
variance
5,400 hours
$4
$4 × 100 hours
$400 (F)
358
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Example 3 (Solution):
The variances may be summarised as follows
Overhead variance
$1,550 (F)
Expenditure variance
$450 (A)
Volume variance
$2,000 (F)
Volume
capacity
variance
$1,600 (F)
Volume
efficiency
variance
$400 (F)
359
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.4.2
Fixed overhead variances
Causes of fixed overhead variances
Favorable
Fixed
overhead
expenditure
Fixed
overhead
volume
Adverse
•
Decrease in price
•
Increase in price
•
Seasonal effects
•
Seasonal effects
•
Increase in production
•
Decrease in production
volume
volume
•
Increase in demand
•
Decrease in demand
•
Change is productivity of
•
Production lost through
labour
Fixed overhead
volume
capacity
Fixed
overhead
volume
efficiency
•
Hours worked higher
strikes
•
than budget
•
As for labour efficiency
Hours
worked
lower
than budget
•
As for labour efficiency
360
I. BASIC VARIANCES
2. Revision of basic variance analysis
2.5
Labour idle time
Idle time occurs when employees are paid for time when they are not working
Machine breakdown
Low demand
Stockouts
Idle time
Actual hours paid
Actual hours worked
Idle time variance
Idle time
Standard rate
Idle time variance is always an adverse variance (A)
361
II. OPERATING STATEMENTS
Definition
Operating statements (also called statement of variances) show how the combination
of variances reconcile budgeted profit and actual profit.
There are several ways in which an operating statement may be presented. Perhaps the
most common format is one which reconciles budgeted profit to actual profit.
OPERATING STATEMENT
Under absorption costing
Under marginal costing
Identifying the different effects of
each item of cost/income on profit
compared to the expected profit as
following.
•
Sales variances are reported
first
•
the total of the budgeted profit
and the two sales variances
results in a figure for 'actual
sales minus the standard cost
of sales’
•
The cost variances are then
reported, and an actual profit
calculated.
The operating statement under
marginal costing is the same as that
under absorption costing except:
•
A sales volume contribution
variance is included instead of
a sales volume profit variance
•
The only fixed overhead
variance is the expenditure
variances
•
The reconciliation is from
budgeted
to
actual
contribution
then
fixed
overheads are deducted to
arrive at a profit.
362
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Here is a proforma for an operating statement under standard absorption costing.
Sales
$
$
$
Budgeted profit
X
Sales volume profit variance
X
Standard profit from actual sales
X
Variances
(F)
(A)
X
X
Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
Actual profit
X
363
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Question): Operating statement under absorption costing
Sydney manufactures one product, and the entire product is sold as soon as it is
produced. There are no opening or closing inventories and work in progress is
negligible. The company operates a standard costing system and analysis of variances
is made every month. The standard cost card for the product, a boomerang, is as
follows.
STANDARD COST CARD – BOOMERANG
$
Direct materials
0.5 kilos at $4 per kilo
2.00
Direct wages
2 hours at $2.00 per hour
4.00
Variable overheads
2 hours at $0.30 per hour
0.60
Fixed overhead
2 hours at $3.70 per hour
7.40
Standard cost
14.00
Standard profit
6.00
Standing selling price
20.00
Budgeted (planned) output for the month of June 20X7 was 5,100 units.
Actual results for June 20X7 were as follows.
•
Production of 4,850 units was sold for $95,600.
•
Materials consumed in production amounted to 2,300 kg at a total cost of $9,800.
•
Labour hours paid for amounted to 8,500 hours at a cost of $16,800.
•
Actual operating hours amounted to 8,000 hours.
•
Variable overheads amounted to $2,600.
•
Fixed overheads amounted to $42,300.
Required: Calculate all variances and prepare an operating statement for the month
ended 30 June 20X7.
364
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
Budgeted (planned) sale volume: 5,100 units
Actual results summary
Sales
Direct materials
Direct labour
Variable overheads
Fixed overhead
Units/kg/hours
4,850
2,300
8,000
500 hours is idle time
$
95,600
9,800
16,800
2,600
42,300
365
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
SYDNEY – OPERATING STATEMENT JUNE 20X7
Sales
Budgeted profit
Sales volume profit variance (2)
Standard profit from actual sales
$
$
Variances
Sales price (1)
Material price (3)
Material usage (4)
Labour rate (5)
Labour efficiency (6)
Labour idle time (7)
Variable overhead expenditure (8)
Variable overhead efficiency (9)
Fixed overhead expenditure (10)
Fixed overhead volume capacity
(11)
Fixed overhead volume efficiency
(12)
F
A
1,400
600
500
200
3,400
1,000
200
510
4,560
6,290
8,140
10,900
Actual profit
$
30,600
1,500 (A)
29,100
15,900
5,000 (A)
24,100
366
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
Notice: This is a rounded figure, you
should use the figure appears on the
calculator screen to avoid arithmetic error
(1) Selling price variance
Actual sales price
$95,600/4,850 units
Budgeted sales price
$19.7113
$20.00
$0.2887
Actual sale volume
Selling price variance
4,850 units
$0.29 × 4,850 units
$1,400 (A)
(2) Sale volume variance
Actual sales volume
4,850 units
Budgeted sales volume
5,100 units
Sales volume variance in units
250 units (A)
Standard profit margin
Sales volume profit variance
$6
$6 × 250 units
$1,500 (A)
367
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
Rounded
(3) Material price variance
Actual material price
Standard material price
Actual quantity usage
Material price variance
(4) Material usage variance
$9,800/2,300kg
$0.26 × 2,300 units
Standard usage ×
actual sale volume
Actual quantity usage
Standard quantity usage
$4.2619
$4
$0.2619
2,300 kg
$600 (A)
2,300 kg
0.5 kg × 4,850 units
2,425 kg
125 kg (F)
Standard price per kilogram
Material price variance
$4
$500 (F)
368
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
Rounded
(5) Labour rate variance
Actual labour rate
Standard labour rate
$16,800/8,500 hours
Actual labour hours
Labour rate variance
(6) Labour efficiency variance
Actual active labour hours
Standard labour hours
Standard rate per hours
Labour efficiency variance
$1.9765
$2
$0.0235
8,500 hours
$200 (F)
Standard hour ×
actual sale volume
2 hours × 4,850 units
8,000 hours
9,700 hours
1,700 hours (F)
$2
$3,400 (F)
369
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
(7) Idle time variance: 500 hours × $2 = $1,000 (A)
(8) Variable overhead expenditure variance
Actual Variable overhead
Standard material cost
(of actual variable overhead hours)
$2,600
$0.3 × 8,000 hours
Material price variance
$2,400
$200 (A)
(9) Variable overhead efficiency variance
Variable overhead efficiency variance in hours is the same as the labour efficiency
variance:
1,700 hours (F) × $0.30 per hour = $510 (F)
(10) Fixed overhead expenditure variance
Actual fixed overhead cost
Budgeted fixed overhead at standard rate
Fixed overhead total variance
(= under-/over-absorbed overhead)
Budgeted hours
× standard rate
5,100 units x 2 hours
× $3.70
$42,300
$37,740
$4,560 (A)
370
II. OPERATING STATEMENTS
1. Operating statement under absorption costing
Example 5 (Solution): Operating statement under absorption costing
(11) Fixed overhead volume capacity variance
Budgeted hours of work
Actual hours of work
Fixed overhead volume capacity variance in hour
Standard fixed overhead absorption rate per hour
Fixed overhead volume capacity variance
10,200 hours
8,000 hours
2,200 hours (A)
$3.70
$8,140 (A)
(12) Fixed overhead volume efficiency variance
Acutal hours of work
Standard hours of work (4,850 units * 2 hours)
Fixed overhead volume efficiency variance in hour
Standard fixed overhead absorption rate per hour
Fixed overhead volume capacity variance
8,000 hours
9,700 hours
1,700 hours (F)
$3.70
$6,290 (F)
371
II. OPERATING STATEMENTS
2. Operating statement under marginal costing
Here is a proforma for an operating statement under standard marginal costing.
Sales
Budgeted contribution
Sales volume contribution variance
$
$
Standard contribution from actual sales
Variances
Sales price
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead expenditure
Variable overhead efficiency
Actual contribution
Budgeted fixed costs
Fixed costs expenditure variance
Actual fixed overheads
Actual profit
$
X
X
X
(F)
(A)
X
X
X
X
X
X
X
X
Notes:
There is no fixed overhead volume variance (and therefore no fixed overhead volume
efficiency and volume capacity variances).
372
II. OPERATING STATEMENTS
2. Operating statement under marginal costing
Example 6 (Question): Operating statement under marginal costing
(example 5 continue)
Required:
Calculate all variances and prepare an operating statement under marginal costing
for the month ended 30 June 20X7.
373
II. OPERATING STATEMENTS
2. Operating statement under marginal costing
Example 6 (Solution): Operating statement under marginal costing
(example 5 continue)
Adjustments from operating statement under absorption costing
•
Variable cost per unit = 2.00 + 4.00 + 0.60 = $6.60
•
The standard contribution per unit of boomerang is $(20 – 6.60) = $13.40
•
The budgeted contribution: $30,600 + budgeted fixed production costs $37,740
= $68,340
•
The sales volume contribution variance: (5,100 units – 4,850 units) × $13.40 =
$3,350 (A)
•
Other remaining variances are computed in the previous example.
•
Actual contribution is highlighted in the statement.
•
Budgeted (planned) fixed production overhead is adjusted by the fixed overhead
expenditure variance to show the actual fixed production overhead expenditure.
374
II. OPERATING STATEMENTS
2. Operating statement under marginal costing
Example 6 (Solution): Operating statement under marginal costing
(example 5 continue)
Therefore, a marginal costing operating statement might look like this.
SYDNEY – OPERATING STATEMENT JUNE 20X7
Sales
$
$
$
Budgeted contribution
68,340
Sales volume contribution variance
3,350 (A)
Standard contribution from
64,990
actual sales
Variances
Sales price
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Actual contribution
Budgeted fixed costs
Fixed costs expenditure variance
Actual fixed overheads
Actual profit
(F)
(A)
1,400
600
500
200
3,400
1,000
200
510
4,610
1,410
3,200
1,410 (F)
66,400
37,740
4,560 (A)
42,300
42,300 (A)
24,100
375
III. INVESTIGATING FOR BASIC VARIANCES
Factors affecting the variance
Before management decide whether or not to investigate the reasons for the occurrence of
a particular variance. There are a number of factors which should be considered in assessing
the significance of the variance.
Factors
Explanations
Materiality
Because a standard cost is really only an average expected cost,
small variations between actual and standard are bound to occur
and are unlikely to be significant
Controllability
Only controllable variances should be investigated.
Uncontrollable variances call for a change in plan, not an
investigation into the past.
The type
of standard
being used
The efficiency variance reported in any control period, whether
for materials or labour, will depend on the efficiency level set.
•
If an ideal standard is used, variances will always be adverse.
•
If basic standards are used, variances are likely to be
favourable.
Variance trend
The trend provides an indication of whether the variance is
fluctuating within acceptable control limits or becoming out of
control.
376
III. INVESTIGATING FOR BASIC VARIANCES
Factors affecting the variance
Factors
Explanations
Interdependence
between
variances
One variance might be interrelated with another, and much of it
might have occurred only because the other variance occurred
too.
When two variances are interdependent (interrelated), one will
usually be adverse and the other favourable.
Costs of
investigation
The costs of an investigation should be weighed against the
benefits of correcting the cause of a variance.
377
III. INVESTIGATING FOR BASIC VARIANCES
Variance investigation models (self-reading)
Variance investigation models can be used to determine whether a variance should be
investigated. There are three kinds of variance investigation models are commonly used.
Models
Explanations
This involves deciding a limit:
The rule
of thumb
model
The size of a variance is
within the limit
The size of a variance
exceeds the limit
Immaterial
Material
Variance size
Material threshold
time
378
III. INVESTIGATING FOR BASIC VARIANCES
Variance investigation models (self-reading)
Models
Explanations
Historical data is used to calculate both a standard as an
expected average and the expected standard deviation
around this average when the process is under control.
Variance size
Statistical
significance
model
Upper material
threshold
time
379
III. INVESTIGATING FOR BASIC VARIANCES
Variance investigation models (self-reading)
Models
Explanations
By marking variances and control limits on a control chart,
investigation is signalled not only when
•
A particular variance exceeds the control limit (including
characteristic of Statistical significance model)
Variance size
Statistical
control
charts
Upper material
threshold
time
380
III. INVESTIGATING FOR BASIC VARIANCES
Variance investigation models (self-reading)
Models
Explanations
By marking variances and control limits on a control chart,
investigation is signalled when
•
The trend of variances shows a progressively worsening
movement in actual results.
Variance size
Immaterial
Statistical
control
charts
time
Variance size
Material
time
381
IV. MATERIALS MIX AND YIELD VARIANCES
Definition
The materials usage variance can be subdivided into a materials mix variance and a
materials yield variance when more than one material is used in the product.
Material variance
Price variance
Usage variance
Mix variance
Yield variance
Calculating a mix and yield variance is only meaningful for control purposes when
management is in a position to control the mix of materials used in production.
The financial impact of using a different proportion
of raw materials.
The mix variance
Represent
The yield variance
The financial impact of the input yielding a different
level of output to the standard.
382
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
Mix variance: A mix variance occurs when the materials are not mixed or blended in
standard proportions and is a measure of whether the actual mix is cheaper or more
expensive than the standard mix.
For example:
More of an
expensive material
Less of a
cheap material
The cost
will be higher
Variance adverse
Method:
Material
Actual Quantity,
Actual Mix
(AQAM)
Actual Quantity,
Standard Mix
(AQSM)
(1)
M1
X kg
M2
Y kg
M3
Z kg
Sum
X+Y+Z
A+B+C
Difference
Standard
price
(2)
(3)
(4)
(5)
A kg
A–X
$x
$Var.(F/A)
B kg
B–Y
$y
$Var.(F/A)
C kg
C–Z
$z
$Var.(F/A)
Variance
Mix (F/A)
383
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
1
Write down the actual input of each material in a column (this is
the actual total quantity split in the actual mix = AQAM).
2
Take the actual input in total and copy across to another column.
Then, work it back in the standard proportions (this is the actual
total quantity split in the standard mix = AQSM). A+B+C = X+Y+Z
3
Calculate the difference between the standard mix (AQSM) and the
actual mix (AQAM).
4
Multiply the difference by the standard price per kilogram (We are
calculating material usage variance).
5
This gives the mix variance in financial term.
384
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
Example 7 (Question): Mix variance
Hondru operates a standard costing system. The standard direct materials to produce
1,000 units of output is as follows:
Material grade
Input quantity (kg)
Standard price per kg ($)
A
600
1.10
B
240
2.40
C
360
1.50
Total
1,200
During April the actual output of the product was 21,000 units. The actual materials
issued to production were:
Material grade
Quantity (kg)
A
14,000
B
5,500
C
5,500
Total
25,000
Required:
Calculate the material mix variance for each material, and in total. Comment on the
figures calculated.
385
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
Example 7 (Guidance): Mix variance
In order to calculate mix variance, we have to calculate:
• AQAM: Actual quantity split in actual mix for each material
• AQSM: Actual quantity split in standard mix for each material
Step 1
Step 2
Calculating the AQAM, AQSM Using Material mix variance method
to calculate Material mix variance
386
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
Example 7 (Guidance): Mix variance
Step 1: Calculating the AQAM, AQSM
As we have known AQAM (per question), we then need to identify
AQSM & variances by these following steps:
Material
Standard
mix
Actual total
quantity usage
Actual Quantity, Standard Mix
(AQSM)
A
600/1,200
B
240/1,200
C
360/1,200
260/1,200 × 25,000kg = 7,500 kg
Sum
1
25,000
600/1,200 × 25,000kg = 12,500 kg
25,000 kg
240/1,200 × 25,000kg = 5,000 kg
387
IV. MATERIALS MIX AND YIELD VARIANCES
1. Material mix variance
Example 7 (Guidance): Mix variance
Step 2: Using Material mix variance method to
calculate Material mix variance.
Material
Standard
mix
Actual
Quantity,
Actual Mix
(AQAM)
A
600/1200
14,000 kg
12,500 kg
1,500 (A)
$1.10
$1,650 (A)
B
240/1200
5,500 kg
5,000 kg
500 (A)
$2.40
$1,200 (A)
C
360/1200
5,500 kg
7,500 kg
2,000 (F)
$1.50
3,000 (F)
25,000
25,000
0
Sum
Actual
Quantity,
Standard
Difference
Variance
Standard Mix
price
(AQSM)
150 (F)
Material mix variance in total is 150 (F).
Comment: The favourable mix variance is due to more of materials A and B
being used in place of material C.
388
IV. MATERIALS MIX AND YIELD VARIANCES
2. Material yield variance
Yield variance: A yield variance arises because there is a difference between what the
input should have been (considering the output achieved) and the actual input.
A yield variance measures the efficiency of turning the inputs into outputs.
Yield variance
is adverse
Actual input is higher than
the expected input.
This could be due to the following reasons:
Labour inefficiencies
Higher waste
Inferior materials
Cheaper mix with
a lower yield
Method:
Material
Actual Quantity, Standard Quantity,
Standard Mix
Standard Mix
Difference
(AQSM)
(SQSM)
Standard
price
Variance
(1)
(2)
(3)
(4)
(5)
M1
X kg
A kg
A–X
$x
$Var.(F/A)
M2
Y kg
B kg
B–Y
$y
$Var.(F/A)
M3
Z kg
C kg
C–Z
$z
Sum
X+Y+Z
A+B+C
$Var.(F/A)
Yield (F/A)
389
IV. MATERIALS MIX AND YIELD VARIANCES
2. Material yield variance
1
2
Copy Actual Quantity, Standard Mix (AQSM) from the mix variance.
Calculate Standard Quantity, Standard Mix (SQSM) for EACH material
using the following formula:
•
Material quantity used from standard cost card × Total actual
output produced/Material output quantity produced by the standard
cost card.
Or
•
Calculate the total standard quantity of all materials used to
produce the actual output then share this out between the different
materials using the standard proportions calculated from the
standard cost card.
3
Calculate difference between the Standard Quantity, Standard Mix
(SQSM) and Actual Quantity, Standard Mix (AQSM) for each material.
4
Multiply by the difference by the standard price per kilogram (We are
calculating material usage variance)
5
This gives the yield variance in financial term.
Notes: Yield variances for the individual method are meaningless variances
390
IV. MATERIALS MIX AND YIELD VARIANCES
2. Material yield variance
Example 8 (Question): Yield variance
Hondru operates a standard costing system. The standard direct materials to produce
1,000 units of output is as follows:
Material grade
Input quantity (kg)
Standard price per kg ($)
A
600
1.10
B
240
2.40
C
360
1.50
Total
1,200
During April the actual output of the product was 21,000 units. The actual materials
issued to production were:
Material grade
Quantity (kg)
A
14,000
B
5,500
C
5,500
Total
25,000
Required:
Calculate the material yield variance
391
IV. MATERIALS MIX AND YIELD VARIANCES
2. Material yield variance
Example 8 (Solution): Yield variance
In order to calculate yield variance, we have to calculate:
• SQSM: standard material quantity split in standard mix for each material given the
actual output.
• AQSM: actual material quantity split in standard mix for each material
As we have known AQSM (per example 8), we then need to identify SQSM by the
following table:
Standard materials quantity for producing 21,000 units
(Standard quantity, standard mix).
Material grade
A
B
C
Sum
Input quantity (kg)
for 1,000 units
for 21,000 units
600
600 × 21 = 12,600
240
240 × 21 = 5,040
360
360 × 21 = 7,560
1,200
25,200
392
IV. MATERIALS MIX AND YIELD VARIANCES
2. Material yield variance
Example 8 (Solution): Yield variance
Then the yield variance is calculated as follows:
Material
A
B
C
Sum
Actual Quantity, Standard Quantity,
Standard
Standard Mix
Standard Mix
Difference
Variance
price
(AQSM)
(SQSM)
Kg
12,500
5,000
7,500
25,000
Kg
12,600
5,040
7,560
25,200
Kg
100 (F)
40 (F)
60 (F)
200 (F)
$
1.10
2.40
1.50
$
110 (F)
96 (F)
90 (F)
296 (F)
The material yield variance is 296 (favourable).
Notes: The examining team has noted in the past that some candidates calculate the
variances in kg but do not convert them into a monetary value using the standard costs for
each ingredient. Variances need to be given a value in order to be used properly within a
business. It is not sufficient to simply stop at quantity and you will lose marks.
393
IV. MATERIALS MIX AND YIELD VARIANCES
3. Interpretation of material mix and yield variances
Material mix and yield variances may be interrelated
MIX
A favorable total
mix variance
Higher proportion of a cheaper
material is being used
Reduce the overall
average cost per unit
Yield
An adverse total
yield variance
Less output has been
achieved for a given input
394
IV. MATERIALS MIX AND YIELD VARIANCES
4. Issues involved in changing the mix
Material mix and yield variances may be interrelated
The materials
mix variance
Indicate
Cost of a change in
the mix of materials
The yield
variance
Indicate
Productivity of the
manufacturing process
Changing the mix of
material can impact on
Cost
Quality
Wider
implications
Performance measurement
The production manager’s performance may be measured by mix and yield
variances, however these performance measures may fail to indicate problems
with falling quality and the impact on other areas of the business.
Quality targets may also be needed.
395
IV. MATERIALS MIX AND YIELD VARIANCES
5. Alternative methods of controlling production processes
As well as variances, organisations can also use other performance measures and targets for
controlling production processes.
Quality measures
(Reject rate, time spent reworking goods, % waste, % yield,…)
Average cost of inputs
Average cost of outputs
Average prices achieved
for finished products
Average margins
Percentage of on-time
deliveries
Customer satisfaction ratings
Detailed timesheets
Percentage of idle time
Note:
• The examining team report for June 2017 noted that a common error was to use
standard cost per unit in the mix and yield calculations instead of standard cost per kg.
Make sure you think about this carefully!
• The examining team report for June 2018 noted that a question on material variances
was poorly answered by many. Make sure you know that:,
o Total material cost variance = material price variance + material usage variance
o Material usage variance = material mix variance + material yield variance
396
V. SALES MIX AND QUANTITY VARIANCES
Definition
The sale volume variance can be subdivided into a sales mix variance and a sales
quantity variance.
Sale variance
Selling price variance
Sale volume variance
Sales mix
variance
Sales quantity
variance
In Performance management (F5), a firm may prefer to calculate combined sales mix and
sales quantity variances instead of separate sales volume variances Where:
Management can control the
allocation of the advertising
and sales promotion budget
between different products
Management
may be able
to control the
sales mix
The same basic product is
sold in different sizes or
packaging, such as large size
and small size
Note:
It is possible to analyse the overall sales volume variance into a sales mix variance and a
sales quantity variance If a company sells more than one product.
397
V. SALES MIX AND QUANTITY VARIANCES
1. Sales mix variances
The sales mix variance occurs when the proportions of the various products sold are
different from those in the budget.
A sales mix variance indicates the effect on profit of changing the mix of actual sales from
the standard mix.
Method:
The difference between the actual total quantity sold in the standard mix and the actual
quantities sold, valued at the standard profit per unit:
Products
Actual Quantity,
Actual Mix
(AQAM)
Actual Quantity,
Standard Mix
(AQSM)
(1)
(2)
(3)
(4)
(5)
M1
X units
A units
A–X
$M1
$Var.(F/A)
M2
Y units
B units
B–Y
$M2
$Var.(F/A)
M3
Z units
C units
C–Z
$M3
$Var.(F/A)
Sum
X+Y+Z
A+B+C
Difference
Standard
margin
Variance
Mix (F/A)
398
V. SALES MIX AND QUANTITY VARIANCES
1. Sales mix variances
1
Write down the actual sales quantity for each product in a column
(this is the actual total sales quantity split in the actual mix =
AQAM).
2
Take the actual sales quantity in total and copy across to another
column. Then, work it back in the standard proportions (this is the
actual total sales quantity split in the standard mix = AQSM).
3
Calculate the difference between the standard mix (AQSM) and the
actual mix (AQAM).
4
Multiply the difference by the standard margin per unit.
5
This gives the sales mix variance in financial terms.
399
V. SALES MIX AND QUANTITY VARIANCES
1. Sales mix variances
Example 10 (Question): Sales mix variances
CAB Co operates an absorption costing system and sells three products S, A and PP
which are substitutes for each other. The following standard selling price and cost
data relate to these three products:
Product
S
A
PP
Unit selling price
$14.00
$15.00
$18.00
Direct material/unit
3 kg @ $1.80/kg
1.25 kg @ $3.28/kg
1.94 kg @ $2.50/kg
Direct labour/unit
0.5 hours @ $6.50/hour
0.8 hours @ $6.50/hour
0.7 hours @ $6.50/hour
Budgeted fixed production overhead for the last period was $81,000.
This was absorbed on a machine hour basis. The standard machine hours for each
product and the budgeted levels of production and sales for each product for the last
period are as follows:
Product
Standard machine hours per unit
Budgeted production and sales
S
0.3 hours
10,000 units
A
0.6 hours
13,000 units
PP
0.8 hours
9,000 units
Actual volumes and selling prices for the three products in the last period were as
follows:
Product
Actual selling price per unit
Actual production and sales
S
$14.50
9,500 units
A
$15.50
13,500 units
Required:
Calculate the sales mix variances for overall sales for the last period.
PP
$19.00
8,500 units
400
V. SALES MIX AND QUANTITY VARIANCES
1. Sales mix variances
Example 10 (Solution): Sales mix variances
Products Std mix
Actual
Actual
Quantity,
Quantity,
Difference
Actual Mix Standard Mix
(AQAM)
(AQSM)
Standard
margin
[w2]
Variance
Units
343.75 (A)
$
4.00
$
1,375 (A)
S
Units
10,000
Units
9,500
Units
9,843.75
A
13,000
13,500
12,796.875
703.125 (F)
3.00
2,109.375 (F)
PP
Sum
9,000
32,000
8,500
31,500
8,859.375
31,500
359.375 (A)
0
5.00
1,796.875 (A)
$1,062.5 (A)
For example, this figure is calculated by:
9,000
31,500 ×
32,000
Total mix variance
401
V. SALES MIX AND QUANTITY VARIANCES
1. Sales mix variances
Example 10 (Solution): Sales mix variances
Working 1: Overhead absorption rate (OAR)
OAR=

$81,000
= $4.5 per machine hour
3,000 +7,800 +7,200
Absorbed overhead cost for each product:
Product
S
A
PP
Absorbed overhead
$1.35
($4.5 × 0.3 hours)
$2.70
($4.5 × 0.6 hours)
$3.60
($4.5 × 0.8 hours)
Working 2: Standard profit
Product
S
A
PP
Materials
$5.40
$4.10
$4.85
$4.55
Labour
$3.25
$5.20
Absorbed overheads [w1]
$1.35
$2.70
$3.60
Total cost
$10.00
$12.00
$13.00
Selling price
$14.00
$15.00
$18.00
Standard margin
$4.00
$3.00
$5.00
402
V. SALES MIX AND QUANTITY VARIANCES
2. Sales quantity variances
The sales quantity variance shows the difference in contribution/profit because of a
change in sales volume from the budgeted volume of sales.
A sales quantity variance indicates the effect on profit of selling a different total quantity
from the budgeted total quantity.
Method:
The difference between actual sales volume in the standard mix and budgeted sales valued
at the standard profit per unit.
Product
Actual Quantity, Budgeted Quantity,
Standard
Standard Mix
Standard mix
Difference
margin
(AQSM)
(BQSM)
P1
P2
P3
(1)
X units
Y units
Z units
(2)
A units
B units
C units
Sum
X+Y+Z
A+B+C
(3)
X–A
Y–B
Z–C
(4)
$M1
$M2
$M3
Variance
(5)
$Var.(F/A)
$Var.(F/A)
$Var.(F/A)
Total sales
quantity (F/A)
403
V. SALES MIX AND QUANTITY VARIANCES
2. Sales quantity variances
1
Copy Actual Quantity, Standard Mix (AQSM) from the mix variance
method 1.
2
Copy the budgeted sales units under the column Budget Sales
Quantity, Standard Mix (BQSM).
3
Calculate difference between the Actual Sales Quantity, Standard
Mix (AQSM) and Budgeted Sales Quantity, Standard Mix (BQSM) for
each product.
4
Multiply by the difference by the standard margin per unit.
5
This gives the sales quantity variance in financial terms.
404
V. SALES MIX AND QUANTITY VARIANCES
2. Sales quantity variances
Example 11 (Question): Sales quantity variances (example 10 continued)
CABCo operates an absorption costing system and sells three products S, A and PP
which are substitutes for each other. The following standard selling price and cost
data relate to these three products:
Product
S
A
PP
Unit selling price
$14.00
$15.00
$18.00
Direct material/unit
3 kg @ $1.80/kg
1.25 kg @ $3.28/kg
1.94 kg @ $2.50/kg
Direct labour/unit
0.5 hours @ $6.50/hour
0.8 hours @ $6.50/hour
0.7 hours @ $6.50/hour
Budgeted fixed production overhead for the last period was $81,000.
This was absorbed on a machine hour basis. The standard machine hours for each
product and the budgeted levels of production and sales for each product for the last
period are as follows:
Product
Standard machine hours per unit
Budgeted production and sales
S
0.3 hours
10,000 units
A
0.6 hours
13,000 units
PP
0.8 hours
9,000 units
Actual volumes and selling prices for the three products in the last period were as
follows:
Product
Actual selling price per unit
Actual production and sales
S
$14.50
9,500 units
A
$15.50
13,500 units
PP
$19.00
8,500 units
Required:
Calculate the sales quantity variances for overall sales for the last period.
405
V. SALES MIX AND QUANTITY VARIANCES
2. Sales quantity variances
Example 11 (Solution): Sales quantity variances (example 10 continued)
These figures are mentioned in
previous example
Product
S
A
PP
Actual Quantity, Budgeted Quantity,
Standard
Standard Mix
Standard mix
Difference
margin
(AQSM)
(BQSM)
Units
9,843.75
12,796.875
8,859.375
Units
10,000
13,000
9,000
Units
156.25 A
203.125 A
140.625 A
Check:
Actual total quantity (units)
31,500
Budgeted total quantity (units)
32,000
Variance in unit
500 (A)
× Standard margin ($)
Sales quantity variance ($)
3.875
1,937.50 (A)
$
4
3
5
Variance
$
625.00 (A)
609.375 (A)
703.125 (A)
$1,937.50 (A)
406
V. SALES MIX AND QUANTITY VARIANCES
2. Sales quantity variances
Example 11 (Solution): Sales mix and quantity variances
Sales volume variance
$3,000 (A)
Sales mix variance
$1,062.50 (A)
Sales quantity variance
$1,937.50
407
CHAPTER 14:
PLANNING AND OPERATIONAL
VARIANCES ANALYSIS
408
OVERVIEW
What will you learn?
Revising a
budget or
standard cost
Planning and
operational
variances analysis
Reasons for revising a
budget or standard cost
Manipulation issues
Planning and operational
variances for sales
Planning and
operational
variances
Planning and operational
variances for materials
Planning and operational
variances for labour
409
I. INTRODUCTION
1. Revising a budget or standard cost
The standard is set as part of the budgeting process which occurs before the period to
which it relates.
Due to an
unrealistic budget
Difference
between
standard and
actual
Not solely due to
operational factors
The budget may need to be revised to enable
actual performance to be compared with a
standard that reflects these changed conditions.
410
I. INTRODUCTION
1. Revising a budget or standard cost
1.1
Reasons for revising a budget or standard cost
Occasionally, circumstances may occur that make the original budget or standard cost
invalid or inappropriate.
Criteria
Asumption
Changes
The sales
budget
May have been based
on expectations of the
total size of the market
for the organisation’s
product
Market size may be much larger or
smaller than first assumed due to:
• Unexpected change in economic
conditions
• Unexpected technological change
• Radical change in customer
attitudes
• Unexpected new regulations
may be based on an
assumption
about
what the market price
for
the
materials
should be.
A major change in the market, the
available market price for the
materials may become much higher
or much lower than originally
expected
Standard
cost of
materials
411
I. INTRODUCTION
1. Revising a budget or standard cost
1.1
Reasons for revising a budget or standard cost
Criteria
Asumption
Changes
Standard
quantity of
materials
made
May be based on
product specification
An unexpected change in specification,
requiring much more or much less of
the material in the product content
Standard
labour cost
May be based on
expected labour rates
Become unrealistic due to an
unexpected increase in pay rates for
employees
Standard
time to
produce a
unit of
product
May be estimated
based on expected
time to produce one
unit
Be affected by a change in the labour
grade or upgraded machinery or
other unexpected reasons
412
I. INTRODUCTION
1. Revising a budget or standard cost
1.1
Reasons for revising a budget or standard cost
In these circumstances:
If the budget or standard cost is not revised
in these circumstances
Original budget
Revised budget
It may be appropriate to
revise the budget
or revise the
standard cost
Variances reported to
operational managers
will be unrealistic
Variances will be due to
changes that are outside
the control of the
operational managers.
Uncontrolable cost
Notes:
• These types of situations do not occur frequently. The need to report planning and
operational variances should therefore be an occasional, rather than a regular, event.
• If the budget is revised on a regular basis, the reasons for this should be
investigated. It may be due to management attempting to shift the blame for poor
results or due to a poor planning process.
413
I. INTRODUCTION
1. Revising a budget or standard cost
1.2
Calculating a revised budget
The syllabus requires you to be able to calculate a revised budget, which could involve
revising standards for sales, materials and/or labour so that only operational variances
are highlighted when actual results are compared to the revised budget.
Example 1 (Question): Revise the budget
A company produces Widgets and Splodgets which are fairly standardised products.
The following information relates to Period 1.
Sales revenue
The standard selling price of Widgets is $50 each and Splodgets $100 each.
In Period 1, there was a special promotion on Splodgets with a 5% discount being
offered. All units produced are sold and no inventory is held.
Material cost
Material X
To produce a Widget they use 5kg of X and in Period 1, their plans were based on
a cost of X of $3 per kg. Due to market movements, the actual price changed; if
they had purchased efficiently, the cost would have been $4.50 per kg. Production
of Widgets was 2,000 units.
Material Z
A Splodget uses raw material Z, but again the price of this can change rapidly. It
was thought that Z would cost $30 per tonne but in fact they only paid $25 per
tonne and if they had purchased correctly the cost would have been less, as it was
freely available at only $23 per tonne. It usually takes 1.5 tonnes of Z to produce
one Splodget and 500 Splodgets are usually produced.
414
I. INTRODUCTION
1. Revising a budget or standard cost
1.2
Calculating a revised budget
The syllabus requires you to be able to calculate a revised budget, which could involve
revising standards for sales, materials and/or labour so that only operational variances
are highlighted when actual results are compared to the revised budget.
Example 1 (Question): Revise the budget
Labour cost
Each Widget takes three hours to produce and each Splodget two hours. Labour is
paid $5 per hour. At the start of Period 1, management negotiated a job security
package with the workforce in exchange for a promised 5% increase in efficiency –
that is, that the workers would make the Widgets and Splodgets in 95% of the time
stated in the original budget.
Overhead
Fixed overheads are usually $12,000 every period and variable overheads are $3 per
labour hour.
Required:
Produce the original budget and a revised budget allowing for controllable factors
in a suitable format.
415
I. INTRODUCTION
1. Revising a budget or standard cost
1.2
Calculating a revised budget
Example 1 (Solution): Revise the budget
Original budget for Period 1
Sales revenue
Material costs X
Material costs Z
Labour costs
Variable overheads
Fixed overheads
Profit
(2,000 × $50) + (500 × $100)
2,000 × 5 kg × $3
500 × $30 × 1.5
(2,000 × 3 × $5) + (500 × 2 × $5)
(2,000 × 3 × $3) + (500 × 2 × $3)
$
150,000
30,000
22,500
35,000
21,000
12,000
29,500
Revised budget for Period 1
Sales revenue
Material costs X
Material costs Z
Labour costs
Variable overheads
Fixed overheads
Profit
(2,000 × $50) + (500 × $100)
2,000 × 5 kg × $4.5
500 × $23 × 1.5
((2,000 × 3 × $5) + (500 × 2 × $5)) × 0.95
((2,000 × 3 × $3) + (500 × 2 × $3)) × 0.95
$
150,000
45,000
17,250
33,250
19,950
12,000
22,550
416
I. INTRODUCTION
1. Revising a budget or standard cost
1.3
Revising budgets: manipulation issues
Revisions to the budget or standard
cost may be manipulated to make
operating results seem much better
than is really.
To prevent manipulation,
there should be strict rules
about revising a budget or
standard cost.
In particular, the revision to the budget or standard cost should ideally be based on
independent and verifiable evidences (that could not be manipulated).
Example 2
The change in The evidences must be obtained should ideally be
market price •
an official price index
for materials •
price benchmark
417
I. INTRODUCTION
1. Revising a budget or standard cost
1.4
Advantages and disadvantages of revising the budget
Here are some advantages and disadvantages of revising the budget:
Advantages
Highlights those variances
which are controllable
Ensures
that operational
performance is appraised by
reference to realistic targets
Should ensure that future
budgets are more realistic
Problems
Determination of revised budget
•
Biased
•
Need external information
Use of revised budget may
undermine original budget as
a target and as a motivator.
Employees may use this
system to their advantage by
excusing operating problems
as poor planning if this
method is used.
418
I. INTRODUCTION
2. Planning and operational variances
A planning and operational approach to variance analysis divides the total variances into:
Operational variances
Planning variances
Caused by adverse or
favourable
operational
performance, compared
with a standard which has
been revised in hindsight
Have arisen because of
inaccurate planning or
faulty standards
419
I. INTRODUCTION
2. Planning and operational variances
Benefits and problems of planning and operating variances
Problems
Advantages
In
volatile
and
changing
environments, standard costing
and variance analysis are more
useful using this approach
Provide up to date information
about current levels of efficiency.
Make the standard costing
system more acceptable and to
have a positive effect on
motivation.
It emphasises the importance of
the planning function in the
preparation of standards.
Helps to identify
deficiencies.
planning
Element of subjectivity for
example in setting the revised
standards.
A large amount of labour time
involved in continually establishing
up to date standards and
calculating additional variances.
There is a great temptation to put
as much as possible of the total
variances down to outside,
uncontrollable factors.
There can then be a conflict
between operating and planning
staff.
420
I. INTRODUCTION
2. Planning and operational variances
Planning and operational variances may be calculated for:
Planning and
operational variances
Sales
Materials
Labour
The operating statement would include a separate line for each variance calculated.
421
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
Overview
The sales variance can be sub-divided into a planning and operational variance:
Sales variance
Revise budgeted sales price
Revise budgeted sales volume
Sales price variance
Sales volume variance
Sales price
planning
variance
Sales price
operational
variance
Sales volume
planning
variance
Sales volume
operational
variance
Market size
variance
Market share
variance
422
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
1. Planning and operational variances for sales volume
As there has been no change in the budgeted sales price or standard cost of products,
these two variances can be converted from units into a monetary value
The standard margin (*)
Variance in units
Original budget
Revise budget
Actual
Original
budgeted sales
Revised
budgeted sales
Actual sales
Standard margin*
Standard margin*
Standard margin*
Market size variance
(sales volume planning variance)
Market share variance
(sales volume operational variance)
(*) Margin = contribution per unit (marginal costing) or profit per unit (absorption costing)
423
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
1. Planning and operational variances for sales volume
Example 3 (Question): Operational and planning variance for sales volume
PG budgeted sales for 20X8 were 5,000 units. The standard contribution is $9.60
per unit. A recession in 20X8 meant that the market for PG's products declined by
5%. PG's market share also fell by 3%. Actual sales were 4,500 units.
Required: Calculate planning and operational variances for sales volume.
424
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
1. Planning and operational variances for sales volume
Example 3 (Solution): Operational and planning variance for sales volume
Sales volume planning variance (Market size variance)
Original budgeted sales
Revised budget sales (–5%)
5,000 units
5,000 units × 95%
4,750 units
250 units (A)
Standard contribution per unit
Sales volume planning variance
$9.60
$9.60 × 250 units
$2,400 (A)
Sales volume operational variance (Market share variance)
Revised budget sales (–5%)
Actual sales
Standard contribution per unit
Sales volume operational variance
$9.60 × 250 units
4,750 units
4,500 units
250 (A)
$9.60
$2,400 (A)
425
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
2. Planning and operational variances for sales price
There may be a situation where a revision is made to the budgeted or standard selling
price for a product. When this happens, a sales price planning variance and a sales price
operational variance can be calculated.
Original budget
Revise budget
Actual
Original budgeted
sales price
Revised budgeted
sales price
‘Normal’ sales
price
Actual sales
Actual sales
Actual sales
Sales price planning variance
Sales price operational variance
Notes:
The planning variance is generally outside the control of sales management, but the
operational sales price variance is a sales management responsibility.
426
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
2. Planning and operational variances for sales price
Example 4 (Question): Planning and operational variances for sales price
KSO budgeted to sell 10,000 units of a new product during 20X0. The budgeted sales
price was $10 per unit, and the variable cost $3 per unit.
Actual sales in 20X0 were 12,000 units and variable costs of sales were $30,000, but
sales revenue was only $5 per unit. With the benefit of hindsight, it is realised that
the budgeted sales price of $10 was hopelessly optimistic, and a price of $4.50 per
unit would have been much more realistic.
Required:
Calculate planning and operational variances for sales price.
427
II. PLANNING AND OPERATIONAL
VARIANCES FOR SALES
2. Planning and operational variances for sales price
Example 4 (Solution): Planning and operational variances for sales price
Sales price planning variance
Original budgeted sales price
$10
Revised budget sales price
$4.5
$5.5 (A)
Actual sales volume
Sales price planning variance
12,000 units
$5.5 × 12,000 units
$66,000 (A)
Sales price operational variance
Revised budget sales price
$4.5
Actual sales price price
$5
$0.5 (F)
Actual sales volume
Sales price operational variance
12,000 units
$0.5 × 12,000 units
$6,000 (F)
428
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
Overview
Planning and operational variances can be reported for direct materials, when the
standard cost is revised for the material price, material usage per unit, or both.
The traditional variances we have seen so far can be investigated further to look at the
elements driven by a wrong standard (planning variances) and the elements that were
within the manager’s control (operational variances).
Material variance
Revise standard material price
Revise standard material usage
Material price variance
Material usage variance
Material price
planning
variance
Material price
operational
variance
Material usage
planning
variance
Material usage
operational
variance
429
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
1. Planning and operational variance for material price
Material price variance can be subdivided into material price planning variance and the
material price operational variance.
Material price
variance
Material price
planning variance
Material price
operational variance
Original budget
Revised budget
Actual
Original standard
material price
Revised standard
material price
Actual material
price
Actual usage
Actual usage
Actual usage
430
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
1. Planning and operational variance for material price
Example 5 (Question): Planning and operational variances for material price
Product X had a standard direct material cost in the budget of:
4 kg of Material M at $5 per kg = $20 per unit.
Due to disruption of supply of materials to the market, the average market price
for Material M during the period was $5.50 per kg, and it was decided to revise the
material standard cost to allow for this.
During the period, 6,000 units of Product X were manufactured. They required
26,300 kg of Material M, which cost $139,390.
Required: Calculate:
(a) The material price planning variance.
(b) The material price operational variance.
(c) The material usage variance.
431
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
1. Planning and operational variance for material price
Example 5 (Solution): Planning and operational variances for material price
•
•
•
The original standard cost was $5 per kg
The revised standard cost is $5.50 per kg
Actual material cost per kilogram is $139,390/26,300kg = $5.3 per kg
(a) Material price planning variance
Original standard material price
$5
Revised standard material price
$5.5
$0. 5 (A)
Actual materials usage
Material price planning variance
26,300 kg
$0.5 × 26,300 kg
$13,150 (A)
(b) Material price operational variance
Revised standard material price
$5.5
Actual material price
$5.3
$0.2 (F)
Actual materials usage
Material price operational variance
26,300 kg
$0.2 × 26,300 kg
$5,260 (F)
432
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
1. Planning and operational variance for material price
Example 5 (Solution): Planning and operational variances for sales price
(c) The material usage variance
Actual usage
Standard usage
26,300 kg
6,000 units × 4 kg
24,000 kg
2,300 kg (A)
Original standard price per kg
Material usage variance
$5
$5 × 2,300 kg
$11,500 (A)
Notes:
This variance is calculated by comparing the actual material usage with the standard
usage (because only material price is altered), but it is then converted into a monetary
value by applying the original standard price for the materials, not the revised standard
price.
433
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
1. Planning and operational variance for material price
Example 5 (Solution): Planning and operational variances for material price
The variances may be summarised as follows.
Material variance
$19,390 (A)
Material price variance
$7,890 (A)
Material price
planning
variance
$13,150 (A)
Material usage variance
$11,500 (A)
Material price
operational
variance
$5,260 (F)
Check
6,000 units of Product X at original std cost ($20)
Actual material cost
Total material cost variance
$120,000
$139,390
19,390 (A)
434
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
2. Planning and operational variance for material usage
Material usage variance can be subdivided into material usage planning variance and the
material usage operational variance.
Material usage
variance
Material usage
planning variance
Material usage
operational variance
Original budget
Revised budget
Actual
Original standard
material usage
Revised standard
material usage
Actual material
material usage
Original standard
price
Original standard
price
Original standard
price
435
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
2. Planning and operational variance for material usage
Example 6 (Question): Revise standard material usage
Product X had a standard direct material cost in the budget of:
4 kg of Material M at $5 per kg = $20 per unit.
Due to the change in product specification, the average usage for Material M during
the period was 5 kg per unit, and it was decided to revise the material standard
usage to allow for this.
During the period, 6,000 units of Product X were manufactured. They required
26,400 kg of Material M, which cost $137,280.
Required:
Calculate:
(a) The material usage planning variance.
(b) The material usage operational variance.
(c) The material price variance.
436
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
2. Planning and operational variance for material usage
Example 6 (Solution): Revise standard material usage
•
•
•
The original standard usage was 4 kg per unit.
The revised standard usage is 5 kg per unit.
Actual material usage per unit is 26,400kg/6,000 units = 4.4kg per unit.
(a) Material usage planning variance
Original standard material usage
Revised standard material usage
6,000 units × 4kg
6,000 units × 5kg
Original standard material price
Material usage planning variance
$5 × 6,000kg
24,000 kg
30,000 kg
6,000 kg (A)
$5
$30,000 (A)
$5 × 3,600kg
30,000 kg
26,400 kg
3,600 (F)
$5
$18,000 (F)
(b) Material usage operational variance
Revised standard material usage
Actual material usage
Original standard material price
Material usage operational variance
437
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
2. Planning and operational variance for material usage
Example 6 (Solution): Revise standard material usage
(c) The material price variance
•
Actual material price is $137,280/26,400kg = $5.2 per kg.
Actual material price
$5.2
Original standard material price
$5
$0.2 (A)
Actual usage
Material price variance
26,400 kg
$0.2 × 26,400kg
$5,280 (A)
438
III. PLANNING AND OPERATIONAL VARIANCES
FOR MATERIALS
2. Planning and operational variance for material usage
Example 6 (Solution): Revise standard material usage
The variances may be summarised as follows.
Material variance
$17,280 (A)
Material price variance
$5,280 (A)
Material usage variance
$12,000 (A)
Material usage
planning
variance
$30,000 (A)
Check
6,000 units of Product X at original std cost ($20)
Actual material cost
Total material cost variance
Material usage
operational
variance
$18,000 (F)
$120,000
$137,280
17,280 (A)
439
IV. PLANNING AND OPERATIONAL
VARIANCES FOR LABOUR
1. Planning and operational variance for labour
Example 7 (Question): Labour variances and the learning curve
Num Co hires temporary workers on six-month contract whenever production
requirements increase. Last month Num Co started producing a new product.
The standard labour cost of the new product is 5 hours × $20.00 per hour = $100.00.
Actual production of 520 units in the first month took 1,092 hours at a cost of
$21,840.
In retrospect it was realised that the standard labour hours per unit (5 hours) was
actually the time taken to produce the first unit and that a learning rate of 90%
should have been applied. The standard cost was revised to take this into account.
The learning index for a 90% learning curve is –0.1520.
Required:
Calculate the labour efficiency planning and operational variances after taking
account of the learning effect.
440
IV. PLANNING AND OPERATIONAL
VARIANCES FOR LABOUR
1. Planning and operational variance for labour
Example 7 (Solution): Labour variances and the learning curve
Firstly, we calculate the revised hours for the actual production by applying the
learning curve formula.
Y = a.Xb
Where:
•
Y = the cummulative average time per unit taken to produce X units
•
a = the time taken to produce the first unit = 5 hours (given)
•
X = the cumulative number of units = 520 units (given)
•
b = the index of learning = –0.1520 (given)
 Y = 5 × 520–0.1520 = 1.9326
Therefore, revised time for 520 units = 520 × 1.9326 = 1,005 hours.
441
IV. PLANNING AND OPERATIONAL
VARIANCES FOR LABOUR
1. Planning and operational variance for labour
Example 7 (Solution): Labour variances and the learning curve
Labour efficiency planning variance
Revised standard labour hours
Original standard labour hours (520 units * 5 hours)
1,005 hours
2,600 hours
1,595 hours (F)
Original standard price per hour
Labour efficiency planning variance
$20
$31,900 (F)
Labour efficiency operational variance
Actual labour hours
1,092 hours
Revised standard labour hours
1,005 hours
87 hours (A)
Original standard rate per hour
Labour efficiency operational variance
$20
$1,740 (A)
442
V. THE VALUE OF PLANNING AND
OPERATIONAL VARIANCES
Advantages and limitations
There are some advantages and limitations of a system of planning and operational
variances:
Advantages
•
•
Disadvantages
The analysis highlights those
variances which are controllable
(operational variances) and those
which
are
non-controllable
(planning variances).
Using variances for performance
measurement is likely to increase
if they know they will not be held
responsible for poor planning and
faulty standard setting.
•
The planning and standard-setting
processes should improve
•
Standards should be
accurate,
relevant
appropriate.
•
Provide a more realistic and ‘fair’
reflection of actual performance
more
and
•
Difficult to decide what the
realistic standard should have
been.
•
Too easy to justify all the
variances as being due to bad
planning, so no operational
variances will be highlighted.
•
Revising and analysing variances
into planning and operational will
take time and can be costly.
•
Managers may be resistant to the
very idea of variances and refuse
to see the virtues of the approach.
443
CHAPTER 15:
PERFORMANCE ANALYSIS
AND BEHAVIOURAL ASPECTS
444
OVERVIEW
What will you learn?
Using variance
analysis
Behavioural
implications
Evaluating past performance
Improving performance in the future
Motivation
Poor attitudes when setting budgets
Establishment
Performance
analysis and
behavioural
aspect
Setting the
difficulty level
for a budget
Participation in
budgeting
Variances in a
JIT or TQM
environment
Standard costs in a
rapidly changing
environment
Target
Standard
Effect on staff action
Top-down
budgeting
Bottom-up
budgeting
Negotiated
budgeting
Variance in JIT
Variance in TQM
445
I. USING VARIANCE ANALYSIS
Overview
Variance analysis is used to
Analyse and evaluate past performance
Control purposes: significant variances may indicate that an aspect
of performance is out of control and that measures should be taken
to improve performance in the future.
Evaluating past
performance
Variance
analysis
Improving performance
in the future
446
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
Basic principles of variance reporting are that:
The monetary value
that is given to variances
Should be a reasonable indication of
how much profit has been made or
lost as a result of actual performance
differing from the budget or standard.
The managers responsible
for variances
(Adverse or favourable)
Should be identified, and they should
be expected to account for the
variance and, where appropriate,
indicate what corrective or control
measures they are taking.
Responsibility
for planning
variances
Responsibility
for operational
variances
Notes:
For the exam, you also need to show an awareness of what variances tell us, and what
control measures management should take when a variance is reported.
447
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
Responsibility for planning variances
1.1
Planning variances arising because the budget or standard cost was inappropriate
should not be attributed to operational management.
In many cases, revisions to a budget or standard cost are due to causes outside the
control of the planners. Such as:
An unexpected increase in the market price for materials, for example,
is beyond the control of planners.
An unexpected collapse in market demand for an industry's products,
resulting in an adverse sales volume planning variance.
Even so, planning variances, where they occur, should be identified separately.
Therefore
Planning variance are
deemed not controllable by
management.
Management may not
be held responsible for
planning variances
448
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
1.2
Responsibility for operational variances
An operational variance
is deemed controllable
by management.
Management is held
responsible for
operational variances.
Responsibility
between
management
Organisation
structure and
the division of
authority
Responsibility
for operational
variances
Managers who are in a position of authority and
control over operations where the variances occur
449
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
Responsibility for operational variances
1.2
Example 1:
A material price variance is the difference between actual and standard purchase
costs of materials.

The operational manager responsible for this variance should be the
manager who makes the decisions about buying materials. This may be the
head of buying in one organisation, and the production manager in a
different organisation.
450
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
1.2
Responsibility for operational variances
Variance
Responsibility
Sales price variance
Sales or marketing management
Sales volume variance
•
•
Normally sales or marketing management
If sales are less than budget due to problems with
production, the production manager is responsible
Material price variance
The manager responsible for purchasing materials –
Purchasing manager
Material usage variance
Normally the production manager
•
Labour rate variance
•
The manager responsible for pay rates. This may be
senior management or HR management.
The production manager will be responsible for any
adverse rate variances caused by working overtime
and paying employees a premium rate per hour.
451
I. USING VARIANCE ANALYSIS
1. Analysing past performance with variance analysis
1.2
Responsibility for operational variances
Variance
Labour efficiency
variance
Responsibility
Normally the production manager
This depends on the cause of the idle time.
Caused by
Idle time variance
Responsibility
Lack of sales orders
Sales management
Inefficient production
management
Production
management
Delays in deliveries of
key raw material
Purchasing manager
452
I. USING VARIANCE ANALYSIS
2. Using variance analysis to improve future performance
Variance analysis provide guidance for operational management about aspects of
performance that need improving. Variances should be a guide to control action and
improving future performance.
It is important to understand that:
A reported variance is a
measurement that relates
to historical performance
Control action affects the
future, not the past.
Example 2:
If an adverse labour efficiency variance of $10,000 is reported one month, and
the production manager takes measures to improve efficiency:
•
The effect of the control measures should be to improve efficiency, but the
value of the efficiency improvement in future months is unlikely to be
$10,000. Control measures may result in savings of more or less than
$10,000 per month, depending on how effective the measures are.
•
The effect of control measures should have a reasonably long-term impact,
so control measures may result in savings not just in the following control
period but also for a reasonably long time into the future.
453
I. USING VARIANCE ANALYSIS
2. Using variance analysis to improve future performance
2.1
The significance of variances
Control action to improve future performance should only be taken when a variance
seems significant.
Some variances are inevitable, because it is most unlikely that actual results will be exactly
the same as the budget or standard.
Both favourable and adverse variances should be investigated if they
seem significant. Control action to improve poor performance may
seem an obvious requirement.
Variances need not be investigated if they do not seem significant.
Management may not use variances in a single reporting period as a
guide to control action.
Since a variance in one month may be due to a once-only event. Management may monitor
cumulative variances over a period of time, and identify those that should be investigated
on the basis of performance or trend over a number of months.
454
I. USING VARIANCE ANALYSIS
2. Using variance analysis to improve future performance
2.2
The cost of control action
Taking control measures to deal with the cause of a variance takes effort and costs
money.
Control measures should only be taken if it seems probable that
The costs of investigating
the causes of the variance
and taking control action
The benefits arising from
improved performance
Insignificant
variances
are not
investigated
455
I. USING VARIANCE ANALYSIS
2. Using variance analysis to improve future performance
2.3
Improving performance
Notes:
An exam question may ask about the nature of control action that an operational
manager may take to deal with the cause of an adverse variance and so improve
performance.
The appropriate control measures will obviously depend on the circumstances and the
reasons why a variance occurred.
Use common sense and judgement in
dealing with any question on this topic.
456
I. USING VARIANCE ANALYSIS
2. Using variance analysis to improve future performance
Improving performance
2.3
A few ideas are set out in the following table to give you an idea of the issues that may be
considered.
Variance
Possible control action
Adverse sales
volume variance
Consider reducing the sales price in order to increase sales
demand, although this will result in an adverse sale price
variance
Adverse material
price variance
Search for a supplier who is prepared to offer a lower price
Consider purchasing in bulk quantities in order to obtain
large-order discounts
Adverse material
usage variance
Consider providing training for the workforce, with the
objective of improving labour efficiency and reducing
wastage of materials
457
II. BEHAVIOURAL IMPLICATIONS
Overview
The appropriate use of control information from the budgetary control and variance
reporting system depends not only on the content of the information itself but also on the
behaviour of its recipients.
 This is because control in business is exercised by people.
A number of behavioural problems can arise:
The managers who set the budget or standards are often not the managers who
are then made responsible for achieving budget targets.
Dysfunctional behaviour: the goals of the organisation as a whole, as expressed in
a budget, may not coincide with the personal aspirations of individual managers.
Control is applied at different stages by different people.
•
A supervisor may receive weekly control reports, and act on them;
•
Their superior may receive monthly control reports, and decide to take
different control action.
•
Different managers can get in each other's way, and resent the interference
from others.
When setting the budget, there may be budgetary slack.
458
II. BEHAVIOURAL IMPLICATIONS
Overview
Budgetary slack is a deliberate over-estimation of expenditure and/or under-estimation
of revenues in the budgeting process.
Meaningless variances and a budget
which has no use for control purposes
459
II. BEHAVIOURAL IMPLICATIONS
1. Motivation
Motivation is what makes people behave in the way that they do. It comes from
individual attitudes, or group attitudes.
Individuals will be motivated by personal desires and interests.
In line with the objectives
of the organisation
Unrelated to the objectives
of the organisation
It is vital that the goals of management and the employees harmonise with the goals of
the organisation as a whole. This is known as goal congruence.
460
II. BEHAVIOURAL IMPLICATIONS
1. Motivation
Little organizational
accomplishment
Degree of
attainment
Organization
goal
Successful congruence,
high achievement environment
Degree of
attainment
Organization
goal
Although obtaining goal congruence is essentially a behavioural problem, it is possible to
design and run a budgetary control system which will go some way towards ensuring that
goal congruence is achieved.
461
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
Poor attitudes or hostile behaviour towards the budgetary control system can begin at
the planning stage.
If managers are involved in preparing a budget the following may happen.
Managers may complain that they are too
busy to spend much time on budgeting.
They may build 'slack'
expenditure estimates.
into
their
They may argue that formalising a budget
plan on paper is too restricting and that
managers should be allowed flexibility in
the decisions they take.
They may set budgets for their budget
centre and not co-ordinate their own
plans with those of other budget centres.
They may base future plans on past results, instead of using the opportunity
for formalised planning to look at alternative options and new ideas.
On the other hand, managers may not be involved in the budgeting process.
462
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
Not be involved in the
budgeting process
Subordinate managers
Senior management or
administrative decision
Set up
Budget
Do not achieve goal congruence
It is hard for people to be motivated to achieve targets set by someone else
463
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
2.1
Poor attitudes when putting plans into action
Poor attitudes also arise when a budget is implemented.
Managers may put in only just enough effort to achieve budget targets, without
trying to beat targets.
A formal budget may encourage rigidity and discourage flexibility.
Short-term planning in a budget can draw attention away from the longerterm consequences of decisions.
There may be minimal co-operation and communication between managers.
Managers will often try to make sure that they spend up to their full budget
allowance, and do not overspend, so that they will not be accused of having
asked for too much spending allowance in the first place.
464
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
2.2
Poor attitudes and the use of control information
The attitude of managers towards the accounting control information they receive might
reduce the information's effectiveness.
Management accounting control reports could well be seen as having a relatively
low priority in the list of management tasks. Managers may take the view that
they have more pressing jobs on hand than looking at routine control reports.
Managers may resent control information; they may see it as part of a system of
trying to find fault with their work. This resentment is likely to be particularly
strong when budgets or standards are imposed on managers without allowing
them to participate in the budget-setting process.
If budgets are seen as pressure devices to push managers into doing better,
control reports will be resented.
Managers may not understand the information in the control reports because
they are unfamiliar with accounting terminology or principles.
Managers may have a false sense of what their objectives should be. A
production manager may consider it more important to maintain quality
standards regardless of cost. They would then dismiss adverse expenditure
variances as inevitable and unavoidable.
465
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
2.2
Poor attitudes and the use of control information
The attitude of managers towards the accounting control information they receive might
reduce the information's effectiveness.
If there are flaws in the system of recording actual costs, managers will dismiss
control information as unreliable.
Control information may be received weeks after the end of the period to
which it relates, in which case managers may regard it as out of date and no
longer useful.
Managers may be held responsible for variances outside their control.
Management accountants and senior management should try to implement
systems that are acceptable to budget holders and which produce positive effects.
466
II. BEHAVIOURAL IMPLICATIONS
2. Poor attitudes when setting budgets
2.3
Pay as a motivator
Pay can be an important motivator when there is a formal link between higher pay (or
other rewards) and achieving budget targets.
Individuals are likely to work harder to achieve budget if they know that they will be
rewarded for their successful efforts.
However, there are problems with using pay as an incentive.
Formal reward and performance evaluation systems can encourage
dysfunctional behaviour.
The targets must be challenging but fair, otherwise individuals will become
dissatisfied. Pay can be a demotivator as well as a motivator.
467
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
Overview
The level of difficulty in a standard cost may range from very challenging to fairly
undemanding:
•
Many establish either a target or a currently attainable level of performance
•
Standard costs may be ideal
468
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
1. Establishing either a target or a
currently attainable level of performance
'Aspirations' budgets can be used as targets to motivate higher levels of performance but a
budget for planning and decision-making should be based on reasonable expectations.
Budgets can motivate managers to achieve a high level of performance.
But how difficult should budget targets or standard levels of efficiency be?
How might people react to targets of differing degrees of difficulty in achievement?
A high standard
of performance
A low standard
of performance
An unchanged
budget level
There is likely to be a demotivating effect where an ideal
standard of performance is set.
 Adverse efficiency variances will always be reported.
A low standard of efficiency is also demotivating, because there
is no sense of achievement in attaining the required standards.
The targets will be achieved easily, and there will be no
impetus for employees to try harder to do better than this.
A budgeted level of attainment could be the same as the level
that has been achieved in the past.
 Arguably, this level will be too low. It might encourage
budgetary slack.
469
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
1. Establishing either a target or a
currently attainable level of performance
Academics have argued that each individual has a personal 'aspiration level'. This is a level
of performance, in a task with which individuals are familiar, which individuals undertake for
themselves to reach.
Individual aspirations might be much higher or much lower than the organisation's
aspirations, however.
The solution: Having two budgets:
Expectations
budget
A budget for planning and decision-making based on reasonable
expectations.
Aspirations
budget
A budget for motivational purposes, with more difficult targets of
performance.
470
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
2. Standard cost establishment
Similarly, the level of difficulty in a standard cost may vary.
Type of standard
Ideal
Characteristics
•
A desirable target, but not at all achievable at the moment.
•
Reported variances will always be adverse. This can be
demotivating for the managers responsible for performance.
•
The targets are not unrealistic.
•
The value of target standards depends on the strength of
motivation of management to improve performance.
•
An incentive scheme may be needed to persuade managers to
'buy in' to the target standard.
•
They do not provide an incentive to improve performance,
although they may encourage management to avoid a
deterioration in performance.
•
It is used to measure trends and changes in performance
standards over time.
•
It is not a useful type of standard for control purposes.
Target
Currently
attainable
standard
Basic standard
471
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
3. The effect of reported variances on staff action
Reported variances
if significant and adverse
Managers take control
action to improve performance
The success of a variance reporting system in achieving this objective will depend on several
factors.
Factors
Explanations
Appropriate manager
The manager who is considered responsible for the
variance should agree and accept that the cause of the
variance is their responsibility
Realistic measure
The manager should consider the reported variance to
be 'fair'. This is a reason
•
Why it is advisable to separate planning variances
from operational variances when a budget or
standard needs revision.
•
Why variances reported using ideal standards may
be demotivating.
472
III. SETTING THE DIFFICULTY LEVEL FOR A BUDGET
3. The effect of reported variances on staff action
Factors
Explanations
Motivation
The manager should want to do something to deal
with the causes of the variance.
 Incentives and motivation are important factors
A timely manner
Report variance as soon as reasonably practical.
If a reported variance relates to events occurring a long
time ago, managers will be reluctant to investigate
them 'now' because the variance will seem out of date.
Control area
The manager must believe that the cause of the
variance is something they are in a position to control.
If a manager considers the cause of a variance to be
outside their sphere of authority, or to be due to a
factor that they cannot do anything to change, they will
not be motivated to look for control measures.
Provoke a defensive reaction, with the manager trying to justify what has gone wrong.
In contrast, if there is an 'improvement culture', variances are considered as useful
indicators for control action and improving performance.
473
IV. PARTICIPATION IN BUDGETING
Overview
Participation in the budgeting process will improve motivation and so will improve the
quality of budget decisions and the efforts of individuals to achieve their budget targets.
However, obviously this will depend on:
The personality of
the individual
The nature of the task
(narrowly defined
or flexible)
There are basically three ways in which a budget can be set:
The organisational
culture.
474
IV. PARTICIPATION IN BUDGETING
1. Top-down budgeting (Imposed budgeting)
In this approach to budgeting, top management prepare a budget with little or no input
from operating personnel which is then imposed on the employees who have to work
to the budgeted figures.
2. Bottom-up budgeting (Participative budgeting)
In this approach to budgeting, budgets are developed by lower-level managers who
then submit the budgets to their superiors. The budgets are based on the lower-level
managers perceptions of what is achievable and the associated necessary resources.
475
IV. PARTICIPATION IN BUDGETING
3. Negotiated budgeting
In this approach to budgeting, different levels of management often agree budgets by a
process of negotiation. Negotiated budgeting is a budgeting process that combines both
top-down budgeting and bottom-up budgeting.
Final budgets are therefore most likely to lie between what top management would really
like and what junior managers believe is feasible.
The budgeting process is a bargaining process and it is this bargaining which is of vital
importance
476
V. VARIANCES IN A JIT OR TQM ENVIRONMENT
(Self-reading)
1. Variances and a JIT environment
In a JIT manufacturing environment, production is managed on the principle that items
should not be produced until they are required to meet sales orders. There should be no
accumulation of inventories of work in progress and finished goods.
A JIT approach implies that if there are no sales orders, production resources should be kept
idle.
In addition, the volume of production should be restricted to the output capacity of the
bottleneck resource, meaning that there will inevitably be idle capacity for all resources that
are not the bottleneck resource.
In JIT manufacturing, idle time should therefore be expected.
In a system of standard costing, idle time is an adverse labour efficiency
variance, and is undesirable.
477
V. VARIANCES IN A JIT OR TQM ENVIRONMENT
(Self-reading)
1. Variances and a JIT environment
If idle time variances are reported for a manufacturing operation that is based on JIT
methods:
Idle time variances are reported for a manufacturing operation
that is based on JIT methods
The variances will encourage managers to use idle capacity in
a productive way
By producing more and building up inventories
With increases in inventory, there will be a higher reported profit.
But this is unacceptable in a JIT environment.
478
V. VARIANCES IN A JIT OR TQM ENVIRONMENT
(Self-reading)
2. Variances and a TQM environment
2.1
TQM and standard costing
Total Quality Management (TQM) is an approach to management that originated from
different sources, and has a number of different aspects.
1
The view
that work
should be
“right first
time”
2
Items should be
produced only
when they are
needed for the
next stage in the
production
process
Total Quality
Management
(TQM)
3
The principle
of continuous
improvement
or “kaizen”
Improvements should
be made continually
479
V. VARIANCES IN A JIT OR TQM ENVIRONMENT
(Self-reading)
2. Variances and a TQM environment
2.1
TQM and standard costing
Each of these principles of TQM may be inconsistent with standard costing and variance
analysis. The inconsistency between standard costing and the view that production
resources should be kept idle until required has already been discussed in the context of JIT.
TQM
Standard costing
Do not Allow for normal loss so,
it is more consistent with
environmental cost accounting.
The philosophy
in TQM of 'right
first time'
Taking account of allowance for
wastage in the standard cost.
The principle of ‘kaizen’ or
continuous improvement is that
a steady state of production
will never be achieved because
further
improvements
will
always be possible
The principle of
'kaizen' or
continuous
improvement
A standard cost is based on an
assumption of a desirable
steady-state, this view is
inconsistent with the principle
of continuous improvement.
480
V. VARIANCES IN A JIT OR TQM ENVIRONMENT
(Self-reading)
2. Variances and a TQM environment
2.2
Can standard costing and TQM coexist?
Arguably, there is little point in running both a Total Quality Management program and a
standard costing system simultaneously.
Predetermined standards are at odds with the philosophy of continual
improvement inherent in a TQM program.
Continual improvements are likely to alter methods of working, prices, quantities
of inputs, and so on, whereas standard costing is most appropriate in a stable,
standardised and repetitive environment.
Material standard costs often incorporate a planned level of scrap. This is at odds
with the TQM aim of zero defects and there is no motivation to 'get it right first
time'.
Attainable standards which make some allowance for wastage and inefficiencies
are commonly set. The use of such standards conflicts with the elimination of
waste which is such a vital ingredient in a TQM programme.
Standard costing control systems make individual managers responsible for the
variances relating to their part of the organisation's activities. A TQM
programme, on the other hand, aims to make all personnel aware of, and
responsible for, the importance of supplying the customer with a quality product.
481
VI. STANDARD COSTS IN
A RAPIDLY CHANGING ENVIRONMENT
(Self-reading)
Overview
Standard costs have limited relevance and value in the modern business world, where
the environment is continually changing, and the life cycle of products can be very short.
Standard costs are appropriate for a 'steady state' production environment where the
manufacturing system produces standard products, often in large quantities, using standard
and repetitive production methods and processes.
Traditional
manufacturing
Modern environment
Impacts of standard costing
High labour cost,
low overhead
Low labour cost,
high overhead
Overhead variances do not have enough detail to
aid performance measurement.
Stable environment/
products
Rapidly changing
environment/products
Regular revision of standards can be demotivating
for employees as the goal posts keep moving.
Standard product
Customised product
Differences between products make developing a
standard difficult. Resulting variances may not be
meaningful and certain employees may be unfairly
penalised.
Focus on cost
Focus on quality
Variance analysis encourages cost control. Desired
quality may drive adverse price variances.
Raw material and
finished goods
inventories are
important
JIT philosophy
Inventory may be built up in an effort to improve
efficiency variances.
482
VI. STANDARD COSTS IN
A RAPIDLY CHANGING ENVIRONMENT
(Self-reading)
Overview
The role of standards and variances in modern business
However, a survey by Drury et al (1993) indicated the continued widespread use of standard
costing systems. Although this survey is now somewhat out of date, the following points
should be noted.
Criteria
Explanation
Planning
Even in a TQM environment, budgets will still need to be
quantified.
For example, the planned level of prevention and
appraisal costs needs to be determined. Standards, such
as returns of a particular product should not exceed 1%
of deliveries during a budget period, can be set.
Control
Cost and mix changes from the plan will still be relevant
in many processing situations
Decision-making
Existing standards can be used as the starting point in the
construction of a cost for a new product.
483
VI. STANDARD COSTS IN
A RAPIDLY CHANGING ENVIRONMENT
(Self-reading)
Overview
Criteria
Explanation
Performance
measurement
If the product mix is relatively stable, performance
measurement may be enhanced by the use of a system
of planning and operational variances.
Product pricing
Target costs may be compared with current standards,
and the resulting 'cost gap' investigated with a view to
reducing it or eliminating it using techniques such as
value engineering.
Improvement and change
Variance trends can be monitored over time
Accounting valuations.
Although the operation of a JIT system in conjunction
with backflush accounting will reduce the need for
standard costs and variance analysis, standards may be
used to value residual inventory and the transfers to cost
of sales account.
484
CHAPTER 16: INFORMATION
SYSTEMS AND DATA ANALYTICS
485
OVERVIEW
What will you learn?
Information systems and data analytics
I.
Overview of information
II.
Types of information system
III.
Closed and open systems
IV.
Big data
486
I. OVERVIEW OF INFORMATION
Overview
Data consists of numbers, letters, symbols, raw facts, events and transactions, which have
been recorded but not yet processed into a form that is suitable for making decisions.
Information is data that has been processed in such a way that it has meaning to the
person that receives it, who may then use it to improve the quality of their decisionmaking.
The conversion of data into information is illustrated as follows:
Data
Analysed and processed
to be meaningful
Information
487
I. OVERVIEW OF INFORMATION
1. The need of information for management
It is a vital requirement within any business to use information for management. Details are
as follows:
Information provides records, both current and historical
Information analyses what is happening within the business
Information provides the basis of decision making in the short and long term
Information monitors the performance of the business by comparing actual
results with plans and forecasts
Furthermore, numerous third parties require information about the business such as
shareholders, customers and suppliers and government agencies.
488
I. OVERVIEW OF INFORMATION
2. Levels of management activity
There are 3 management levels for planning, control and decision-making within an
organisation:
Strategic planning is the process of deciding on objectives of the organisation, changes
in these objectives, the resources used to attain these objectives, and the policies that
are to govern the acquisition, use and disposition of these resources.
Management control (Tactical planning) is the process by which managers assure that
resources are obtained and used effectively and efficiently in the accomplishment of the
organisation's objectives.
Operational control (Operational planning) is the process of assuring that specific tasks
are carried out effectively and efficiently.
489
I. OVERVIEW OF INFORMATION
2. Levels of management activity
3 these levels have significant differences. Details are as follows:
Management level
Key characteristics
•
Strategic
planning
Takes place at the top of
the organisation
Concerned with setting
a future course of action
for the organisation
The board might decide that more
capital is needed and that factoring
debts or invoice discounting might
offer useful ways of raising cash
balances.
•
Concerned with the
effective use of
resources to achieve
targets set at strategic
planning
Credit control managers will be
concerned to follow up slow paying
customers to ensure that bad debts
are minimised and that cash flow is
kept healthy.
•
Sales ledger staff will be posting the
Concerned with the daysales leger accounts, sending out
to-day implementation
statement, dealing with accounts
of the plans of the
queries and approve credit for new
organisation
orders.
•
Management
control
Operational
control
Example
490
I. OVERVIEW OF INFORMATION
3. Three levels of information
As mentioned above, information is necessary for management activity of a business. Each
level of management requires a corresponding level of information.
Management level
Information level
Top
Strategic information
Strategic
Middle
Tactical
Tactical information
Bottom
Operational
Operational information
491
I. OVERVIEW OF INFORMATION
3. Three levels of information
1
Strategic information
Strategic information would relate to the longer-term strategy on the company's market
share, which in turn informs the production plan.
Pre-determine the level of investment required in capital equipment in
the longer term
Investigate new methods and technology.
492
I. OVERVIEW OF INFORMATION
3. Three levels of information
2
Tactical information
The information would be in a summarised form but detailed enough to allow tactical
planning of resources and manpower.
Example
The short-term budget for 12 months and would show the budgeted machine
use in terms of machine hours for each item of plant.
The total machine hours being predetermined from the production budget
for the period
493
I. OVERVIEW OF INFORMATION
3. Three levels of information
3
Operational information
The information must be detailed and precise.
Example
Operational information would include a current week's report for a cost
centre on the capacity of the plant used in the period.
494
II. TYPES OF INFORMATION SYSTEM
1. What is an information system?
Information systems refer to the provision and management of information to support the
running of the organization.
Information systems are also seen as a valuable strategic source which can help an
organisation gain competitive advantages. Details are as follows:
Link the organisation to customers or suppliers
Create effective integration of the use of information in a value-adding process
Enable the organisation to develop, produce, market and deliver new products
or services based on information
Give senior management information to help develop and implement strategy.
495
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
In order to operate smoothly, an organization needs numerous systems to process, analyse
and hold information. There are 4 main information systems:
Types of information systems
Transaction
processing
systems (TPS)
Management
information
systems
(MIS)
Executive
information
systems
(EIS)
Operational
control
Management
control
Strategic
planning
Enterprise
resource planning
systems
(ERPS)
496
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
1
Transaction processing system
A transaction is an event that generates or modifies data which is eventually stored on
an information system.
Transaction processing systems (TPS) collect, store, modify and retrieve the
transactions of an organization.
TPS has the following characteristics:
Characteristics
Controlled processing
Inflexibility
Rapid response
Reliability
Explanations
Processing must support an organisation's operations
Every transaction to be processed in the same way regardless
of user or time
Input must become output in seconds
Back-up and recovery procedures must be quick and accurate
497
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
Transaction processing system
1
2 types of TPS:
Batch transaction
processing (BTP)
Real time transaction
processing (RTTP)
•
•
Transaction data is collected as a
group and processes it later, after a
time delay, as batches of identical
data
Definition
Cheque clearance.
The payee cannot withdraw the
money until the cheque is cleared.
Cheques are cleared in a group for 3
working days
Examples
•
Data is processed immediately
Use a terminal workstation to
enter data + display results and
provides instant confirmation
A large number of users can
perform transactions at the
same time but access to a
central online database is
required
Reservation systems for flight or train
bookings and hotel reservations,
which require an acceptable response
time, as transactions are made in the
presence of customers.
Notes: TPS are used mainly by operational managers to make basic decisions
498
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
2
Management information system
MIS extracts, processes and summarises data from the TPS and provide periodic (weekly,
monthly, quarterly) reports to managers.
5 characteristics of a MIS:
Support structured decisions at operational and management control levels
Designed to report on existing operations
Little analytical capability
Relatively inflexible
An internal focus
499
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
Management information system
2
4 types of MIS:
Types of MIS
Database
systems
Description
Process and store
organisation’s memory
information,
which
becomes
the
Direct control
systems
Monitor and report on activities such as output levels, sales
ledger and credit accounts in arrears
Enquiry
systems
Based on databases to provide specific information such as the
performance of a department or an employee
Support
systems
Provide computer-based methods and procedures
conducting analyses, forecasts and simulations.
Notes: MIS is useful for middle managers.
for
500
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
3
Executive information system
Executive information systems (EIS) provide a generalised computing
communication environment for senior managers to support strategic decisions.
and
An EIS summarises and tracks strategically critical information from the MIS and includes
data from external sources such as competitors, legislation. A model of a typical EIS shown
below:
EIS
workstation
•
•
•
•
•
•
•
•
Menus
Graphics
Communications
Local processing
EIS
workstation
Internal data
External data
Menus
Graphics
Communications
Local processing
TPS/MIS data
Financial data
Office systems
Modelling/analysis
Share prices
Market research
Legislation
Competitors
EIS
workstation
•
•
•
•
Menus
Graphics
Communications
Local processing
501
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
4
Enterprise resource planning system
Executive resource planning systems (ERPS) are modular software packages designed to
integrate the key processes in an organisation so that a single system can serve the
information needs of all functional areas.
ERP systems primarily support business operations - those activities in an organisation that
support the selling process, including order processing, manufacturing, distribution,
planning, customer service, human resources, finance and purchasing.
Operations
Controls inventory throughout the supply chain,
from procurement to distribution
Finance
Reports customer’s
credit rating and
current selling
ERP software
Manages information flow
among all database
applications
Marketing
Co-ordinates sales activities and
handles customer relationship
Accounting
Records sales and
payments and tracks
business performance
Human resources
Recruits, trains, evaluates and
compensates employees
502
II. TYPES OF INFORMATION SYSTEM
2. Types of information system
4
Enterprise resource planning system
ERP systems offer:
On-line/real-time
information throughout
all the functional areas
of an organization
Standardisation of data
across the entire
organization
Common data files for
all functions, thereby
saving duplication.
503
III. CLOSED AND OPEN SYSTEM
1. Closed system
A closed system is isolated and shut off from the environment. Information is not
received from or provided to the environment.
Example
A production line is a closed system within an organization.
The daily work that takes place on production or assembly lines can be insulated
from outside factors such as day-to-day meetings between upper-level
executives, or information from other similar, competing production lines.
Instead, workers on an assembly line are generally only responsible for
completing their tasks on the line, depending on what type of line it is.
•
•
Closed systems are rare because interaction with the environment is
necessary for business survival.
These systems will not provide adequate information for performance
management.
504
III. CLOSED AND OPEN SYSTEM
1. Closed system
Subsystem 1
Environment
System
boundary
System
Subsystem 2
It can be seen that systems sit in their environments and are separated from their
environment by the systems boundary. Thus, a closed system has some below limitations:
Have only short lives because without input, closed systems will usually run
out of energy, material, information or some other resource
Normally become increasingly irrelevant as environmental changes are not
reflected in the system so the system becomes out of date
Internal information is easy for organisations to capture, but that is not
enough to ensure success, that requires external information which is much
more difficult to know and capture that reliably.
505
III. CLOSED AND OPEN SYSTEM
2. Open system
As disadvantages of closed systems, open systems should be preferred to use.
An open system is connected to and interacts with the environment and is influenced by
it.
As disadvantages of closed systems, open systems should be preferred to use.
Subsystem 1
Input
System
Output
Subsystem 2
Example (Question)
SAP Co manufactures sports clothing for professional athletes. Products are
designed to prevent injury and aid the post-exercise recovery process. The
company regularly seeks feedback from athletes regarding the effectiveness of
products and recommendations to take forward.
Required: Explain which kind of system the organisation has.
506
III. CLOSED AND OPEN SYSTEM
2. Open system
As disadvantages of closed systems, open systems should be preferred to use.
An open system is connected to and interacts with the environment and is influenced by
it.
As disadvantages of closed systems, open systems should be preferred to use.
Subsystem 1
Input
System
Output
Subsystem 2
Example (Question)
It is obvious that SAP Co operates an open system because it interacts with its
environment. Details are as follows:
•
•
It takes feedback from its customers about the effectiveness of its products
and accordingly advises the product design department about customer
preferences.
Based on customer feedback, SAP Co may decide to alter product design and
specification.
507
III. CLOSED AND OPEN SYSTEM
2. Open system
Using an open system has following advantages and disadvantages:
Advantages
Disadvantages
Encourage strong communication,
which helps to operate efficiently
and become effective
Non-linear relationships could
exist among variables such as a
small change in one variable could
cause a large change in another
Adapt to changing
environment
business
Support management by helping
them to understand overall
structures, to determine what
must do
Help planning by identifying
desired results, what measures or
outputs, what processes will
produce those outputs, and what
inputs are required.
Difficult to measure the success of
the system such as input,
processing and output.
508
IV. BIG DATA
1. Overview on big data
Big data refers to the mass of data that society creates each year, extending far beyond
the traditional financial and enterprise data created by companies.
3 characteristics of big data:
•
•
Volume
Characteristics
(Three Vs)
Velocity
Variety
The scale of information can now be created
and stored is staggering
Advances in data storage technology & a fall
in price have allowed for captured data to be
stored for further analysis
Timeliness is a key factor to decision makers
Big data consists
unstructured data
of
both
structured and
509
IV. BIG DATA
1. Overview on big data
Big data is used for numerous purposes. Details are as follows:
Purposes
Comment
Big data and
business value
Big data can be used to analyse opportunities to increase
revenue and reduce costs, thereby increasing profit
Big data and
the customer
Understanding the customer is a key benefit of big data
analytics
•
Big data and
corporate strategy
•
•
After identifying how value can be improved,
requirements of the customer, business priorities can
be determined
Big data is a key source of innovation, helping to create
new products and services
Volume and velocity of data helps speed up decision
making.
510
IV. BIG DATA
2. Big data analytics
Data analytics is the process of collecting and examining data in order to extract
meaningful business insights, which can be used to inform decision making and improve
performance.
There are numerous potential benefits to performance improvements of organisations
when big data analytics used. Details are as follows:
Benefits
Comment
Better understanding
of customer behaviour
Big data analytics helps business identify how well it is
meeting customers’ needs and potential changes needed to
its products or service to meet customers’ needs more
effectively
Targeted marketing
messages
Big data could facilitate targeted promotions and
advertising
Improves
organisational
decision making
Better data analysis helps management to take advantage
of current social trends, in real time to to manage
inventories and pricing
511
IV. BIG DATA
2. Big data analytics
Data analytics is the process of collecting and examining data in order to extract
meaningful business insights, which can be used to inform decision making and improve
performance.
There are numerous potential benefits to performance improvements of organisations
when big data analytics used. Details are as follows:
Benefits
Comment
New products
and services
Big data could provide new business opportunities in their
own right by introducing new products that is similar
interests with customers
Performance
measurement
Big data can provide more detailed and up-to-date
information for performance measurement to react quickly
to variances
Cost reduction
Improved data about customers and internal operations
may help to reduce costs.
512
IV. BIG DATA
3. Risks and challenges of big data
Beside mentioned above benefits, using big data could have some below risks and
challenges:
Risks and challenges
Comment
Quality of data
Not more data, more better decisions made. In order to be
useful, data has to be relevant and reliable
Veracity
In order to be valuable, data needs to be reliable and
validated. Enterprises should maintain strong governance
on data quality
Cost
It is expensive to establish the hardware and analytical
software needed and to comply with data protection
regulations which vary from country to country
Skills
The scale and complexity of data sets may require
organisations to have staff with necessary analytical skills
for data mining, deriving algorithms and predictive analytics
Loss and theft of data
Companies could face legal action if data is stolen so they
need to consider data protection and privacy issues to
ensure to comply with current legislation.
513
CHAPTER 17: SOURCES OF
INFORMATION AND
MANAGEMENT REPORTS
(ADDITIONAL READING)
514
OVERVIEW
What will you learn?
Sources of information and management reports
I.
Sources of management information
II.
Management reports
515
I. SOURCES OF MANAGEMENT INFORMATION
Overview
As studied in chapter 16. Information systems and data analytics, information is necessary
for management activity of a business.
Management information is gathered from 2 sources:
Internal sources
Sources of
management
information
External sources
516
I. SOURCES OF MANAGEMENT INFORMATION
1. Internal sources
Internal sources of information include the financial accounting records and other
systems closely tied to the accounting system.
517
I. SOURCES OF MANAGEMENT INFORMATION
1. Internal sources
1.1
Sources of internal information
Types of internal sources of information:
Sources
Information
Sales ledger system
•
•
•
•
Number and value of invoices
Volume of sales
Value of sales, analysed by customer
Value of sales, analysed by product
Purchase ledger system
•
•
Number and value of invoices
Value of purchases, analysed by supplier
Payroll system
•
•
•
•
Number of employees
Hours worked; Wages earned
Output achieved
Tax deducted
Fixed asset system
•
•
•
•
Date of purchase; Initial cost; Location
Depreciation method and rate
Service history
Production capacity
•
•
•
•
Machine breakdown times
Number of rejected units
Types of customer
Market research results
Production
Sales and marketing
518
I. SOURCES OF MANAGEMENT INFORMATION
1. Internal sources
Costs of internal information
1.2
Costs of internal information can be divided into 3 types:
Costs
Examples
•
•
Direct data
capture
•
•
•
•
Payroll department time spent processing and analysing
personnel costs
Time for personnel to input data
•
•
•
•
•
Information collected but not needed
Information stored long after it is needed
Information disseminated more widely than necessary
Collection of the same information by more than one method
Duplication of information
Processing
Indirect costs
of producing
information
Use of bar coding and scanners in retailing and manufacturing
Use of OCR (Optical Character Recognition) to capture data
from printed documents
Use of ICR (Intelligent Character Recognition) to capture data
from hand written documents
Use of RFID (Radio Frequency Identification) tags to identify,
locate and track vehicles, staff, inventory
519
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
External sources of information include information from outside the organization.
520
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
2.1
Sources of external information
There are many sources of external information. Details are as follows:
Sources
Information
Suppliers
•
•
•
•
Bid information
Operational information
Pricing information
Technology
Newspapers, journals
•
•
•
•
Share price
Information on competitors
Technological developments
National and market surveys
Government
•
•
•
•
•
Industry statistics
Taxation policy
Inflation rates
Demographic statistics
Forecasts for economic growth
521
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
2.1
Sources of external information
There are many sources of external information. Details are as follows:
Sources
Information
Customers
•
•
Product requirements
Price sensitivity
Employees
•
•
Wage demands
Working conditions
Banks
•
•
Information on potential customers
Information on national markets
Business enquiry agents
•
•
Information on competitors
Information on customers
•
Almost everything via databases, discussion
groups and mailing lists
Internet
522
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
2.2
Benefits and limitations of external information
Using external information has following advantages and disadvantages:
Disadvantages
Advantages
•
The quality of decisions is ensured
as information is considered
•
Risk/uncertainties avoided
having information
•
Ability to respond appropriately
to environment or to improve its
performance
•
Information may not be accurate,
old and out of date so the source
of information must always be
checked
•
Sample used to generate the
secondary data may be too small
•
Company publishes information
may not be reputable
•
Information may not meet the
exact needs of the business
•
Difficult to gather information.
by
523
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
Costs of external information
2.3
Costs of external information can be divided into 5 types:
Costs
Direct search
costs
Examples
•
•
•
•
Cost of a marketing research survey
Subscriptions to online databases
Subscriptions to magazines, services
Download fees
•
Management and employee time spent finding useful
information
Wasted management and employee time on unsuccessful
searches for information
Spurious accuracy/ redundancy
Wasted management and employee time on excessive
searching
Wasted time on trying to find spurious accuracy
•
Indirect access
costs
•
•
•
•
Management
costs
Infrastructure
costs
•
•
•
Recording, processing and dissemination of external
information
Wasted time due to information overload
Wasted time on excessive processing
Installation and maintenance of computer networks,
servers, landlines to facilitate internet searching and
internal electronic communication
524
I. SOURCES OF MANAGEMENT INFORMATION
2. External sources
Costs of external information
2.3
Costs of external information can be divided into 5 types:
Costs
Examples
•
Time theft
•
•
•
Wasted time caused by abuse of internet and email access
facilities
Lost time
Cost of monitoring and disciplinary procedures
Information overload.
Notes:
Information always comes with costs; however, companies should ensure that the
benefit received from management information exceeds the costs of gaining that
information.
Exam focus: Identify and discuss costs of information from the given data.
525
II. MANAGEMENT REPORTS
1. Controls over generating and distributing internal information
Information of an organization will often consist of information that is either confidential or
commercially sensitive. Thus, controls will be required when generating and distributing this
information.
3 types of control:
Types of control over
generating and distributing information
Input
Process
Output
526
II. MANAGEMENT REPORTS
1. Controls over generating and distributing internal information
Controls over input
1.1
Inputs should be complete, accurate and authorised. Detailed methods are as follows:
Method
Purposes
Input
Help to ensure data is authorised and they provide a software
audit trail
Range tests
Help to ensure data is accurate.
Example: Month fields to be in the range 1-12
Format checks
Help to ensure data is accurate.
Example: All account numbers must be in the format A123
Check digits
Help to ensure data is accurate.
Example: Specially constructed numbers which comply with a
mathematical test
Sequence checks
Matching
Help to ensure data is completed.
Example: Ensuring all cheques are accounted for
Primarily addresses completeness.
Example: A system checking that each employee has input a
time sheet for the month
527
II. MANAGEMENT REPORTS
1. Controls over generating and distributing internal information
1.2
Controls over processing
Processing should be initiated by appropriate personnel and logs should be kept of any
processing.
Some methods could be considered:
Passwords and software audit trails are important to track what processing was
carried out
Programs should not be altered without authorisation and testing; otherwise,
incorrect or fraudulent processing could be carried out.
528
II. MANAGEMENT REPORTS
1. Controls over generating and distributing internal information
1.3
Controls over output
Output should be available to authorised persons and third parties only.
Some methods could be considered:
Each password allocated suitable access rights
Sensitive printed output could have a distribution list and should be physically
safeguarded.
529
II. MANAGEMENT REPORTS
2. Security of confidential information
In order to protect highly confidential information that is not for external consumption,
businesses may use a number of following procedures:
Procedures
Comment
Passwords
To access a system the user first needs to enter a string of
characters. If what is entered matches a password, the
system permits access. Otherwise the system shuts down
and may record the attempted unauthorised access.
Logical access
systems
This prevents those who already have access to a terminal or
a computer from gaining access to data or software through
3 operations:
•
Identification of the user
•
Authentication of user identity
•
Check on user authority
Database
controls
This is conducted by limiting the number of queries or
controlling the overlap between questions
Firewalls
This is used to prevent unauthorised internet users from
accessing private networks connected to the internet,
especially intranets
530
II. MANAGEMENT REPORTS
2. Security of confidential information
In order to protect highly confidential information that is not for external consumption,
businesses may use a number of following procedures:
Procedures
Comment
Anti-virus and
anti-spyware
software
Anti-virus software is carried out as follows:
•
Scanning files to look for known viruses
•
Identifying suspicious behavior
Anti-spyware software combats spyware in 2 ways:
•
Real-time protection prevents the installation of
spyware
•
Detection and removal of spyware by scanning software
and removing files and entries that match known
spyware
Encryption
Data is encoded in a way that makes it extremely difficult for
people to decode and then use data if they were to gain
access to it
Personnel
security
planning
Recruitment, training and supervision needs to be in place to
ensure the competence of those responsible for
programming and data entry.
Exam focus: Determine and discuss control methods and procedures applied from the
given data.
531
II. MANAGEMENT REPORTS
3. Output reports
The output reports produced for management should contain good information. A good
information should be:
Accurate
Complete
Cost < benefit
Understandable
Relevant to avoid information overload
Adaptable to needs of users
Timely
Easy to use
53
2
II. MANAGEMENT REPORTS
3. Output reports
However, before any report is created the following controls should be adopted:
Undertake cost/benefit analysis to ensure benefits from the reports is
higher costs spent to achieve the
Consider making a prototype of reports
Check that the report is not duplicated to avoid inefficient reports.
533
CHAPTER 18:
DIVISIONAL PERFORMANCE
AND TRANSFER PRICING ISSUES
534
OVERVIEW
What will you learn?
Characteristics and needs
in a divisional organization
Decentralisation
Divisionalisation
Problems associated with
divisional structures
Responsibility accounting
Divisional
performance and
Transfer pricing
Divisional
performance
measurement
Return on investment (ROI)
Residual income (RI)
General theory
Transfer pricing
Criteria for designing a
transfer pricing policy
Setting the transfer price
535
I. DIVISIONALISATION
Overview
In general, a large organisation can be structured in one of two ways:
Functionally
All activities of a similar type within a company, such as
production, sales and research, are under the control of the
appropriate departmental head
Divisionally
Split into divisions in accordance with the products or
services made or provided.
Divisionalisation is a term for the division of an organisation into divisions. Each
divisional manager is responsible for the performance of the division
536
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
The divisional form is characterised by autonomy given to managers lower down the line.
The prime coordinating mechanism is a standardisation of outputs.
There are three types of division:
Types of division
Cost center
Profit center
Investment center
537
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
1.1
Characteristics of divisionalisation
Divisionalisation is the division of a business into autonomous
regions or product businesses, each with its own revenues,
expenditures and profits.
Communication between divisions and head office is restricted,
formal and related to performance standards. Influence is
maintained by headquarters' power to hire and fire the managers
who are supposed to run each division.
Headquarters management influences prices and therefore
profitability in divisions when it sets transfer prices between
divisions.
Divisionalisation is a function of organisation size, in numbers and
in product-market activities.
538
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
1.1
Characteristics of divisionalisation
The multi-divisional structure might be implemented in one of two forms:
Multi-divisional structure organised by product-market areas
•
This enables concentration on particular product-market areas.
•
Problems arise with the power of the head office, and control of the resources.
Organization ‘s head office
Division A
Division B
Division C
Functions
Functions
Functions
539
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
1.1
Characteristics of divisionalisation
The multi-divisional structure might be implemented in one of two forms:
Holding company organisational structure
•
The holding company (group) structure is a radical form of divisionalisation.
•
Subsidiaries are separate legal entities.
Holding company
Subsidiary A
Sub-Subsidiary D Sub-Subsidiary E
Subsidiary B
Subsidiary C
Sub-Subsidiary F
540
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
1.2
Information needs of divisional structures
In a divisional structure each division is self-contained and based on geography or
product/service area.
Divisional managers have more authority to act autonomously than in a
functional structure (where planning and control are exercised centrally).
Divisional organisations tend to be more decentralised than functional ones.
Divisional managers are clear about an organisation's strategy and objectives,
so that they can ensure that their divisions perform according to that strategy the goal congruence.
Performance information needs to be available to all these managers.
Managers will be accountable for, and rewarded on the basis of, divisional
performance. Accordingly, divisional performance measures can be
appropriate here.
541
I. DIVISIONALISATION
1. Information characteristics and needs in a divisional organisation
1.2
Information needs of divisional structures
In a divisional structure each division is self-contained and based on geography or
product/service area.
Divisional managers are therefore responsible for all operations
(production, sales, and so on) relating to their product, the
functional structure being applied to each division.
It is possible that only part of a company is divisionalised and activities such
as administration are structured centrally on a functional basis with the
responsibility of providing services to all divisions.
542
I. DIVISIONALISATION
2. Decentralisation
Generally, a company with several divisions will be a decentralised organisation. In such
organisations, divisional managers tend be responsible for making their own decisions
concerning the operation of the division.
A divisional structure will lead to decentralisation of the decision-making
process and divisional managers may have the freedom to:
Choose suppliers
Make product mix
and output decisions
Set selling prices
Decentralisation is a matter of degree, depending on how much freedom divisional
managers are given.
543
I. DIVISIONALISATION
2. Decentralisation
There are some advantages and disadvantages of decentralisation in a corporation:
Advantages
Disadvantages
Decisions made more
quickly
Potential for dysfunctional
decision making
Increased motivation of
management
Duplication amongst divisions
leading to greater cost
Reduced head office
bureaucracy
Senior management loss of
control
Better training for all levels
of management
Notes:
Appropriate performance evaluation methods are therefore needed in order to
counteract the possible disadvantages.
544
I. DIVISIONALISATION
3. Problems associated with divisional structures
Before looking at the methods for divisional performance appraisal it is worth noting that
divisional structures may result in the following problems:
Co-ordination
How to co-ordinate different divisions to achieve overall corporate objectives.
Goal congruence
Managers will be motivated to improve the performance of their division, possibly at
the expense of the larger organisation.
Controllability
Divisional managers should only be held accountable for those factors that they can
control. The performance of a division's manager must be appraised separately to the
performance of the division. It may be difficult to determine exactly what is and what is
not controllable.
Inter-dependence of divisions
The performance of one division may depend to some extent on others, making it
difficult to measure performance levels.
Head office costs
Whether or how head office costs should be reapportioned.
Transfer prices
How transfer prices should be set as these effectively move profit from one division to
another.
545
I. DIVISIONALISATION
4. Responsibility accounting
Responsibility accounting is the term used to describe decentralisation of authority,
with the performance of the decentralised units measured in terms of accounting
results.
Responsibility accounting is used to measure performance of decentralised units
Responsibility
structure
Cost centre
Revenue centre
Profit centre
•
•
•
•
Manager’s area of
responsibility
Controllable costs
Revenues only
Controllable costs
Sales prices (including
transfer prices)
•
•
•
•
•
•
•
•
Investment centre
•
•
•
•
Controllable costs
Sales prices (including
transfer prices)
Output volumes
Investment in non-current
assets and working capital
•
•
•
•
Principal performance
measures
Variance analysis
Efficiency measures
Revenues
All of the above PLUS:
Total sales and market
share.
Profit.
Sales variances.
Working capital ratios
(depending on the
division concerned).
All of the above PLUS:
Return on investment
Residual income
Other financial ratios
546
II. DIVISIONAL PERFORMANCE MEASUREMENT
Overview
Within an investment centre, as well as being responsible for profits, managers also have
responsibility over investments and assets. To measure their performance purely on say
profit would be focusing only on part of the picture. To overcome this, we use two methods
that measure the assets and the profit they generate.
Return in investment
(ROI)
Performance of
an investment
centre
Residual income
(RI)
547
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
Return on investment (ROI) shows how much profit has been made in relation to the
amount of capital invested.
ROI is generally regarded as the key performance measure. The main reason for its
widespread use is that it ties in directly with the accounting process, and is identifiable
from the statement of profit or loss and statement of financial position.
548
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.1
Measuring ROI
Popular formula:
ROI =
Divisional controllable profit
Divisional investment
× 100%
Where:
•
Divisional controllable profit = profit before interest and tax (PBIT).
•
Divisional investment = opening book value of total assets less current liabilities OR
an average book value of net assets may be used.
Decision rules
If ROI > cost of capital (required return), then accept the project or
appraise the division as performing favourably.
Notes:
•
ROI is the divisional equivalent of ROCE.
•
There is no generally agreed method of calculating ROI, and it can have behavioural
implications and lead to dysfunctional decision-making when used as a guide to
investment decisions
549
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.1.1
Profits
The performance of the investment centre manager
It should seem reasonable to base profit on the revenues and costs controllable
by the manager and exclude service and head office costs except those costs
specifically attributable to the investment centre.
The performance of the investment centre
The inclusion of general service and head office costs would seem reasonable.
550
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.1.2
Elements of the investment base
Although we have looked at how the investment base should be valued, we need to
consider its appropriate constituent elements.
The manager's performance evaluation
•
•
Only those assets which can be traced directly to the division and are
controllable by the manager should be included.
Head office assets or investment centre assets controlled by head office should
not be included.
For example, only those cash balances actually maintained within an investment
centre itself should be included.
The evaluation of the performance of the investment centre
A proportion of the investment in head office assets would need to be included
because an investment centre could not operate without the support of head office
assets and administrative backup.
551
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.1.3
Problems with ROI
Using ROI as a divisional performance measure can incur the following problems:
1
Dysfunctional behaviour – only projects which increase ROI will be accepted;
this could be at the expense of growth in corporate profits
2
The ratio will be distorted by the age of the assets
3
Profit can be manipulated
Manipulating the ROI
•
•
If a manager’s bonus depends on ROI being met, the manager may feel pressured
into manipulating the measure.
The asset base of the ratio can be altered by increasing/decreasing payables and
receivables (by speeding up or delaying payments and receipts).
Notes: Exam focus point
You must learn the problems with using ROI. A Section C question could contain a
scenario in which ROI is being used and abused. You would need to use the scenario to
demonstrate each problem.
552
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.2
ROI and new investments
If investment centre performance is judged by ROI, we should expect that the managers of
investment centres will probably decide to undertake new capital investments only if these
new investments are likely to increase the ROI of their centre.
Example 1 (Question): ROI and new investment
Suppose that an investment centre, A, currently makes a return of 40% on capital
employed. The manager of centre A would probably only want to undertake new
investments that promise to yield a return of 40% or more, otherwise the
investment centre's overall ROI would fall.
If investment centre A currently has assets of $1,000,000 and expects to earn a
profit of $400,000.
Required:
How would the centre's manager view a new capital investment which would
cost $250,000 and yield a profit of $75,000 pa?
553
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
ROI and new investments
1.2
Example 1 (Solution): ROI and new investment
Without the new investment
With the new investment
Profit
$400,000
$475,000
Capital employed
$1,000,000
$1,250,000
40%
38%
ROI
The new investment would reduce the investment centre's ROI from 40% to 38%,
and so the investment centre manager would probably decide not to undertake
the new investment.
If the group of companies of which investment centre A is a part has a target ROI
of 25%, the new investment would presumably be seen as beneficial for the
group as a whole.
But even though it promises to yield a return of 75,000/250,000 = 30%, which is
above the group's target ROI, it would still make investment centre A's results
look worse.
 The manager of investment centre A would be motivated to do not what is
best for the organisation as a whole, but what is best for his or her division.
554
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.2
ROI and new investments
Notes:
The June 2018 examining team report highlighted an error that students continue to
make with regard to investments and ROI. You must read exam questions carefully. If
the ROI of an investment is asked for, rather than the ROI of the division as a whole, you
must only include the profits and capital flows relating to the investment itself. If the
question asks for the ROI of the division after an investment has been made, then you
would include the other business's profit and assets in the calculation.
From above example, we see that:
ROI should not be used to guide investment decisions as there is a difficult
motivational problem.
If management performance is measured in terms of ROI, any decisions which
benefit the company in the long term but which reduce the ROI in the immediate
short term would reflect badly on the manager's reported performance.
Good investment decisions would make a manager's performance seem
worse than if the wrong investment decision were taken instead
555
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.2
ROI and new investments
Notes:
The June 2018 examining team report highlighted a question on performance
management that caused problems for students in the exam. The question related to
decisions made by a manager which could lead to a bonus without benefiting the
organisation. Make sure you understand the relationship between ROI, investments and
bonuses. The examining team said, 'Holding on to heavily depreciated assets gives a low
figure for ‘capital employed’ which, in turn, gives a higher figure for ROI which could
lead to bonuses for divisional managers. However, there are likely to be higher running
costs for an old machine, making the organisation less profitable than it might be. Low
depreciation charges may also hide this but cash flow would be affected.'
556
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
ROI is a popular measure for divisional performance but has some serious failings which
must be considered when interpreting results.
Advantages
It is widely used and accepted
since it is line with ROCE which is
frequently used to assess overall
business performance.
As a relative measure it enables
comparisons to be made with
divisions or companies of different
sizes.
It can be broken down into
secondary ratios for more detailed
analysis (profit margin and asset
turnover).
Disadvantages
It may lead to
decision making.
dysfunctional
ROI increases with the age of the
asset if NBVs are used, thus giving
managers an incentive to hang on
to possibly inefficient, obsolescent
machines.
It may encourage the manipulation
of profit and capital employed
figures to improve results.
Different accounting policies can
confuse comparisons.
557
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Question): (December 2017 - Q32a)
Sports Co is a large manufacturing company specialising in the manufacture of a
wide range of sports clothing and equipment. The company has two divisions:
Clothing (Division C) and Equipment (Division E). Each division operates with little
intervention from Head Office and divisional managers have autonomy to make
decisions about long-term investments.
Sports Co measures the performance of its divisions using return on investment
(ROI), calculated using controllable profit and average divisional net assets. The
target ROI for each of the divisions is 18%. If the divisions meet or exceed this
target the divisional managers receive a bonus.
Last year, an investment which was expected to meet the target ROI was rejected
by one of the divisional managers because it would have reduced the division’s
overall ROI. Consequently, Sports Co is considering the introduction of a new
performance measure, residual income (RI), in order to discourage this
dysfunctional behaviour in the future. Like ROI, this would be calculated using
controllable profit and average divisional net assets.
558
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Question): (December 2017 - Q32a)
The draft operating statement for the year, prepared by the company’s trainee
accountant, is shown below:
Sales revenue
Less variable costs
Contribution
Less fixed costs
Net profit
Opening divisional controllable net assets
Closing divisional controllable net assets
Division C
$’000
3,800
(1,400)
2,400
(945)
1,455
13,000
9,000
Division E
$’000
8,400
(3,030)
5,370
(1,420)
3,950
24,000
30,000
559
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Question): (December 2017 - Q32a)
Notes:
(1) Included in the fixed costs are depreciation costs of $165,000 and $460,000 for
Divisions C and E respectively.
30% of the depreciation costs in each division relates to assets controlled but not
owned by Head Office.
Division E invested $2m in plant and machinery at the beginning of the year, which is
included in the net assets figures above, and uses the reducing balance method to
depreciate assets. Division C, which uses the straight-line method, made no
significant additions to non-current assets. It is the policy of both divisions to charge
a full year’s depreciation in the year of acquisition.
(2) Head Office recharges all of its costs to the two divisions. These have been
included in the fixed costs and amount to $620,000 for Division C and $700,000 for
Division E.
(3) Sports Co has a cost of capital of 12%.
560
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Question): (December 2017 - Q32a)
Required:
(i) Calculate the return on investment (ROI) for each of the two divisions of Sports
Co.
(ii) Discuss the performance of the two divisions for the year, including the main
reasons why their ROI results differ from each other. Explain the impact the
difference in ROI could have on the behaviour of the manager of the worst
performing division.
561
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Solution): (December 2017 - Q32a)
(i) Formula:
Controllable profit
Return on investment = Divisional investment
Controllable profit
Net profit
Add back depreciation on non-controllable assets
Add back Head Office costs
Controllable profit
Division C
$’000
Division E
$’000
1,455
49.5
620
2,124.5
3,950
138
700
4,788
Division C
$’000
13,000
9,000
11,000
Division E
$’000
24,000
30,000
27,000
Divisional investment = Average divisional net assets
Opening assets
Closing assets
Average assets
562
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
Evaluation of ROI as a performance measure
1.3
Example 2 (Solution): (December 2017 - Q32a)
ROI for each division:
Division C
$’000
Division E
$’000
Controllable profit
2,124.5
4,788
Average assets
11,000
27,000
ROI
19.3%
17.7%
(ii) Division performance
Whilst Division C has exceeded the target ROI, Division E has not. If controllable
profit in relation to revenue is considered, Division C’s margin is 56% compared to
Division E’s margin of 57%, so Division E is actually performing slightly better.
However, Division E has a larger asset base than Division C too
 Hence the fact that Division C has a higher ROI.
563
II. DIVISIONAL PERFORMANCE MEASUREMENT
1. Return on investment (ROI)
1.3
Evaluation of ROI as a performance measure
Example 2 (Solution): (December 2017 - Q32a)
Explanation:
•
Higher net assets
Since Division E appears to be a much larger division and is involved in sports
equipment manufacturing, then it could be expected to have more assets. Division
E’s assets have gone up partly because it made substantial additions to plant and
machinery.
•
Lower profit
This means that as well as increasing the average assets figure, the additions will
have been depreciated during the year, thus leading to lower profits. This may
potentially have had a large impact on profits since Division E uses the reducing
balance method of depreciation, meaning that more depreciation is charged in the
early years.
Division manager evaluation
Based on the ROI results, the manager of Division C will get a bonus and the
manager of Division E will not. This will have a negative impact on the motivation
level of the manager of Division E and may discourage him from making future
investments, unless a change in the performance measure used is adopted.
564
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
An alternative way of measuring the performance of an investment centre, instead of using
ROI, is residual income (RI).
Residual income is a measure of the centre’s profits after deducting a notional or
imputed interest cost.
The centre's profit is after deducting depreciation on capital equipment.
The imputed cost of capital might be the organisation's cost of borrowing
or its weighted average cost of capital.
RI can sometimes give results that avoid the behavioural
problem of dysfunctionality.
565
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.1
Measuring RI
Formula:
RI = Controllable profit – Notional interest on capital
Where:
•
Controllable profit is calculated in the same way as for ROI – it may be PBIT.
•
Notional interest on capital = the capital employed × notional cost of capital.
o Capital employed is calculated in the same way as for ROI.
o Cost of capital could be the company’s average cost of funds (cost of capital) or
other interest rates might be selected (the current cost of borrowing, or a
target ROI).
Decision rules
If the RI is positive:
•
Accept the project
•
Appraise the division as performing favourably.
566
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
Measuring RI
2.1
Example 2 (Question): Residual income
A division with capital employed of $400,000 currently earns an ROI of 22%. It can
make an additional investment of $50,000 for a five-year life with nil residual value.
The average net profit from this investment would be $12,000 after depreciation.
The division's cost of capital is 14%.
Required:
What are the residual incomes before and after the investment?
Solution:
Divisional profit
Imputed interest
Residual income
Before investment
$
88,000
($400,000 × 22%)
56,000
(400,000 × 0.14)
32,000
After investment
$
100,000
63,000
(450,000 × 0.14)
37,000
567
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.2
Evaluation of RI as a performance measure
Compared to using ROI, RI has several advantages and disadvantages:
Advantages
Disadvantages
It reduces the problems of ROI, i.e.
dysfunctional
behaviour
and
holding onto old assets.
It is difficult to decide upon an
appropriate cost of capital.
Interpreting the result is simple; if
the RI is positive then the division is
generating a return above that
required by the finance providers.
The cost of financing a division is
brought home to divisional
managers.
Different costs of capital can be
applied to different divisions based
on their risk profiles.
It does not facilitate comparisons
between divisions since the RI is
driven by the size of the divisions
and their investment.
It does not always result in
decisions that are in the best
interests of the company.
Different accounting policies can
confuse comparisons.
It is based on accounting measures
of profit and capital employed
which may be subject to
manipulation.
568
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.2
Evaluation of RI as a performance measure
Example 2 (Question): December 2017 - Q32a
Sports Co is a large manufacturing company specialising in the manufacture of a
wide range of sports clothing and equipment. The company has two divisions:
Clothing (Division C) and Equipment (Division E). Each division operates with little
intervention from Head Office and divisional managers have autonomy to make
decisions about long-term investments.
Sports Co measures the performance of its divisions using return on investment
(ROI), calculated using controllable profit and average divisional net assets. The
target ROI for each of the divisions is 18%. If the divisions meet or exceed this target
the divisional managers receive a bonus.
Last year, an investment which was expected to meet the target ROI was rejected
by one of the divisional managers because it would have reduced the division’s
overall ROI. Consequently, Sports Co is considering the introduction of a new
performance measure, residual income (RI), in order to discourage this
dysfunctional behaviour in the future. Like ROI, this would be calculated using
controllable profit and average divisional net assets.
569
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.2
Evaluation of RI as a performance measure
Example 2 (Question): December 2017 - Q32a
The draft operating statement for the year, prepared by the company’s trainee
accountant, is shown below:
Division C
$’000
Division E
$’000
Sales revenue
3,800
8,400
Less variable costs
(1,400)
(3,030)
Contribution
2,400
5,370
Less fixed costs
(945)
(1,420)
Net profit
1,455
3,950
Opening divisional controllable net assets
13,000
24,000
Closing divisional controllable net assets
9,000
30,000
570
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.2
Evaluation of RI as a performance measure
Example 2 (Question): December 2017 - Q32a
Notes:
(1) Included in the fixed costs are depreciation costs of $165,000 and $460,000 for
Divisions C and E respectively.
30% of the depreciation costs in each division relates to assets controlled but not
owned by Head Office.
Division E invested $2m in plant and machinery at the beginning of the year, which is
included in the net assets figures above, and uses the reducing balance method to
depreciate assets. Division C, which uses the straight-line method, made no
significant additions to non-current assets. It is the policy of both divisions to charge
a full year’s depreciation in the year of acquisition.
(2) Head Office recharges all of its costs to the two divisions. These have been
included in the fixed costs and amount to $620,000 for Division C and $700,000 for
Division E.
(3) Sports Co has a cost of capital of 12%.
Required:
Calculate the residual income (RI) for each of the two divisions of Sports Co and
briefly comment on the results of this performance measure.
571
II. DIVISIONAL PERFORMANCE MEASUREMENT
2. Residual income (RI)
2.2
Evaluation of RI as a performance measure
Example 2 (Solution): December 2017 - Q32a
Residual income
Division C
$’000
Division E
$’000
Controllable profit
2,124.5
4,788
Less: imputed charge on assets at 12%
(1,320)
(3,240)
Residual income
804.5
1,548
Comment
From the residual income results, it can clearly be seen that both divisions have
performed well, with healthy RI figures of between $0·8m and $1·55m.
The cost of capital of Sports Co is significantly lower than the target return on
investment which the company seeks, making the residual income figure show a
more positive position.
572
II. DIVISIONAL PERFORMANCE MEASUREMENT
3. ROI versus RI
Used more frequently
in practice
ROI
RI
Technically superior
ROI is consistent with corporate assessment (ROCE).
Ratios are more easily understood compared with, say, costs of capital
and are more appropriate for comparing divisions of different sizes.
Calculation of the cost of capital in RI is subjective and time-consuming.
A company may feel that the dysfunctional behaviour associated with
ROI, such as underinvestment, is unlikely to occur.
For example, if a company is using ROI as a part of a balanced scorecard then
customer, internal business and innovation measures should all highlight the impact
of underinvestment.
573
II. DIVISIONAL PERFORMANCE MEASUREMENT
3. ROI versus RI
Using ROI or RI can lead to different decision whether a marginally profitable investment
should be undertaken or not.
Return on investment (ROI)
A marginally profitable investment
would be less likely to be undertaken
because it would reduce the average
ROI earned by the centre as a whole.
VS
Residual income (RI)
A marginally profitable investments
are likely to be undertaken by the
investment centre manager. Because
Residual income will increase if
•
Earned profit in excess of the
imputed interest charge on the
acquisition.
•
The investment only just exceeds
the imputed interest charge.
574
II. DIVISIONAL PERFORMANCE MEASUREMENT
3. ROI versus RI
Example 3 (Question): ROI versus RI
Suppose that Department H has the following profit, assets employed and an
imputed interest charge of 12% on operating assets.
$
Operating profit
Operating assets
Imputed interest (12%)
Return on investment
Residual income
$
30,000
100,000
12,000
30%
18,000
Suppose now that an additional investment of $10,000 is proposed, which will
increase operating income in Department H by $1,400. The effect of the investment
would be:
Operating profit
Operating assets
Imputed interest (12%)
Return on investment
Residual income
$
31,400
$
110,000
13,200
28.5%
18,200
Required: Assess the projects using both ROI and RI.
575
II. DIVISIONAL PERFORMANCE MEASUREMENT
3. ROI versus RI
Example 3 (Solution): ROI versus RI
If the Department H manager is made responsible for the department's
performance, since there would be a marginal increase of $200 in RI from the
investment, but a fall of 1.5% in ROI.
They would resist the new investment if they were to be judged on ROI
They would welcome the investment if they were judged according to RI
The marginal investment offers a return of 14% ($1,400 on an investment of
$10,000) which is above the 'cut-off rate' of 12%. Since the original return on
investment was 30%, the marginal investment will reduce the overall divisional
performance.
Indeed, any marginal investment offering an accounting rate of return of less
than 30% in the year would reduce the overall performance.
Notes:
Examination questions on residual income may focus on the sort of behavioural aspects
of investment centre measurement that we have discussed above; for example, why it is
considered necessary to use residual income to measure performance rather than ROI,
and why residual income might influence an investment centre manager's investment
decisions differently.
576
II. DIVISIONAL PERFORMANCE MEASUREMENT
3. ROI versus RI
Both ROI and RI are calculated based on “profit” and “divisional investment”, so the
following problem with calculation can arise:
Calculation of ‘profit’
May need to be adjusted to reflect
controllable and traceable items
only
Transfer prices or quantities may
be imposed or set at noncommercial rates.
Calculation of ‘investment’
Historical,
net
replacement value.
book
or
Using net book value (NBV)
discourages replacement.
Replacement value is complex
to obtain and update
Both ignore tax.
Cash may be controlled by the
company’s treasury department.
Intangible assets may have no
accounting value or may be
complex to update. Hard to apply
to service divisions (create more
value from intangible assets).
577
III. TRANSFER PRICING
1. General theory
A transfer price is the price at which goods or services are transferred from one
department to another, or from one member of a group to another.
Within a decentralised organisation, there may be a division which makes units that
are then transferred to another division.
It will usually be necessary to charge the receiving division for the goods that it has
received in order for performance to be measured equitably.
The price charged is called a transfer price and it can be calculated in several different ways.
Transfer
pricing
Organization ‘s head
office
Division A
Division B
Division C
Transfer
pricing
The transfer pricing policy will have a significant impact on responsibility accounting and
performance measurement.
578
III. TRANSFER PRICING
1. General theory
It is vital that the transfer price is carefully selected to ensure all parties act in the best
interest of the company. The overriding question should be:
Whether the transfer is in the company’s best interest
Objectives of a transfer pricing system
Terms
Explanations
Goal congruence
The decisions made by each profit centre manager should be
consistent with the objectives of the organisation as a whole.
Performance
measurement
The buying and supply divisions will be treated as profit
centres. The transfer price should allow the performance of
each division to be assessed fairly.
Divisional managers will be demotivated if this is not
achieved.
Autonomy
The system used to set the transfer price should seek to
maintain the autonomy of the divisional managers.
This autonomy will improve managerial motivation.
Recording the
movement of goods
and services
Assist in recording the movement of goods and services
579
III. TRANSFER PRICING
1. General theory
Example 4: Transfer pricing illustration
Subsidiary A might make a component that is used as part of a product made by
subsidiary B of the same company, but that can also be sold to the external market,
including makers of rival products to subsidiary B's product. There will therefore be
two sources of revenue for A.
•
External sales revenue from sales made to other organisations.
•
Internal sales revenue from sales made to other responsibility centres within
the same organisation, valued at the transfer price.
The diagram below shows how two divisions of a company could make decisions
that are not in the best interests of the whole company.
This is an essential described
diagram for transfer pricing
580
III. TRANSFER PRICING
1. General theory
Example 4: Transfer pricing illustration
The Supply
division
May want to sell their products to external customers as
they are willing to pay a higher price than the internal
transfer price
The Receive
division
May be able to source the products cheaper from an
external supplier
Overall, these decisions may have negative impacts (both financial and
non-financial) on the company as a whole, so a transfer price must be
set at a level that satisfies both divisions
581
III. TRANSFER PRICING
2. Criteria for designing a transfer pricing policy
Transfer prices shoule be set in a way that:
Promote but still control divisional autonomy
Ideally when not prejudicing divisional performance measurement
Avoid discouraging overall corporate profit maximisation (goal congruence)
582
III. TRANSFER PRICING
2. Criteria for designing a transfer pricing policy
2.1
Divisional autonomy
Logic:
Transfer prices are particularly appropriate for profit centres because if one profit
centre does work for another, the size of the transfer price will affect the costs of one
profit centre and the revenues of another.
However, the following problem may arise:
A danger with profit centre accounting is that the business
organisation will divide into a number of self-interest segments, each
acting at times against the wishes and interests of other segments.
A profit centre manager might take decisions in the best interests of
their own part of the business, but against the best interests of other
profit centres and possibly the organisation as a whole.
583
III. TRANSFER PRICING
2. Criteria for designing a transfer pricing policy
2.1
Divisional autonomy
With the problem, following solutions are suggested:
A task of head office is therefore to try to prevent dysfunctional decision
making by individual profit centres. To do this, it must reserve some power
and authority for itself and so profit centres cannot be allowed to make
entirely autonomous decisions.
A balance ought to be kept between divisional autonomy to provide
incentives and motivation, and retaining centralised authority to ensure that
the organisation's profit centres are all working towards the same target, the
benefit of the organisation as a whole (in other words, retaining goal
congruence among the organisation's separate divisions).
584
III. TRANSFER PRICING
2. Criteria for designing a transfer pricing policy
2.2
Divisional performance measurement
Logic:
Profit centre managers tend to put their own profit performance above everything else.
Since profit centre performance is measured according to the profit they earn, no profit
centre will want to do work for another and incur costs without being paid for it.
Profit centre managers are likely to dispute the size of transfer prices
with each other, or disagree about whether one profit centre should
do work for another or not. Transfer prices affect behaviour and
decisions by profit centre managers.
585
III. TRANSFER PRICING
2. Criteria for designing a transfer pricing policy
2.3
Corporate profit maximization (goal congruence)
Logic:
When there are disagreements about how much work should be transferred between
divisions, and how any sales the division should make to the external market, there is
presumably a profit-maximising level of output and sales for the organisation as a
whole.
However, unless each profit centre also maximises its own profit at
this same level of output, there will be interdivisional disagreements
about output levels and the profit-maximising output will not be
achieved.
586
III. TRANSFER PRICING
3. Setting the transfer price
There are 2 main methods available:
Method
Marketbased
In perfect
market
In imperfect
market
Full cost
Impact on supply division
•
•
Earns same profit as •
external sales or higher.
Equitable performance
management
•
Full cost plus
%
Happy to accept transfer
(cannot buy cheaper
elsewhere)
Equitable performance
management
No incentive to transfer Happy to accept (if less than
unless spare capacity
market price)
Variable cost No incentive to transfer
Costbased
Impact on buying division
Happy to accept
Covers
all
costs
and May not accept as price
contributes to profit so could be higher than market
happy to sell
price
Variable cost May not cover all fixed costs
plus %
Will accept if lower than
market price
587
III. TRANSFER PRICING
3. Setting the transfer price
3.1
Market-based approach
Market-based approach will be used where there is an external market for the product
being transferred.
The choice of the market price of a product that is equivalent and comparable to the
intermediate product is one option for the determination of a transfer price.
Now, we remind the transfer pricing diagram from Example 4:
588
III. TRANSFER PRICING
3. Setting the transfer price
3.1.1
Market-based approach in the perfect market
In a perfect market, the following conditions must apply:
A market for the intermediate
product or a full substitute exists
Transactions of the company
divisions may not influence the
market price
There is a uniform market price
The market price should fit the
decision. It should not be affected
by short-term price considerations.
Therefore, in the perfect market, there is one and only one price of the transferred product
on the market. That means the price of external sales is equal to its of the alternative
supplier.
589
III. TRANSFER PRICING
3. Setting the transfer price
3.1.1
Market-based approach in the perfect market
Example 8 (Question): Transferring goods in a perfect market
A company has two profit centres, A and B. Centre A sells half of its output on the
open market and transfers the other half to B. Costs and external revenues in an
accounting period are as follows. Assume that, Division A sells goods externally at
market price and the market is perfect.
A
$’000
B
$’000
Total
$’000
External sales
8
24
32
Costs of production
12
10
22
Company profit
10
Required: What are the consequences of setting a transfer price at market value?
590
III. TRANSFER PRICING
3. Setting the transfer price
3.1.1
Market-based approach in the perfect market
Example 8 (Solution): Transferring goods in a perfect market
If the transfer price is at market price, A would be happy to sell the output to B for
$8,000, which is what A would get by selling it externally instead of transferring it.
A
B
Total
$’000 $’000 $’000 $’000
$’000
Market sales
Transfer sales
Total sales
Transfer costs
Own cost
Total cost
Profit
8
8
16
(12)
24
24
(8)
(10)
(12)
4
32
(22)
(18)
6
10
The consequences, therefore, are as follows:
•
A earns the same profit on transfers as on external sales. B must pay a
commercial price for transferred goods, and both divisions will have their profit
measured fairly.
•
A will be indifferent about selling externally or transferring goods to B because
the profit is the same on both types of transactions. B can therefore ask for and
obtain as many units as it wants from A.
591
III. TRANSFER PRICING
3. Setting the transfer price
3.1.1
Market-based approach in the perfect market
Notes:
•
A market-based transfer price can only be applied if a valid market price is
available for the goods being transferred between the divisions. That means if a
perfectly competitive market exists for the product, then the market price is the
best transfer price.
•
Adjusted market price: care must be taken to ensure the division's product is the
same as that offered by the market (for example, quality and delivery terms are the
same). If not, an adjusted market price should be used.
592
III. TRANSFER PRICING
3. Setting the transfer price
3.1.1
Market-based approach in the perfect market
Advantages
Disadvantages
Divisional autonomy
•
•
•
Division A has the freedom to sell
on the open market, or with B
Simply B can decide whether to buy
from the open market or from A
So autonomy is good using a
market-based transfer price
Corporate Profit Maximisation
•
•
•
Using market price, strangely you
can still expect B to buy from A - as
there should be a better quality of
service, greater flexibility, and
dependability of supply.
Division A will more likely sell to B
than the open market due to
cheaper costs of administration,
selling and transport.
A market price as the transfer price
would therefore result in decisions
that would be in the best interests
of the group as a whole.
The market price may not be perfect affected temporarily perhaps by adverse
economic conditions, or dumping, or
depend on the volume of output supplied
to the external market
Similarly, products may not be identical in
the market
A market price works better when
Division A is at full capacity
If Division A has the spare capacity (it
means no more demand from the
external market) then charging a market
price doesn't make sense
593
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
In an imperfect market, where the market price is affected by factors such as the amount
the company setting the transfer price supplies to it, or there is only a limited external
demand
The market prices which is issued by other parties are different
Apply for transfer pricing diagram, we have prices of external sales and the alternative
supplier are different.
For example,
$10 Per product
$11 Per product
$9 Per product
In this case, there is no way to set an optimal transfer price, but we ought to determine the
range of internal transfer price
594
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
a. Transfer price range (Range of potential agreement – ROPA)
The limits within which transfer prices should fall are as follows.
Minimum
The sum of the supplying division's marginal cost and the opportunity cost of the item
transferred.
Maximum
The lower of external market price and net marginal margin, less any internal cost
savings in packaging and delivery.
595
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
a. Transfer price range (Range of potential agreement – ROPA)
The limits within which transfer prices should fall are as follows.
596
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
a. Transfer price range (Range of potential agreement – ROPA)
Opportunity cost is defined as the 'value of the best alternative that is foregone when a
particular course of action is undertaken'
The opportunity cost included in determining the minimum limit will be one of the
following.
The maximum contribution is forgone by the supplying division in transferring
internally rather than selling goods externally.
The contribution is forgone by not using the same facilities in the producing division
for their next best alternative use.
597
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
a. Transfer price range (Range of potential agreement – ROPA)
Example 6:
Division X produces product L at a marginal cost per unit of $100. If a unit is
transferred internally to division Y, a $25 contribution is forgone on an external sale.
The item can be purchased externally for $150. Ignore internal cost-saving.
The lowest market price which is purchased externally
$150
Transfer price
Maximum
$150
Minimum
$125
Marginal cost
$100
Opportunity cost
$25
The difference between the two results ($25) represents the savings from producing
internally as opposed to buying externally.
598
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Following the opportunity cost definition, there will only be an opportunity cost if the seller
does not have any spare capacity.
Scenario 1: The supply division has a surplus capacity (spare capacity)
Following the opportunity cost definition, there will only be an opportunity cost if the
seller does not have any spare capacity.
(*) The marginal cost of buying division final product
599
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Following the opportunity cost definition, there will only be an opportunity cost if the seller
does not have any spare capacity.
Scenario 2: The supply division does not have any surplus capacity (full capacity)
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to
meet all external demand and internal demand
(*) The marginal cost of buying division final product
600
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Question): Spare and full capacity
Until recently, Strike Co focused exclusively on making soles for work boots and
football boots. It sold these rubber soles to boot manufacturers. Last year the
company decided to take advantage of its strong reputation by expanding into the
business of making football boots. As a consequence of this expansion, the company
is now structured as two independent divisions, the Boot Division and the Sole
Division.
The Sole Division continues to make rubber soles for both football boots and work
boots and sells these soles to other boot manufacturers. The Boot division
manufactures leather uppers for football boots and attaches these uppers to rubber
soles. During its first year, the Boot Division purchased its rubber soles from outside
suppliers so as not to disrupt the operations of the Sole Division.
Strike management now wants the Sole Division to provide at least some of the
soles used by the Boot Division. The table below shows the contribution margin for
each division when the Boot Division purchases from an outside supplier.
601
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Question): Spare and full capacity
Boot Division
Selling price of football boot
Variable cost of making boot
(not including sole)
Sole Division
$
100
Selling price of sole
$
28
(45)
Variable cost per sole
(21)
Contribution margin per unit
7
Cost of sole purchased from
outside suppliers
(25)
Contribution margin per unit
30
The information above indicates that the total contribution margin per unit is $37
($30 + $7).
Required:
What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot
Division?
602
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Solution): Spare and full capacity
The answer depends on how busy the Sole Division is – that is, whether it has spare
capacity.
Supply division
Receive division
Sole Division
Boot Division
Full capacity
The Sole Division charges $28 and derives a contribution margin of $7 per sole. The
Sole Division has no spare capacity and produces and sells 80,000 units (soles) to
outside customers.
 Opportunity cost has occurred.
Minimum price supply division will accept:
The Sole Division must receive from the Boot Division a payment that will at least
cover its variable cost per sole plus its lost contribution margin per sole (scenario 2).
The minimum transfer price that would be acceptable to the Sole Division is: $21
(variable cost) + $7 (opportunity cost) = $28
603
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Solution): Spare and full capacity
The Boot Division cannot cover the minimum selling price of Sole Division, it should
not sell soles to the Boot Division.
604
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Solution): Spare and full capacity
Spare capacity
The minimum transfer price is different if a division has spare capacity.
Assume the Sole Division produces 80,000 soles but can only sell 70,000 to the open
market. As a result, it has an available capacity of 10,000 units.
 The Sole Division does not lose its contribution margin of $7 per unit, and
therefore the minimum price it would now accept is $21 (variable cost) + $0
(opportunity cost) = $21
605
III. TRANSFER PRICING
3. Setting the transfer price
3.1.2
Market-based approach in the imperfect market
b. The transfer price at full and spare capacity
Example 7 (Solution): Spare and full capacity
In this case, the Boot Division and the Sole Division should negotiate a transfer price
within the range of $21 and $25 (cost from an outside supplier).
606
III. TRANSFER PRICING
3. Setting the transfer price
3.2
Cost-based approaches
Cost-based approaches to transfer pricing are often used in practice because in practice the
following conditions are common:
There is no external market for the product that is being transferred.
Although there is an external market, it is an imperfect one (because the
market price is affected by factors such as the amount the company setting
the transfer price supplies to it, or there is only a limited external demand).
In either case, there will not be a suitable market price on which to base the
transfer price.
607
III. TRANSFER PRICING
3. Setting the transfer price
3.2
Cost-based approaches
The supply division may well just be a cost centre
Transfer prices determined on the the costs of the supplying division
(the recieve division only knows the transfer price afterwards)
The supply division would supply the goods at:
Cost
A standard cost should be used rather
than the actual cost since:
Actual costs do not encourage the
supply division to control costs.
If a standard cost is used, the buying
division will know the cost in advance
and can therefore put plans in place.
Different standard costs that could
be used:
Full cost
Marginal cost
(variable cost)
Profit margin
Should be based on the cost of product
and presented under the percentage of
cost.
608
III. TRANSFER PRICING
3. Setting the transfer price
3.2.1
Transfer prices based on full cost & full cost plus
Under this approach, the full cost (including fixed overheads absorbed) incurred by the
supplying division in making the 'intermediate' product is charged to the receiving division.
If a full cost plus approach is used, a profit margin is also included in this transfer price.
An intermediate product is one that is used as a component of another product, for
example, car headlights or food additives.
609
III. TRANSFER PRICING
3. Setting the transfer price
3.2.1
Transfer prices based on full cost & full cost plus
Example 9 (Question): Transfers at full cost and full cost plus
S company has two profit centres, A and B. Centre A can only sell half of its
maximum output externally because of limited demand. It transfers the other half
of its output to B, which also faces limited demand. Costs and revenues in an
accounting period are as follows.
A
B
Total
$’000
$’000
$’000
External sales
Costs of production
Company profit
8
12
24
10
32
22
10
Note that:
•
There are no opening or closing inventories.
•
It does not matter here whether marginal or absorption costing is used and we
shall ignore the question of whether the current output levels are profit
maximising and congruent with the goals of the company as a whole.
Required:
What are the consequences of setting a transfer price at full cost?
610
III. TRANSFER PRICING
3. Setting the transfer price
3.2.1
Transfer prices based on full cost & full cost plus
Example 9 (Solution): Transfers at full cost and full cost plus
Transfer price at full cost only
If the transfer price is at full cost, A in our example would have 'sales' to B of $6,000
(costs of $12,000 × 50%). This would be a cost to B, as follows.
A
$’000
Open market sales
Transfer sales
Total sales
Transfer costs
Own cost
Total cost
Profit
B
$’000
$’000
8
6
14
(12)
$’000
24
24
(6)
(10)
(12)
2
Total
$’000
32
(22)
(16)
8
10
The transfer sales of A are self-cancelling with the transfer costs of B so that
total profits are unaffected by the transfer items. The transfer price simply
spreads the total profit of $10,000 between A and B.
611
III. TRANSFER PRICING
3. Setting the transfer price
3.2.1
Transfer prices based on full cost & full cost plus
Example 9 (Solution): Transfers at full cost and full cost plus
Analysis
The obvious drawback to the transfer price at cost is that A makes no profit on its
work, and the manager of Division A would much prefer to sell output on the open
market to earn a profit, rather than transfer to B, regardless of whether or not
transfers to B would be in the best interests of the company as a whole. Division A
needs a profit on its transfers in order to be motivated to supply B.
Transfer pricing at cost is inconsistent with the use of a profit centre
accounting system.
612
III. TRANSFER PRICING
3. Setting the transfer price
3.2.1
Transfer prices based on full cost & full cost plus
Example 9 (Solution): Transfers at full cost and full cost plus
Transfer price at full cost plus
An obvious way of solving this problem is to include a margin in the price which A
charges to B for its work. If the transfers are at cost, plus a margin of 25% for
example, A's sales to B would be $7,500 ($12,000 × 50% × 1.25).
A
B
Total
$’000
$’000
$’000
$’000
$’000
Open market sales
8
24
32
Transfer sales
7.5
Total sales
15.5
24
Transfer costs
(7.5)
Own cost
(12)
(10)
(22)
Total cost
(12)
(17.5)
Profit
3.5
6.5
10
Compared to a transfer price at cost, A gains some profit at the expense of B.
However, A makes a bigger profit on external sales in this case because the profit
mark-up of 25% is less than the profit mark-up on open market sales. The choice of
25% as a profit mark-up was arbitrary and unrelated to external market conditions.
613
III. TRANSFER PRICING
3. Setting the transfer price
3.2.2
Transfer price at variable cost (Marginal cost)
A variable cost approach entails charging the variable cost (which we assume to be the
same as the marginal cost) that has been incurred by the supplying division to the
receiving division.
The supply division (S) should transfer goods to the receive division at the variable cost
(marginal cost) of production if:
S has a spare capacity as the marginal costs reflect the true cost to the
company of the transfer taking place
S has no external market so could operate as a cost centre. If S is a profit
centre, it will be demotivated as fixed costs will not be covered
614
III. TRANSFER PRICING
3. Setting the transfer price
3.2.2
Transfer price at variable cost (Marginal cost)
Example 10 (Question): Transfers at marginal cost (example 9 continue)
S company has two profit centres, A and B. Centre A can only sell half of its
maximum output externally because of limited demand. It transfers the other half
of its output to B, which also faces limited demand. Costs and revenues in an
accounting period are as follows.
A
B
Total
$’000
$’000
$’000
External sales
8
24
32
Costs of production
12
10
22
Company profit
10
Note that:
•
There is no opening or closing inventories.
•
It does not matter here whether marginal or absorption costing is used and we
shall ignore the question of whether the current output levels are profit
maximising and congruent with the goals of the company as a whole.
Required:
What are the consequences of setting a transfer price at marginal cost?
615
III. TRANSFER PRICING
3. Setting the transfer price
Transfer price at variable cost (Marginal cost)
3.2.2
Example 10 (Solution): Transfers at marginal cost (example 9 continue)
A marginal cost approach entails charging the marginal cost that has been incurred
by the supplying division to the receiving division. As above, we shall suppose that
A's cost per unit is $15, of which $6 is fixed and $9 variable.
A
$’000
B
$’000
$’000
Total
$’000
$’000
32
Open market sales
8
24
Transfer sales ($6,000 × 9/15)
3.6
-
Total sales
Transfer costs
11.6
24
-
(3.6)
Own variable cost
(7.2)
(6)
Own fixed cost
(4.8)
(4)
(22)
Total cost
(12)
(13.6)
Profit
(0.4)
10.4
10
616
CHAPTER 19: PERFORMANCE
MANAGEMENT AND CONTROL
617
OVERVIEW
What will you learn?
Performance management and control
I.
Performance management in private organisation
II.
Performance management in not-for-profit organisation
III.
Other considerations in performance management
618
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.1
Use of basic ratios
Ratio
Formula
GPM
Gross profit
×100%
Revenue
High GPM is desirable, indicating either
sales prices are high or production costs are
being kept well under control
Methods to improve:
•
Introduce new product that match the
interest of customers so that it can be
sold at higher margin
•
Use target costing for cost control
OPM
Profit before interest and tax (PBIT)
×100%
Revenue
High OPM is desirable, indicating either
sales prices are high or production costs &
S&A expenses are being kept well under
control
Methods to improve:
•
Introduce new product that match the
interest of customers so that it can be
sold at higher margin
•
Use target costing for cost control
•
Better
control
on
selling
&
administrative expenses
Possible indications and ways to improve
Profitability
619
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.1
Use of basic ratios
Ratio
Formula
ROCE
PBIT
Capital employed (∗) x 100% or
Possible indications and ways to improve
Profitability
More details:
ROCE = Asset turnover x Operating margin
PBIT
Revenue
PBIT
Capital employed = Capital employed x Revenue
(*) Capital employed = Shareholders′ equity+
long-term liabilities (or total assets - current
liabilities)
High ROCE is desirable; which could be
improved by investing in projects that
generate a higher return on capital.
Besides, increase in ROCE could be achieved
by:
•
Increasing operating profit (e.g.
through increase in sales price or
better cost control)
•
Reducing capital employed (e.g.
through the repayment of long term
debt)
Other accounting manipulations to increase
ROCE (e.g delaying investment in new NCA
or intangible assets) should be avoided as
these techniques actually harm the business
Note:
As ROCE can be subdivided into Asset turnover and Operating profit margin, if the business is experiencing
a declining ROCE, this could be due to decline in these 2 ratios.
Make sure to analysize both Asset turnover and OPM to get better insight at ROCE when taking the exam
620
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.1
Ratio
Use of basic ratios
Formula
Possible indications and ways to improve
Liquidity
Current
ratio
Current assets
Current liabilities
This reflects how many times a company can pay its shortterm liabilities with its short-term assets.
Acceptable level could be over 1.
Decrease in this ratio year on year or it is below industry
average could indicate liquidity problems.
Quick ratio
Current assets − Inventories
Current liabilities
Same comment as above (a more conservative way of
current ratio)
Inventory
holding
period
Inventories
x 365
COS
This indicates the average number of days that inventory
items are held for.
•
Increase in this figure could indicate problems in
selling products, leading to obsolete inventory.
•
Decrease in this figure should be investigated as the
company may struggle to manage liquidity
621
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.1
Ratio
Use of basic ratios
Formula
Possible indications and ways to improve
Efficiency
Receivables
collection
period
Trade receivables
×365
Credit sales
An increase in the receivables collection period could
indicate that the company is struggling to management
its debts. Possible steps to improve:
•
Credit checks on customers
•
Improve credit control
A decrease in the receivables collection to amount lower
than industry average may make the company less
competitive.
Payables
payment
period
Trade account payable
×365
Purchases
An increase in payable period could indicate company is
struggling to pay its debts when due. However, it could
simply indicate the company is taking better advantage
of credit period offered.
A decrease in payable period could indicate an improved
ability to pay debts; however, it might also indicate the
company is taking less advantage of credit offer as a
source of finance
622
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.1
Ratio
Use of basic ratios
Possible indications and ways to
improve
Formula
Risk
Gearing
Total long−term debt
Shareholders′ equity + total long−term debt
Interest
cover
Profit before interest and tax
Interest charges
x 100%
High level of gearing indicates a
potential of high risk as company relies
heavily on debt to finance its long-term
needs.
This could be improved by reducing
level of long-term debt and raising
long-term finance using equity.
A decrease in the interest cover
indicates that the company is facing an
increased risk of not being able to meet
its finance payments as they fall due.
The ratio could be improved by taking
steps to increase the operating profit
Notes:
In performance analysis exam questions, remember that financial ratios are one of the
indicators for the performance, its use will only be valuable if further investigated the
reasons behind those figures.
623
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
1. Financial indicators – Financial ratios
1.2
Issues surrounding the use of financial indicator to monitor performance
Short-termism
Linking rewards to financial performance may tempt managers to make decisions
that will improve short-term financial performance but may have a negative
impact on long-term profitability.
For example: Managers may decide to cut investment or to purchase cheaper but
poorer quality materials.
Manipulation of results
In order to achieve financial target, manager may be tempted to manipulate
results by:
Accelerating
revenue
Delaying
costs
Understanding
a provision or
accrual
Manipulation of
accounting
policies
624
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
The only use of financial indicators cannot convey the full picture regarding the factors
that will drive long-term profitability, e.g. customer satisfactions, quality.
When monitoring performance, a broader range of
measurement should be used.
625
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.1. Main perspectives
How we look to shareholder?
Revenue
Expense
Cash flow
At what must we
excel?
Orders
Resource allocation
Quality control
How our customers see us?
Customer satisfaction
Customer retention
Financial
perspective
Customer
perspective
Internal
process
perspective
Learning/
growth
perspective
How can we grow &
change?
Employee satisfaction
Employee skills
Employees turnover
626
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.2 Setting Objectives and Performance measures
Objectives
Measures
Something business want
to achieve
How business determine
whether the objectives have
been met
Note:
In PM exam, the questions of determining objectives/goals and corresponding measures
of 4 aspects in balanced scorecard are highly examinable.
Specifically, for each aspect of the balanced scorecard, we need to determine:
•
Objectives: What is the objective of this aspect?
•
Measures: On what basis can the business determine that the goal has been
achieved?
627
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.3 Example of balanced scorecard
Example 1 (Question): (March/July 2020 Sample past exam extracted)
Exam focus point: Discuss the performance of an organisation under Balanced
scorecard perspectives
Hammock Co owns and operates a small chain of luxury vacation resorts. Hammock
Co’s management currently focus on two objectives:
(1) to make a profit long term;
(2) to create customer loyalty
Extracts from TripEvent, an influential online customer forum:
I love Hammocks Co; the service and attention to detail is exemplary and the
resorts are always pristine. However, their competitor “Loungers” has full
body driers, ionised water taps and a range of professional haircare
equipment in all their rooms.
Our third time back to Hammocks Co this year and we continue to be amazed
by the wonderful level of service. One thing though is the menus don’t seem
to have changed much from one visit to the next.
628
I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.3 Example of balanced scorecard
Example 1 (Question): (March/July 2020 Sample past exam extracted)
We booked Hammocks Co on the spur of the moment but then found that
we couldn’t get a flight. We called Hammocks Co administration centre to
change our booking to another resort where we could get a flight to and
were told that it would not be a problem. However, it took two more calls
and three emails to get confirmation and then our credit card was charged
twice in error. Of course, it was eventually all resolved, the incorrect charge
refunded, a complimentary limousine provided to and from the airport and
we received the most amazing customer service at the resort, but it was
frustrating at the time.
When I made my booking, I was assured that my bed would be made with the
special anti-allergenic bedding which I need for a good night’s sleep and that
my favorite blend of tea would be available. When I arrived, neither of these
requirements were met. To be fair to Hammocks Co though, everything was
in order two hours later when I went to bed.
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ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.3 Example of balanced scorecard
Example 1 (Question): (March/July 2020 Sample past exam extracted)
Required:
Suggest and justify ONE goal and TWO performance measures for each of the TWO
perspectives of the balanced scorecard which are not currently addressed by
Hammock Co’s objectives. (9 marks)
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I. PERFORMANCE MANAGEMENT IN PRIVATE
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2. Non-financial indicators
Balanced scorecard
2.1
2.1.3 Example of balanced scorecard
Example 1 (Solution): (March/July 2020 Sample past exam extracted)
Perspective
Internal
business
process
Goals
(What possible
goal representing
the perspectives)
Justification for goals
(Why?)
Efficient and
effective
administration
Feedback on TripEvent
shows customer
complaints on poor
administration:
•
Repetitive
calls/emails for
confirmation
•
Double credit card
charge in error
•
Neither of special
requirements
were met
Measures
(How are the
goal possibly
measured?)
Justification for
measures
(Why?)
Number of
corrections to
booking due
to admin
errors
More corrections will
lead to more
customer complaints
% customer
requests met
Measuring the % of
guest requests met
will identify when the
guest experience was
not as expected
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.3 Example of balanced scorecard
Example 1 (Solution): (March/July 2020 Sample past exam extracted)
Perspective
Innovation
and
learning
Goals
(What possible
goal representing
the perspectives)
Modernised
facilities and
services
Justification for
goals
(Why?)
Feedback said
the competitors
offer better
facilities
Measures
(How are the goal
possibly measured?)
Justification for
measures
(Why?)
Number of
appliances in-room
offered by
competition but not
by Hammocks
Show where
Hammock could
improve to match the
competition
Number of new
menu items
Show whether the
menus are being kept
fresh for the
customers
Notes:
Remember that any reasonable goals and measures could absolutely be used!
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.3 Example of balanced scorecard
Notes:
This is a highly examinable topic, it is important to apply the knowledge from this
section, to the specifics of the scenario given.
It was noted in the December 2014 exam report, that candidates did not consider the
company in the question and instead presented a generic balanced scorecard. That will
not be awarded marks at this level
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.1
Balanced scorecard
2.1.4 Discussion about balanced scorecard
Advantages
Helps to clarify how sustained, good
financial performance can be achieved
Show how different aspects of the
business result in good financial
performance
Highlight how poor performance in any
area can damage long-term prosperity.
Measure and monitor all important
aspects of a company’s existence
Targets are set for current and future
performance across a wide range of
important activities and measures.
Help to balance long-term and shortterm objectives.
Disadvantages
Potential information overload
Picking or inventing measures can be
difficult and perhaps arbitrary
Difficulty and cost in obtaining the
information needed
Conflict. For example, flexibility in
supplying a customer with a product
might adversely affect the quality of
the product if it is made in a rush
Too little attention to external factors
such as competitor activity. It focus
on our innovation, our processes, our
customers.
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Fitzgeral and Moon’s Building block model (BBM) is an evolution of the Balanced
scorecard, developed to meet the needs of performance evaluation in service
organisations, which linked to reward schemes for managers
Results
Dimensions
Financial performance
Competitiveness
Determinants
Quality
Innovation
Flexibility
Resource utilisation
Standards
Rewards
Ownership
Achievability
Equity
Clarity
Controlability
Motivation
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
2.2.1. Dimensions
Some performance measurement that might be used for each of these dimensions are as
follows
Dimensions
Performance measures
Results - outcome of decisions and actions taken in the past
Financial performance
Competitiveness
•
Profitability
•
Profit growth
•
Profit margin
•
Growth in sales
•
Retention rate for customers
•
Success rate in converting enquiries into sales
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
2.2.1. Dimensions
Dimensions
Performance measure
Determinants – forward-looking dimensions of the model: what areas of future
performance are most important for a company to achieve positive financial and
competitive results?
Service quality
•
Number of complaints
•
Customer satisfaction, as revealed by customer
opinion surveys
•
Varied product ranges meet the needs of different
customer segment.
•
Speed in responding to customer requests
•
Efficiency/ productivity measures
•
Capacity utilization rates
•
Number of new services offered within the
previous year or two years
Flexibility
Resource allocation
Innovation
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ORGANISATIONS
2. Non-financial indicators
Building block model
2.2
2.2.2. Standards
After the organisations’s dimensions are understood, standards can be set. These will be
the benchmarks, targets, directly linked to performance metrics under headings for each
dimensions
There are three (03) aspects to consider in setting standards:
Ownership
Who is responsible for achieving the standard?
Achievability
What level are the standards set at?
Equity
Can we use the standards for a fair appraisal across the company?
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
Building block model
2.2
2.2.3. Rewards
The last part of the mode looks at the overall reward structure of the organization and is
the link to HR systems. Do compensation packages in the company lead people to achieve
the standards of performance which are set out above?
This part has three (03) aspects:
Clarity
Is the system understandable to all employees?
Motivation
Will the system drive employees to achieve their objectives?
Controllability
Do employees have control over their areas of responsibility?
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Question): OSC Co (September 2018)
Exam focus point: Performance analysis using Building Block model
The One Stop Car Co (OSC Co) offers a range of services for car owners at its 55
service centres across the country. The car maintenance business is extremely
competitive in all regions across the country. Each service centre operates
autonomously and managers are able to choose how to package up the services
they offer. OSC Co’s aim is to ‘make the task of car maintenance a pleasure and not
a chore’.
Its national website states the following:
•
Range of service packs available, including express service and full valet
•
‘We work whilst you wait’ service, with average wait times of only two hours
•
Watch our friendly, experienced mechanics producing high quality work
•
Freshly made tea and coffee and free internet in our comfortable lounges
•
Monthly free prize draw for all customers completing an online feedback form
Customers initially access the national website, but depending on their location,
they are automatically redirected to the website of their nearest service centrer so
that they can view the offers available at that center. All bookings are made through
the OSC website.
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ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Question): OSC Co (September 2018)
Results for one of the service centres, the Midlands Service Centre (MSC), for the
year which has just ended are given below. The column headed ‘OSC’ shows the
average figures for all of OSC Co’s 55 service centres.
MSC
OSC average
Sales revenue ($)
Notes
760,500
890,365
Gross profit ($)
304,200
328,146
Number of mechanics: senior
1
7
7.8
Number of mechanics: junior
2
5
5.2
Number of new service pack developed
3
3
2
Number of website hits
14,000
18,260
Total number of jobs booked and completed
9,506
11,870
Number of jobs from repeat customers only
1,500
1,660
Time spent completing jobs (hours)
23,100
24,800
80%
70%
% of customer feedback forms showing score 9 or 10
4
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Question): OSC Co (September 2018)
Notes:
(1) mechanics are classified as ‘senior’ if they have been qualified for more than five
years.
(2) ‘Junior’ mechanics includes both trainee mechanics who are unqualified and
mechanics who have been qualified for less than five years.
(3) The MSC introduced three new service packs during the year:
•
Free valets for orders over $100
•
A safety check costing on $20, instead of the usual $40, for all customers
booking a full service
•
A $10 air conditioning efficiency check, which usually costs $20, for all
customers booking an oil change.
These three new service packs produced revenues of $66,000, $58,000 and $54,000
respectively. Two comparable new service packs developed by other centers
produced revenues of $44,000 and $42,000.
(4) The online feedback form asks customers to rate the center from 1 to 10, with
10 being the best.
The CEO of OSC Co has recently attended a business seminar and heard about
Fitzgeral and Moon’s building block model of performance management. The CEO is
interested in how the dimensions block could be applied at OSC Co. The dimensions
of performance identified in the model are: competitiveness, financial performance,
quality of service, flexibility, resource utilisation and innovation.
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Question): OSC Co (September 2018)
Required:
For each of the dimensions of the building block model, calculate one performance
indicator for MSC and one for the OSC average using the data available. Briefly
justify your choice of performance indicator and discuss MSC’s performance relative
to the other OSC service centres. (16 marks)
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
Building block model
2.2
Example 2 (Solution): OSC Co (September 2018)
Overview of solution:
Dimensions
Competitiveness
Financial
performance
Quality of service
Flexibility
Resource
allocation
Innovation
Calculation of
Discuss of MSC’s
Justification of choice of
performance
performance
performance indicator
indicators
compared to OSC’s
% of website hits Indicating attractiveness of 2 – 3 sentences of:
converted into orders services provided
• Compare MSC’s
performance to
Gross profit margin
Key performance indicator
OSC’s
• Provide (potential)
% of jobs from repeat Aim of MSC’s
customers
(identified by given input: reasons
national website information, • Comment on
range of service packs, MSC’s peformance
average wait times)
Time taken per job
Sales per mechanics
Shorter time is better
Staff (human) is key resource
in service company
% revenue from new wide variety of service packs
service packs
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Solution): OSC Co (September 2018)
Dimensions (used as heading)
Competitiveness
% of website hits
converted into orders
MSC
67.9%
(9,506/14,000) x 100
Performance
indicator’s
detailed
calculation
OSC average
65%
(11,870/18,260) x 100
Justify choice of
performance indicator
This ratio indicates whether MSC’s services are attractive compared to its
competitors, which is important if it is going to survive in such a competitive
market.
It has performed substantially better than other OSC service centres on average,
having converted 67.9% of website hits into jobs, compared to the 65% converted
by other service centres. This is a good result.
Discuss MSC’s performance
2 sentences:
•
Compare performance
•
Comment
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Solution): OSC Co (September 2018)
Financial performance
Gross profit margin
MSC
40%
(304,200/760,500) x 100
OSC average
36,8%
(328,146/890,365) x 100
Gross profit margin is the preferred measure for financial performance from the
data presented. It shows the percentage of revenue which exceeds the cost of
goods sold.
MSC’s gross profit margin is almost 3 percentage points higher than the average,
which is a good result. This could be partly because they did relatively well on their
new service pack sales (note 3) but it is also likely to be because their ratio of senior
mechanics to junior mechanics is lower than the average, and junior mechanics will
invariably be paid less than senior ones.
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
Building block model
2.2
Example 2 (Solution): OSC Co (September 2018)
Time spent completing job/total
jobs booked & completed
Flexibility
Time taken per job
MSC
2.43 hours
(23,100/9,506)
OSC average
2.09 hours
(24,800/11,870)
The time taken to complete each job is important as many customers will use MSC
because they can sit and wait for the work to be done, rather than having to hire a
rental car for the day, for example.
The comparison shows that MSC takes longer to complete a job than the OSC
average. This is not really a good thing and is probably because they have slightly
less experienced staff on the whole, but it could also be that they do a more
thorough job than other service centres. Given the fact that they have a higher level
of return customers than the average and they are graded 9 or 10 by their
customers (10 percentage points higher than the average), this is presumably not
viewed negatively by customers
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Solution): OSC Co (September 2018)
Quality of service
% of jobs from
repeated customers
Number of jobs from repeated
customers/Total number of jobs
MSC
15.78%
(1,500/9,506) x 100
OSC average
13.98 %
(1,660/11,870) x 100
Quality is a key element of MSC’s service to customers and if it is poor, customers
will not return.
Again, MSC has outperformed the other service centres on average by 1.8
percentage points. This could be because it has a higher ratio of senior mechanics to
junior mechanics than other service centres, so the quality of work is probably
better, hence the higher level of repeat customers.
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I. PERFORMANCE MANAGEMENT IN PRIVATE
ORGANISATIONS
2. Non-financial indicators
2.2
Building block model
Example 2 (Solution): OSC Co (September 2018)
Total sales/ number of mechanics
Resource allocation
Sales per mechanics
MSC
$63,375
($760,500/12)
OSC average
$68,490
($890,365/13)
The key resource in a service company is its staff and so these indicators measure
how this resource is being utilised.
MSC’s utilisation of its staff is lower than that of the other service centres by $5,115
per mechanic. This clearly ties in with the fact that the average time to complete a
job is longer at MSC than other service centres. However, given that they use a
slightly less experienced staff on average than other centres and the fact that their
gross margin is higher than average, this should not be viewed too negatively.
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I. PERFORMANCE MANAGEMENT IN PRIVATE
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2. Non-financial indicators
2.2
Building block model
Example 2 (Solution): OSC Co (September 2018)
Innovation
% of revenue from new
service packs
MSC
23.4%
($66,000+$58,000+$54,000)/
$760,500
OSC average
9.66%
($44,000+$42,000)/
890,365
MSC wants to offer a wide variety of service packs to its customers and needs to be
innovative in packaging services up.
The 23.4% indicates that MSC is indeed innovative in their approach to their
customers’needs, offering an innovative mix of services. MSC has really
outperformed other service centres on this front, generating a far larger part of its
revenue by the introduction of new service packs, which must have attracted
customers. This is a really strong performance
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2. Non-financial indicators
2.3
Target setting in qualitative areas
The balanced scorecard and Fitzgerald and Moon's Building Block model are based on the
assumption that performance targets can be set and measured for non-financial aspects
of performance.
In practice, criticial non-financial aspects of performance may be difficult to quantify in
reliable way, because:
By nature, qualitative data cannot be quantified
Unlikely to have a reliable and comprehensive system for qualitative data
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II. PERFORMANCE MANAGENENT IN
NOT-FOR-PROFIT ORGANISATIONS
1. Problems with not-for-profit organisations’ objectives
Major problem with many not-for-profit (NFPOs)’s objectives is that:
It is extremely difficult
to define their objectives
Multiple objectives make it
impossible to say which is the
overriding objectives
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II. PERFORMANCE MANAGENENT IN
NOT-FOR-PROFIT ORGANISATIONS
2. Performance management in not-for-profit organisations
2.1
Value for money
Value for money (VFM) means providing a service in a way which is economical,
efficient and effective.
A common method of assessing public sector performance is to assess VFM which
comprises:
The three Es
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II. PERFORMANCE MANAGENENT IN
NOT-FOR-PROFIT ORGANISATIONS
2. Performance management in not-for-profit organisations
2.1
Value for money
3Es represents:
Economy:
Minimising the costs of inputs required to achieve a defined level of output.
Efficiency:
Ratio of outputs to inputs – achieving a high level of output in relation to
the resources put in (input driven) or providing a particular level of service
at reasonable input cost (output driven)
Effectiveness:
Whether outputs achieved met the predetermined objectives.
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II. PERFORMANCE MANAGENENT IN
NOT-FOR-PROFIT ORGANISATIONS
2. Performance management in not-for-profit organisations
2.1
Value for money
Example 3:
Value for money in a university would comprise three elements:
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III. PERFORMANCE MANAGENENT IN
NOT-FOR-PROFIT ORGANISATIONS
2. Performance management in not-for-profit organisations
2.2
Problems
Public sectors, as well as profit-making organization, also face the same
difficulties in using NFPIs & FPIs:
Target setting in
qualitative areas
Short-termism
Manipulation
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III. Other considerations in
performance management
External consideration
Performance management needs to allow for external considerations including:
Stakeholders
•
Internal (employee,
management)
•
Connected
(shareholders,
customers, suppliers)
•
External (government,
community)
Economic environment
•
Economic growth
•
Local economic trends
•
Inflation
•
Interest rate
•
Exchange rates
•
Governemnt policies
Competitors
•
Pricing strategies