ACCA
Applied Skills
Performance
Management
Workbook
For exams in September
2020, December 2020,
March 2021 and June 2021
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First Edition 2020
ISBN 9781 5097 8438 7
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Contents
Introduction
Helping you to pass
v
Chapter features
vi
Introduction to the Essential reading
vii
Introduction to Performance Management (PM)
x
Essential skills areas to be successful in Performance Management (PM)
xiii
1
Managing information
1
2 Information systems and data analytics
19
3 Activity based costing
39
4 Target costing
57
5 Life cycle costing
73
6 Throughput accounting
87
7
Environmental management accounting
107
Skills checkpoint 1
119
8 Cost volume profit (CVP) analysis
127
9
Limiting factor analysis
151
10 Pricing decisions
187
11 Short-term decisions
211
Skills checkpoint 2
243
12 Risk and uncertainty
249
13 Budgetary systems
279
14 Quantitative analysis in budgeting
307
15 Budgeting and standard costing
325
Skills checkpoint 3
339
16 Variance analysis
341
17 Planning and operational variance analysis
361
Skills checkpoint 4
381
18 Performance analysis and behavioural aspects
391
19 Performance measurement
403
20 Divisional performance and transfer pricing
431
21 Skills checkpoint 5
457
22 Further aspects of performance management
465
Essential Reading
Managing information
479
Information systems and data analytics
491
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Activity based costing 499
Target costing 511
Life cycle costing 515
Throughput accounting 519
Environmental management accounting 523
Cost volume profit (CVP) analysis 527
Limiting factor analysis 533
Pricing decisions
541
Short-term decisions 547
Risk and uncertainty 553
Budgetary systems 561
Quantitative analysis in budgeting 569
Budgeting and standard costing 575
Variance analysis 583
Planning and operational variance analysis 597
Performance analysis and behavioural aspects 601
Performance measurement 607
Divisional performance and transfer pricing 615
Further aspects of performance management 621
Further question practice
631
Further question solutions
658
Appendix 1: Exam formulae
692
Index 695
Bibliography
701
Glossary705
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Helping you to pass
BPP Learning Media – ACCA Approved Content Provider
As an ACCA Approved Content Provider, BPP Learning Media gives you the opportunity to use
study materials reviewed by the ACCA examining team. By incorporating the examining team’s
comments and suggestions regarding the depth and breadth of syllabus coverage, the BPP
Learning Media Workbook provides excellent, ACCA-approved support for your studies.
These materials are reviewed by the ACCA examining team. The objective of the review is to
ensure that the material properly covers the syllabus and study guide outcomes, used by the
examining team in setting the exams, in the appropriate breadth and depth. The review does not
ensure that every eventuality, combination or application of examinable topics is addressed by
the ACCA Approved Content. Nor does the review comprise a detailed technical check of the
content as the Approved Content Provider has its own quality assurance processes in place in this
respect.
BPP Learning Media does everything possible to ensure the material is accurate and up to date
when sending to print. In the event that any errors are found after the print date, they are
uploaded to the following website: www.bpp.com/learningmedia/Errata.
The PER alert
Before you can qualify as an ACCA member, you not only have to pass all your exams but also
fulfil a three-year practical experience requirement (PER). To help you to recognise areas of the
syllabus that you might be able to apply in the workplace to achieve different performance
objectives, we have introduced the ‘PER alert’ feature (see the next section). You will find this
feature throughout the Workbook to remind you that what you are learning to pass your ACCA
exams is equally useful to the fulfilment of the PER requirement. Your achievement of the PER
should be recorded in your online My Experience record.
Introduction
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Chapter features
Studying can be a daunting prospect, particularly when you have lots of other commitments. This
Workbook is full of useful features, explained in the key below, designed to help you to get the
most out of your studies and maximise your chances of exam success.
Key term
Central concepts are highlighted and clearly defined in the Key terms feature.
Key terms are also listed in bold in the Index, for quick and easy reference.
Formula to learn
This boxed feature will highlight important formula which you need to learn for
your exam.
PER alert
This feature identifies when something you are reading will also be useful for your
PER requirement (see ‘The PER alert’ section above for more details).
Real world examples
These will give real examples to help demonstrate the concepts you are reading
about.
Illustration
Illustrations walk through how to apply key knowledge and techniques step by step.
Activity
Activities give you essential practice of techniques covered in the chapter.
Essential reading
Links to the Essential reading are given throughout the chapter. The Essential
reading is included in the free eBook, accessed via the Exam Success Site (see inside
cover for details on how to access this).
At the end of each chapter you will find a Knowledge diagnostic, which is a summary of the main
learning points from the chapter to allow you to check you have understood the key concepts. You
will also find a Further study guidance section that contains suggestions for ways in which you
can continue your learning and enhance your understanding. This can include: recommendations
for question practice from the Further question practice and solutions, to test your understanding
of the topics in the chapter; suggestions for further reading which can be done, such as technical
articles and ideas for your own research. The chapter summary provides more detailed revision of
the topics covered and is intended to assist you as you prepare for your revision phase.
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Introduction to the Essential reading
The digital eBook version of the Workbook contains additional content, selected to enhance your
studies. Consisting of revision materials and further explanations of complex areas (including
illustrations and activities), it is designed to aid your understanding of key topics which are
covered in the main printed chapters of the Workbook.
To access the digital eBook version of the BPP Workbook, follow the instructions which can be
found on the inside cover; you’ll be able to access your eBook, plus download the BPP eBook
mobile app on multiple devices, including smartphones and tablets.
A summary of the content of the Essential reading is given below.
Chapter
1
2
Summary of Essential reading content
Managing
information
Information systems
and data analytics
•
The role of information systems in
– Recording transactions
– Decision-making
– Planning
– Performance measurement
•
•
•
How intranets may be used within a business
Wireless technology and its drawbacks
Security and confidential information
– Passwords
– Logical access systems
– Database controls
– Firewalls
– Encryption
– Other safety measures
– Personal data
– Personal security planning
– Anti-virus and anti-spyware software
•
•
•
Internal sources of information
External sources of information
Information for control
– Internal information, eg payroll, inventory, sales
– External information for benchmarking
•
Strategic planning, control and decision making and
its external orientation
Examples of management/tactical planning activities
Examples of management control activities
Comparison of management control and strategic
planning
Example showing the link between strategic plans and
operational/management control decisions
Illustration on how an ERP system works
Real world example of company using big data
McKinsey’s Big data report (McKinsey, 2011) showing
benefits of big data
•
•
•
•
•
•
•
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Chapter
3
Summary of Essential reading content
Activity based
costing
•
Traditional absorption costing
– For inventory valuation
– For pricing decisions
– For establishing profitability
•
Revision of allocation, apportionment and overhead
absorption
Choosing an appropriate absorption basis
Illustrations on choosing a basis, calculating OAR and
under- and over-absorption (brought forward
knowledge from Management Accounting)
Marginal costing (brought forward knowledge from
Management Accounting)
•
•
•
4
Target costing
•
No Essential reading
5
Life cycle costing
•
No Essential reading
6
Throughput
accounting
•
No Essential reading
7
Environmental
management
accounting
•
No Essential reading
8
Cost volume profit
(CVP) analysis
•
•
How breakeven charts can be drawn if a constant
product sales mix is assumed
Multi-product PV charts
9
Limiting factor
analysis
•
•
•
•
Two potentially limiting factors
Non-financial considerations in make or buy decisions
Shadow prices and limiting factors
Slack example
10
Pricing decisions
•
Influences on price
11
Short-term decisions
•
Examples of non-quantifiable factors
12
Risk and uncertainty
•
•
•
•
The role of market research
The use of focus groups
Example of simulation and spreadsheets
Standard deviation and coefficient of variation
13
Budgetary systems
•
•
•
Objectives of budgeting systems
The planning and control cycle
Other aspects of budget preparation such as budget
manuals, functional budgets, master budgets
14
Quantitative analysis
in budgeting
•
•
•
How to derive the learning rate
The relevance of learning curve effects in
management accounting
Limitations of learning curve theory
•
•
Deriving standards
Flexible budgets and performance management
15
Budgeting and
standard costing
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Chapter
Summary of Essential reading content
16
Variance analysis
•
•
•
Basic variances and illustration
Reasons for variances
Operating statements
17
Planning and
operational variance
analysis
•
Variances and the learning curve
18
Performance
analysis and
behavioural aspects
•
Analysing past performance with variance analysis
and who is responsible
Using variance analysis to improve future
performance
Performance
measurement
•
19
•
•
•
•
•
Which non-financial performance indicators should
be measured?
Methods to encourage a long-term view
Steps to improvement
The balanced scorecard – goals and measures
Building block model (Fitzgerald and Moon)
20
Divisional
performance and
transfer pricing
•
•
•
ROI and new investments
RI versus ROI: marginally profitable investments
Problems with transfer pricing
21
Further aspects of
performance
management
•
Problems with performance measurement of not for
profit organisations
The 3Es
External factors – stakeholders, economic
environment, competition
•
•
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Introduction to Performance Management (PM)
Overall aim of the syllabus
The aim of the syllabus is to develop knowledge and skills in the application of management
accounting techniques to quantitative and qualitative information for planning, decision-making,
performance evaluation and control. PM is the middle exam in the management accounting
section of the qualification structure. Management Accounting (MA) concerns just techniques and
Advanced Performance Management (APM) thinks strategically and considers environmental
factors. PM requires you to be able to apply techniques and think about their impact on the
organisation.
Brought forward knowledge
The Performance Management syllabus includes a number of topics which were covered in
Management Accounting but develops them further, requiring you to apply them to more complex
scenarios in the exam. For example, CVP analysis in PM covers multiple-product situations and
variance analysis covers mix and yield variances and planning and operational variances. You
therefore need a good understanding of the basic CVP and variance analysis that you covered in
MA. Absorption costing and marginal costing are also key brought-forward knowledge.
The syllabus
The broad syllabus headings are:
A
Information, technologies and systems for organisational performance
B
Specialist cost and management accounting techniques
C
Decision-making techniques
D
Budgeting and control
E
Performance measurement and control
Main capabilities
On successful completion of this exam, you should be able to:
A
Deal with the objective test questions demonstrating understanding of the subject
across the entire syllabus.
B
Carry out calculations for longer questions, with clear workings and a logical structure.
C
Interpret data.
D
Explain management accounting techniques and discuss whether they are appropriate
for a particular organisation.
E
Apply your skills in a practical context.
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Links with other exams
Strategic Business
Leader (SBL)
Advanced Performance
Management (APM)
Performance
Management (PM)
Management
Accounting (MA)
The diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist
between this exam and other exams preceding or following it. The Performance Management (PM)
syllabus assumes knowledge acquired in Management Accounting (MA) and develops and applies
this further and in greater depth.
Achieving ACCA’s Study Guide Learning Outcomes
This BPP Workbook covers all the PM syllabus learning outcomes. The tables below show in which
chapter(s) each area of the syllabus is covered.
A
Information, technologies and systems for organisational performance
A1
Managing information
Chapter 1
A2
Sources of information
Chapter 1
A3
Information systems and data analytics
Chapter 2
B
Specialist cost and management accounting techniques
B1
Activity-based costing
Chapter 3
B2
Target costing
Chapter 4
B3
Life-cycle costing
Chapter 5
B4
Throughput accounting
Chapters 6 & 9
B5
Environmental accounting
Chapter 7
C
Decision-making techniques
C1
Relevant cost analysis
Chapter 11
C2
Cost volume profit analysis (CVP)
Chapter 8
C3
Limiting factors
Chapter 9
C4
Pricing decisions
Chapter 10
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C5
Make or buy and other short-term decisions
Chapter 11
C6
Dealing with risk and uncertainty in decisionmaking
Chapter 12
D
Budgeting and control
D1
Budgeting systems and types of budget
Chapters 13 & 18
D2
Quantitative analysis in budgeting
Chapter 14
D3
Standard costing
Chapter 15
D4
Material mix and yield variances
Chapter 16
D5
Sales mix and quantity variances
Chapter 16
D6
Planning and operational variances
Chapter 17
D7
Performance analysis
Chapter 18
E
Performance and measurement and control
E1
Performance analysis in private sector
organisations
Chapters 19
E2
Divisional performance and transfer pricing
Chapter 20
E3
Performance analysis in not for profit organisations
and the public sector
Chapters 19 & 21
E4
External considerations and the impact on
performance
Chapter 21
The complete syllabus and study guide can be found by visiting the exam resource finder on the
ACCA website: www.accaglobal.com/gb/en.html.
The exam
Computer-based exams
Applied Skills exams are all computer-based exams.
Approach to examining
• There is no choice in this exam; all questions have to be answered. You must therefore study
the entire syllabus, there are no short-cuts.
• You should then practise extensively on examination-style questions. Practice will improve your
ability to answer questions well, and should enable you to answer them more quickly. BPP’s
Practice & Revision Kit contains questions on all areas of the syllabus.
• Keep an eye out for articles, as the examining team will use Student Accountant to
communicate with students.
• Read journals etc to pick up on ways in which real organisations apply management
accounting and think about your own organisation if that is relevant.
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Essential skills areas to be successful in Performance
Management (PM)
We think there are three areas you should develop in order to achieve exam success in PM:
(a) Knowledge application
(b) Specific PM skills
(c) Exam success skills
These are shown in the diagram below.
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
l y si s
How to
approach
your PM
exam
Performance
management
questions
ti m
ana
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
r planning
Answe
c al
e ri
an
en
en
em
tn
ag
um
em
Effective
use of
spreadsheets
t
Effi
ci
Effe cti
ve writing
a nd p r
esentation
Specific PM skills
These are the skills specific to PM that we think you need to develop in order to pass the exam.
In this Workbook, there are five Skills Checkpoints which define each skill and show how it is
applied in answering a question. A brief summary of each skill is given below.
Exam success skills
Passing the PM exam requires more than applying syllabus knowledge and demonstrating the
specific PM skills; it also requires the development of excellent exam technique through question
practice.
We consider the following six skills to be vital for exam success. The skills checkpoints show how
each of these skills can be applied in the exam.
Exam skill 1: Managing information
Questions in the exam will present you with a lot of information. The skill is how you handle this
information to make the best use of your time. The key is determining how you will approach the
exam and then actively reading the questions.
Advice on developing managing information
Approach
The exam is three hours long. There is no designated ‘reading’ time at the start of the exam.
However, one approach that can work well is to start the exam by spending 10–15 minutes
carefully reading through all of the questions to familiarise yourself with the exam. Once you feel
familiar with the exam consider the order in which you will attempt the questions; always attempt
them in your order of preference. For example, you may want to leave to last the question you
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consider to be the most difficult. If you do take this approach, remember to adjust the time
available for each question appropriately – see Exam success skill 6: Good time management.
If you find that this approach doesn’t work for you, don’t worry – you can develop your own
technique.
Active reading
You must take an active approach to reading each question. In Section C questions in particular,
focus on the requirement first, making a note of key verbs such as ‘explain’ and ‘discuss’, to ensure
you answer the question properly. Then read the rest of the question, making notes on important
and relevant information you think you will need.
Exam skill 2: Correct interpretation of the requirements
The active verb used often dictates the approach that written answers should take (eg ‘explain’,
‘discuss’). It is important you identify and use the verb to define your approach. The correct
interpretation of the requirements skill means correctly producing only what is being asked for by
a requirement. Anything not required will not earn marks.
Advice on developing the correct interpretation of the requirements
This skill can be developed by analysing question requirements and applying this process:
Step 1
Read the requirement
Firstly, read the requirement a couple of times slowly and carefully and
note the active verbs. Use the active verbs to define what you plan to do.
Make sure you identify any sub-requirements.
Step 2
Read the rest of the question
By reading the requirement first, you will have an idea of what you are
looking out for as you read through the scenario. This is a great time
saver and means you do not end up having to read the whole question in
full twice. You should do this in an active way – see Exam success skill 1:
Managing information.
Step 3
Read the requirement again
Read the requirement again to remind yourself of the exact wording
before starting your written answer. This will capture any
misinterpretation of the requirements or any missed requirements
entirely. This should become a habit in your approach and, with
repeated practice, you will find the focus, relevance and depth of your
answer plan will improve.
Exam skill 3: Answer planning: Priorities, structure and logic
This skill requires the planning of the key aspects of an answer which accurately and completely
responds to the requirement.
Advice on developing answer planning priorities, structure and logic
Everyone will have a preferred style for an answer plan. For example, it may be a mind map, bullet
pointed lists or simply making some notes. Choose the approach that you feel most comfortable
with, or, if you are not sure, try out different approaches for different questions until you have
found your preferred style.
Exam skill 4: Efficient numerical analysis
This skill aims to maximise the marks awarded by making clear to the marker the process of
arriving at your answer. This is achieved by laying out an answer such that, even if you make a
few errors, you can still score subsequent marks for follow-on calculations. It is vital that you do
not lose marks purely because the marker cannot follow what you have done.
Advice on developing efficient numerical analysis
This skill can be developed by applying the following process:
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Step 1
Use a standard proforma working where relevant
If answers can be laid out in a standard proforma then always plan to do
so. This will help the marker to understand your working and allocate the
marks easily. It will also help you to work through the figures in a
methodical and time-efficient way.
Step 2
Show your workings
Keep your workings as clear and simple as possible and ensure they are
cross-referenced to the main part of your answer. Where it helps, provide
brief narrative explanations to help the marker understand the steps in
the calculation. This means that if a mistake is made you do not lose any
subsequent marks for follow-on calculations.
Step 3
Keep moving!
It is important to remember that, in an exam situation, it can sometimes
be difficult to get every number 100% correct. The key is therefore
ensuring you do not spend too long on any single calculation. If you are
struggling with a solution then make a sensible assumption, state it and
move on.
Exam skill 5: Effective writing and presentation
Written answers should be presented so that the marker can clearly see the points you are
making, presented in the format specified in the question. The skill is to provide efficient written
answers with sufficient breadth of points that answer the question, in the right depth, in the time
available.
Advice on developing effective writing and presentation
Step 1
Use headings
Using the headings and sub-headings from your answer plan will give
your answer structure, order and logic. This will ensure your answer links
back to the requirement and is clearly signposted, making it easier for
the marker to understand the different points you are making. Making
your headings bold will also help the marker.
Step 2
Write your answer in short, but full, sentences
Use short, punchy sentences with the aim that every sentence should say
something different and generate marks. Write in full sentences, ensuring
your style is professional.
Step 3
Do your calculations first and explanation second
Questions sometimes ask for a discussion or explanation with suitable
calculations. The best approach is to prepare the calculation first then
add the explanation. Performing the calculation first should enable you
to explain what you have done.
Exam skill 6: Good time management
Good time management
This skill means planning your time across all the requirements so that all tasks have been
attempted at the end of the three hours available and actively checking on time during your
exam. This is so that you can flex your approach and prioritise requirements which, in your
judgement, will generate the maximum marks in the available time remaining.
Advice on developing good time management
The exam is 3 hours long, which translates to 1.8 minutes per mark. Therefore a 10-mark
requirement should be allocated a maximum of 18 minutes to complete your answer before you
move on to the next task. At the beginning of a question, work out the amount of time you should
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be spending on each requirement. If you take the approach of spending 10–15 minutes reading
and planning at the start of the exam, adjust the time allocated to each question accordingly.
Keep an eye on the clock
Aim to attempt all requirements but be ready to be ruthless and move on if your answer is not
going as planned. The challenge for many is sticking to planned timings. Be aware this is difficult
to achieve in the early stages of your studies and be ready to let this skill develop over time. If you
find yourself running short on time and know that a full answer is not possible in the time you
have, consider recreating your plan in overview form and then add key terms and details as time
allows. Remember, some marks may be available, for example, simply stating a conclusion which
you don’t have time to justify in full.
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Managing information
1
1
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain the role of information systems in
organisations
A1 (a)
Discuss the costs and benefits of information
systems
A1 (b)
Explain the uses of the internet, intranet,
wireless technology and networks
A1 (c)
Discuss the principal controls required in
generating and distributing internal
information
A1 (d)
Discuss the procedures that may be
necessary to ensure security of highly
confidential information that is not for external
consumption
A1 (e)
Identify the principal internal and external
sources of management accounting
information
A2 (a)
Demonstrate how these principal sources of
management information might be used for
control purposes
A2 (b)
Identify and discuss the direct data capture
and process costs of management accounting
information
A2 (c)
Identify and discuss the indirect costs of
producing information
A2 (d)
1
Exam context
Accountants are surrounded by data and information and the volume of information is only
getting bigger. In this chapter, we look at information systems, their role within organisations and
their costs and benefits. We also look at how the internet, intranet, wireless technology and
networks are used.
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We then move on to the principal controls and procedures involved in generating and distributing
information and information security. We also look at internal and external sources of
management information, including financial accounting records, government agencies and
consumer panels.
1
The topics covered in this chapter could form part of a scenario question in the exam or could
feature as an objective test question in Section A or B. Ensure that you are able to discuss these
topics as well as being able to answer objective test (OT) questions.
Chapter overview
Managing information
The role and benefits of
information systems in organisations
How can information
be shared?
Link between management accounting and
information systems
Networks
Intranets
Why are information systems needed?
Wireless technology
Benefits of information systems
The internet
Costs of information systems
Extranet
Types of information costs
Cloud computing
Controls over information
Security and confidential information
Reports
Distribution
Internal sources of information
Information for control purposes
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External sources of information
1 The role and benefits of information systems in
organisations
PER alert
In order to fulfil performance objective 12 of the PER, you must demonstrate that you can
monitor new developments in management accounting and consider their potential impact on
performance and management accounting systems. You can apply the knowledge you obtain
from this chapter to help demonstrate this competence.
1.1 Link between management accounting and information systems
Information systems: An information system is a combination of hardware, software and
communications capability, where information is collected, processed and stored.
KEY
TERM
The title of this exam is Performance Management. Management accounting and information
systems play a vital role in performance management because they provide the information that
managers use as a basis for planning, control, decision-making and measuring performance.
1.2 Why are information systems needed?
Most organisations rely heavily on their information systems and some businesses cannot
function without their information system (eg banks).
Organisations require information systems for a range of purposes.
Supporting operations:
• Processing and recording transactions (eg as legal requirement/information about
profitability)
Supporting managerial activities:
• Planning (eg available resources/timescales)
• Control
• Decision making
• Performance measurement
Planning: Planning means formulating ways of proceeding.
KEY
TERM
Decision-making: Decision-making means choosing between various alternatives. This and
planning are virtually inseparable: you decide to plan in the first place and the plan you make
is a collection of decisions.
Control: Control is used in the sense of monitoring something to keep it on course (like the
‘controls’ of a car) not merely in the sense of imposing restraints or exercising power over
something.
As well as facilitating communication, information systems can be used for sales and marketing,
HR management, inventory control and process efficiency.
Activity 1: Use of information systems in hotels
1 Required
For each of the following activities, suggest how an information system in a hotel may be used.
• Processing and recording transactions
• Planning
• Control
• Decision-making
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Solution
1
Essential reading
See Chapter 1 Section 1 of the Essential reading for more detail on information systems.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
1.3 Benefits of information systems
Information is now recognised as a valuable
resource, and a key tool in the quest for a
competitive advantage.
For example, information on customers’
preferences can help inform businesses on
what to produce, how to sell it (eg online) and
so on.
Easy access to information, the quality of
that information and speedy methods of
exchanging the information have become
essential elements of business success.
For example, a business that has timely
information on how well a product is being
received by customers, can react quickly to
ensure that inventory is sufficient and
demand is met.
Organisations that make good use of
information in decision-making, and which
use new technologies to access, process and
exchange information are likely to be best
placed to survive in increasingly competitive
world markets.
For example, many taxi firms now take
bookings via a mobile phone app which can
report real time locations and calculate prices
in advance based on current traffic
conditions.
Real life example
The use of technology and the resulting information for business decisions are, at times, almost
unbelievable. Chocolate manufacturer, Cadbury, has state of the art machinery capable of
measuring taste. When tasting-staff chew the chocolate, they breathe through their nose into the
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machine and it records the way the chocolate is perceived in the mouth. Cadbury used this
technology to develop their new bar containing 30% less sugar. The machine showed that the new
chocolate bar created the same profile and therefore the same signature flavour that customers
would expect from a Cadbury bar.
1.4 Costs of information systems
Set-up costs for a new system include hardware and software costs, implementation costs
associated with development and installation (especially labour costs) and day-to-day costs,
such as salaries and accommodation.
Many organisations invest large amounts of money in information systems, but not always wisely.
The unmanaged proliferation of IT is likely to lead to expensive mistakes. Two key benefits of
information systems, the ability to share information and the avoidance of duplication, are likely
to be lost.
All IT expenditure should therefore require approval to ensure that it enhances rather than
detracts from the overall information strategy.
Effective budgeting may be required to keep costs under control, particularly the purchase of new
equipment. An activity-based approach may be appropriate.
1.5 Types of information costs
The costs to an organisation of the collection, processing and production of internal information
can be divided into three types:
• Direct data capture costs (ie using technology to capture data)
• Process costs
• Indirect costs of internal information
Cost
Examples
Direct data capture
•
•
•
•
Process
•
•
Indirect costs of
producing information
•
•
•
•
•
Use of bar coding and scanners (eg 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 (eg tracking vehicles, staff, inventory)
Payroll department time spent processing and analysing
personnel costs
Time for personnel to input data (eg in relation to production)
on to the management information system
Information collected but not needed
Information stored long after it is needed
Information disseminated more widely than necessary
Collection of same information by more than one method
Duplication of information
Exam focus point
The syllabus states that you need to be able to identify the indirect costs of producing
information. You need to remember that a direct cost can be completely attributed to
obtaining the information. An indirect cost cannot be completely attributed to it.
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2 How can information be shared?
Communicating information is much easier when computers are connected to form a network.
Various forms of networks can be formed – global in the form of the internet and local in the form
of the intranet. Wireless technology (covered below) facilitates mobile networking.
2.1 Networks
Computers which are connected and can send information together are networked. This boosts
efficiency and productivity with some computers within the network dedicated to file storage,
known as file servers, or other dedicated services such as printing. Others could be charged with
performing major number crunching tasks. These server computers are usually stored in a
dedicated room in a secure location.
The main benefits are:
(a) Resource sharing – eg file sharing or sharing hardware such as a printer
(b) Storage requirement reduction – eg storing shared files on a central server
(c) Software cost reduction – eg single licence on central server
2.2 Intranets
A cluster of computers can be networked together to form an organisation-wide network. This is
known as an intranet and used to share information internally. Intranets are effectively private
networks.
Potential applications include company newspapers, induction material, online procedure and
policy manuals, employee web pages where individuals post details of their activities and
progress, and internal databases of the corporate information store.
Essential reading
See Chapter 1 Section 2 of the Essential reading for more detail on the uses of intranets.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2.3 Wireless technology
Historically, networks would have been physically connected via cables (eg ethernet). However,
the development of portable computers and radio technologies has led to wireless networks (WiFi).
Wireless technology allows easier communication as WiFi converts an internet signal into radio
waves which can then be picked up by devices (eg laptops and tablets) containing a wireless
adaptor.
The main benefits of wireless technology include:
(a) Remote working and increased mobility
(b) Increased productivity (because employees can work together wherever they need to)
(c) Reduced costs as the business expands (because it is easier to add new users to a wireless
network than to install new cabling)
2.4 The internet
The internet is a global network connecting millions of computers.
The internet is essentially a public network and hence allows communication with external
stakeholders such as other businesses. Computers across the world communicate via
telecommunications links and information can be exchanged through email or through accessing
and entering data via a website. Over 10% of sales in the second quarter of 2019 in the US were
via e-commerce.
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2.5 Extranet
An extranet is a form of intranet that authorised parties outside of the organisation can access
using a username and password. They are a useful means for business partners to share
information.
2.6 Cloud computing
This is the provision of computing services, generally applications and data centres, over a
network (usually the internet). Google is one of the most prominent companies offering software
as a free online service. Software and storage for your account will exist on the service’s computer
cloud rather than on your computer. A cloud can be public or private.
The main benefits of a cloud computing contract include:
(a) Reduced IT costs – software and hardware upgrades may be included in the contract, which
means that there is no need for expert staff
(b) Safe storage – eg back-ups stored in the cloud helping to support business continuity plans
(c) Improved access – eg file sharing of records with accountants or access for staff working
from home
3 Controls over information
Controls need to be in place over the generation of internal information in routine and ad hoc
reports.
3.1 Reports
Before any report is created the following controls should be adopted:
(a) Cost/benefit analysis
(b) Prototype
(c) Check that the report is not duplicated
3.2 Distribution
To ensure efficiency and security of data, the following controls should be created:
(a) Procedures manual
(b) Format controls
(c) Distribution list
(d) Disposal controls (especially if confidential)
3.3 Controls over generating internal information in routine reports
(a) Carry out a cost-benefit analysis. How easy is the report to prepare compared with the
usefulness of the decisions that can be taken as a result of its production? The cost of
preparing the report will in part be determined by who is preparing it. The cost can be
reduced if its preparation can be delegated by a director to a junior member of staff.
(b) A trial preparation process should be carried out and a prototype prepared. Users should be
asked to confirm that their requirements will be met.
(c) A consistent format and consistent definitions should be used to ensure that reporting is
accurate and the chance of misinterpretation is minimised. Standard house styles will ensure
that time is not wasted by managers, staff and report writers on designing alternative
layouts.
(d) The originator of the report should be clearly identified so that user queries can be dealt with
quickly.
(e) The report should clearly set out limits to the action that users can take as a result of the
information in the report. This will ensure that the organisation’s system of responsibilities is
maintained.
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(f)
The usefulness of the report should be assessed on a periodic basis to ensure that its
production is necessary.
3.4 Controls over generating internal information in ad hoc reports
(a)
(b)
(c)
(d)
(e)
Carry out a cost-benefit analysis as above.
Ensure that the required information does not already exist in another format.
Brief the report writer so that onlytherelevant information is provided.
Ensure that the originator is clearly identified.
Ensure that report writers have access to the most up-to-date information.
3.5 Controls over distributing internal information
(a) Procedures manual (for standard reports)
(i) Indicates what standard reports should be issued and when (eg budgetary control report
for department X on a monthly basis)
(ii) Sets out the format of standard reports
(iii) Makes clear who should receive particular standard reports
(iv) Indicates whether reports should be shredded (if confidential) or just put in the recycle
bin
(v) Makes clear what information should be regarded as highly confidential
(b) Other controls
(i) Payroll and personnel information should be kept in a locked cabinet or be protected by
password access on a computer system.
(ii) All employees should be contractually required not to divulge confidential information.
(iii) The internal mail system should make use of ‘private and confidential’ stamps.
(iv) An appropriate email policy should be set up.
(1) Email is best suited for short messages rather than detailed operational problems.
(2) Email provides a relatively permanent means of communication, which may be
undesirable for confidential/’off-the-record’ exchanges.
(3) Staff may suffer from information overload.
(4) It is uncomfortable to read more than a full screen of information. Longer messages
will either not be read properly or will be printed out (in which case they may just as
well have been circulated in hard-copy form).
(v) Physical computer security
(1) Internal security. Management can regulate which staff members have access to
different types of data. For instance, access to HR records may be restricted to
members of the HR team by keeping these records on a separate server or
database. In this way, only certain terminals may access servers with sensitive or
confidential data stored on them.
(2) External security. The organisation can also protect its data from external access by
using firewalls. A firewall is designed to restrict access to a network by selectively
allowing or blocking inbound traffic to parts of an organisation’s system. It examines
messages entering and exiting the system and blocks any that do not conform to
specified criteria, for example, blocking incoming traffic from non-specific IP
addresses. In this way, firewalls can be used to protect data and databases from
being accessed by unauthorised people or terminals. For example, access to key
servers can be restricted to a small number of terminals only.
3.6 If information is held on a server
If information is held on a server, then the following are required:
(a) Controls over viruses and hacking
(b) Clearly understood policy on the use of emails and corporate IT
(c) Password system to restrict access to particular files
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4 Security and confidential information
IT systems are particularly vulnerable to unauthorised access, or use, from both internal and
external parties unless they are protected.
Ways of protecting information:
• Passwords – where logon access requires the entry of a string of characters
• Logical access systems – restricted access depending on user authority
• Database controls – limiting view of database content
• Firewalls – prevent unauthorised access to company systems
• Encryption – scrambling information in case of interception
• Anti-virus and anti-spyware software
• Personnel policies
Essential reading
See Chapter 1 Section 3 of the Essential reading for more detail on the protection measures.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Activity 2: IT systems
The following statements have been made about IT systems:
(a) Employees should be able to change customer records if they notice an error or omission.
(b) Transmitted data should usually be encrypted to prevent hackers gaining access to it.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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5 Internal sources of information
Internal sources of information include the financial accounting records and other systems
closely tied to the accounting system. Internal information is usually operational in nature, but
can include information on customers and suppliers.
Capturing data/information from inside the organisation involves the following:
(a) A system for collecting or measuring transactions data (eg sales, purchases, inventory and
revenue) which sets out procedures for what data is collected, how frequently, by whom and
by what methods, and how it is processed and filed or communicated
(b) Informal communication of information between managers and staff (eg by word of mouth
or at meetings)
(c) Communication between managers
Essential reading
See Chapter 1 Section 4 of the Essential reading for more detail on internal sources of information.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
6 External sources of information
External information is more relevant than internal information to strategic decisions.
Capturing external information is potentially expensive as it has so many sources. Information
technology is helping to reduce the cost of data collection.
Sources of external information include:
(a) Directories
(b) Associations
(c) Government agencies
(d) Customers/consumer panels
(e) Suppliers
(f) Internet
(g) Databases/data warehouses
External information can be out of date by the time it has been collated.
Extremely large amounts of data are known as big data. We will look at this in detail in Chapter 2.
Essential reading
See Chapter 1 Section 5 of the Essential reading for more detail on external sources of
information.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
7 Information for control purposes
Management information can be used for control purposes.
Control is dependent on the receipt and processing of information, both to plan in the first place
and to compare actual results against the plan, so as to judge what control measures are needed.
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Plans will be based on an awareness of the environment (from externally sourced information)
and on the current performance of the organisation (based on internal information such as, for
example, sales volumes and costs).
Control is achieved through feedback – information about actual results produced from within
the organisation (that is, internal information) such as variance control reports for the purpose of
helping management with control decisions.
Essential reading
See Chapter 1 Section 6 of the Essential reading for more detail on using management
information for control.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Managing information
The role and benefits of
information systems in organisations
Link between management accounting and
information systems
How can information
be shared?
Networks
IS provide information for planning, control,
decision making and managing performance
• Resource sharing
• Storage requirement reduction
• Software cost reduction
Why are information systems needed?
Intranets
• Process efficiency (transactions, planning,
control, decisions)
• Facilitating communication
• Inventory control
• Sales and marketing
• HR management
• Organisation-wide network
• Sharing information internally
Benefits of information systems
Wireless technology
• Remote working and increased mobility
• Increase productivity
• Reduced costs as the business expands
• Tool used for competitive advantage
• Access to quality information quickly
• Better decisions
The internet
Costs of information systems
Extranet
Hardware/software/implementation costs
An intranet that authorised parties outside
organisation can access
Public network
Types of information costs
• Direct data capture
• Process costs
• Indirect costs of producing internal
information
Controls over information
Reports
• Cost/benefit analysis first
• Prototype
• Check for duplications
Cloud computing
• Reduced IT costs
• Safe storage
• Improved access
Security and confidential information
Use passwords/logical access systems/
encryption etc
Distribution
Ensure security (eg secure disposal if
confidential)
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Internal sources of information
Eg accounting records and other systems
External sources of information
• More relevant than internal information to
strategic decisions
• Eg consumer panels/suppliers/internet/
associations
Information for control purposes
Control is achieved through feedback
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Knowledge diagnostic
1. Role and benefits of information systems in organisations
Information is required for a wide range of reasons, including supporting operations and
managerial activities; it is now seen as a key tool.
2. Communication of information
Communication is improved when computers are joined together. Information can be shared
using:
• Networks
• Intranets
• Wireless technology
• Internet
• Extranet
• Cloud computing
3. Controls over information
Controls are required over access to, and use of, information hardware and software. This is
important both when information is available to external parties and when it is only available
internally.
4. Security of highly confidential information not for external consumption
• Passwords
• Logical access systems
• Database controls
• Firewalls
• Personnel security planning
• Anti-virus and anti-spyware software
5. Internal and external sources of information
Information can be internal to organisations or available in the external environment.
Data can be:
• Out of date
• Expensive
• Biased
6. Control and feedback
Much control is achieved through the feedback of internal information.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q1
Examination
2
4 mins
Section A Q2
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Information Systems, which covers
topics included in this chapter and the next chapter.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Use of information systems in hotels
1 The correct answer is:
Activity
Use of information system
Processing and
recording transactions
Taking online bookings
Card payment devices
Guests’ details
Printing customer receipts
Occupancy rates
Number of repeat bookings
Employee management/staff details in human resource
systems
All transactions used to produce financial statements
• Sales receipts
• Payments received/outstanding
• Costs, eg rates, electricity, labour, consumables
• Capital expenditure on beds/furniture
Cloud based software and storage costs
Planning
Based on internal information (local level)
Budget production/resources needed:
•
•
Number of employees
Food and drink inventory levels based on average food and
drink spend per customer
• Cleaning products/toiletries
• New bedding/other items
• Forecasting costs/sales
Provide communication between managers/different
hotels/head office
Based on externally accessed information (global level)
•
•
Trends/customer preferences (eg ages of visitors to region)
Sales forecasting (relates to big data in the next chapter)
Control
Weekly/monthly variance reports on occupancy/food and drink
spend
Customer feedback reports (eg TripAdvisor)
Decision-making
Pricing based on occupancy demand at weekends vs weekdays
Profitability/expansion plans
Staffing levels based on occupancy/staff cost forecasts
Making changes based on customer feedback
Activity 2: IT systems
The correct answer is:
(b) only
It is not appropriate for all employees to have the ability to alter, or even view, all customer
records. Instead, access controls should be in place to ensure that only information required to
carry out their duties is made available to employees. Information sent outside of the organisation
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is especially vulnerable and so should be protected via encryption or use of firewalls, or both.
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Information systems and
data analytics
2
2
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Identify the accounting information
requirements and describe the different types
of information systems used for strategic
planning, management control and
operational control and decision-making.
A3 (a)
Define and discuss the main characteristics of
transaction processing systems; management
information systems; executive information
systems; enterprise resource planning systems
and customer relationship management
systems.
A3 (b)
Describe the characteristics (volume, velocity,
variety) of big data.
A3 (c)
Explain the uses and benefits of big data and
data analytics for planning, costing, decisionmaking and performance management.
A3 (d)
Discuss the challenges and risks of
implementing and using big data and data
analytics in an organisation.
A3 (e)
2
Exam context
This chapter covers issues relating to performance management information systems and their
design.
We begin with a look at the accounting information needs at all levels of the organisation. Next,
we consider the characteristics of a range of management information systems, including
transaction processing systems and executive information systems.
The last section of this chapter looks at the concept of big data.
As mentioned in Chapter 1, performance management information systems provide the
information which enables performance measurement to take place.
2
The topics covered in this chapter could form part of a Section C constructed response question in
the exam or could feature as an objective test question in Section A or B. Ensure that you are able
to discuss these topics as well as being able to answer objective test (OT) questions.
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Chapter overview
Information systems and data analytics
Information
levels
Information for strategic management accounting
Anthony's hierarchy
External orientation
Goal congruence
Future orientation
What information could
strategic management
accounting provide?
Information for management control
Information for operational control
Information requirements
Information requirements
Types of information system
Big data
Transaction processing systems (TPS)
Characteristics of big data
Management information systems (MIS)
Big data analytics
Executive information systems (EIS)
Benefits of big data
Enterprise resource planning systems (ERP systems)
Risks and challenges of big data
Customer relationship management systems
(CRM systems)
Costs vs benefit
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1 Information levels
Within and at all levels of the organisation, information is continually flowing back and forth,
being used by people to formulate plans and take decisions, and to draw attention to the need
for control action, when the plans and decisions don’t work as intended. We defined planning,
control and decision making in Chapter 1.
PER alert
One of the competencies needed for performance objective 12 of the PER is the ability to
contribute to development and improvements of management accounting systems and
internal reporting. You can apply the knowledge you obtain from this section of the text to
help demonstrate this competence.
1.1 Anthony’s hierarchy
Robert Anthony, a leading writer on organisational control, suggested what has become a widely
used hierarchy, classifying the information used at different management levels for planning,
control and decision-making into three tiers: strategic planning, management control and
operational control (Anthony, 1965).
Top
Middle
Bottom
KEY
TERM
Strategic
Long-term planning decisions
Tactical
Medium-term planning and
management control decisions
Operational
Operational/short-term decisions,
routine processing of transactions
Strategic planning: The process of deciding on objectives of the organisation changes the
resources used to attain these objectives, and the policies that are to govern the acquisition,
use and disposition of these resources.
Management (or tactical) control: Management (or tactical) control is the process by which
managers assure that resources are obtained and used effectively and efficiently in the
accomplishment of the organisation’s objectives. It is sometimes called ‘tactics’ or ‘tactical
planning’.
Operational control (or operational planning): Operational control (or operational planning) is
the process of assuring that specific tasks are carried out effectively and efficiently.
Strategic decisions: Strategic decisions are long-term decisions and are characterised by their
wide scope, wide impact, relative uncertainty and complexity.
Activity 1: Classifying information
Hydra Co is a bicycle retailer that has a significant presence in the South of Teeland. Each retail
outlet has a manager who is responsible for day to day operations and is supported by an
administrative assistant. All other staff at each location are involved in retailing operations.
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Required
How would information concerning the development of new services such as the provision of car
parts be classified?
 Strategic information
 Tactical information
 Operational information
 None of the above
Solution
2 Information for strategic management accounting
KEY
TERM
Strategic management accounting: Strategic management is a form of management
accounting in which emphasis is placed on information about factors which are external to the
organisation, as well as non-financial and internally generated information.
Strategic management accounting differs from traditional management accounting because it
has an external and future orientation.
2.1 External orientation
Towards:
• Customers
• Competitors
• Suppliers
• Other stakeholders
For example, while a traditional management accountant would report on an organisation’s own
revenues, the strategic management would report on market share or trends in market size and
growth.
2.2 Future orientation
A criticism of traditional management accounts is that they are backwards looking.
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(a) Decision-making is a forward- and outwards-looking process.
(b) Accounts are based on costs whereas decision-making is concerned with values.
Strategic management accountants will use relevant costs (ie incremental costs and opportunity
costs) for decision-making. We will revisit this topic later in the Workbook.
2.3 Goal congruence
Goal congruence is achieved when individuals or groups in an organisation take actions which are
in their self-interest and also in the best interest of the organisation as a whole.
Business strategy involves the activities of many different functions, including marketing,
production and human resource management; the strategic management accounting system will
require inputs from many areas of the business. This helps to ensure goal congruence by
translating business activities into the common language of finance.
2.4 What information could strategic management accounting provide?
Bearing in mind the need for goal congruence, external considerations and future orientation, the
following are examples of strategic management accounting information:
Item
Information provided
Competitors’ costs
What are they? How do they compare with
ours? Can we beat them? Are competitors
vulnerable because of their cost structure?
Financial effect of competitor response
How might competitors respond to our
strategy? How could their responses affect
our sales or margins?
Product profitability
A firm should not only want to know the profits
or losses that are being made by each of its
products, but also why one product should be
making good profits compared to another
equally good product which might be making
a loss.
Customer profitability
Some customers or groups of customers are
worth more than others.
Pricing decisions
Accounting information can help to analyse
how profits and cash flows will vary according
to price and prospective demand.
The value of market share
A firm ought to be aware of what it is worth to
increase the market share of one of its
products.
Capacity expansion
Should the firm expand its capacity and, if so,
by how much? Should the firm diversify into a
new area of operations, or a new market?
Brand values
How much is it worth investing in a brand
which customers will choose over competitors’
brands?
Shareholder wealth
Future profitability determines the value of a
business.
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Item
Information provided
Cash flow
A loss-making company can survive if it has
adequate cash resources, but a profitable
company cannot survive unless it has
sufficient liquidity.
Effect of acquisitions and mergers
How will the merger affect levels of
competition in the industry?
Decisions to enter or leave a business area
What are the barriers to entry or exit? How
much investment is required to enter the
market?
Essential reading
See Chapter 2 Section 1 of the Essential reading for more detail on strategic planning.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
3 Information for management control
Management control is at the level below strategic planning in Anthony’s decision-making
hierarchy. While strategic planning is concerned with setting objectives and strategic targets,
management control is concerned with decisions about the efficient and effective use of an
organisation’s resources to achieve these objectives or targets.
3.1 Information requirements
Futures of management control information
(a) Primarily generated internally (but may have a limited external component)
(b) Embraces the entire organisation
(c) Summarised at a relatively low level
(d) Routinely collected and disseminated
(e) Relevant to the short and medium terms
(f) Often quantitative (labour hours, volumes of sales and production)
(g) Collected in a standard manner
(h) Commonly expressed in money terms
Types of information
(a) Productivity measurements
(b) Budgetary control or variance analysis reports
(c) Cash flow forecasts
(d) Staffing levels
(e) Profit results within a particular department of the organisation
(f) Labour revenue statistics within a department
(g) Short-term purchasing requirements
Essential reading
See Chapter 2 Section 2 of the Essential reading for more detail on management control.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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4 Information for operational control
Operational control, the lowest tier in Anthony’s hierarchy, is concerned with assuring that
specific tasks are carried out effectively and efficiently.
4.1 Information requirements
(a) Operational information is information which is needed for the conduct of day to day
implementation of plans.
(b) It will include a lot of ‘transaction data’, such as data about customer orders, purchase
orders, cash receipts and payments, and is likely to have an endogenous (internal) source.
(c) Operating information must usually be consolidated into totals in management reports
before it can be used to prepare management control information.
(d) The amount of detail provided in information is likely to vary with the purpose for which it is
needed, and operational information is likely to go into much more detail than tactical
information, which in turn will be more detailed than strategic information.
(e) Whereas tactical information for management control is often expressed in money terms,
operational information, although quantitative, is more often expressed in terms of units,
hours, quantities of material, and so on.
Essential reading
See Chapter 2 Section 3 of the Essential reading for more detail on operational control.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
5 Types of information system
You should be aware of the main characteristics of the following five systems.
5.1 Transaction processing systems (TPS)
KEY
TERM
Transaction processing system (TPS): A transaction processing system (TPS) collects, stores,
modifies and retrieves the transactions of an organisation.
TPS are used by operational staff and data in a TPS is likely to be high frequency and short term.
There are two main types: batch transaction processing which collects data as a group and
processes it later and real time transaction processing, which involves immediate processing of
data.
Characteristics of TPS:
(a) Controlled processing. The processing must support an organisation’s operations.
(b) Inflexibility. A TPS wants every transaction to be processed in the same way regardless of
user or time. If it were flexible there would be too many opportunities for non-standard
operations.
(c) Rapid response. Fast performance is critical. Input must become output in seconds so
customers are not forced to wait.
(d) Reliability. Organisations rely heavily on transaction processing systems. Back-up and
recovery procedures must be quick and accurate as failure can potentially stop business.
An example of a TPS in a hotel chain is a booking system.
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5.2 Management information systems (MIS)
KEY
TERM
Management information systems (MIS): Management information systems (MIS) generate
information for monitoring performance (eg productivity information) and maintaining coordination (eg between purchasing and accounts payable).
Information is extracted from TPS and summarised to provide periodic reports for management
for structured decision making and control.
Characteristics of MIS:
• Support structured decisions at operational and management control levels
• Report on existing operations
• Little analytical capability
• Internal focus
MIS in a hotel chain might help managers to decide on staffing levels or laundry requirements
based on booking levels.
5.3 Executive information systems (EIS)
KEY
TERM
Executive information systems (EIS): Executive information systems (EIS) provide a
generalised computing and communication environment for senior managers to support
strategic decisions.
EIS are designed to facilitate senior managers’ access to information quickly and effectively in
order to analyse organisational performance. They have:
• Menu-driven user-friendly interfaces
• Interactive graphics to help visualisation of the situation
• Communication capabilities linking the executive to external databases
An EIS summarises and tracks strategically critical information from the MIS and includes data
from external sources, eg competitors, legislation and databases such as Reuters.
A good way to think about an EIS is to imagine the senior management team in an aircraft cockpit
with the instrument panel showing them the status of all the key business activities (a
‘dashboard’). EIS typically involve lots of data analysis and modelling tools, such as what-if
analysis to help strategic decision-making.
EIS in a hotel chain could provide senior managers with images that show key performance
indicators, eg pie charts showing booking capacity or colour spectrums showing profitability
across the different hotels.
There is a different need for volume of data at each level of the organisation. For example, the
CEO is not going to be concerned with the detail of every sale (which would be represented in the
TPS) but is going to require strategic information, including external data (represented in the EIS),
so that they can set strategy for the business. The volume of data decreases the higher you go in
the organisation.
5.4 Enterprise resource planning systems (ERP systems)
KEY
TERM
Enterprise resource planning systems (ERP systems): Enterprise resource planning systems
(ERP systems) 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. ERP systems help to identify and
plan the resources needed to make, account for, and fulfil customer orders, by improving the flow
of information between business functions within an organisation.
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The real time operation of ERP systems ensures that the exact status of everything is always
available.
You may have heard of the ERP system, SAP.
Essential reading
See Chapter 2 Section 4 of the Essential reading for an ERP illustration.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
5.5 Customer relationship management systems (CRM systems)
Customer relationship management systems (CRM systems): Customer relationship
management systems (CRM systems) are software applications that specialise in providing
information concerning an organisation’s products, services and customers.
KEY
TERM
Usually based on a database, these systems offer companies a cost-effective way of offering a
personalised service to customers, which should lead to greater levels of customer retention. CRM
software captures customers’ interactions with an organisation so that this can be used to
improve the organisation’s understanding of the customer (eg by tailoring future marketing
communications more precisely to the customer’s interests or requirements).
Activity 2: ERP benefits
1 Fix It Co is a chain of garages with eight branches and one warehouse that supplies spare parts
to the garages. Mechanics are assigned to a particular garage but can work in different locations.
As well as repairs, the company also carries out MOTs for which specialist testing equipment is
required.
Fix It Co has decided to implement an ERP system.
Required
What benefits could management hope to see following the implementation of the ERP system?
Solution
1
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5.6 Costs vs benefit
Exam focus point
The benefits of information systems must outweigh the costs.
Potential costs and problems:
• Hardware
• Software
• Staff resistance and morale
• Time and disruption
6 Big data
Technological advances including increased data storage and analytical capability have resulted
in a new concept called big data. Big data is a term given to extremely large collections of data
(‘data sets’) that are available to organisations to analyse.
The internet, smartphones, social media, sensors and other digital technologies are all helping to
create big data.
6.1 Characteristics of big data
The three V’s of big data are:
Volume
The quantity of data now being produced is being driven by social media and
transactional-based data sets recorded by large organisations, for example
data captured from in-store loyalty cards and till receipts. Data is also now
being derived from the increasing use of ‘sensors’ in business.
Velocity
The speed at which ‘real time’ data is being streamed into the organisation. To
make data meaningful it needs to be processed in a reasonable time frame.
Variety
Modern data takes many different forms. Structured data may take the form of
numerical data whereas unstructured data may be in the format of images,
video, location information, call centre recordings, email, and social media
posts.
Processing these sources may require significant investment in people and IT.
6.2 Data analytics
KEY
TERM
Data analytics: 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.
It is difficult to grasp the significance and meaning of big data without having a basic
understanding of machine learning (ML) and algorithms. However, machine learning and
algorithms are not mentioned on the PM syllabus.
Algorithm: A set of instructions or rules used to solve a problem (especially by a computer).
KEY
TERM
Machine learning (ML): A subset of artificial intelligence where a system learns automatically
how to predict outcomes based on data, without being explicitly programmed to do so.
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ML has been around for a long time but the advances in technology, including data capture,
storage and analytical capabilities, means that it can now be used with big data to make
business predictions.
Machine learning example
Ask system
'What will sales
demand be?'
System produces
algorithm based
on big data
Algorithm says sales
demand will be X
Results are used to
improve the algorithm
(ie system 'learns' to
make better predictions)
Actual results of sales
demand collected and
compared with prediction
The results of the algorithm (predictions) become better and better as more data is analysed.
6.3 Benefits of big data analytics
Big data analytics could result in performance improvements in the following areas:
(a) Better understanding of customer behaviour
For example, identifying what customers are saying on social media about an organisation’s
products or its customer service could help the organisation identify how well it is meeting
customers’ needs.
Customers’ conversations could help the organisation identify potential changes which are
needed to its products, or the way they are delivered, in order to meet customers’ needs more
effectively – and thereby to increase sales.
(b) Targeted marketing messages
Big data could facilitate targeted promotions and advertising – for example, by sending a tailored
recommendation to customers’ mobile devices while they are in the right area to take advantage
of the offers.
(c) Decision-making
For example, trends identified by a retailer in in-store and online sales, in real time, could be used
to manage inventories and pricing.
(d) New products and services
More generally, big data could also provide new business opportunities in their own right.
For example, the online retailer Amazon makes recommendations for customers linked to the
purchases made by other customers with similar interests.
(e) Performance measurement
Big data can provide more detailed and up-to-date information for performance measurement.
For example, performance reports can be produced in real-time allowing management to react
quickly to variances.
(f) Costing
Big data can be used to provide insights into costs. Big data’s main use is in identifying trends and
providing forecasts and this can be applied to costing. For example, it can be used to forecast
events or conditions that may occur at a specific time which will have an impact on the business
and its costs. A cost model can be developed.
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Essential reading
See Chapter 2 Section 5 of the Essential reading for more detail about the potential value of big
data.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Real world example
In 2013, Tesco used big data analytics to ensure its in-store refrigeration units worked at the
correct temperature. On initial investigation, they were being kept much colder than the Energy
and Carbon Manager expected them to be. Cooling cost savings of up to £20 million were
realised by Tesco once refrigeration performance was being monitored.
Real world example
Tesco partnered with customer science company, Dunnhumby to create the Tesco Clubcard, a
loyalty programme the company used to track customer behaviour through a vast database of
customer data.
6.3.1 Big data and the finance professional
Five traits of a data-enabled finance professional:
• Understands the fundamental drivers and metrics of the business
• Has a clear sense of what customers care about, and how to track this
• Embraces new, unconventional sources of data
• Comfortable with uncertainty
• Looks for new visual ways to present data with impact
6.4 Risks and challenges of big data
Critics have argued that although data sets may be big, they are not necessarily representative
of the entire data population as a whole; eg if a firm uses ‘tweets’ from the social networking site,
Twitter to provide insight into public opinion on a certain issue, there is no guarantee the ‘tweets’
will be representative.
Quality of data
There can be a misconception that increasing the amount of data available automatically
provides managers with better information for decision making. However, in order to be useful,
data has to be relevant and reliable.
Veracity
In order to be valuable, data also needs to be reliable. A fourth V – veracity – is often added to the
other ‘V’ characteristics of big data (volume, velocity and variety).
Using big data requires organisations to maintain strong governance on data quality. For
example, the validity of any analysis of that data is likely to be compromised unless there are
effective cleansing procedures to remove incomplete, obsolete or duplicated data records.
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.
IT teams or business analysts may become burdened with increasing requests for data, ad hoc
analysis and one-off reports. Equally, this will mean that the information and analysis will not be
available to decision makers as quickly as the ‘velocity’ may initially imply.
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Skills
Do organisations have staff with the necessary analytical skills to process and interpret the data?
The scale and complexity of data sets may require a data scientist’s level of analytical skills for
data mining, deriving algorithms and predictive analytics.
Loss and theft of data
Companies could face legal action if data is stolen. More generally, when collecting and storing
data they need to consider data protection and privacy issues, and ensure they comply with
current legislation in these areas (eg having appropriate controls in place to prevent breaches of
data security).
Activity 3: Big data analytics
BB Chocolat Co is a leading premium chocolate manufacturing company with a brand image
built on luxury. It has both retail outlets and an online shop and uses social media for marketing
purposes. It is worried about certain trends which encourage customers to avoid sugary foods due
to their propensity to cause obesity and, as such, is looking to cost control.
1 Required
What are the benefits of big data analytics for BB Chocolat Co in its focus on customer trends
and cost reduction?
Solution
1
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Chapter summary
Information systems and data analytics
Information
levels
Information for strategic management accounting
Anthony's hierarchy
External orientation
Goal congruence
• Strategic – Long term
• Tactical – Medium term
• Operational – Day-to-day
Towards customers/competitors/
suppliers
Taking actions in the best interest
of the organisation as a whole
Future orientation
What information could
strategic management
accounting provide?
Traditional management
accounts are backward looking
• Profitability
• Costs
• Pricing decisions
• Market share
• Cash flow
Information for management control
Information for operational control
Information requirements
Information requirements
• About efficient and effective use of resources
• Primarily internally generated
• Short and medium term
• About carrying out specific tasks effectively
and efficiently
• Detailed
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Types of information system
Big data
Transaction processing systems (TPS)
Characteristics of big data
• Used by operational staff
• High frequency/short term
• Volume
• Velocity
• Variety
Management information systems (MIS)
Big data analytics
• Operational and management control decisions
• Internal focus
Extracting insights and trends
Executive information systems (EIS)
Benefits of big data
Support strategic decisions
• Customer behaviour insights
• Targeted marketing
• Decision making
Enterprise resource planning systems (ERP systems)
Software to integrate key processes
Risks and challenges of big data
Customer relationship management systems
(CRM systems)
Used to improve organisation's understanding of the
customer
• Veracity
• Costs
• Skills
• Loss and theft of data
Costs vs benefit
Benefit must outweigh cost
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Knowledge diagnostic
1. Information levels
Management accounting information can be used at strategic, tactical and operating levels.
Managers need information according to their responsibilities.
2. Strategic management accounting
Information aimed at long-term decisions, which will often be external to the organisation and
with a future orientation.
3. Management control
Management control is concerned with decisions about the efficient and effective use of an
organisation’s resources to achieve these objectives or targets.
4. Operational control
Operational control, the lowest tier in Anthony’s hierarchy, is concerned with assuring that
specific tasks are carried out effectively and efficiently.
5. Information systems
Provide information at different levels and for different purposes:
• TPS
• MIS
• EIS
• ERP
• CRM
6. Big data
Refers to the mass of data created by society.
There are three V’s of big data:
• Volume
• Velocity
• Variety
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q3
Examination
2
4 mins
Section A Q4
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Information Systems, which covers
topics included in Chapter 1 and this chapter.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Classifying information
The correct answer is:
Strategic information
Strategic information is required by the management of an organisation in order to enable
management to take a longer-term view of the business and assess how the business may
perform during that period. The length of this longer-term view will vary from one organisation to
another, being very much dependent upon the nature of the business and the ability of those
responsible for strategic direction to be able to scan the planning horizon. Strategic information
tends to be holistic and summary in nature.
Activity 2: ERP benefits
1 The correct answer is:
Fix It Co could use an ERP system to assist with the following:
• Scheduling of repair jobs
• Scheduling of MOTs, ensuring that the testing equipment and trained MOT testing staff are
available at the correct garage, reducing the need to have some at every site all day
• Invoicing customers
• Ordering parts from the central warehouse for individual garages
• Reordering inventory from suppliers to replenish the warehouse
• Planning preventative maintenance for machinery
• Producing staff rota
Activity 3: Big data analytics
1 The correct answer is:
The benefits of using big data analytics in its focus on cost control include:
Speed
Big data analytics allow for large quantities of data (both structured and unstructured) to be
examined to identify trends and correlations. Since big data is collected by the business in real
time, big data analytics will enable this data to be examined quickly, speeding up the
organisation’s decision making. For example, since BB Chocolat Co makes extensive use of social
media for marketing purposes, it is likely that customers will also provide feedback about products
through social media channels. If there is extensive negative feedback about the quality of the
products then quick action could be taken to rectify the problem (for example, stopping the supply
of cocoa beans from a particular supplier in the short-term). This will help to reduce external
failure cost, such as refunds and damaged reputation, since the brand image is built on luxury.
Decision making
Better data analysis provided by big data analytics helps to improve organisational decision
making by taking advantage of current social trends. This will help to introduce new products to
the market that meet customers’ needs more effectively in light of trends. For example, feedback
from the market identified by our social media feed and other online sources (such as blogs) will
help BB Chocolat Co to identify how quickly the trend against unhealthy foods is growing. This
will help to use the design team more effectively by switching their focus from traditional flavoured
chocolate to healthier alternatives, such as raw chocolate. Unnecessary development cost can
therefore be avoided.
Focus on the customer
Big data analytics enables BB Chocolat Co to understand individual customers more fully so that
it can apply target marketing more effectively to them. While this may be hard to achieve for
customers buying chocolate in the physical shops, this could be achieved with customers
purchasing chocolate online since BB Chocolat Co can link the product purchased more
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specifically to these customers. This will help to use the marketing resource more effectively,
especially for more niche products. For example, if a customer only purchases diabetic chocolate,
BB Chocolat Co can focus on advertising diabetic chocolate products to them. This may help to
reduce marketing costs since a mass marketing campaign is less likely to be needed for the
diabetic range.
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Activity based costing
3
3
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Identify appropriate cost drivers under ABC
B1 (a)
Calculate costs per driver and per unit using
ABC
B1 (b)
Compare ABC and traditional methods of
overhead absorption based on production
units, labour hours or machine hours
B1 (c)
3
Exam context
In this chapter, we will be looking at a method of cost accumulation called activity based costing
(ABC), which is an alternative to traditional absorption costing. ABC attempts to overcome the
problems of costing in a modern manufacturing environment, where a very large proportion of
total production costs are overhead costs.
3
You can expect to see a question on ABC in the exam, either in Section A as an objective test (OT)
question or in Section B as a scenario question containing five OTs.
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Chapter overview
Activity based costing
Activity based costing
(ABC) principles
Traditional absorption
costing vs ABC
Implications
of ABC
Traditional absorption costing
Cost driver analysis
When ABC should be used
Reasons for development
Benefits of ABC
Definition of ABC
Criticisms of ABC
Steps in ABC
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1 Activity base costing (ABC) principles
PER alert
One of the competencies needed to fulfil performance objective 12 of the PER is the ability to
apply appropriate costing techniques to products and services. You can apply the knowledge
you obtain from this section of the Workbook to help demonstrate this competence.
1.1 Traditional absorption costing
Traditional absorption costing uses a single basis for absorbing all overheads into cost units for a
particular production department cost centre.
A business will choose the basis that best reflects the way in which overheads are being incurred,
eg in an automated business much of the overhead cost will be related to maintenance and repair
of the machinery. It is likely that this will vary to some extent with machine hours worked, so in this
instance, we would have used a machine hour absorption rate.
Production set-up cost
Machine oil
Supervisor salary
Production
department
A
OAR =
Machine
hours
Machine repairs
In a business where labour is intensive, overheads may be absorbed based on the number of
direct labour hours worked.
Essential reading
See Chapter 3 Sections 1 and 2 of the Essential reading for more detail on traditional absorption
costing, as well as marginal costing. Much of this is assumed knowledge brought forward from
ACCA Management Accounting and is still examinable in Performance Management.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
1.2 Reasons for the development of ABC
Traditional absorption costing was developed in a time when:
(a) Most manufacturers produced only a narrow range of products.
(b) Products underwent similar operations and consumed similar proportions of overheads.
(c) Overhead costs were only a very small fraction of total production costs: direct labour and
direct material costs accounted for the largest proportion of the costs.
Modern businesses:
(a) Have experienced a dramatic fall in the costs of processing information
(b) Use advanced manufacturing technology (AMT) and therefore overhead costs have become a
much larger proportion of total production costs, and direct labour has become much less
important.
Therefore, it is now difficult to justify the use of direct labour hours as the basis for absorbing
overheads to produce ‘realistic’ product costs.
Many resources are used in non-volume related support activities, which have increased due to
AMT. Non-volume related support activities are activities that support production, but where the
level of support activity (and so the level of cost) depends on something other than production
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volume – such as setting-up production runs, production scheduling and inspection. These
support activities assist the efficient manufacture of a wide range of products and are not, in
general, affected by changes in production volume. They tend to vary in the long term
according to the range and complexity of the products manufactured, rather than the volume of
output.
The wider the range and the more complex the products, the more support services are required.
Traditional absorption costing systems, which assume that all products consume all support
resources in proportion to production volumes, tend to allocate:
(a) Too great a proportion of overheads to high volume products, which cause relatively little
diversity and hence use fewer support services; and
(b) Too small a proportion of overheads to low volume products, which cause greater diversity
and therefore use more support services.
Activity based costing (ABC) attempts to overcome this problem.
1.3 Definition of ABC
KEY
TERM
Activity based costing (ABC): Activity based costing 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 on the basis of the
product’s usage of the factor driving the overheads.
The major ideas behind activity based costing are as follows.
(a) Activities cause costs. Activities include ordering, materials handling, machining, assembly,
production scheduling and despatching.
(b) Manufacturing products creates demand for the support activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of these
activities.
ABC is an extension of absorption costing specifically considering what causes each type of
overhead category to occur, ie what the cost drivers are. Each type of overhead is absorbed using
a different basis depending on the cost driver.
Cost driver: Cost driver is a factor that has most influence on the cost of an activity.
KEY
TERM
Overhead
Production set-up costs
Machine oil and machine repairs
Supervisor salary
Cost driver
Number of production set ups
Number of machine hours
Number of labour hours
Ordering costs:
handling customer orders
Number of orders
Materials handling costs
Number of production runs
1.4 Steps in ABC
(a) Identify an organisation’s major activities that support the manufacture of the organisation’s
products or the provision of its services.
(b) Group overheads into activities, according to how they are driven. These are known as cost
pools.
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(c) Identify the cost drivers for each activity, ie what causes the activity cost to be incurred.
(d) Calculate a cost per unit of cost driver.
(e) Absorb activity costs into production based on usage of cost drivers.
2 Traditional absorption costing vs ABC
Illustration 1: Absorption costing vs ABC
1 Suppose that Cooplan 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
production
runs in the
period
2
2
5
5
14
Material cost
per unit
Direct labour Machine hours
hours per unit
per unit
20
80
20
80
1
3
1
3
1
3
1
3
Direct labour 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:
(a) Conventional absorption costing
(b) ABC
Assume that, in the traditional absorption costing system, overheads are absorbed at a direct
labour hour rate.
Solution
1 The correct answer is:
(a) Using a conventional absorption costing approach, the absorption rate for overheads based
on direct labour hours or machine hours is:
$30,800 ÷ 440 hours = $70 per direct labour hour.
The product costs would be as follows:
Direct material
Direct labour
Overhead
Cost per unit
W
$
20
5
70
X
$
80
15
210
Y
$
20
5
70
Z
$
80
15
210
95
305
95
305
(b) Using activity based costing, it will be assumed that the number of production runs is the cost
driver for set-up costs, expediting and scheduling costs and materials handling costs; and
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that machine hours are the cost driver for short-run variable costs. Product costs per unit are
as follows:
Direct material
(no change)
Direct labour (no
change)
Overheads (W)
Cost per unit
Workings
Short-run
variable
overheads (W1)
Set-up costs (W2)
Expediting,
scheduling
costs (W3)
Materials
handling costs
(W4)
Units produced
Overhead cost
per unit
W
$
20
X
$
80
Y
$
20
Z
$
80
5
15
5
15
403
417
106
120
428
512
131
215
70
210
700
2,100
1,560
1,300
1,560
1,300
3,900
3,250
3,900
3,250
1,100
1,100
2,750
2,750
4,030
10
403
4,170
10
417
10,600
100
106
12,000
100
120
Workings
1
2
3
4
$3,080 / 440 machine hours =
$10,920 / 14 production runs =
$9,100 / 14 production runs =
$7,700 / 14 production runs =
$7 per machine hour
$780 per production run
$650 per production run
$550 per production run
Summary
Product
W
X
Y
Z
Conventional
absorption
costing unit cost
$
95
305
95
305
ABC unit cost
$
428
512
131
215
Difference per Difference in total
unit
$
+333
+207
+36
-90
$
+3,330
+2,070
+3,600
-9,000
These figures might suggest that the traditional volume-based absorption costing system is
flawed, because the low-volume products W and X are not being charged with a ‘fair share’ of the
costs of overhead support activities.
More specifically, traditional absorption costing may be unsatisfactory for two main reasons.
(a) It under-allocates overhead costs to low-volume products (here, W and X) and overallocates overheads to higher-volume products (here Z in particular).
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(b) It under-allocates overhead costs to smaller products (here W and Y, with just one hour of
work needed per unit) and over-allocates overheads to larger products (here X and
particularly Z).
ABC addresses these problems and arguably produces a more ‘realistic’ or ‘satisfactory’ cost.
Formula to learn
Absorption costing:
Overhead absorption rate (OAR) = budgeted production overheads / budgeted level of activity
Activity 1: Comparing absorption costing and ABC
Dodo Co manufactures three products, A, B and C. Data for the period just ended is as follows:
Output (units)
Sales price $
Direct material cost $
Labour hours/unit
Wages paid at $5/hr
1
2
A
20,000
20
5
2
B
25,000
20
10
1
Total production overheads for Dodo Co amount to $190,000.
Required
Calculate the profit per unit obtained on each product if production overheads are absorbed
based on labour hours (traditional absorption costing).
The following data is now also available:
$
55,000
90,000
30,000
15,000
190,000
Machining
Quality control and set up costs
Receiving
Packing
Output (units)
Cost driver data
Labour hours/unit
Machine hours/unit
No. of production runs
No. of component
receipts
No. of customer orders
3
C
2,000
20
10
1
A
20,000
B
25,000
C
2,000
2
2
10
10
1
2
13
10
1
2
2
2
20
20
20
Required
Using ABC, show the cost and gross profit per unit for each product during the period and
contrast this with the profit calculated using absorption costing.
Required
What factors should be considered when comparing the results?
Solution
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2
3
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2.1 Cost driver analysis
Today’s complex business environment means that costs are incurred because cost drivers occur
at different levels.
There are four key categories for activities and their related costs.
Categories
Type of cost
Cost driver
Unit
Direct
Units produced
Batch
Set ups
Inspections
Batches produced
Product
R&D
Marketing
Products produced
Facility sustaining
Depreciation
Rent
None
The difference between unit costs under traditional absorption costing and ABC depends upon
the proportion of overheads in each category.
If most overheads are unit level or facility sustaining the costs will be similar.
If overheads are batch or product sustaining costs, the resulting unit costs will be very different.
3 Implications of ABC
3.1 When ABC should be used
(a)
(b)
(c)
(d)
When production overheads are high relative to prime costs (eg service sector)
When there is a whole diversity of product range
When there are considerable differences in the use of resources by products
Where consumption of resources is not driven by volume
ABC has both advantages and disadvantages and tends to be more widely used by larger
organisations and the service sector.
3.2 Benefits of ABC
The use of ABC provides opportunities for:
(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Re-analysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in a performance appraisal
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3.3 Criticisms of ABC
(a) It is time consuming and expensive.
(b) It will be of limited benefit if overhead costs are primarily volume related.
(c) The benefit is reduced if the company is producing only one product or a range of products
with similar costs.
(d) Complex situations may have multiple cost drivers.
(e) Some arbitrary apportionment may still exist.
Activity 2: ABC
The following statements have been made about activity based costing.
(a) Implementation of ABC is unlikely to be cost effective when variable production costs are a
low proportion of total production costs.
(b) The cost driver for materials handling and despatch costs is likely to be the number of orders.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
3.4 Identifying appropriate cost drivers
Activity 3: Cost drivers
1 Required
Match the most appropriate cost driver to each cost.
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Cost
Cost driver
(a)
Machine set up costs
Number of production runs
(b)
Machine operating costs
Number of set-ups
(c)
Materials handling and
despatch
Number of machine hours
(d)
Quality inspection
Number of orders executed
Solution
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Chapter summary
Activity based costing
Activity based costing
(ABC) principles
Traditional absorption
costing vs ABC
Implications
of ABC
Traditional absorption costing
Cost driver analysis
When ABC should be used
Absorption using single basis eg
labour hours
• Costs are more closely linked
to the causes of overheads,
making ABC more appropriate
where
– Overheads are high
compared with prime costs
– Product ranges are diverse
– Resources are not merely
driven by volume
• When production overheads
are high relative to prime costs
• When there is a whole diversity
of product range
• When there are considerable
differences in the use of
resources by products
• Where consumption of
resources is not driven by
volume
Reasons for development
• Dramatic fall in costs of
processing information in
modern businesses
• Overhead costs are now a
much larger proportion of total
production costs
• Traditional absorption costing
allocates too great a
proportion of overheads to
high volume products
Benefits of ABC
• Better analysis of costs
leading to
– Cost control
– Production decisions
– Pricing decisions
– Profitability analysis
Definition of ABC
Identifying the costs of the main
support activities and the factors
that 'drive' the costs of each
activity
Criticisms of ABC
• Time consuming
• Costly
• Still some arbitrary
apportionment
• Limited benefit if products
have similar cost structures
Steps in ABC
• Identify major activities
• Group overheads into cost
pools
• Identify cost drivers
• Calculate a cost per unit of
cost driver
• Absorb activity costs into
production based on usage of
cost drivers
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Knowledge diagnostic
1. Activity based costing
Activity based costing groups overheads into activities. These are referred to as cost pools.
The item that causes the costs to be incurred is the cost driver.
Overheads are absorbed into products using the cost drivers.
2. Absorption costing vs ABC
Overhead absorption rates under ABC should be more closely linked to the causes of overhead
costs.
3. Implications of ABC
ABC results in a more meaningful product cost when overheads are high and there is a wide
diversity of product range.
ABC has both advantages and disadvantages and tends to be more widely used by larger
organisations and the service sector.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q5
Examination
2
4 mins
Section A Q6
Examination
2
4 mins
Section B ‘Southcott’
Examination
10
18 mins
Further reading
There is a technical article available on ACCA’s website, called Activity based costing, which
illustrates how ABC can give a more accurate estimate of costs than traditional approaches, when
a business produces different types of unit. ABC may be more time consuming and costly to
implement but enables managers to understand the drivers of costs.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Comparing absorption costing and ABC
1
The correct answer is:
Under traditional absorption costing
OAR = $190,000 ÷ 67,000 = $2.836/hr
A
$/unit
20.67
20.00
(0.67)
Revised product cost
Sales price
Profit
2
B
$/unit
17.84
20.00
2.16
C
$/unit
17.84
20.00
2.16
The correct answer is:
Under ABC
Workings: recovery rates
Machine cost
$55,000 / (40,000 + 50,000 + 4,000) = $0.585 per machine hour
QC & set up
$90,000 / (10 + 13 + 2) = $3,600 per production run
Receiving
$30,000 / (10 + 10 + 2) = $1,363.64 per component receipt
Packing
$15,000 / (20 + 20 + 20) = $250 per customer order
Machining costs
Quality control & set up
Receiving
Packing
Total overhead costs
A
$
23,404
36,000
13,636
5,000
78,040
B
$
29,255
46,800
13,636
5,000
94,691
C
$
2,341
7,200
2,728
5,000
17,269
Units produced
20,000
25,000
2,000
$3.90
$3.79
$8.63
Overhead cost/unit
Direct materials cost
Direct labour cost
Production overhead cost
Sales price
Gross profit/unit
3
A
$/unit
5.00
10.00
3.90
18.90
20.00
1.10
The correct answer is:
Items to consider are:
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B
$/unit
10.00
5.00
3.79
18.79
20.00
1.21
Total
$
55,000
90,000
30,000
15,000
190,000
C
$/unit
10.00
5.00
8.63
23.63
20.00
(3.63)
•
•
•
•
•
•
How much more cost have we been able to allocate on a meaningful basis?
Have we the right cost drivers?
Why have the costs changed?
Do we need to revisit selling prices?
Do we need to alter the product mix?
Should we cease production of C (bear in mind decisions should be based upon contribution)?
Activity 2: ABC
The correct answer is:
(b) only
Implementation of ABC is likely to be cost effective when variable costs are a low proportion of
total production costs and overhead costs, meaning that Statement (a) is false.
Activity 3: Cost drivers
1 The correct answer is:
Cost
Cost driver
(a)
Machine set-up costs
Number of set-ups
(b)
Machine operating costs
Number of machine hours
(c)
Materials handling and despatch
Number of orders executed
(d)
Quality inspection
Number of production runs
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Target costing
4
4
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Derive a target cost in manufacturing and
service industries.
B2 (a)
Explain the difficulties of using target costing
in service industries.
B2 (b)
Suggest how a target cost gap might be
closed.
B2 (c)
4
Exam context
Target costing is the second specialist cost accounting technique we will consider. It is a process
which involves setting a target cost for a product by subtracting a desired profit margin from a
target selling price.
In a competitive market where organisations are continually redesigning older products and
developing new ones, target costing can be an invaluable technique for helping them to make a
satisfactory profit on the items that they sell.
4
Target costing may be examined in the Section A objective test questions or it may form part of a
Section B mini case study question. For example, the calculation of a target cost may be required,
followed by an objective test question on the theory of target costing and how a target gap might
be closed.
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Chapter overview
Target costing
Target costing
Deriving a target cost
Traditional approaches
to pricing
Implementing target costing
Target costing
Implications
Target costing in
service industries
Characteristics of services
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Closing a target cost gap
1 Target costing
1.1 Traditional approaches to pricing
Under traditional approaches to pricing, businesses calculate the cost of manufacturing and
selling a product, and then add mark up, to give the profit element. These methods are known as
‘cost plus pricing’.
A major criticism of cost plus pricing techniques is that they do not consider any external factors
(eg demand for product, number of competitors). They are therefore unlikely to maximise the
profits that a business will generate.
1.2 Target costing
Target costing: Target costing involves setting a target cost by subtracting a desired profit
margin from a target selling.
KEY
TERM
Target cost: 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.
In a modern environment with shortening product life cycles, organisations must redesign their
products frequently. As product life cycles have become much shorter, the planning,
development and design stage of a product is critical to an organisation’s cost management
process. Cost reduction must be considered at this stage of a product’s life cycle, rather than
during the production process.
Functional analysis (ie reducing costs by amending features of a product) can be applied at the
design stage of a new product and a target cost for each function can be set.
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.
2 Deriving a target cost
Traditionally:
Target costing:
mark up
(2nd)
cost
(1st)
margin
(2nd)
selling price
(3rd)
target cost
(3rd)
selling price
(1st)
2.1 Implementing target costing
(a) Define product specification and estimate sales volume.
(b) Set a target selling price at which the company will be able to achieve the desired market
share.
(c) Estimate required profit based on profit margins or return on investment.
(d) Calculate target cost:
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$
X
(X)
Target selling price
Less target profit
Target cost
X
(e) Prepare an estimated cost for the product based on the product specification and current
cost levels.
(f) Calculate the target cost gap: Estimated product cost – target cost = cost gap
(g) Make efforts to close the cost gap. Aim to ‘design out’ costs before production starts.
Illustration 1: Target costing and the target cost gap
1 Great Games, a manufacturer of computer games, is in the process of introducing a new game to
the market and has undertaken market research to find out about customers’ views on the value
of the product, as well as to obtain a comparison with competitors’ products. The results of this
research have been used to establish a target selling price of $60. This is the price that the
company thinks it will have to sell the product at to achieve the required sales volume.
Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost
Direct material
Direct labour
Direct machinery costs
Ordering and receiving
Quality assurance
$
3.21
24.03
1.12
0.23
4.60
Non-manufacturing costs
Marketing
Distribution
After-sales service
8.15
3.25
1.30
The target profit margin for the game is 30% of the target selling price.
Required
Calculate the target cost of the new game and the target cost gap.
Solution
1 The correct answer is:
Target selling price
Target profit margin (30% of selling price)
Target cost (60.00–18.00)
Projected cost
$
60.00
18.00
42.00
45.89
The projected cost exceeds the target cost by $3.89. This is the target cost gap. Great Games will
therefore have to investigate ways to reduce the cost from the current estimated amount down to
the target cost.
3 Closing a target cost gap
Increasing the selling price will not close the cost gap (because increasing the selling price will
negatively affect the sales volume).
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Value analysis: Value analysis involves examining the factors which affect the cost of a product or service, so as to devise ways of achieving the intended purpose most economically at
the required standards of quality and reliability.
KEY
TERM
Value can be viewed from a number of different perspectives:
• Cost value is the cost of producing and selling an item
• Exchange value is the market value of the product or service
• Use value is what the article does; the purposes it fulfils (performance, reliability)
• Esteem value is the prestige the customer attaches to the product
Value analysis seeks to refine the design of the product to reduce unit cost (so cost value is the
one aspect of value to be reduced) and to provide the same (or a better) use value at the lowest
cost. Value analysis also attempts to maintain or enhance the esteem value of a product at the
lowest cost. The aim is to reduce cost without compromising other aspects of value.
Management can set benchmarks for improvement towards the target cost, by improving
production technologies and processes. Various techniques can be employed; for instance:
• Reducing the number of components
• Using cheaper staff (where this does not affect quality)
• Using standard components wherever possible
• Acquiring new, more efficient technology
• Training staff in more efficient techniques
• Cutting out non-value added activities
• Using different materials (identified using activity analysis* etc)
*Activity analysis is an analysis of how much is being spent on particular activities.
However, the most effective time to eliminate unnecessary cost and reduce the expected cost to
the target cost level is during the product design and development phase, not after ‘live’
production has begun.
Exam focus point
The syllabus states that you must be able to suggest how to close a target cost gap. Make
sure that you understand the list above and can apply it to a scenario in an OT question.
Activity 1: Target costing
House it Co produces rabbit hutches. It is about to launch a new top of the range hutch which it
believes can be sold for $125. House it Co demands a margin of 25% on sales.
1
2
Cost information for the new hutch is as follows:
• Timber – The hutch needs 10 metres (m) of good quality planed timber. House it 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 – 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
What is the target cost of the rabbit hutch? (Give your answer to two decimal places.)
$
Required
What is the expected cost to make the hutch?
 $93.00
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3
 $98.50
 $101.50
 $125.00
Required
Which TWO of the following options would be the most appropriate strategies for House it Co to
close the cost gap?
 Make the hutch smaller
 Raise the selling price
 Make the window bigger – increasing the proportion of wire and reducing the proportion of
wood
 Use lower skilled labour for all elements of production
 Use lower quality timber to make the hutch
Solution
1
2
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3
4 Implications
Target costing turns the traditional cost plus approach to pricing on its head, meaning pricing is
the first consideration. Cost control is a primary consideration of the development of the product,
not merely as an activity which happens alongside production.
Performance management will therefore focus on two things; Ensuring sales targets are met as
well as finding ways of improving the processes to achieve the target cost..
5 Target costing in service industries
The target costing approach is a sensible basis for estimating and reducing costs regardless of
the type of business. However, due to the nature of service industries, this process is more difficult
in these businesses.
5.1 Characteristics of services
Unlike manufacturing, service industries have the following characteristics which make cost and
performance measurement more difficult:
• Intangibility
• Inseparability/simultaneity
• Variability/heterogeneity
• Perishability
• No transfer of ownership
5.2 Problems with target costing for services
A target cost for a product is a cost for an item whose design and make-up is specified in exact
detail in a product specification. A target cost is the cost for this detailed specification.
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Services are much more difficult to specify exactly. This is due to some of the characteristics of a
service.
Intangibility. This refers to the lack of substance which is involved with service delivery. Unlike
goods (physical products such as confectionery), there are no substantial material or physical
aspects to a service: no taste, feel, visible presence, and so on.
Some of the features of a service cannot be properly specified because they are intangible. What
exactly does a customer receive, for example, when they go to a cinema? When services are
provided by a human, the quality of the personal service can be critically important for the
customer, but this is difficult or impossible to specify.
When services do not have any material content, it is not possible to reduce costs to a target level
by reducing material costs. In comparison, reducing material costs can be an effective approach
to target costing for products.
Inseparability/simultaneity. Many services are created at the same time as they are consumed.
(Think of dental treatment.) No service exists until it is actually being experienced or consumed by
the person who has bought it.
Variability/heterogeneity. Many services face the problem of maintaining consistency in the
standard of output. It may be hard to attain precise standardisation of the service offered, but
customers expect it (such as with fast food). When services are delivered by humans, it is very
difficult to ensure that the same service is provided in exactly the same way every time and a
standard service may not exist. For example, repairing a motor car, providing an accountancy
service, or driving a delivery truck from London to Paris are never exactly the same each time.
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.
Perishability. Services are innately perishable. The services of a beautician, for example, are
purchased for a period of time.
No transfer of ownership. Services do not result in the transfer of property or ownership. The
purchase of a service only confers on the customer access to or a right to use a facility.
Services also vary widely in nature. For example, services include banking, transport, parcel
delivery, energy supply, entertainment, education, hotels and holidays, car repairs and
maintenance, professional services such as law and accountancy, cleaning, security services,
and so on are all examples of services.
A feature of many services, however, is that although the labour content may be high, the
material content is often quite low. With products, the material content is always higher but the
labour element may be lower.
Activity 2: Implementing target costing
The following statements have been made about target costing.
(a) It is more difficult to implement target costing in service industries compared to
manufacturing because of the lack of a tangible product.
(b) Target costing makes the business look at what competitors are offering at an early stage in
the new product development process.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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Activity 3:
Target cost gap
Required
Which TWO of the following methods can be used to move a currently attainable cost closer to
target cost?
 Using standard components wherever possible
 Acquiring new, more efficient technology
 Making staff redundant
 Reducing the quality of the product in question
Solution
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Essential reading
There is no essential reading for this chapter.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Target costing
Target costing
Deriving a target cost
Closing a target cost gap
Traditional approaches to
pricing
• Cost measurement is more
difficult
• Price set is based upon
qualitative information
• Target cost – estimated cost =
cost gap
• Any cost gap needs to be
closed through product design
and processing improvements
Calculate the cost of
manufacturing and selling a
product, and then add mark up
Implementing target costing
Target costing
• Externally focused approach
• A selling price is set with
reference to the market
• The desired profit margin is
then deducted leaving a
target cost
Implications
• Turns traditional pricing on its
head
• Cost control is considered
upfront as part of the product
development
• Performance management
focuses on
– Sales targets and selling
price
– Improving processes/
development to drive down
cost
• Target costing is suitable in
today's environment as short
product life cycles mean it is
essential to consider costs
upfront
• Calculate target cost
• Calculate target cost gap
• Make efforts to close the
cost gap
Target costing in
service industries
Characteristics of services
• Simultaneity
• Heterogeneity
• Intangibility
• Perishability
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Knowledge diagnostic
1. Target costing
Target costing is an approach that sets the selling price of a product or service with reference to
the marketplace.
2. Deriving a target cost
Selling price less desired margin = target cost.
Any cost gap should be closed via the design and development of the product.
3. Closing a target cost gap
• Reducing the number of components
• Using cheaper staff (where this does not affect quality)
• Using standard components wherever possible
• Acquiring new, more efficient technology
• Training staff in more efficient techniques
• Cutting out non-value added activities
• Using different materials
4. Implications
Cost control is considered up front during the development stage.
5. Target costing in service industries
Target costing can be applied to service industries but the measurement of cost is more difficult.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q7
Examination
2
4 mins
Section A Q8
Examination
2
4 mins
Section A Q9
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Target costing and lifecycle
costing, which discusses target costing and life cycle costing (the subject of the next chapter).
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Target costing
1
The correct answer is:
$93.75
$
125.00
31.25
93.75
Selling price
Margin (25%)
Target cost
2
The correct answer is:
$101.50
Expected cost
Timber
Roofing material
Wire
Labour
Variable overhead
3
$
48.00
35.00
1.50
14.00
3.00
101.50
The correct answers are:
•
Make the hutch smaller
•
Make the window bigger – increasing the proportion of wire and reducing the proportion of
wood
Using lower quality timber and labour would be likely to reduce the quality of the finished product
and so would not be suitable strategies. Again, raising the selling price is not an appropriate
strategy for closing the cost gap
Activity 2: Implementing target costing
The correct answer is:
Both (a) and (b)
A lack of tangible product means that target costing cannot be easily applied to service industries,
but this does not mean that it is never appropriate.
In order to identify the desirable features for a new product and set a target sales price, it is
necessary to look first at what competitors are offering in the market.
Activity 3: Target cost gap
The correct answers are:
•
Using standard components wherever possible
•
Acquiring new, more efficient technology
To make improvements towards the target cost, technologies and processes must be improved.
The use of standard components is a way of improving the production process.
Making staff redundant will not improve technologies and processes.
Reducing the quality of the product in question does not do this either.
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Life cycle costing
5
5
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Identify the costs involved at different stages
of the life cycle.
B3 (a)
Derive a life cycle cost or profit in
manufacturing and service industries.
B3 (b)
Identify the benefits of life cycle costing.
B3 (c)
5
Exam context
Life cycle costing is the third specialist cost accounting technique we will consider. It is an
approach that accumulates costs over a product’s entire life, rather than calculating them for
each accounting period through the product’s life. It is used to determine the total expected
profitability of a product over its entire life, from its design and development stage, through its
market introduction, to its eventual withdrawal from the market.
It is a costing technique used primarily for planning lifetime costs and profitability. It is not a
technique for recording and reporting historical costs of production and sales.
5
A question on life cycle costing could appear in the exam, either in Section A as an objective test
(OT) question or in Section B as a scenario question containing five OTs.
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Chapter overview
Life cycle costing
Life cycle costing
74
Product life cycle
Implications
Maximising return over the
product life cycle
Advantages
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1 Life cycle costing
Life cycle costing: Life cycle costing is the accumulation of costs over a product’s entire life.
KEY
TERM
Life cycle costing aims to cost a product, service, customer or project over its entire life cycle with
the aim of maximising the return over the total life while minimising costs.
Traditionally, the costs and revenues of a product are assessed on a financial year or period by
period basis.
Product 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.
2 Product life cycle
The product life cycle (PLC) can be divided into five stages.
Sales and
profits
Sales revenue
Profit
Time
Development Introduction
Growth
Maturity
Decline
Characteristics of the product life cycle
Stage
Sales volume
Costs
Development
None
Research and development
Introduction
Very low levels
Very high fixed costs (eg noncurrent assets, advertising)
Growth
Rapid increase
Increase in variable costs
Some fixed costs increase (eg
increased number of
factories)
Maturity
Stable
High volume
Primarily variable costs
Decline
Falling demand
Primarily variable costs (now
decreasing)
Some fixed costs (eg
decommissioning costs)
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2.1 Costs over the product life cycle
A product’s life cycle costs are incurred from its design stage through development to market
launch, production and sales, and finally to its eventual decline and withdrawal from the
market.
The component elements of a product’s cost over its life cycle could therefore include the
following.
• Research and development costs
- Design cost
- Cost of making a prototype
- Testing costs
- Production process and equipment: development and investment
• The cost of purchasing any technical data required (eg purchasing the right from another
organisation to use a patent)
• Training costs (including initial operator training and skills updating)
• Production costs, when the product is eventually launched in the market
• Distribution costs (including transportation and handling costs)
• Marketing and advertising
- Customer service
- Field maintenance
- Brand promotion
• Inventory costs (holding spare parts, warehousing, and so on)
• Retirement and disposal costs, ie costs occurring at the end of a product’s life, which may
include the costs of cleaning up a contaminated site
Some of these costs, such as design costs, are ‘once-only costs’. Others are incurred regularly
throughout the product’s life but vary with production and sales volumes. Production costs, for
example, will vary each year with changes in annual production volumes throughout the product’s
life.
Life cycle costs can also be estimated for services, customers and projects as well as for physical
products.
Traditional cost accumulation systems are based on the financial accounting year and tend to
dissect a product’s life cycle into a series of 12-month periods. This means that traditional
management accounting systems do not accumulate costs over a product’s entire life cycle and
do not therefore assess a product’s profitability over its entire life. Instead they do it on a
periodic basis.
Life cycle costing, on the other hand, tracks and accumulates actual costs and revenues
attributable to each product over the entire product life cycle. Hence, the total profitability of
any given product can be determined.
2.2 Maximising return over the product life cycle
There are a number of ways that return can be increased over the life cycle.
(a) Design costs out of products
Approximately 70%–90% of a product’s life cycle costs are determined by decisions made early in
the life cycle at the design and development stage. Therefore, design and production teams must
work together to ensure costs are minimised.
(b) Minimise the time to market
This is the time from the conception of the product to its launch. If a company can get a product
to the marketplace very quickly, it will give the product as long a span as possible without
competitors’ rival products in the marketplace. This should mean that market share is increased in
the long run.
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(c) Minimise breakeven time
Pricing strategies will affect both contribution and volumes generated. A short breakeven time is
very important for liquidity purposes.
(d) Extend the length of the life cycle itself
For example, product development, finding other uses for a product or staggering the launch of
the product in different markets.
2.2.1 Why calculate life cycle costs?
Life cycle costing has a different purpose from cost accumulation systems that measure actual
costs of production and sales. Traditional costing systems are intended to measure the cost of a
product in each accounting period, and the profit or loss that should be reported for the product
for that period.
The purpose of life cycle costing is to assess the total costs of a product over its entire life, to
assess the expected profitability from the product over its full life. Products that are not expected
to be profitable after allowing for design and development costs, or clean-up costs, should not be
considered for commercial development.
A feature of many competitive markets is that product life cycles are getting shorter, and
organisations must continually redesign existing products and develop new ones. The planning,
design and development stages of a product’s cycle are therefore critical to an organisation’s
costs and profits. Cost reduction at this stage of a product’s life cycle, rather than during the
production process, is one of the most important ways of reducing product cost.
Note. The techniques of life cycle costing and target costing can be combined, to plan for
achieving certain levels of cost at different stages of the product’s life cycle. Both are essentially
forward-looking techniques of costing.
3 Implications
Given that there will be different levels of demand for a product over its expected life, it would not
be appropriate to set one price for the product’s entire life.
An understanding of the stages a product goes through enables you to price accordingly to either
manipulate demand (low price, demand will rise and the introduction stage is shortened) or to
maximise profit.
All costs relating to a product including R&D are associated with the product. This enables true
assessment of a product’s profitability.
Looking at a product’s life cycle, it is clear that the product will make a loss initially. Viewing
profitability on a periodic basis can put unnecessary pressure on management because of the
visibility of the loss and could lead to incorrect decisions being taken.
3.1 Advantages
There are a number of benefits associated with life cycle costing.
(a) It helps management to assess profitability over the full life of a product, which in turn helps
management to decide whether to develop the product, or to continue making the product.
(b) It can be very useful for organisations that continually develop products with a relatively
short life, where it may be possible to estimate sales volumes and prices with reasonable
accuracy.
(c) The life cycle concept results in earlier actions to generate more revenue or to lower costs
than otherwise might be considered.
(d) Better decisions should follow from a more accurate and realistic assessment of revenues and
costs, at least within a particular life cycle stage.
(e) It encourages longer-term thinking and forward-planning and may provide more useful
information than traditional reports of historical costs and profits in each accounting period.
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Exam focus point
The syllabus states that you must be able to identify the benefits of life cycle costing.
Illustration 1: Life cycle costing
1 Solaris specialises in the manufacture of solar panels. It is planning to introduce a new slimline
solar panel specially designed for small houses. Development of the new panel is to begin shortly,
and Solaris is in the process of determining the price of the panel. It expects the new product to
have the following costs:
Year 1
2,000
Year 2
15,000
Year 3
20,000
Year 4
5,000
$
1,900,000
100,000
500
$
100,000
75,000
450
$
_
50,000
400
$
_
10,000
450
50
40
40
40
Units
manufactured
and sold
R&D costs
Marketing costs
Production cost
per unit
Customer service
costs per unit
Disposal of
specialist
equipment
300,000
The Marketing Director believes that customers will be prepared to pay $500 for a solar panel but
the Financial Director believes this will not cover all the costs throughout the life cycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on the suggested price.
Solution
1 The correct answer is:
R&D (1,900 + 100)
Marketing (100 + 75 + 50 + 10)
Production (1,000 + 6,750 + 8,000 + 2,250)
Customer service (100 + 600 + 800 + 200)
Disposal
Total life cycle costs
Total production (‘000 units)
Cost per unit
$’000
2,000
235
18,000
1,700
300
22,235
42
529.40
The total life cycle costs are $529.40 per solar panel, which is higher than the selling price
proposed by the marketing director of $500. At this price and cost, the slimline solar panel would
not be profitable. Solaris will either have to charge a higher price or look at ways to reduce costs.
It may be difficult to increase the price if customers are price sensitive and not prepared to pay
more. Costs could be reduced by analysing each part of the costs throughout the life cycle and
actively seeking cost savings; for example, using different materials, using cheaper staff or
acquiring more efficient technology.
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Activity 1: Life cycle cost per unit
X Co is in a high tech industry and is often first to market with new technological advances. It has
recently spent $500,000 designing and developing a new product. The new product is expected
to have a life of four years.
The anticipated performance of this product is as follows:
Sales volume
(units)
Marketing costs
Variable
production
cost per unit
Customer service
cost per unit
Disposal costs
Year 1
4,000
Year 2
9,000
Year 3
30,000
Year 4
10,000
$
1.2m
249
$
0.4m
249
$
0.1m
199
$
0.1m
149
100
100
60
75
0.2m
Required
What is the expected life cycle cost per unit? $
Solution
Activity 2: When costs are determined
Required
When are the bulk of a product’s life cycle costs normally determined?
 At the design/development stage
 When the product is introduced to the market
 When the product is in its growth stage
 On disposal
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Solution
Activity 3: Calculating life cycle costs
Required
Which of the following items would be included in the calculation of the life cycle costs of a
product?
(a)
Planning and concept design costs
(b)
Preliminary and detailed design costs
(c)
Testing costs
(d)
Production costs
(e) Distribution and customer service costs
 (b), (c) and (d)
 (a), (c) and (d)
 (d) only
 All of them
Solution
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Essential reading
There is no Essential reading for this chapter.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Life cycle costing
Life cycle costing
Consider all costs and revenues
throughout a product's life
Product life cycle
• Development
• Introduction
• Growth
• Maturity
• Decline
Maximising return over the
product life cycle
• Design costs out of products
• Minimise the time to market
• Minimise breakeven time
• Extend the length of the life
cycle itself
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Implications
Advantages
• Promotes maximisation of
return over the product life
cycle
• Considers all costs leading to
cost reduction
• Suitable for modern
environment with short life
cycles
• Considers external factors
throughout product's life
Knowledge diagnostic
1. Life cycle costing
Life cycle costing considers all costs and revenues of a product throughout its life rather than on a
periodic basis.
2. Product life cycle
The product life cycle is divided into five stages:
• Development
• Introduction
• Growth
• Maturity
• Decline
3. Implications
Understanding the product life cycle enables you to price accordingly to either manipulate
demand or maximise profit.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q10
Examination
2
4 mins
Section A Q11
Examination
2
4 mins
Section A Q12
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Target costing and lifecycle
costing, which discusses target costing and life cycle costing.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Life cycle cost per unit
The correct answer is:
Required
What is the expected life cycle cost per unit? $321.64
Sales volume (units)
Total variable cost per
unit $
Total variable cost $m
Marketing $m
Development cost $m
Disposal costs $m
Year 1
4,000
349
Year 2
9,000
349
Year 3
30,000
259
Year 4
10,000
224
Total
$m
1.396
1.2
0.5
3.141
0.4
0
7.77
0.1
0
2.24
0.1
0
0.2
14.547
1.8
0.5
0.2
17.047
$321.64
Life cycle cost per unit
53,000
Activity 2: When costs are determined
The correct answer is:
At the design/development stage
The bulk of a product’s life cycle costs will be determined at the design/development stage (being
designed in at the outset during product and process design, plant installation and setting up of
the distribution network).
Activity 3: Calculating life cycle costs
The correct answer is:
All of them
Life cycle costs are incurred from design stage through to withdrawal from the market
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Throughput accounting
6
6
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Discuss and apply the theory of constraints.
B4 (a)
Calculate and interpret a throughput
accounting ratio (TPAR).
B4 (b)
Suggest how a TPAR could be improved.
B4 (c)
6
Exam context
Throughput accounting (TA) is the fourth management accounting technique in Section B of the
syllabus. It is based on the theory of constraints and is consistent with the use of just-in-time (JIT)
production methods. The basic concept in throughput accounting is that an organisation should
seek to maximise ‘throughput‘ by identifying and eliminating bottlenecks.
6
Questions in Section B on this topic are likely to be a mixture of (see later in this Workbook). You
can also expect objective test questions on both the theory of constraints and throughput
accounting calculations in Section A.
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Chapter overview
Throughput accounting
Theory of constraints
Throughput accounting (TA)
Throughput
Interpreting the TPAR
Bottleneck
How can a business improve a
throughput accounting ratio?
Goldratt's five steps for dealing
with a bottleneck activity
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1 Theory of constraints (TOC)
1.1 Throughput
KEY
TERM
Theory of constraints: The theory of constraints (TOC) is a production system where the key
financial concept is the maximisation of throughput while keeping conversion and investment
costs to a minimum.
Throughput contribution (or throughput return or throughput) = sales revenue - direct material
cost
TOC is an approach to production management and optimising production performance that
was formulated by Goldratt and Cox in the US in 1986. Its key financial concept is to turn
materials into sales as quickly as possible, thereby maximising the net cash generated from
sales.
Formula to learn
Throughput = sales revenue – direct material cost
In throughput accounting, all operational expenses except materials are assumed to be ‘fixed‘
costs.
1.2 Bottlenecks
KEY
TERM
Bottleneck resource or binding constraint: Bottleneck resource (or binding constraint) is a
process which has a lower capacity than preceding or subsequent activities, thereby limiting
throughput.
The theory of constraints also states that at all times there will be a bottleneck resource or factor
that sets a limit on the amount of throughput that is possible. This bottleneck resource could in
theory be sales demand for an organisation’s output, but it is more likely to be a resource that an
organisation uses.
Raw Materials
Materials
Preparation
Component
Preparation
Final
Assembly
100 units
per hour
50 units
per hour
100 units
per hour
Sales
One process will inevitably act as a bottleneck and this is known as a binding constraint. Here the
bottleneck is component preparation because it can only deal with 50 units per hour whereas
materials preparation and final assembly can handle 100 units per hour each.
In the exam, the bottleneck resource is likely to be a production factor, such as machine time or
labour time. You may be familiar with the concept of ‘limiting factor’ in production. A bottleneck
resource is a limiting factor. In the theory of constraints and throughput accounting, a bottleneck
resource is also known as the binding constraint.
Activity 1: Bottleneck
A company passes its products through four production processes and is currently operating at
optimal capacity. The following data is available:
Process
Time per unit
Loading
3 mins
Washing
6 mins
Drying
1.5 mins
Labelling
2 mins
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Process
Machine hours
available
Loading
800
Washing
1,000
Drying
450
Labelling
450
Required
Which process is the bottleneck?
 Loading
 Washing
 Drying
 Labelling
Solution
1.3 Goldratt’s five steps for dealing with a bottleneck activity
The only way to increase throughput is to increase the capacity of the bottleneck constraint. All
the focus of management attention should be on increasing the capacity of the bottleneck
resource, or ‘elevating the bottleneck’.
Goldratt devised a five-step approach to summarise the key stages of TOC.
Step 1 – Identify the binding constraint/bottleneck
Step 2 – Exploit. The highest possible output must be achieved from the binding constraint. This
output must never be delayed and as such a buffer inventory should be held immediately before
the constraint.
Step 3 – Subordinate. Operations prior to the binding constraint should operate at the same
speed as it so that work in progress (WIP) does not build up.
Step 4 – Elevate the system’s bottleneck. Steps should be taken to increase resources or improve
its efficiency.
Step 5 – Return to Step 1. The removal of one bottleneck will create another elsewhere in the
system.
1.4 Production scheduling and the bottleneck resource
Taking the theory of constraints a stage further, since there is one bottleneck resource, it follows
that all the other resources in production and elsewhere are not bottlenecks. Since production and
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throughput are limited by the bottleneck resource, it follows that there will be idle capacity for all
the other resources.
Idle time should be accepted. Since all operational costs are fixed, idle time is not costing any
money.
Resources that are not the bottleneck resource should not be used beyond the amount required
for the maximum achievable throughput, given the bottleneck resource. Using non-binding
constraints beyond this amount will simply result in a build-up of inventories.
(a) In traditional cost accounting, improving efficiency and creating more inventory will increase
profits. Higher inventories reduce the cost of sales and increase reported profits.
(b) In the theory of constraints, using non-bottleneck resources above the amount required for
maximum throughput is wasteful. It does not increase throughput; it only increases unused
inventory levels.
To avoid the build-up of work in progress, production must be limited to the capacity of the
bottleneck resource but this capacity must be fully utilised as the focus should be to maximise
throughput.
Output through the binding constraint should never be delayed or held up, otherwise sales will be
lost. To avoid this happening, a small buffer inventory should be built up immediately prior to the
bottleneck constraint. This is the only inventory that the business should hold, with the exception
of possibly a very small inventory of finished goods and raw materials, which is consistent with a
JIT approach.
Operations in the production line prior to the binding constraint should operate at the same speed
as the binding constraint, otherwise excess and unwanted work in progress (other than the buffer
inventory) will be built up. According to TOC, inventory costs money in terms of storage space and
interest costs, and so inventory is not desirable.
1.5 Increasing throughput: elevating the bottleneck
The theory of constraints states that the aim should be to maximise total throughput. The only
way to increase throughput is to increase the capacity of the bottleneck constraint. All the focus
of management attention should be on increasing the capacity of the bottleneck resource, or
‘elevating the bottleneck’.
For example, time on Machine Type X may be a bottleneck resource. The only way to increase
throughput is to increase the output capacity of Machine Type X. Ways in which this might be
done, without buying a new Type X machine, could include:
• Moving from working five days a week to working six or seven days a week
• Moving from working a 12-hour production day to an 18-hour or 24-hour production day
• Carrying out routine maintenance work on the machine outside normal working hours, so that
it does not disrupt production
If the capacity of a bottleneck resource is elevated (increased) sufficiently it will eventually cease
to be a bottleneck resource. Another resource in the system will become the new bottleneck
resource.
The same approach is now used for the new bottleneck resource: maximise total throughput given
the restriction of this resource, and seek to increase total throughput by increasing the capacity
of the bottleneck resource.
2 Throughout accounting (TA)
KEY
TERM
Throughout accounting: Throughput accounting is an approach to production management
which aims to maximise throughput contribution, while also reducing inventory and
operational expenses.
TA is an accounting system based on the theory of constraints. It is very similar to the marginal
costing technique (covered in ACCA MA) but uses a different definition of contribution
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(throughput contribution = sales – direct material costs). It is most appropriate to use in a just-intime (JIT) environment because of the emphasis on throughput and inventory minimisation.
TA emphasises throughput, inventory minimisation and cost control.
(a) The only variable cost is materials. All other factory costs are fixed in the short run so this
means that labour is treated as a fixed cost in TA.
(b) In a JIT environment, producing solely for inventory is a bad thing. Products should not be
made unless there is a customer for them. This means accepting some idle time in nonbottleneck operations. WIP should be valued at material cost only, so that no value is added
to profit until a sale is made.
(c) Profit is determined by the rate at which throughput can be generated, ie how quickly raw
materials can be turned into sales to generate cash. Producing for the sole purpose of
increasing inventory creates no profit and so should not be encouraged.
Traditional costing
Throughput accounting
Labour costs and variable overheads are
treated as variable costs.
All costs other than materials are seen as fixed
in the short term.
Inventory is valued at total production cost.
Inventory is valued at material cost only.
Value is added when an item is produced.
Value is added when an item is sold.
Product profitability can be determined by
deducting a product cost from selling price.
Profitability is determined by the rate at which
money is earned.
3 Ratios
By evaluating production in a throughput environment, companies can check how a product is
‘performing‘ by comparing the returns it delivers with the costs incurred in producing it. This is
done using a throughput accounting ratio (which ACCA abbreviate to TPAR) which is the return
divided by a comparable cost.
The formulae below compare throughput return and throughput cost on a per-factory-hour basis.
The theory of constraints means that the throughput of the factory will be determined by the
speed of the bottleneck process. This is also reflected in the following list:
Formula to learn
(a)
Total factory costs (TFC) = Fixed production costs, including labour
(b)
Return per factory hour =
(c)
Sales revenue−material purchases
Time on bottle neck resources
Total factory costs
Cost per factory hour = Time on bottleneck resource
(d)
TPAR =
KEY
TERM
Rerturn per factory hour
Cost per factory hour
Factory costs or conversion cost: These are all costs except direct material cost (ie all costs
except totally variable costs).
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Exam focus point
It’s crucial that you know how to calculate and interpret the throughput accounting ratio
(TPAR) for your exam.
Activity 2: TPAR
Each unit of Product B requires four machine hours. Machine time is the bottleneck resource with
only 650 machine hours available per week.
Product B is sold for $120 per unit and has a direct material cost of $35 per unit. Total factory
costs are $13,000 per week.
Required
What is the TPAR for Product B (to two decimal places)?
Solution
3.1 Interpreting the TPAR
Total throughput should exceed total factory costs otherwise the organisation will make a loss.
This means that the TPAR should exceed 1.0.
A TPAR that is not much higher than 1.0 is barely profitable. The aim should be to achieve as high
a TPAR as possible.
TPARs can also be used to assess the relative earning capabilities of different products. Products
can be ranked in order of priority for manufacture and sale in order of their TPAR. Higher TPARs
should be given priority over lower TPARs. Different divisions of a business can also be ranked
based on TPAR.
3.2 How can a business improve a throughput accounting ratio?
In an exam question on throughput accounting, you may be asked about ways in which the TPAR
for a product might be increased. The ratio is increased by either:
• Increasing the throughput per bottleneck hour; or
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•
Reducing the operating cost per bottleneck hour
The TPAR could be increased in any of the following ways:
(a) Increase the selling price for the product. This will increase the throughput per unit, and so
will increase the throughput per unit of bottleneck resource.
(b) Reduce the material cost per unit. This will increase the throughput per unit, and so will
increase the throughput per unit of bottleneck resource.
(c) Reduce expenditure on operating costs/factory costs. This will reduce the operating cost per
unit of bottleneck resource.
(d) Improve efficiency, and increase the number of units or product that are made in each
bottleneck hour. This would increase total throughput per hour. The operating costs per hour
would be unaffected, therefore the TPAR ratio would increase.
(e) Elevate the bottleneck, so that there are more hours available of the bottleneck resource.
Throughput per unit of bottleneck resource would be unaffected but, since operating costs
are all fixed costs and there are more bottleneck hours available, the operating cost per
bottleneck hour would fall, and the TPAR ratio would increase.
However, there may be adverse consequences from some of these measures.
Measures
Consequences
Increase sales price per unit
Demand for the product may fall
Reduce material costs per unit, eg change
materials and/or suppliers
Quality may fall and bulk discounts may be
lost
Reduce operating expenses
Quality may fall and/or errors increase
Exam focus point
Make sure you know how a TPAR could be improved as this is specifically mentioned on the
syllabus.
Activity 3: Bottleneck and TPAR
MN Co manufactures automated industrial trolleys. Each trolley sells for $2,000 and the material
cost per unit is $600. Labour and variable overhead are $5,500 and $8,000 per week respectively.
Fixed production costs are $450,000 per year and marketing and administrative costs are
$265,000 per year.
The trolleys are made on three different machines. Machine X makes the four frame panels
required for each trolley. Its maximum output is 180 frame panels per week. Machine X is old and
unreliable and it breaks down from time to time. It is estimated that 20 hours of production are
lost per month. Machine Y can manufacture parts for 52 trolleys per week and machine Z, which
is old but reasonably reliable, can process and assemble 30 trolleys per week.
1
2
The company has recently introduced a just-in-time (JIT) system and it is company policy to hold
little work in progress and no finished goods inventory from week to week. The company operates
a 40-hour week, 48 weeks a year.
Which is the bottleneck machine?
 Machine X
 Machine Y
 Machine Z
 All of the machines
What is the throughput accounting ratio (TPAR)?
 1.84
 3.11
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 6.67
 7.03
Solution
1
2
Activity 4: Improving TPAR
Required
In the theory of constraints and throughput accounting, which THREE of the following actions
may be used to improve a throughput accounting ratio?
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




Increase selling price
Decrease selling price
Buy cheaper materials
Reduce time spent on the bottleneck machine
Increase time spent on the bottleneck machine
Solution
Activity 5: Capacity and TPAR
Teeth Co is a private cosmetic dental surgery offering two types of teeth whitening procedures: A
and B.
Both procedures are carried out by one of three dentists. The surgery also has two receptionists
and three dental nurses.
Every patient is first seen by the receptionist, who books them in and completes the paperwork;
next by the dentist, who applies the treatment; then finally a dental nurse, who rinses the
treatment off. The average length of time spent with each member of staff is as follows:
Treatment A
Hours
Treatment B
Hours
Receptionist
0.15
0.25
Dentist
1.25
2.4
Dental nurse
0.5
0.5
The surgery is open for eight hours each day for five days per week. It closes for two weeks each
year. Staff salaries per employee are as follows:
Receptionist
$25,000
Dentist
$70,000
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Dental Nurse
$30,000
The cost of the products used for procedure A is $40 and $74 for procedure B. Other surgery costs
amount to $200,000 each year.
Teeth Co charges $270 for procedure A and $365 for procedure B.
1
2
3
4
The dentists’ time has been correctly identified as the bottleneck activity.
What is the capacity of the bottleneck activity?
 Treatment A: 1,600 and Treatment B: 833
 Treatment A: 1,600 and Treatment B: 2,500
 Treatment A: 4,800 and Treatment B: 2,500
 Treatment A: 4,800 and Treatment B: 4,800
The surgery calculated the cost per hour to be $91.67. What is the throughput accounting ratio
(TPAR) for both treatments?
 Treatment A: 2.01 and Treatment B 1.32
 Treatment A: 2.01 and Treatment B 3.98
 Treatment A: 2.95 and Treatment B 1.32
 Treatment A: 2.95 and Treatment B 3.98
Which THREE of the following activities could the surgery use to improve the TPAR?
 Increase the time spent by the bottleneck activity on each treatment
 Identify ways to reduce the material costs for the treatments
 Increase the level of inventory to prevent stock-outs
 Increase the productivity of the receptionists
 Improve the control of the surgery’s total operating expenses
 Apply an increase to the selling price of the services
What would be the effect on the bottleneck if the surgery employed another dentist?
 The dentists’ time would be the bottleneck for treatment A only.
 The dentists’ time would be the bottleneck for treatment B only.
 The dentists’ time will remain the bottleneck for both treatments.
 There will no longer be a bottleneck.
Solution
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2
3
4
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Exam focus point
We will return to throughput accounting in the context of limiting factors in Chapter 9.
Essential reading
There is no Essential reading for this chapter.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Throughput accounting
Theory of constraints
Throughput accounting (TA)
Ratios
• Aim is turn materials into sales
as quickly as possible
• Focuses on bottlenecks in
production that stop
throughput maximisation
• In the short-term, all
production should be at pace
of bottleneck
• Based on the theory of
constraints
• Material is the only variable
cost
• Operates in a JIT environment
• Only inventory is a small buffer
inventory before bottleneck
• WIP valued at material cost
only
• Return per factory hour =
(sales revenue – material
purchases)/time on
bottleneck resource
• Cost per factory hour = total
factory costs/time on
bottleneck resource
• TPAR = return per factory hour
/cost per factory hour
Throughput
Interpreting the TPAR
Throughput = sales revenue –
direct material cost
Bottleneck
• TPAR should exceed 1
• Products or divisions can be
ranked in order of their TPAR
(higher = better)
Activity with lower capacity than
preceding or subsequent
activities, thereby limiting
throughput
How can a business improve a
throughput accounting ratio?
• Increase selling price
• Buy cheaper materials
• Decrease labour/overhead
• Speed up production through
the bottleneck
Goldratt's five steps for dealing
with a bottleneck activity
• Identify
• Exploit
• Subordinate
• Elevate
• Return to step one
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Knowledge diagnostic
1. Throughput accounting and the theory of constraints
Throughput accounting focuses on maximising throughput.
Throughput = sales – materials.
All labour and variable overheads are seen as fixed in the short term.
A JIT production system is operated, with some buffer inventory kept only when there is a
bottleneck resource
2. Ratios
Return per factory hour = (sales revenue - material purchases) / time on the bottleneck resource
Cost per factory hour = total factory costs / time on bottleneck resources
TPAR = return per factory hour / cost per factory hour
TPAR should be as high as possible, and certainly more than 1.0.
3. Improving TPAR
Improving TPAR can be done by:
• Increasing selling price
• Buying cheaper materials
• Decreasing labour
• Decreasing overhead
• Speeding up production through the bottleneck
4. Throughput accounting and decision making
When an organisation makes more than one product, total throughput is maximised by giving
priority to those products that earn the largest throughput per unit of bottleneck resource.
Products should be ranked in order of priority according to their throughput per unit of bottleneck
resource
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q13
Examination
2
4 mins
Section A Q14
Examination
2
4 mins
Section B ‘Bottlenecks’
Examination
10
18 mins
Further reading
There are two technical articles available on ACCA’s website, called Throughput accounting and
the theory of constraints – parts 1 and 2. The first article summarises the story contained in a
book called The Goal (Goldratt and Cox, 1992) that presents the theory of constraints and
throughput accounting within the context of a novel. The second article talks through a practical
approach to questions on throughput accounting.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Bottleneck
The correct answer is:
Washing
Operation
Loading
Washing
Units
Units
(800 × 60) (1,000 × 60)
48,000
60,000
3
6
16,000
10,000
(a) Capacity in mins
(b) Time in minutes per unit
Capacity in units ((a)/(b))
Drying
Units
(450 × 60)
27,000
1.5
18,000
Labelling
Units
(450 × 60)
27,000
2
13,500
Therefore, washing is the bottleneck as it is the process which determines the maximum number of
units which can be produced.
Activity 2: TPAR
The correct answer is:
1.06
Return per factory hour = ($120 - $35)/4 = $21.25
Cost per factory hour = $13,000/650 = $20
TPAR = $21.25/$20 = 1.0625 (1.06 to two decimal places)
Activity 3: Bottleneck and TPAR
1
The correct answer is:
Machine Z
Machine X
loses 20 hours / mth = 5 hours / week
loss of 12.5%
Max output of panels is therefore 180 – 12.5%
No of trolleys = panels / 4
Machine Y
Machine Z
2
158
39
52
30
The bottleneck is therefore Machine Z.
The correct answer is:
1.84
Return/hr
Cost/hr
TPAR
(2,000 – 600 hours) × 30
trolleys = 42,000
5,500 + 8,000 + (450,000/48) =
22,875
Return/hour
Cost/hour
Activity 4: Improving TPAR
The correct answers are:
•
Increase selling price
•
Buy cheaper materials
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42,000 / 40 =
1,050
572
1.84
•
Reduce time spent on the bottleneck machine
In fact, any of the following actions will improve the throughput return:
• Increase selling price
• Buy cheaper materials
• Decrease labour
• Decrease overhead
• Speed up production through the bottleneck
Activity 5: Capacity and TPAR
1
The correct answer is:
Treatment A: 4,800 and Treatment B: 2,500
Dentists’ hours available per year: 8 hours × 5 days × 50 weeks × 3 dentists = 6,000
Treatment A: 6,000/1.25 = 4,800
2
Treatment B: 6,000/2.4 = 2,500
The correct answer is:
Treatment A: 2.01 and Treatment B 1.32
The correct answer is: Treatment A: 2.01 and Treatment B: 1.32
3
Treatment A
Treatment B
Throughput contribution
(270 – 40) = 230
(365 – 74) = 291
Bottleneck time per
treatment
1.25
2.4
Return per hour
(230/1.25) = 184
(291/2.4) = 121.25
Cost per hour
91.67
91.67
TPAR
(184/91.67) = 2.01
(121.25/91.67) = 1.32
The correct answers are:
•
Identify ways to reduce the material costs for the treatments
•
Improve the control of the surgery’s total operating expenses
•
Apply an increase to the selling price of the services
The factors which are included in the TPAR are the selling price, material costs, operating costs
and bottleneck time. Increasing the selling price and reducing costs will therefore lead to an
improvement in the TPAR.
4
Increasing the time spent on the bottleneck activity by each treatment will actually make the TPAR
worse, as would increasing the productivity of the stage prior to the bottleneck as this would lead
to an increase in WIP.
The correct answer is:
The dentists’ time will remain the bottleneck for both treatments.
Hours available
Treatment A
capacity
Treatment B
capacity
Receptionist
4,000
26,667
16,000
Dentist
6,000
4,800
2,500
Dental nurse
6,000
12,000
12,000
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If another dentist was employed, this would add another 2,000 hours per year – meaning they
would have the capacity to do another 1,600 treatment As or 833 treatment Bs. This would still
mean that dentists’ time is the bottleneck activity.
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Environmental
management accounting
7
7
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Discuss the issues businesses face in the
management of environmental costs.
B5 (a)
Describe the different methods a business
may use to account for its environmental
costs.
B5 (b)
7
Exam context
Environmental accounting is the fifth and final management accounting technique in Section B of
the syllabus.
Environmental issues are becoming increasingly important in the business world. Businesses are
responsible for the environmental impact of their operations and are becoming increasingly aware
of problems such as carbon emissions.
The growth of environmental issues and regulations has also brought greater focus on how
businesses manage and account for environmental costs.
The focus of this chapter is on methods of providing information to management on
environmental costs. It does not deal with environmental reporting to shareholders and other
stakeholders.
7
For your exam, you should try to understand the nature of environmental costs, and you should
be able to recognise the four methods of environmental management accounting that are
described in this chapter. A question on environmental costing could appear in the exam, either in
Section A as an objective test (OT) question or in Section B as a scenario question containing five
OTs.
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Chapter overview
Environmental management accounting
Principles of
environmental costing
Defining
environmental costs
Managing environmental costs
Accounting for
environmental costs
Input/output flow analysis
Flow cost accounting
Activity based costing
Life cycle costing
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1 Principles of environmental costing
1.1 Managing environmental costs
Management accountants need to be aware of the environmental costs associated with business
activities. The general public are becoming more conscious about the environment and therefore
customer habits and choices are being influenced by environmental factors and whether
businesses are perceived as being ‘green’.
Businesses, however, often face difficulties with defining, identifying and controlling
environmental costs.
Environmental costs such as energy costs are often treated as production overheads and
therefore effectively hidden from management scrutiny. As well as being more difficult to
identify, environmental costs may also be more difficult to quantify. For example, businesses may
suffer a loss of reputation if problems arise.
Even where environmental costs are captured within accounting systems, the difficulty lies in
pinpointing them and allocating them to a specific product or service. Typical environmental
costs are listed below.
• Consumables and raw materials
• Transport and travel
• Waste
• Waste and effluent disposal
• Water consumption
• Energy
Once a business has defined, identified and allocated environmental costs, it can begin the task
of trying to control them through environmental management systems.
KEY
TERM
Environmental management accounting (EMA): Environmental management accounting
(EMA) is the generation and analysis of both financial and non-financial information in order
to support internal environmental management processes.
1.2 Benefits of understanding environmental costs
Many benefits accrue from a clear understanding and effective management of the environmentrelated costs of business activities.
(a) Environmental costs may be significant for some companies. Once identified, environmental
costs can be controlled and reduced.
(b) There is increasing worldwide regulation and a need for regulatory reporting of
environmental costs.
(c) Ethical issues – businesses should be aware of how their production methods will affect the
environment (eg carbon emissions).
(d) Improved brand image – ‘green’ ways of doing business can be a selling point.
(e) Associating environmental costs with individual products will lead to more accurate pricing
and improved profitability.
Activity 1: Environmental budget cost
Raxo plc is a multinational organisation, manufacturing chemicals for use in the agricultural
industry.
Required
Which of the following environmental costs should NOT be included in an environmental cost
budget?
 Cost of disposal of unused raw materials
 Cost of fines for environmental contamination
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 Cost of disposal of chemical packaging
 Cost of using pollution-prevention methods and technology
Solution
2 Defining environmental costs
Definitions of environmental costs vary widely. This can make it difficult to identify the costs
involved and therefore control them. They may be hidden inside ‘general overheads’.
Hansen and Mendoza (1999) suggested that environmental costs could be classified as:
Classification
Definition
Examples
Environmental prevention
costs
Costs of activities undertaken
to prevent environmental
impacts before they occur
Forming environmental
policies
Performing site and feasibility
studies
Staff training
Environmental detection costs
Costs involved with
establishing whether activities
comply with environmental
standards and policies
Developing performance
measures
Monitoring, testing and
inspection costs
Site survey costs
Environmental internal failure
costs
Costs of activities that must
be undertaken when
contaminants and waste have
been created by a business
but not released into the
environment
Maintaining pollution
equipment
Recycling scrap
Environmental external failure
costs
Costs that arise when a
business releases harmful
waste into the environment
Cleaning up oil spills
Decontaminating land
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To aid comparison with future periods, the environmental costs should also be expressed as a
percentage of turnover or operating costs.
The US Environmental Protection Agency (1998) as cited by ACCA (2016) defined the following
costs:
Classification
Definition
Examples
Conventional costs
Ordinary use of equipment,
material and overhead costs
where the environment would
benefit from decreased use
Electricity
Potentially hidden costs
Costs hidden in overheads
Design cost of more
environmentally friendly
processes
Contingent costs
Costs that may be incurred at
a later date
Decontaminating land
Image and relationship costs
Costs incurred to manage
perception/image
Tree planting
Much business activity takes place at the cost of the environment, and some of these costs are felt
by society as a whole. Externalised costs are those for which wider society has to ‘pay’ at least
an element – eg global warming. Costs can also be classified as internalised in that the impacts
are contained within the organisation.
Activity 2: Environmental costs
Required
Which of the following is an example of an environmental external failure cost?
 Maintaining pollution equipment
 Decontaminating land
 Recycling scrap
 Record keeping
Solution
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3 Accounting for environmental costs
The PM syllabus is concerned with information for internal decision making only. It is not
concerned with how environmental information is reported externally.
There are a range of management accounting techniques for the identification and allocation of
environmental costs. The United Nations Division for Sustainable Development (UNDSD, 2003) as
cited by ACCA (2016) identified four techniques.
3.1 Input/output flow analysis
The idea of this analysis is that what comes in, must go out. Material inflows are recorded and
balanced with outflows. This forces the business to account for the difference between material
input and material output and focus on environmental costs.
Finished output 75%
Input 100%
Process
Scrap 10%
Residual = waste 15%
3.2 Flow cost accounting
Material flows through an organisation are divided into three categories.
• Material
• System and delivery
• Disposal
The value and cost of each material flow is then calculated. The aim is to reduce the quantity of
materials thereby saving costs.
3.3 Activity based costing
In order to fully integrate environmental costs into their management accounting, organisations
can apply activity based costing principles to environmental costs.
Environmental costs would be grouped together into environmental cost pools, and each pool
would be associated with an environmental cost driver.
Individual products that passed through the most polluting processes would therefore absorb
more environmental costs than cleaner or more ‘green’ products.
As for ABC in general, this will lead to:
(a) Increased awareness of how environmental costs behave
(b) Better product pricing
(c) Better production decisions
KEY
TERM
Environment related costs: Environment related costs are costs that can be attributed to a
cost centre such as a waste treatment centre.
Environmental driven costs: Environment driven costs are costs that are caused by events in
the environment but usually hidden in general overheads, such as an increase in electricity
costs.
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3.4 Life cycle costing
Environmental costs are considered from the design stage of a new product right up to the end of
life costs such as decommissioning and removal.
The consideration of future disposal or remediation costs at the design stage may influence the
design of the product itself, saving on future costs.
Essential reading
There is no Essential reading for this chapter.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Environmental management accounting
Principles of
environmental costing
Defining
environmental costs
Managing environmental costs
• Environmental prevention costs
• Environmental detection costs
• Environmental internal failure
costs
• Environmental external failure
costs
Historically environmental costs
were treated as production
overheads and effectively hidden
Accounting for
environmental costs
Input/output flow analysis
• What comes in, must go out
• Material inflows are balanced
with outflows
Flow cost accounting
• Material flows are divided into
– Material
– System and delivery
– Disposal
Activity based costing
Using environmental cost pools
Life cycle costing
Environmental costs are
considered from design stage to
end of life
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Knowledge diagnostic
1. Principles of environmental costing
Environmental costs need to be clearly understood by management, and not ‘hidden’ in with
production overheads.
2. Defining environmental costs
Prevention, detection, internal failure, external failure.
Conventional, potentially hidden, contingent, image and relationship.
3. Accounting for environmental costs
There are four management accounting techniques for the identification and allocation of
environmental costs: input/output analysis, flow cost accounting, activity based costing and life
cycle costing.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q15
Examination
2
4 mins
Section A Q16
Examination
2
4 mins
Section A Q17
Examination
2
4 mins
Section A Q18
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Environmental management
accounting, which covers this topic.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Environmental budget cost
The correct answer is:
Cost of fines for environmental contamination
A company may incur costs for contamination of the environment, but this cost should not be
included within budgeted environmental costs as this implies that it is an acceptable cost.
Activity 2: Environmental costs
The correct answer is:
Decontaminating land
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Skills checkpoint 1
Approach to objective test
(OT) questions
Chapter overview
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
ly sis
How to
approach
your PM
exam
Performance
management
questions
ti m
an a
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
Answer planning
an
en
cal
e ri
en
em
tn
ag
um
em
Effective
use of
spreadsheets
t
Effi
ci
Effective writing
and presentation
Introduction
Sections A and B of the PM exam will contain OTs worth 60 marks (ie 60% of your exam) and
therefore being able to answer OT questions effectively is extremely important.
The ‘specialist cost and management accounting techniques’ area of the syllabus will only be
examined in OT questions in Section A and B. These areas include: Activity-based costing, Target
costing, Life cycle costing, Throughput accounting and Environmental accounting. You should be
prepared for at least one of the Section B case questions, containing five OTs, to be on these
topics.
Section A – Single OT questions
OT questions are single, short questions that are auto-marked and worth two marks each. You
must answer the whole question correctly to earn their two marks. There are no partial marks.
The OT questions in Section A aim for a broad coverage of the syllabus, and so all areas of the
syllabus need to be carefully studied. You need to work through as many practice objective test
questions as possible, reviewing carefully to see how correct answers are derived.
The following types of OT questions commonly appear in the PM exam:
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Question type
Explanation
Multiple choice (MCQ)
You need to choose one correct answer from four given response
options.
Multiple response options
(MRO)
These are a type of multiple-choice question where you need to
select more than one answer from a number of given options. The
question will specify how many answers need to be selected. It is
important to read the requirement carefully.
Fill in the blank (FIB)
This question type requires you to type a numerical answer into a
box. The unit of measurement (eg $) will sit outside the box, and if
there are specific rounding requirements these will be displayed.
You must follow any rounding requirements shown - this is very
important!
Drag and drop
Drag and drop questions involve you dragging an answer and
dropping it into place. Some questions could involve matching
more than one answer to a response area and some questions
may have more answer choices than response areas, which means
not all available answer choices need to be used.
Drop down list
This question type requires you to select one answer from a dropdown list. Some of these questions may contain more than one
drop down list and an answer has to be selected from each one.
This requires the same skills as a multiple-choice question.
Section B – OT Case questions
As with Section A, questions can come from any area of the syllabus, reinforcing the need for
candidates to study the whole syllabus. Section B will include three OT case questions.
Each OT Case contains a group of five OT questions based around a single scenario. These can
be any combination of the single OT question types and they are auto-marked in the same way
as the single OT questions.
OT Cases are worth ten marks (each of the five OTs contained within are worth two marks, and as
with the OT questions described above, students will receive either two marks or zero marks for
those individual questions).
OT cases are written so that there are no dependencies between the individual questions. So, if
you did get the first question wrong, this does not affect your ability to get the other four correct.
The OT Case scenario remains on-screen so you can see it while answering the questions.
Each OT case normally consists of three numerical and two discursive style questions. It is often
quicker to tackle the discursive questions first leaving some additional time to tackle calculations.
You don’t need to show any workings in OT answers, but you will probably have to write down
some workings to help you answer calculation questions. You will be given scrap paper in the
exam for this purpose and it will be collected and thrown away afterwards. Although you do not
need to produce neat and tidy workings because no-one else will see them, it is worth labelling
your workings with the question number so that if you have time at the end, you can go back and
check them. Note that the exam software contains a ‘flag’ functionality, meaning that you can
flag any questions that you want to return to and review, if you have spare time at the end.
Approach to OT questions
PM Skill: Approach to OT questions
A step-by-step technique for approaching OT questions is outlined below. Each step will be
explained in more detail in the following sections as the OT case question, ‘Triple Co’ is answered
in stages.
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General guidance for approaching OT questions
STEP 1: Answer the questions you know first.
If you’re having difficulty answering a question, move on and come back to tackle it
once you’ve answered all the questions you know.
It is often quicker to answer discursive style OT questions first, leaving more time
for calculations.
General guidance for approaching OT questions
STEP 2: Answer all questions.
There is no penalty for an incorrect answer in ACCA exams; there is nothing to be
gained by leaving an OT question unanswered. If you are stuck on a question, as a
last resort, it is worth selecting the option you consider most likely to be correct
and moving on. Make a note of the question, so if you have time after you have
answered the rest of the questions, you can revisit it.
Guidance for answering specific OT questions
STEP 3: Read the requirement first!
The requirement will be stated in bold text in the exam. Identify what you are
being asked to do, any technical knowledge required and what type of OT
question you are dealing with. Look for key words in the requirement such as
"which TWO of the following," "which of the following is NOT"
Guidance for answering specific OT questions
STEP 4: Apply your technical knowledge to the data presented in the question.
Take your time working through questions, and make sure to read through each
answer option with care. OT questions are designed so that each answer option is
plausible. Work through each response option and eliminate those you know are
incorrect.
Exam success skills
The following question is a Section B OT case question from a past exam worth ten marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in an OT case
question in Section B to feel a little overwhelming. Active reading is a useful technique to avoid
this. This involves focusing on each of the five requirements first on the basis that, until you
have done this, the detail in the question will have little meaning and will seem more
intimidating.
Focus on the requirements, noting key verbs to ensure you understand the requirement properly,
and correctly identify what type of OT question you are dealing with. Then read the rest of the
scenario, making a note of important and relevant information and technical information you
think you will need.
Remember that Sections A and B are computer marked and so your answer will be either right or
wrong. If you misread the information, you could be wasting valuable time as well as choosing the
wrong answer.
• Correct interpretation of requirements. Identify from the requirement the different types of OT
question. This is especially important with multiple response options (MRO) to ensure you
select the correct number of response options.
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•
Good time management. Complete all OTs in the time available. Each OT is worth two marks
and should be allocated 3.6 minutes. A whole Section B question should take 18 minutes.
Skill activity
The following scenario relates to Questions 1 to 5.
Triple Co makes three types of gold watch: the Diva (D), the Classic (C) and the Poser (P). A
traditional absorption costing system is used at present, although an activity-based costing (ABC)
system is being considered. Details of the product lines for a typical period are:
Hours per unit
Labour hours Machine hours
Product D
Product C
Product P
0.5
1.5
1
1.5
1
3
Materials
Cost per unit
$
20
15
10
Production
Units
750
1,250
7,000
Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis.
The overhead absorption rate for the period is $28 per machine hour.
Total production overheads are $654,500 and further analysis shows that the total production
overheads can be divided as follows:
%
20
15
Costs relating to machinery
Costs relating to materials handling
The following total activity volumes are associated with each product line for the period as a
whole:
Number of movements of materials
12
21
87
Product D
Product C
Product P
120
(a) What is the cost per unit for Product D using the current absorption costing system?* Give
your answer to two decimal places. (2 marks)
$
per unit
* This is a FIB question, and so it is important you insert your answer to two decimal places (as
stated). A calculation of the cost per unit under absorption costing is required. This is brought
forward knowledge from ACCA Management Accounting.
(b) What is the total amount of machining overhead that would be allocated to Product C for
the period using ABC?*(2 marks)
• $7,000
• $23,375
• $23,800
• $35,000
* This is an MCQ requiring one correct answer to be selected. A calculation of overhead cost using
ABC is required. Remember that the distracters (incorrect answers) are numbers that you will
obtain if you make a particular mistake. Do not look at the options until you have finished the
calculation as it is possible that a “part finished calculation” is one of the incorrect distracters.
(c) What is the overhead assigned to Product D in respect of materials handling using ABC?*
Give your answer to the nearest hundred $. (2 marks)
$
* This is another FIB question and you need to enter your answer to the nearest hundred $.
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(d) Triple Co is attempting to identify the correct cost driver for a cost pool called quality
control. Using the drop down list below, which would be the correct cost driver to use?*(2
marks)
Select...
‚
Number of units produced
Number of inspections
Labour hours
Number of machine set ups
* This is drop down list question. Like an MCQ, you need to select one correct answer.
(e) If Triple Co decides to adopt ABC, which of the following is a disadvantage that Triple Co
may encounter as a result of this decision*?(2 marks)
• ABC can only be applied to production overheads.
• The cost per unit may not be as accurate as it was under traditional absorption costing.
• The benefits obtained from ABC might not justify the costs.
• It will not provide much insight into what drives overhead costs. (Total = 10 marks)
* This is another MCQ and you need to correctly select one disadvantage of adopting ABC.
STEP 1
Answer the questions you know first.
If you are having difficulty answering a question, move on and come back to tackle it once you have
answered all the questions you know. It is often quicker to answer discursive style OT questions first, leaving
more time for calculations.
Questions 4 and 5 are discursive style questions. It would make sense to answer these two
questions first as it is likely that you will be able to complete them comfortably within the 7.2
minutes allocated to them. Any time saved could then be spent on the more complex calculations
required to answer questions 1, 2 and 3.
STEP 2
Answer all questions.
There is no penalty for an incorrect answer in ACCA exams so there is nothing to be gained by leaving an
OT question unanswered. If you are stuck on a question, as a last resort, it is worth selecting the option you
consider most likely to be correct, and moving on. Make a note of the question, so if you have time after you
have answered the rest of the questions, you can revisit it.
Two of the five questions in the OT case are MCQs and one is a drop down list question. With
these types of questions, you have a 25% chance of getting the question correct so do not leave
any unanswered. It is obviously more difficult to get a fill in the blank question (like Questions 1
and 3) correct by guessing.
STEP 3
Read the requirement first!
The requirement will be stated in bold text in the exam. Identify what you are being asked to do, any
technical knowledge required and what type of OT question you are dealing with. Look for key words in the
requirement such as ‘Which TWO of the following…’, ‘Which of the following is NOT…’
Questions 1 and 3 are FIB questions and so you need to follow the instructions carefully and insert
your answer to the correct number of decimal places. Question 5 asks you to identify which
statements is a disadvantage of adopting ABC. Read through each statement carefully knowing
that you are looking to identify the disadvantage.
STEP 4
Apply your technical knowledge to the data presented in the question.
Take your time working through calculations, and be sure to read through each answer option with care. OT
questions are designed so that each answer option is plausible. Work through each response option and
eliminate those you know are incorrect.
To answer Questions 1, 2 and 3, you need to analyse the data given in the question.
Let’s look at Question 1 in detail.
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The question asks you to calculate the absorption cost per unit for product D. You will therefore
need to find all the costs for D (materials and labour) from the data in the question, as well as the
absorption rate and basis.
Triple Co makes three types of gold watch: the Diva (D), the Classic (C) and the Poser (P). A
traditional absorption costing system is used at present, although an activity-based costing (ABC)
system is being considered. Details of the product lines for a typical period are:
Hours per unit
Labour hours Machine hours
Product D
Product C
Product P
½
1½
1
1½
1
3
Materials
Cost per unit
$
20
15
10
Production
Units
750
1,250
7,000
Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis.
The overhead absorption rate for the period is $28 per machine hour.
Total production overheads are $654,500 and further analysis shows that the total production
overheads can be divided as follows:
%
20
15
Costs relating to machinery
Costs relating to materials handling
The following total activity volumes are associated with each product line for the period as a
whole:
Number of movements of materials
12
21
87
Product D
Product C
Product P
120
(a) What is the cost per unit for Product D using the current absorption costing system? Give
your answer to two decimal places. (2 marks)
$
per unit
Using all the information, the correct answer is $65.00 per unit.
Traditional absorption cost per unit
Material
Labour @ $6 per hour
Direct costs
Production overhead @ $28 per machine hour
Total production cost per unit
Product D
$
20.00
3.00
23.00
42.00
65.00
Let’s look briefly at Question 2.
(b) What is the total amount of machining overhead that would be allocated to Product C for
the period using ABC? (2 marks)
• $7,000
• £23,375 ($23,375 is incorrect. 23,375 is the total number of machine hours).
• $23,800 ($23,800 is incorrect. This is the figure you will get if you forget to multiply the
machine hours by the number of units of production. ($130,900 / 5.5 hours) x 1 hour =
$23,800).
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•
$35,000 ($35,000 is incorrect. This is the figure you will get if you forget to multiply the
overheads by 20%. ($654,500 / 23,375 hours) x 1,250 = $35,000)
The correct answer is: $7,000.
Product C uses 1,250 machine hours (W1) × $5.60 per hour (W2) = $7,000
Workings
(1)
Total machine hours (needed as the driver for machining overhead)
Product
D
C
P
Total machine hours
Hours/unit
1½
1
3
Production units
750
1,250
7,000
Total hours
1,125
1,250
21,000
23,375
(2)
Type of overhead
Machining
Driver
Machine hours
% Total overhead
20
$130,900
Level of driver
activity
23,375 (W1)
Cost/driver
$5.60
To answer Question 5, you can start by eliminating the response options that you know are not
disadvantages.
If Triple Co decides to adopt ABC, which of the following is a disadvantage that Triple Co may
encounter as a result of this decision? (2 marks)
• ABC can only be applied to production overheads*.
• The cost per unit may not be as accurate as it was under traditional absorption costing
because multiple OARs are calculated**.
• The benefits obtained from ABC might not justify the costs.
• It will not provide much insight into what drives overhead costs because each cost pool has its
own OAR***.
* ABC can be applied to all overheads, not just production overheads.
** The cost per unit provided under ABC principles will be more accurate.
*** ABC costing will provide much better insight into what drives overhead costs.
The answers to the other questions are:
3 The correct answer is: $9,800 (to the nearest hundred $).
Type of overhead
Materials handling
Driver
Material movements
Total
overhead
98,175
%
15
Level of
driver activity
120
Cost/driver
818.13
Product D
Activity
Material handling
Level of activity
12
Cost
818.13 × 12 = 9,818
4 The correct answer is: Number of inspections
The number of inspections per product is likely to be the main driver of quality control costs. The
number of set ups is unlikely to have an effect on the quality control costs. Some product lines
may require more inspections than others, therefore ‘number of units produced’ is not sufficient to
use as the cost driver. Labour hours will not reflect the quality control aspect of individual
products.
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Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the Triple Co activity to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Managing information
Did you read each of the five requirements first?
Did you actively read the scenario making a note of relevant
data required such as the absorption rate and absorption
basis?
Correct interpretation of
requirements
Did you identify the correct technical knowledge needed to
answer each requirement? For example, using the correct cost
drivers to answer Questions 2 and 3.
Did you identify what type of OT question you were dealing
with? For example, knowing that only one correct answer is
required for a multiple-choice question.
Did you identify how accurate the answer should be in the FIB
questions? For example, Q1 required the answer to two
decimal places, whereas Q3 required the answer to the
nearest $100.
Good time management
Did you manage to answer all five questions within 18 mins?
Did you manage your time well by answering Questions 4 and
5 first?
Most important action points to apply to your next question
Summary
60% of the PM exam consists of OT questions. Key skills to focus on throughout your studies will
therefore include:
• Always reading the requirements first to identify what you are being asked to do and what
type of OT question you are dealing with
• Actively reading the scenario, making a note of key data needed to answer each requirement
• Answering OT questions in a sensible order, dealing with any easier discursive style questions
first
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Cost volume profit (CVP)
analysis
8
8
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain the nature of CVP analysis.
C2 (a)
Calculate and interpret the breakeven point
and margin of safety.
C2 (b)
Calculate the contribution to sales ratio, in
single and multi-product situations, and
demonstrate an understanding of its use.
C2 (c)
Calculate target profit or revenue in single
and multi-product situations, and
demonstrate an understanding of its use.
C2 (d)
Interpret breakeven charts and profit volume
charts and interpret the information contained
within each, including multi-product
situations.
C2 (e)
Discuss the limitations of CVP analysis for
planning and decision-making.
C2 (f)
8
Exam context
You will have already encountered cost volume profit (CVP) analysis (also known as breakeven
analysis) in your earlier studies, so you should be reasonably familiar with the terminology or
basic techniques that you will meet in this chapter. The PM syllabus moves on to multi-product
CVP analysis.
8
CVP analysis could appear in any section of the PM exam.
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Chapter overview
Cost volume profit (CVP) analysis
Cost volume profit
(CVP) analysis
Single product breakeven analysis
Assumptions
Breakeven, contribution and P/V charts
Multi-product
breakeven point
Contribution to sales (C/S)
ratio for multiple products
Target profit for
multiple products
Margin of safety
for multiple products
Multi-product
graphs
Limitations of
breakeven analysis
Changing the product mix
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1 Cost volume profit analysis (CVP analysis)
CVP analysis looks at the effects of differing levels of activity on the financial results of a business
by examining the relationship between sales volume and profit.
Most businesses need to at least break even when setting prices and output levels. The breakeven
point for a company is the sales volume which will give the company a profit of $nil. If sales
exceed the breakeven point the company will make a profit.
Breakeven point: Breakeven point is the level of sales at which there is neither profit nor loss.
KEY
TERM
1.1 Assumptions
(a) CVP analysis can apply to one product only, or to more than one product if they are sold in a
fixed sales mix (fixed proportions).
(b) Fixed costs per period are same in total, and unit variable costs are a constant amount at all
levels of output and sales.
(c) Sales prices per unit are constant at all levels of activity.
(d) Production volume = sales volume.
These assumptions lead to linear relationships for volume and sales revenue.
2 Single product breakeven analysis
Formula to learn
Contribution per unit = unit selling price - unit variable costs
Breakeven point (BEP)
Fixed costs
Breakeven point (BEP) = Unit contribution
The ratio of contribution to sales is an alternative method of finding the breakeven point. It gives
the amount of contribution earned per dollar of sales. It can be measured as a fraction or a
percentage.
It is also known as the profit‑volume (P/V) ratio and can be used to determine breakeven revenue.
Formula to learn
Contribution/Sales ratio
Contribution per unit
Contribution/Sales ratio = Selling price per unit
Breakeven revenue = fixed costs / C/S ratio or breakeven point × selling price per unit
The margin of safety is a measure of the amount by which sales must fall before we start making
a loss. A loss is made if sales volume is less than the BEP.
Formula to learn
Margin of safety = budgeted sales - breakeven sales
Margin of safety (%) =
Budgeted sales - Breakeven sales
Budgeted sales
The approach used to find an expression for the breakeven sales volumes can be extended to find
the volume needed to attain a required profit level.
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The required profit is like an additional fixed cost which must be covered before the company
‘breaks even’.
Formula to learn
Output required for target profit
Output required for target profit =
Fixed costs + target profit
Unit contribution
Activity 1: Revision of single product CVP analysis
A company has fixed costs of $5,700 and variable costs per unit of $6.50.
(a) If the selling price is $8.00 per unit at all levels, what is the breakeven point (in units)?
(b) What is the breakeven revenue?
(c) What is the C/S ratio?
(d) If budgeted sales are 5,000 units, what is the margin of safety in units?
(e) What is the margin of safety as a %? What does this mean?
(f) What is the sales volume (in units) required to make a profit of $10,000?
Solution
1
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2.1 Breakeven, contribution and P/V charts
Breakeven chart
Contribution (contribution breakeven) chart
$
$
Profit
Breakeven point
Breakeven point
Variable costs
osts
lc
osts
al c
Tot
ue
en
ts
v
e
cos
sr
ble
a
e
i
r
l
a
Va
a
Tot
e
ev
sr
e
nu
Fixed costs
Margin
of safety
le
Sa
Fixed costs
S
Fixed
costs
Contribution
Profit
Margin
of safety
Units
Units
Profit/volume (P/V) chart
Profit
$
Profit
Breakeven point
B'even
Sales volume or revenue Contribution
Fixed
costs
The gradient of the straight line
is the contribution per unit
(if the horizontal axis is
measured in sales value).
Loss
$
2.1.1 Breakeven chart
The breakeven point can also be determined graphically using a breakeven chart.
This shows the relationship between revenue, costs and sales volume.
Activity 2: Breakeven chart
The breakeven chart for the data in Activity 1 has been sketched.
1 Required
Match the following labels to the letters on the graph
• Total cost line
• Margin of safety
• Breakeven point
• Total revenue line
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Sales &
Costs $
C
40,000
38,200
D
A
5,700
3,800
5,000 units
B
Solution
1
We can also draw a contribution graph which shows that the gap between the total revenue line
and the variable cost line is the contribution:
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$
40,000
Profit
Fixed
costs
30,400
a
Tot
sts
Contribution
l co
ue
en
ts
ev
cos
r
s
able
e
i
l
r
a
V
Sa
Margin
of safety
3,800
5,000
2.1.2 Profit volume chart
The profit volume chart is an alternative to the breakeven chart as it illustrates the relationship
between profits and sales. It emphasises the impact of changes in volume on profit.
Activity 3: Profit volume chart
The following is a sketch of the profit volume chart for Activity 1.
Required
What does the letter Z represent?
1,800
Profit
Z
Volume
(Unit)
– 5,700




Breakeven point
Fixed costs
Profit
Contribution
Solution
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3 Multi-product breakeven point
Breakeven analysis can be expanded for a ‘single’ mix of products using a weighted average
contribution figure. A constant product sales mix must be assumed.
Formula to learn
Fixed costs
Breakeven point = Weighted average unit contribution
Fixed costs
Breakeven revenue = Weighted average C/S ratio
Illustration 1: Breakeven point for multiple products
Suppose that PL produces and sells two products. The M sells for $7 per unit and has a total
variable cost of $2.94 per unit, while the N sells for $15 per unit and has a total variable cost of
$4.50 per unit. The marketing department has estimated that for every five units of M sold, one
unit of N will be sold. The organisation’s fixed costs total $36,000.
Required
What is the total breakeven revenue?
$
Solution
The correct answer is:
$58,450
We calculate the breakeven point as follows:
Step 1 Calculate contribution per unit
Selling price
Variable cost
Contribution
134
M
$ per unit
7.00
2.94
4.06
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N
$ per unit
15.00
4.50
10.50
Step 2 Calculate contribution per mix
A mix in this question is 5 Ms and 1 N
= ($4.06 × 5) + ($10.50 × 1) = $30.80
Step 3 Calculate the breakeven point in terms of the number of mixes
= fixed costs/contribution per mix = $36,000/$30.80
= 1,169 mixes (rounded)
Step 4 Calculate the breakeven point in terms of the number of units of the products
= (1,169 × 5) 5,845 units of M and (1,169 × 1) 1,169 units of N (rounded)
Step 5 Calculate the breakeven point in terms of revenue
= (5,845 × $7) + (1,169 × $15)
= $40,915 of M and $17,535 of N = $58,450 in total
It is important to note that the breakeven point is not $58,450 of revenue, whatever the mix of
products. The breakeven point is $58,450 provided that the sales mix remains 5:1. Likewise, the
breakeven point is not at a production/sales level of (5,845 + 1,169) 7,014 units. Rather, it is when
5,845 units of M and 1,169 units of N are sold, assuming a sales mix of 5:1.
Activity 4: Multi-product breakeven point
United Trading sells three products as follows:
Product
Footballs
$
7.00
3.00
2,000
Selling price
Variable costs
Budgeted sales (units)
Baseballs
$
6.00
4.50
4,000
1
Assume that the sales mix is ‘fixed’ in these proportions. Fixed costs are $20,000.
Required
2
What is the breakeven sales volume?
Required
Rugby balls
$
9.00
5.00
3,000
units
What is the breakeven sales revenue? $
Solution
1
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2
4 Contribution to sales (C/S) ratio for multiple products
The C/S ratio can be used to calculate the breakeven point in terms of sales revenue for single
products and this is also the case when there are multiple products.
Illustration 2: C/S ratio for multiple products
1 We can calculate the C/S ratio and use it to calculate the breakeven point of PL (see Illustration
1).
Step 1 Calculate revenue per mix
= (5 × $7) + (1 × $15) = $50
Step 2 Calculate contribution per mix
= $30.80 (see Illustration 1)
Step 3 Calculate average C/S ratio
= ($30.80/$50.00) × 100% = 61.6%
Step 4 Calculate breakeven point (total)
= fixed costs ÷ C/S ratio
= $36,000/0.616 = $58,442 (rounded)
Step 5 Calculate revenue ratio of mix
= $35:$15, or 7:3
This shows that 7 out of every 10 products sold will be an M.
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Step 6 Calculate breakeven revenue and breakeven point
Breakeven revenue M = $58,442 × 7/10 = $40,909 (rounded)
Breakeven point M = $40,090 / $7 = 5,844 units
Breakeven revenue N = $58,442 × 3/10 = $17,533 (rounded)
Breakeven point N = $17,533 / $15 = 1,169 units
Total breakeven revenue = $58,442
Solution
1 The correct answer is:
Total breakeven revenue = $58,442
Activity 5: Using the average C/S ratio
Alpha manufactures and sells three products: the Beta, the Gamma and the Delta. Relevant
information is as follows:
Selling price
Variable cost
Beta
$ per unit
135.00
73.50
Gamma
$ per unit
165.00
58.90
Delta
$ per unit
220.00
146.20
Total fixed costs are $950,000.
An analysis of past trading patterns indicates that the products are sold in the ratio 3:4:5.
1 Required
Calculate the breakeven sales revenue of products Beta, Gamma and Delta using the approach
shown above.
Beta = $
Gamma = $
Delta = $
Solution
1
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5 Target profit for multiple products
The same technique that we have been applying can be used to ensure that a required profit is
achieved, by adding the target profit to the fixed costs when calculating the level of sales
required.
Illustration 3: Target profit for multiple products
An organisation makes and sells three products: F, G and H. The products are sold in the
proportions F:G:H = 2:1:3. The organisation’s fixed costs are $80,000 per month and details of the
products are as follows:
Product
Selling price
$ per unit
Variable cost
$ per unit
F
22
16
G
15
12
H
19
13
The organisation wishes to earn a profit of $52,000 next month.
1 Required
Calculate the required sales value of each product in order to achieve this target profit.
F
=
G
=
H
=
Solution
1 The correct answer is:
Step 1 Calculate contribution per unit
F
G
H
$ per unit
$ per unit
$ per unit
Selling price
22
15
19
Variable cost
16
12
13
Contribution
6
3
6
Step 2 Calculate contribution per mix
= ($6 × 2) + ($3 × 1) + ($6 × 3) = $33
Step 3 Calculate the required number of mixes
= (Fixed costs + required profit)/contribution per mix
= ($80,000 + $52,000)/$33
= 4,000 mixes
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Step 4 Calculate the required sales in terms of the number of units of the products and sales
revenue of each product
Product
Units
Selling price
Sales revenue
required
$ per unit
$
F
4,000 × 2
8,000
22
176,000
G
4,000 × 1
4,000
15
60,000
H
4,000 × 3
12,000
19
228,000
Total
464,000
The sales revenue of $464,000 will generate a profit of $52,000 if the products are sold in the mix
2:1:3.
Alternatively, the C/S ratio could be used to determine the required sales revenue for a profit of
$52,000. The method is again similar to that demonstrated earlier when calculating the breakeven
point.
6 Margin of safety for multiple products
Illustration 4: Margin of safety for multiple products
BA produces and sells two products. The W sells for $8 per unit and has a total variable cost of
$3.80 per unit, while the R sells for $14 per unit and has a total variable cost of $4.20. For every
five units of W sold, 6 units of R are sold. BA’s fixed costs are $43,890 per period.
Budgeted sales revenue for next period is $74,400, in the standard mix.
1 Calculate the margin of safety in terms of sales revenue and also as a percentage of budgeted
sales revenue.
M of S = $
sales in total
M of S =
% of budgeted sales (to one decimal place)
Solution
1 The correct answer is:
To calculate the margin of safety, we must first determine the breakeven point.
Step 1 Calculate contribution per unit
W
R
$ per unit
$ per unit
Selling price
8.00
14.00
Variable cost
3.80
4.20
Contribution
4.20
9.80
Step 2 Calculate contribution per mix
= ($4.20 × 5) + ($9.80 × 6) = $79.80
Step 3 Calculate the breakeven point in terms of the number of mixes
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= fixed costs/contribution per mix = $43,890/$79.80
= 550 mixes
Step 4 Calculate the breakeven point in terms of the number of units of the products
= (550 × 5) 2,750 units of W and (550 × 6) 3,300 units of R
Step 5 Calculate the breakeven point in terms of revenue
= (2,750 × $8) + (3,300 × $14)
= $22,000 of W and $46,200 of R = $68,200 in total
Step 6 Calculate the margin of safety
= budgeted sales – breakeven sales
= $74,400 – $68,200
= $6,200 sales in total, in the standard mix
Or, as a percentage
= ($74,400 – $68,200)/$74,400 × 100%
= 8.3% of budgeted sales
7 Multi-product graphs
Graphs can also be used in multi-product situations to indicate the relationships between cost,
revenue and volume.
Multi-product P/V charts can also be produced whereby each product is plotted individually,
allowing the profitabilities to be compared. They show a profit or loss line rather than the cost and
revenue lines and often two profit or loss lines are drawn. First, a straight line assuming a constant
mix between the products and second, a bow shaped line where products are plotted in order of
profitability, ie products are plotted in the order of their contribution/sales ratio.
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Activity 6: Multi-product profit volume chart
Here is a sketch of a multi-product P/V chart for Activity 4.
Multi-product P/V chart
Profit/
loss
6,000
Y
Z
41,000
50,000
0
14,000
65,000
Revenue
£
12,000
20,000
You can see from the graph that when the company sells its most profitable product first, it breaks
even earlier than when it sells products in a constant mix.
Required
What do the points Y and Z represent?
 Y: Breakeven point if most profitable product made first. Z: Multi-product breakeven point
 Y: Multi-product breakeven revenue. Z: Breakeven revenue if most profitable product made first
 Y: Multi-product breakeven point. Z: Breakeven point if most profitable product made first
 Y: Breakeven revenue if most profitable product made first. Z: Multi-product breakeven revenue
Solution
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7.1 Changing the product mix
As the products have different C/S ratios, any changes in the product range (ie additional
products offered or products discontinued) will have an impact on the breakeven point.
For example, if products are sold in a constant mix and a new product is introduced that increases
the weighted C/S, then the breakeven point will fall. The breakeven point will also fall if the
product with the lowest C/S ratio is discontinued.
Essential reading
See Chapter 8 Section 1 of the Essential reading for information on multi-product breakeven
charts and more detail on multi-product profit-volume charts.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
8 Limitations of breakeven analysis
Breakeven analysis is a useful technique for managers as it can provide simple and quick
estimates. It is a form of sensitivity analysis and is therefore useful for assessing risk surrounding
the estimate of sales volume.
It does, however, have a number of limitations as it assumes that:
• If there are multiple products, they are sold in a constant mix
• All costs can be split into fixed and variable elements
• Fixed costs are constant
• Variable cost per unit is constant
• Selling price is constant
• Inventory levels are constant (sales volume = production volume)
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Chapter summary
Cost volume profit (CVP) analysis
Cost volume profit
(CVP) analysis
Assumptions
• Fixed sales mix (fixed
proportions)
• Fixed costs per period same in
total and unit variable costs
constant
• Sales prices per unit are
constant
• Production volume = sales
volume
Single product breakeven analysis
• Contribution per unit = unit selling price – unit variable costs
• Breakeven point = fixed costs/unit contribution
• Contribution/sales ratio = unit contribution/unit selling price
• Breakeven revenue = fixed costs/C/S ratio
• Margin of safety = budgeted sales – breakeven sales
• Output required for target profit = (fixed costs + target profit)/
unit contribution
Breakeven, contribution and P/V charts
• Breakeven chart
• Contribution chart
$
$
Profit
Breakeven point
To
ue
n
ve
re
es
l
Sa
Breakeven point
Variable costs
osts
tal c
Fixed costs
Margin
of safety
Fixed costs
osts
al c
Tot
e
nu
ts
ve
cos
re
s
iable
le
Var
Sa
Fixed
costs
Contribution
Profit
Margin
of safety
Units
Units
• Profit/volume (P/V) chart
Profit
$
Profit
Breakeven point
B'even
Sales volume or revenue
Contribution
Fixed
costs
Loss
$
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Multi-product
breakeven point
Contribution to sales (C/S)
ratio for multiple products
Target profit for
multiple products
• Breakeven point = Fixed costs/
weighted average unit
contribution
• Breakeven revenue = Fixed
costs/weighted average C/S
ratio
• Step 1 Calculate revenue per
mix
• Step 2 Calculate contribution
per mix
• Step 3 Calculate average C/S
ratio
• Step 4 Calculate breakeven
point (total)
• Step 5 Calculate revenue ratio
of mix
• Step 6 Calculate breakeven
revenue and breakeven
point
• Step 1 Calculate contribution
per unit
• Step 2 Calculate contribution
per mix
• Step 3 Calculate the required
number of mixes
• Step 4 Calculate the required
sales in terms of the
number of units of the
products and sales
revenue of each
product
Margin of safety
for multiple products
Multi-product
graphs
Limitations of
breakeven analysis
• Step 1 Calculate contribution
per unit
• Step 2 Calculate contribution
per mix
• Step 3 Calculate the
breakeven point in
terms of the number
of mixes
• Step 4 Calculate breakeven
point in terms of the
number of units of the
products
• Step 5 Calculate the
breakeven point in
terms of revenue
• Step 6 Calculate the margin
of safety
Products are plotted in the order
of their C/S ratio
• Assumptions
– Products are sold in a
constant mix
– All costs can be split into
fixed and variable elements
– Fixed costs are constant
– Variable cost per unit is
constant
– Selling price is constant
– Sales volume = production
volume
144
Changing the product mix
Any changes in the product
range will have an impact on the
breakeven point
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Knowledge diagnostic
1. CVP analysis assumptions
Constant selling price, variable costs and fixed costs.
2. Single product breakeven analysis
Breakeven point = fixed costs / contribution per unit
3. Multi-product breakeven analysis
Multi-product breakeven analysis can only be performed if a constant product sales mix is
assumed.
Breakeven point = fixed costs / weighted average contribution/per unit
On a P/V chart, products should be plotted individually in order of the size of their C/S ratio.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q19
Examination
2
4 mins
Section A Q20
Examination
2
4 mins
Section A Q21
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Cost-volume-profit analysis, which
explains that profit would be maximised if management were able to make business decisions
based on certainty. Profit, however, is often dependent on sales volume (an unknown) but selling
price and costs are usually known with some accuracy. Breakeven analysis can therefore be used
to help make business decisions. Note that if you print this article out, it refers to graphs that only
appear if you click on the links within the article.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Revision of single product CVP analysis
1 The correct answer is:
(a) BEP = fixed costs / contribution per unit = 5,700 / (8.00 - 6.60) = 3,800 units
(b) Breakeven revenue = 3,800 × $8.00 = $30,400
(c) C/S ratio = contribution per unit / sales price = $1.50 / $8.00 = 0.1875
Breakeven revenue = $5,700 / 0.1875 = $30,400
(d) Margin of safety = 5,000 - 3,800 = 1,200 units or 1,200 / 5,000 × 100 = 24%
The sales volume must fall by 24% from budgeted level before a loss is made.
(e) Sales volume = (10,000 + 5,700) / $1.50 = 10,467 units
Activity 2: Breakeven chart
1 The correct answer is:
A – Breakeven point
B – Margin of safety
C – Total revenue line
D – Total cost line
Activity 3: Profit volume chart
The correct answer is:
The contribution is $7,500 (fixed costs 5,700 + profit 1,800).
Change in profit
Gradient of line = Change in volume = contribution per unit = $1.50
Activity 4: Multi-product breakeven point
1
The correct answer is:
Required
What is the breakeven sales volume? 6,923 units
Footballs
$
7
3
4
Selling price
Variable costs
Contribution
Fixed costs
$20,000
Breakeven point = Average contribution (W1) = $2.889
= 6,923 units
(W1) Average contribution =
($4 × 2) + ($1.50 × 4) + ($4 × 3)
2+4+3
= $2.889
2
The correct answer is:
Required
What is the breakeven sales revenue? $50,000
The 6,923 units would be split as follows:
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Baseballs
$
6
4.50
1.50
Rugby balls
$
9
5
4
Sales mix
Units
2
4
3
9
1,538
3,077
2,308
6,923
Football
Baseball
Rugby ball
SP
$
7
6
9
Revenue
$
10,766
18,462
20,772
50,000
Activity 5: Using the average C/S ratio
1 The correct answer is:
Calculate revenue per
mix
= (3 × $135) + (4 × $165) + (5 × $220)
= $2,165
Calculate contribution
per mix
= ($61.50 × 3) + ($106.10 × 4) + ($73.80 ×
5)
=$977.90
Calculate average C/S
ratio
= ($977.90/$2,165) × 100%
= 45.17%
Calculate breakeven
point (total)
= fixed costs ÷ C/S ratio =
$950,000/0.4517
$2,103,166 (rounded)
Calculate revenue ratio
of mix
= 405:660:1,100, or 81:132:220
Calculate breakeven
sales
Breakeven sales of Beta
Breakeven sales of
Gamma
Breakeven sales of Delta
= 81/433 × $2,103,166 = $393,433
= 132/433 × $2,103,166 = $641,150
= 220/433 × $2,103,166 = $1,068,583
Activity 6: Multi-product profit volume chart
The correct answer is:
Y: Breakeven revenue if most profitable product made first. Z: Multi-product breakeven revenue
Y is the breakeven revenue if products are plotted in order of their C/S ratio (ie the most profitable
product is manufactured first). In this case, footballs would be manufactured first as they have the
highest C/S ratio. (See W1 below.)
Z is the breakeven point based on the weighted average unit contribution.
W1
Footballs
Baseballs
Rugby balls
Contribution
$
8,000
6,000
12,000
Sales
$
14,000
24,000
27,000
C/S ratio
57.1%
25.0%
44.4%
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Limiting factor analysis
9
9
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Apply throughput accounting to a multiproduct decision-making problem.
B4 (d)
Identify limiting factors in a scarce resource
situation and select an appropriate technique.
C3 (a)
Determine the optimal production plan where
an organisation is restricted by a single
limiting factor, including within the context of
‘make’ or ‘buy’ decisions.
C3 (b)
Formulate and solve a multiple scarce
resource problem both linear programming
graphs and using simultaneous equations as
appropriate.
C3 (c)
Explain and calculate shadow prices (dual
prices) and discuss their implications on
decision-making and performance
management.
C3 (d)
Calculate slack and explain the implications
of the existence of slack for decision-making
and performance management.
(Excluding simplex and sensitivity to changes
in objective functions.)
C3 (e)
9
Exam context
All companies have a maximum capacity for producing goods or providing services because there
is a limit to the amount of resources available. There is always at least one resource that is more
restrictive than others: this is known as a limiting factor. This chapter begins with a technique
used to maximise contribution when there is a single limiting factor. When there is more than one
resource constraint, the technique of linear programming can be used. A multiple scarce resource
problem can be solved using a graphical method and simultaneous equations.
9
We also look at the meaning and calculation of shadow prices and slack in this chapter.
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Chapter overview
Limiting factor analysis
Single constraint
Shadow price
Limiting factors and throughput accounting
Make or buy decisions
Linear programming
Graphical linear programming
Slack/surplus
Graphical linear programming steps
Assumptions of linear programming
Linear programming
using simultaneous equations
Limitations of linear programming
Linear programming and shadow pricing
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1 Single constraint
If a business is not constrained by internal factors, it will normally produce and sell as much as
demand allows. However, occasionally, this may not be possible and in this situation the plans of
the business must be built around this internal ‘limiting’ factor. This chapter looks at situations
with one limiting factor as well as situations where there are multiple limiting factors.
The production and sales plans of a business may be limited by a limiting factor/scarce resource
(the ‘principal budget factor’).
This could be:
• Market demand
• Materials
• Manpower (labour)
• Machine hours
• Money
The plans of the business must be built around this factor.
If a business makes more than one product, it will want to find the product mix that will maximise
profit given the limiting factor. This is done by maximising contribution as follows:
(a) Determine limiting factor by producing to maximum demand.
(b) Rank products by contribution per unit of limiting factor.
(c) Prepare a production plan.
Illustration 1: Limiting factors
1 AB Co makes two products: Ay and Be. Unit variable costs are as follows:
Ay
$
Be
$
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 Ay and $11 per Be. During July 20X2, the available direct labour
is limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000
units for Bes.
Determine the profit-maximising production mix, assuming that monthly fixed costs are $20,000
and that opening inventories of finished goods and work in progress are nil.
Optimal number of units of Ay =
Optimal number of units of Be =
Solution
1 The correct answer is:
Optimal number of units of Ay = 1,500. Optimal number of units of Be = 5,000.
Step 1 Confirm that the limiting factor is something other than sales demand.
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Ays
Bes
Total
Labour hours per unit
2 hours
1 hour
Sales demand
3,000 units
5,000 units
Labour hours needed
6,000 units
5,000 units
11,000 hours
Labour hours
available
8,000 hours
Shortfall
3,000 hours
Labour is the limiting factor on production.
Step 2 Identify the contribution earned by each product per unit of limiting factor, that is, per
labour hour worked.
Ay
$
Be
$
Sales price
14
11
Variable cost
8
7
Unit production
6
4
Labour hours per unit
2 hours
1 hours
Contribution per labour hour (= unit of limiting
factor)
$3
$4
Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to
make one Ay. Because labour is in short supply, it is more profitable to make Bes than Ays.
Step 3 Determine the optimal production plan. Sufficient Bes will be made to meet the full sales
demand, and the remaining labour hours available will then be used to make Ays.
(a)
Product
Demand
Hours
required
Hours
available
Priority of
manufacture
Bes
5,000
5,000
5,000
1st
Ays
3,000
6,000
3,000 (bal)
2nd
11,000
8,000
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(b)
Product
Units
Hours
required
Contribution
per hour
$
Total
$
Bes
5,000
5,000
4
20,000
Ays
1,500
3,000
3
9,000
8,000
29,000
Less fixed costs
20,000
Profit
9,000
Conclusion
(a) Unit contribution is not the correct way to decide priorities.
(b) Labour hours are the scarce resource, and therefore contribution per labour hour is the
correct way to decide priorities.
(c) Be earns $4 contribution per labour hour, and the Ay earns $3 contribution per labour hour.
Bes therefore make more profitable use of the scarce resource, and should be manufactured
first.
Activity 1: Optimal production mix
Gorgo Co is preparing its production plan for the next week and has estimated maximum demand
from its customers as follows:
Units
50
50
50
A
B
C
The products have the following cost cards
Sales price
Variable cost:
Materials ($5/kg)
Labour
Fixed cost
Profit
A
$
150
B
$
120
C
$
100
50
50
50
0
30
50
20
20
15
40
10
35
These demand figures do not include a long-term contract for the delivery of five units of each
product to an important customer. If this contract is not satisfied, then Gorgo will have to pay a
substantial penalty.
The production director is concerned as the materials used in production are likely to be in short
supply. Gorgo does not hold any inventory of raw materials and the availability of materials is
expected to be restricted to 845kg.
1 Required
Complete the following working schedules to determine the production mix that will maximise
Gorgo’s profit next week. Assume that labour will be paid a 10% premium.
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A
B
C
A
B
C
Contribution per unit
Kg per unit
Contribution per kg
Rank
Production
Contract units
Demand units
Total units
Contribution
Solution
1
Essential reading
See Chapter 9 Section 1 of the Essential reading for more detail on how to deal with a situation
where two factors are potentially the limiting factor (and there are also sales demand limitations).
The approach is to find out which factor (if any) prevents the business from fulfilling maximum
sales demand.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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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’. (CIMA Official Terminology)
KEY
TERM
A shadow price is:
(a) The additional contribution generated from one additional unit of limiting factor.
(b) The opportunity cost of not having the use of one extra unit of limiting factor.
(c) The maximum extra amount that should be paid for one additional unit of scarce
resource.
Illustration 2: Shadow price
Required
Determine the shadow price for labour in Illustration 1.
$
per hour
Solution
The correct answer is:
$3 per hour
If one extra labour hour was available this would be used to manufacture Ayes, which earn a
contribution of $3 per labour hour.
Therefore, the shadow price is $3 per hour, and the maximum AB Co would be prepared to pay to
obtain additional labour hours would be $6 ($3 cost per labour hour + $3 shadow price).
Activity 2: Shadow price
Required
Using the information from Gorgo in Activity 1, determine the shadow price of material.
$
Solution
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3 Limiting factors and throughput accounting
In a throughput environment, the approach is similar to the approach shown above in Section 1,
except we rank products by throughput contribution per unit of limiting factor (bottleneck
resource) instead of contribution per unit of limiting factor.
Note that ranking products in order of priority according to their TPAR will always give the same
ranking as putting them in order of throughput per unit of bottleneck resource.
Illustration 3: Maximising throughput and multiple products
1 WR Co manufactures three products: A, B and C. Product details are as follows:
Sales price
Materials cost
Direct labour cost
Product A
$
2.80
1.20
1.00
Product B
$
1.60
0.60
0.80
Product C
$
2.40
1.20
0.80
Weekly sales demand
Machine hours per unit
4,000 units
0.5 hours
4,000 units
0.2 hours
5,000 units
0.3 hours
Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week. Direct labour 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.
Solution
1 The correct answer is:
Step 1 Determine the bottleneck resource
The bottleneck resource is machine time (4,000 machine hours available each week).
Step 2 Calculate the throughput per unit for each product
Product A
$
Product B
$
Product C
$
Sales price
2.80
1.60
2.40
Materials cost
1.20
0.60
1.20
Throughput/unit
1.60
1.00
1.20
Step 3 Calculate throughput per unit of limiting factor (machine hours)
Machine hours per
unit
158
Product A
Product B
Product C
0.5 hours
0.2 hours
0.3 hours
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Throughput per
machine hour
Product A
Product B
Product C
$3.20*
$5.00
$4.00
Product A
Product B
Product C
3rd
1st
2nd
* $1.60 / 0.5 hours = $3.20
Step 4 Rank products
Ranking
Step 5 Allocate resources to arrive at optimum production plan
The profit-maximising weekly output and sales volumes are as follows:
Product
Units
Bottleneck
resource
hours/unit
Total hours
B
C
4,000
5,000
0.2 hours
0.3 hours
800
1,500
2,300
A (balance)
3,400
0.5 hours
1,700
4,000
Throughput
per hour
Total
throughput
$
5.00
4.00
$
4,000
6,000
3.20
5,440
15,440
(10,880)
Less:
operating
expenses
Profit per week
4,560
Activity 3: Optimum production plan
Tasty Bread Co makes three types of bread: rolls, baguettes and loaves. The breads pass through
three processes and baking is the bottleneck process. Only 80 hours of baking time are available
per day. Tasty Bread Co uses throughput accounting and the following information is available:
Rolls
Baguettes
Loaves
$
$
$
Selling price per unit
1.20
1.00
1.50
Ingredients cost per
unit
0.25
0.10
0.35
Labour cost per unit
0.50
0.40
0.30
Overhead cost per
unit
0.25
0.25
0.60
Maximum demand
(units) per day
15
10
20
Baking time per unit
(hours)
2.00
1.80
2.00
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Required
Assuming the Tasty Bread Co wants to maximise profit, what is the optimal production plan?
 Rolls 15, Baguettes 5, Loaves 20
 Rolls 11, Baguettes 10, Loaves 16
 Rolls 15, Baguettes 10, Loaves 16
 Rolls 11, Baguettes 10, Loaves 20
Solution
4 Make or buy decisions
In a limiting factor situation, a company could make up a shortfall in its own in-house production
capabilities by subcontracting work to an external supplier. To decide which products to make inhouse and which to buy from the subcontractor, they would need to look at the difference
between the variable cost of making it and the cost of buying it in relation to the scarce resource
that would be saved by using the subcontractor.
Illustration 4: Make or buy decisions with scarce resources
1 MM manufactures three components, S, A and T, using the same machines for each. The budget
for the next year calls for the production and assembly of 4,000 of each component. The variable
production cost per unit of the final product is as follows:
Machine hours
1 unit of S
1 unit of A
1 unit of T
Assembly
3
2
4
Variable costs
$
20
36
24
20
100
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Only 24,000 hours of machine time will be available during the year, and a subcontractor has
quoted the following unit prices for supplying components: S $29; A $40; T $34.
Required
Advise MM.
Solution
1 The correct answer is:
The organisation’s budget calls for 36,000 hours of machine time ((3 × 4,000) + (2 × 4,000) +(4 ×
4,000)), if all the components are to be produced in-house. Only 24,000 hours are available, and
so there is a shortfall of 12,000 hours of machine time, which is therefore a limiting factor. The
shortage can be overcome by subcontracting the equivalent of 12,000 machine hours of output to
the subcontractor.
The assembly costs are not relevant costs because they are unaffected by the decision.
The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce
resource saved (that is, per machine hour saved).
Variable cost of
making
Variable cost of buying
Extra variable cost of
buying
Machine hours saved
by buying
Extra variable cost of
buying per hour
saved
S
$
20
A
$
36
T
$
24
29
9
40
4
34
10
3 hrs
2 hrs
4 hrs
$3
$2
$2.50
This analysis shows that it is cheaper to buy A than T and it is most expensive to buy S. The
priority for making the components in-house will be in the reverse order: S, then T, then A. There
are enough machine hours to make all 4,000 units of S (12,000 hours) and to produce 3,000 units
of T (another 12,000 hours). 12,000 hours’ production of T and A must be subcontracted. The costminimising and so profit-maximising make and buy schedule is as follows:
Component
Make: S
T
Machine hours
used/saved
Number of units Units variable cost
12,000
12,000
24,000
$
20
24
4,000
3,000
Buy: T
A
4,000
1,000
8,000
4,000
12,000
Total variable cost of components, excluding assembly costs = $346,000
34
40
Total variable
cost
$
80,000
72,000
152,000
34,000
160,000
346,000
Activity 4: Make or buy and limiting factors
TW manufactures two products, the D and the E, using the same material for each. Annual
demand for the D is 9,000 units, while demand for the E is 12,000 units. The variable production
cost per unit of the D is $10, that of the E $15. The D requires 3.5 kg of raw material per unit, the E
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requires 8 kg of raw material per unit. Supply of raw material will be limited to 87,500 kg during
the year.
A subcontractor has quoted prices of $17 per unit for the D and $25 per unit for the E to supply
the product. How many of each product should TW manufacture in order to maximise profits?
TW should manufacture
maximise profits.
units of D and
units of E to
Solution
5 Linear programming
5.1 Graphical linear programming
Contribution per unit of limiting factor cannot be used when:
(a) More than one limiting factor exists
(b) Products rank differently for these resources
Under these conditions, linear programming is used and can be solved using either of:
(a) Graphs
(b) Simultaneous equations
5.1.1 Graphical linear programming steps
Follow these steps when you are trying to solve a problem using the graphical method:
(a) Define variables
(b) Formulate objective function
(c) Formulate constraints – generally in the form: amount of resource used ≤ amount available
(d) Plot constraints on a graph
(e) Identify the feasible space, ie those combinations of variables that are possible within the
resource constraints
(f) Plot the slope of the objective function and slide to optimal point (away from the origin for a
maximum, towards the origin for a minimum)
(g) Calculate the value of the objective function at the optimal point
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Objective function: This is a quantified statement of the aim of a resource allocation decision.
Constraint: This is an “activity, resource or policy that limits the ability to achieve objectives”
(CIMA Official Terminology).
Feasible region: This is “The area contained within all of the constraint lines shown on a
graphical depiction of a linear programming problem. All feasible combinations of output are
contained within or located on the boundaries of the feasible region” (CIMA Official
Terminology).
Illustration 5: Graphical linear programming
WX Co manufactures two products: A and B. Both products pass through two production
departments, mixing and shaping. The organisation’s objective is to maximise contribution to fixed
costs.
Product A is sold for $1.50 whereas Product B is priced at $2.00. There is unlimited demand for
Product A but demand for B 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 is as follows:
Machine hours required
Mixing hours
Shaping hours
Product A
0.06
0.04
Product B
0.08
0.12
Variable cost per unit
$
Product A
1.30
Product B
1.70
1 Required
What is the optimum production plan?
Number of units of A =
Number of units of B =
Solution
1 The correct answer is:
Step 1 Define variables
What are the quantities that WX Co can vary? Obviously not the number of machine hours or
the demand for Product B. The only things that it can vary are the number of units of each type
of product produced. It is those numbers that the company has to determine in such a way as to
obtain the maximum possible profit. Our variables (which are usually products being produced)
will therefore be as follows:
Let x = number of units of Product A produced.
Let y = number of units of Product B produced.
Step 2 Establish objective function
We now need to introduce the question of contribution or profit. We know that the contribution
on each type of product is as follows:
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$ per unit
Product A
($1.50 - $1.30) =
0.20
Product B
($2.00 - $1.70) =
0.20
The objective of the company is to maximise contribution and so the objective function to be
maximised is as follows:
Contribution (C) = 0.2x + 0.3y
Step 3 Establish constraints
The value of the objective function (the maximum contribution achievable from producing
Products A and B) is limited by the constraints facing WX Co. To incorporate this into the
problem, we need to translate the constraints into inequalities involving the variables defined in
Step 1. An inequality is an equation taking the form ‘greater than or equal to’ or ‘less than or equal
to’.
(a) Consider the mixing department machine hours constraint.
(i) Each unit of Product A requires 0.06 hours of machine time. Producing five units
therefore requires 5 × 0.06 hours of machine time and, more generally, producing x units
will require 0.06x hours.
(ii) Likewise, producing y units of Product B will require 0.08y hours.
(iii) The total machine hours needed in the mixing department to make x units of Product A
and y units of Product B is 0.06x + 0.08y.
(iv) We know that this cannot be greater than 2,400 hours and so we arrive at the following
inequality: 0.06x + 0.08y ≤ 2,400
(b) The final inequality is easier to obtain. The number of units of Product B produced and sold is
y but this has to be less than or equal to 13,000. Our inequality is therefore as follows: y ≤
13,000
(c) We also need to add non-negativity constraints (x ≥ 0, y ≥ 0) since negative numbers of
products cannot be produced. (Linear programming is simply a mathematical tool and so
there is nothing in this method that guarantees that the answer will ‘make sense’. An
unprofitable product may produce an answer that is negative. This is mathematically correct
but nonsense in operational terms.)
The problem has now been reduced to the following four inequalities and one equation:
Maximise contribution (C) = 0.2x + 0.3y, subject to the following constraints:
0.06x + 0.08y ≤ 2,400
0.04x + 0.12y
≤ 2,400
0 ≤ y ≤ 13,000
0
≤
x
Steps 4 and 5 Graph the problem and define the feasible region
When there are several constraints, the feasible area of combinations of values of x and y must
be an area where all the inequalities are satisfied.
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y
30,000
0.0
6
x+
0.0
8y
=
20,000
2,4
00
y = 13,000
10,000
Feasible area
C
A
7,500
5,000
10,000 15,000 20,000
0
0.04
x
B
30,000
+ 0.
40,000
12y
= 2,
400
50,000
60,000
x
Step 6 Determine the optimal solution
The optimal solution can be found by ‘sliding the iso-contribution (or profit) line out’.
The ‘best’ solution is going to be at a point on the edge of the feasible area rather than in the
middle of it.
This still leaves us with quite a few points to look at but there is a way in which we can narrow
down still further the likely points at which the best solution will be found. Suppose that WX Co
wishes to earn
contribution of $3,000. The company could sell the following combinations of the two products:
(a)
15,000 units of A, no B
(b)
No A, 10,000 units of B
(c)
A suitable mix of the two, such as 7,500 A and 5,000 B
The possible combinations required to earn contribution of $3,000 could be shown by the
straight line 0.2x + 0.3y = 3,000
y
30,000
0.0
6
x+
0.0
8y
=
20,000
2,4
00
y = 13,000
10,000
0.2
x+
Feasible area
0.04
x
0.3
y=
+ 0.
3,0
0
0
0
10,000 15,000 20,000
30,000
40,000
12y
= 2,
400
50,000
60,000
x
Likewise, for profits of $6,000 and $1,500, lines of 0.2x + 0.3y = 6,000 and 0.2x + 0.3y = 1,500
could be drawn showing the combination of the two products which would achieve contribution
of $6,000 or $1,500.
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y
30,000
0.0
6x
+
0.0
8y
20,000
=
2,4
00
y = 13,000
10,000
Feasible area
0.2
5,000
x+
0.3
y=
7,500 10,000
0.12
y
0
0.2x + 0.3y = 1,500
0
0.04
x+
6,0
0
20,000
30,000
40,000
= 2,
400
50,000
60,000
x
The contribution lines are all parallel. (They are called iso-contribution lines, ‘iso’ meaning equal.)
A similar line drawn for any other total contribution would also be parallel to the three lines shown
here. Bigger contribution is shown by lines further from the origin (0.2x + 0.3y = 6,000), smaller
contribution by lines closer to the origin (0.2x + 0.3y = 1,500). As WX Co tries to increase possible
contribution, we need to ‘slide’ any contribution line outwards from the origin, while always
keeping it parallel to the other contribution lines.
As we do this there will come a point at which, if we were to move the contribution line out any
further, it would cease to lie in the feasible region. Greater contribution could not be achieved,
because of the constraints. In our example concerning WX Co this will happen, as you should test
for yourself, where the contribution line just passes through the intersection of 0.06x + 0.08y =
2,400 and 0.04x + 0.12y = 2,400 (at co‑ordinates (24,000, 12,000)).
The point (24,000, 12,000) will therefore give us the optimal allocation of resources (to produce
24,000 units of A and 12,000 units of B).
Assessment focus point
The syllabus states that you must be able to identify limiting factors and select an
appropriate technique to maximise contribution.
Single limiting factor. You must read the question carefully to establish whether to use the
throughput contribution per unit of limiting factor (see Chapter 6) or contribution per unit of
limiting factor to rank products.
Multiple limiting factors. Reading the question will determine whether linear programming or
simultaneous equations should be used.
Activity 5: Optimal contribution
KG Co makes two products, the purse and the handbag. Each purse earns $5 contribution and
each handbag earns $6. Inputs are as follows:
Purse
Handbag
Leather
1.5m2
2m2
Skilled labour
45 mins
30 mins
There are six skilled labourers each working a 35-hour week, and delivery contracts limit the
amount of leather available to 600m2 each week.
The maximum demand for handbags is 250 per week.
Leather costs $8 per m2 and wages are paid at $4.20 per hour.
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1
Required
Define the variables
Let
= the number of purses to manufacture
2
Let
= the number of handbags to manufacture
Required
Formulate the objective function
3
Maximise 5
Required
Formulate the constraints
Leather:
+6
p+
Skilled labour:
p+
Demand:
4
h≤
h≤
≤
Non-negativity: p,h ≥
Required
Identify the lines on the graph
Number of
purses produced (p)
C
400
300
A
Optimal
solution
200
100
60
O
b
fu jec
nc tiv
tio e
n*
50
B
100
200
*any line parallel to this is acceptable
300
400
Number of
handbags
produced (h)
Line A =
Line B =
5
Line C =
Required
What is the optimal production plan?
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Number of
purses produced (p)
Demand
400
300
Le
at
200
he
r
(160,180)
100
60
Lab
O
b
fu jec
nc tiv
tio e
n*
50
our
100
200
*any line parallel to this is acceptable
Purses
6
Handbags
Calculate value of objective function at optimal point.
$
per week
Solution
1
2
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300
400
Number of
handbags
produced (h)
3
4
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5
6
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5.2 Linear programming using simultaneous equations
If the two binding constraints are known, we can use simultaneous equations to find the optimum
number of each product to manufacture as the optimum solution is the point at which the
constraint lines intersect. Using simultaneous equations will give a more accurate result than
reading from the graph.
Illustration 6: Solving simultaneous equations
1 Required
Solve the simultaneous equations for Activity 5.
h=
p=
Solution
1 The correct answer is:
1.5p + 2h = 600
Equation 1:
Equation 2:
0.75p + 0.5h = 210
× 2 = Equation 2a
1.5p + h = 420
h = 180
Equation 1 Equation 2a
When h = 180, substitute value into Equation 1:
1.5p + 2h = 600
1.5p + (2 × 180) = 600
1.5p = 600 – 360
p = 240/1.5
p = 160
Assessment focus point
You need to know all of the linear programming steps, but a single objective test (OT) question
is likely to focus on one step. A Section C constructed response question could ask you to
interpret a graph or explain graphical linear programming.
Activity 6: Binding constraints
A company produces two products and has used linear programming to help determine the
optimal number of each product to manufacture.
a = the number of units of product A to manufacture
b = the number of units of product B to manufacture
Objective function: Maximise contribution = 3a + 5b
Objective function: Maximise contribution = 3a + 5b
Constraints:
Labour
0.5a + b 10,000
(1)
Material 1
5a + 8b 8,000
(2)
Material 2
2a + 4b 3,600
(3)
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Demand product A
a0
(4)
Demand product B
b5,000
(5)
The optimal production point has been determined to be at the point where constraint lines (2)
and (3) intersect.
Required
Which TWO of the following are binding constraints?
 Labour
 Material 1
 Material 2
 Product A
 Product B
Solution
Activity 7: Contribution
A company produces two products and has used linear programming to help determine the
optimal number of each product to manufacture.
g = the number of units of Product G to manufacture
k = the number of units of Product K to manufacture
Objective function: Maximise contribution = 6g + 9k
Constraints:
Labour
5g + 8k 8,000
(1)
Material
2g + 4k 3,600
(2)
Demand product G
g 2,000
(3)
The optimal production point has been determined to be at the intersection of constraints (1) and
(2).
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1 Required
What is the value of the objective function at the optimal point?
Solution
1
Activity 8: Objective function
A company produces two products: M and N, and is currently drawing up its production plan for
the forthcoming month. Information is available as follows:
M
N
Selling price per unit
$40
$50
Material P @ $4 per kg
4kg/unit
3kg/unit
Material Q @ $5 per kg
2kg/unit
3kg/unit
Labour @ $8 per hour
0.5 hours/unit
1 hour/unit
Fixed overheads per unit
$2
$3
Next month only 2,000 units of Material P will be available. Labour is also limited, at 500 hours
per month. The company holds no inventory and aims to maximise profits.
Required
If m is the number of units of Product M sold per month and n is the number of units of Product N
sold per month, which of the following is the correct objective function?
 Maximise 40m + 50n
 Maximise 4m + 3n
 Maximise 8m + 19n
 Maximise 10m + 15n
Solution
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5.3 Linear programming and shadow pricing
Shadow prices can be calculated from the graphical method, by relaxing or constraining one of
the limiting factors at a time by a small amount (usually one unit) and recalculating the optimal
solution and associated contribution.
Illustration 7: Linear programming and shadow pricing
Required
Using the information in Activity 4, what is the maximum price KG Co would be prepared to pay to
obtain one further hour of labour?
 $0
 $1.33
 $4.20
 $5.53
Solution
The correct answer is:
Labour is a limiting factor so KG Co would be prepared to pay to obtain more of this resource.
Shadow price = contribution forgone due to limiting factor
= extra contribution if one more unit of limiting factor obtained at original cost
If
1.5p + 2h = 600 (leather)
0.75p + 0.5h = 211 (labour)
Optimal solution
h = 178
p = 162.67
Contribution = 5p + 6h = $1,881.33
Original contribution
Shadow price
174
= $1,880.00
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Maximum price = shadow price + usual price = $1.33 + $4.20 = $5.53
Essential reading
See Chapter 9 Section 3 of the Essential reading, for more detail on the implications of shadow
prices.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
5.4 Slack/surplus
KEY
TERM
Slack: Slack occurs when maximum availability of a resource or other constraining factor is
not used.
Surplus: Surplus occurs when more than a minimum requirement is used: surplus is the excess
over the minimum amount of constraint, where the constraint is a ‘more than or equal to’
constraint.
If, at the optimal solution, the amount of the resource used equals the amount of the resource
available, there is no spare capacity of a resource and so there is no slack.
If, at the optimal solution, the amount of the resource used is less than the amount of the resource
available, there is spare capacity for the resource and so there is slack.
5.4.1 Implications of slack
(a) High slack indicates inefficient use of a particular resource. If possible, the resource should
be reallocated to another part of the business or if it is labour, it could be subcontracted out
to another company.
(b) Low slack indicates that this resource could become a binding constraint. If the resource is a
particular material, management should investigate whether additional suppliers can be
identified. If the resource is labour time, the human resources department should be readied
for a recruitment drive, should it be needed. This way, if the availability of scarce resources
increases, the company is in a better position to maximise profitability.
Activity 9: Slack
This question is based on an ACCA question in the June 2014 exam.
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 unite
36
14
Optimum production plan
(unit)
20,000
66,000
What were the slack resources for test time and program time?
Test time:
hours
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Programme time:
hours
Solution
Essential reading
See Chapter 9 Section 4 of the Essential reading for more detail on the implications of slack.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
5.5 Assumptions of linear programming
Assumptions made in linear programming techniques include the following:
(a) Fixed costs are unchanged by decision.
(b) Unit variable cost is constant.
(c) Estimates of demand and resource requirements are known with certainty.
(d) Units of output are divisible.
(e) Total amount of each scarce resource is known with certainty.
(f) There is no interdependence of demand between products.
5.6 Limitations of linear programming
(a) It may be difficult to identify which resources are likely to be in short supply and what the
amount of their availability will be.
(b) Management may not make product mix decisions that are profit maximising. They may have
different objectives when setting the production/sales plan.
(c) Linear relationship may not exist, apart from over very small ranges.
(d) The linear programming model is essentially static and is therefore not really suitable for
analysing in detail the effects of changes in the various parameters, for example over time.
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(e) In some circumstances, a practical solution derived from a linear programming model may be
of limited use as, for example, where the variables may only take on integer values. A solution
must then be found by a combination of rounding up and trial and error.
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Chapter summary
Limiting factor analysis
Single constraint
Shadow price
Prioritise production based on contribution/
limiting factor
• The extra contribution from one more unit of
scarce resource
• It is the maximum extra amount you would
pay more one more unit
Limiting factors and throughput accounting
Make or buy decisions
• Limiting factor ranking based on throughput
per unit of bottleneck resource
• Step 1 Determine the bottleneck resource
• Step 2 Calculate the throughput per unit for
each product
• Step 3 Calculate throughput per unit of
limiting factor
• Step 4 Rank products
• Total costs will be minimised if those units
bought from the subcontractor have the
'lowest extra variable cost per unit of scarce
resource saved by buying'
– Extra variable cost of buying = variable cost
of making – variable cost of buying
– Extra variable cost of buying per resource
saved = extra variable cost of buying/
resource saved by buying
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Linear programming
• Formulate the model:
– Define variables
– Establish constraints
– Formulate objective function
Slack/surplus
• Slack is when the maximum amount of a
resource has not been used
• Surplus is when more output than the
minimum requirement is made
Graphical linear programming
Used when more than one limiting factor exists
Graphical linear programming steps
• Plot constraints
• Identify feasible region
• Find optimal point (using iso-contribution line)
• Calculate objective function at optimal point
Assumptions of linear programming
• Fixed costs are unchanged by decision
• Unit variable cost is constant
• Estimates of demand and resource
requirements are known with certainty
• Units of output are divisible
• Total amount of each scarce resource is
known with certainty
• There is no interdependence of demand
between products
Linear programming using simultaneous
equations
• Plot constraints
• Identify feasible region
• Find optimal point (using simultaneous
equations)
• Calculate objective function at optimal point
Linear programming and shadow pricing
Relax one of the limiting factors at a time and
recalculate associated contribution
Limitations of linear programming
• May be difficult to identify which resources
will be in short supply and their availability
• Management may not make product mix
decisions that are profit maximising
• Linear relationship may not exist
• Model is essentially static, therefore not really
suitable for analysing changes in various
parameters
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Knowledge diagnostic
1. Single constraint
Plans of the business are built around the limiting factor. Single limiting factor problems can be
solved by maximising contribution/limiting factor or return per limiting factor if with throughput
accounting.
2. Make or buy decisions
Where a company is able to subcontract work to make up a shortfall in its own in-house
production capabilities, its total costs will be minimised if those units bought from the
subcontractor have the lowest extra variable cost per unit of scarce resource saved by buying.
Extra variable cost is the difference between the variable cost of in-house production and the cost
of buying from the subcontractor.
3. Linear programming
The graphical method of linear programming can be used when there are just two products (or
services). The steps involved are as follows.
(a) Define the problem:
(i) Define variables
(ii) Establish constraints
(iii) Construct objective function
(b) Draw the constraints on a graph.
(c) Establish the feasible region for the optimal solution.
(d) Determine the optimal solution.
The optimum solution to a linear programming problem can be found by ‘sliding the isocontribution line out’.
4. Simultaneous equations
The optimal solution to a linear programming problem can also be found using simultaneous
equations.
5. Slack
Slack occurs when maximum availability of a resource is not used: slack is the amount of the
unused resource or other constraint where the constraint is a ‘less than or equal to’ constraint
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q22
Examination
2
4 mins
Section A Q23
Examination
2
4 mins
Section A Q24
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Linear programming.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Optimal production mix
1 The correct answer is:
A
B
C
Contribution per
unit (W)
$45
$35
$41
Kg per unit
10
6
3
Contribution per kg
(to two decimal
places)
$4.50
$5.83
$13.67
Rank
3
2
1
A
B
C
Contract units
5
5
5
Demand units
30
50
50
Total units
35
55
55
Contribution
$1,575
$1,925
$2,255
A
$
B
$
C
$
Sales
150
120
100
Materials
50
30
15
Labour (10%
premium)
55
55
44
Contribution
45
35
41
Production plan
Workings
Contribution
A
B
C
Contract units
5
5
5
Materials (kg)
50
30
15
Demand units
30 (bal)
50
50
Materials (kg)
300
300
150
Total
95
750
845
Total units
35
55
55
Contribution
$1,575
$1,925
$2,255
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Activity 2: Shadow price
The correct answer is:
$4.50
If 1 more kg of material were available, it would be used towards production of A.
Contribution/kg for A is $4.50.
The shadow price of material is therefore $4.50
Activity 3: Optimum production plan
The correct answer is:
Rolls 11, Baguettes 10, Loaves 20
Step 1 Determine the bottleneck resource.
The question says that baking is the bottleneck.
Step 2 Calculate the throughput per unit for each product.
Sales price
Materials cost
(ingredients)
Throughput/unit
Rolls
$
1.20
0.25
Baguettes
$
1.00
0.10
Loaves
$
1.50
0.35
0.95
0.90
1.15
Step 3 Calculate throughput per unit of limiting factor (machine hours).
Rolls
$0.95
2 hours
$0.475
Throughput/unit
Baking hours per unit
Throughput per baking
hour
Baguettes
$0.90
1.8 hours
$0.50
Loaves
$1.15
2 hours
$0.575
Step 4 Rank products.
Rolls
Baguettes
Loaves
3rd
2nd
1st
Step 5 Allocate resources to arrive at optimum production plan.
Product
Units
Total hours
20
10
Bottleneck resource
hours/unit
2 hours
1.8 hours
Loaves
Baguettes
Rolls (balance)
11
2 hours
22
80
Activity 4: Make or buy and limiting factors
The correct answer is:
TW should manufacture 9000 units of D and 7000 units of E to maximise profits.
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40
18
58
Variable cost of making
Variable cost of buying
Extra variable cost of buying
Raw material saved by buying
Extra variable cost of buying per kg saved
Priority for internal manufacture
D
$ per unit
10
17
7
3.5kg
$2
1st
Production plan
E
$ per unit
15
25
10
8kg
$1.25
2nd
Material used
kg
31,500
56,000
 Make D (9,000 × 3.5kg)
E (7,000 × 8kg)
Total materials consumed (maximum available)
87,500
The remaining 5,000 units of E should be purchased from the subcontractor.
Activity 5: Optimal contribution
1
The correct answer is:
Let p= the number of purses to manufacture
2
Let h = the number of handbags to manufacture
The correct answer is:
3
Maximise 5p + 6h
The correct answer is:
Leather: 1.5p +2h ≤ 600
Skilled labour: 0.75p + 0.5h ≤ 210
Demand: h ≤ 250
4
Non-negativity: p,h ≥ 0
The correct answer is:
Line A = Leather
Line B = Labour
5
Line C = Demand
The correct answer is:
160 Purses
180 Handbags
6
The optimal point solution is the point where the labour and leather lines intersect.
The correct answer is:
$1,880 per week
Contribution = 5p + 6h = (5×160) + (6×180) = $1,880 per week
Activity 6: Binding constraints
The correct answers are:
•
Material 1
•
Material 2
Materials 1 and 2 are binding constraints as the optimal solution is found at the point at which
these constraints intersect. The other three constraints will not actually be binding constraints,
meaning that not all of the labour will be used and that there will be unsatisfied sales demand for
both Products A and B.
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Activity 7: Contribution
1 The correct answer is:
$9,300
Equation 1:
Labour
5g + 8k 8,000
Equation 2:
Material
2g + 4k 3,600
5g + 8k 8,000
×2
4g + 8k 7,200
g = 800
Substitute g = 800 into equation 1:
5g + 8k = 8,000
(5 × 800) + 8k = 8,000
4,000 + 8k = 8,000
8k = 4,000
K = 4,000/8 = 500
Value of the objective function:
(6 × 800) + (9 × 500) = 9,300
Activity 8: Objective function
The correct answer is:
Maximise 10m + 15n
To derive the objective function, it is necessary to calculate the contribution per unit. This is the
selling price less all variable costs.
M
$
N
$
40
50
Material P @ $4 per kg
(16)
(12)
Material Q @$5 per kg
(10)
(15)
Labour @ $8 per hour
(4)
(8)
Contribution per unit
10
15
Selling price per unit
Less:
Activity 9: Slack
The correct answer is:
1,600 hours
600 hours
Test time used: (20,000 x 18)/60 + (66,000 x 4)/60 = 10,400 hours
Therefore, slack hours = 12,000 – 10,400 = 1,600 hours
Program time used: (20,000 x 36)/60 + (66,000 x 14)/60 = 27,400 hours
Therefore, slack hours = 28,000 – 27,400 = 600 hours
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Pricing decisions
10
10
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain the factors that influence the pricing
of a product or service.
C4 (a)
Calculate and explain the price elasticity of
demand.
C4 (b)
Derive and manipulate a straight line demand
equation. Derive an equation for the total cost
function (including volume-based discounts).
C4 (c)
Calculate the optimum selling price and
quantity for an organisation, equating
marginal cost and marginal revenue.
C4 (d)
Evaluate a decision to increase production
and sales levels, considering incremental
costs, incremental revenues and other factors.
C4 (e)
Determine prices and output levels for profit
maximisation using the demand-based
approach to pricing (both tabular and
algebraic methods).
C4 (f)
Explain different price strategies, including:
C4 (g)
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
All forms of cost-plus
Skimming
Penetration
Complementary product
Product-line
Volume discounting
Discrimination
Relevant cost
Calculate a price from a given strategy using
cost-plus and relevant cost.
C4 (h)
10
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Exam context
All profit organisations and many non-profit organisations face the task of setting a price for their
products or services.
In this chapter, we will begin by looking at the factors which influence pricing policy. Perhaps the
most important of these are the prices charged by competitors, and the level of demand for the
organisation’s products or services. In a market that is not so competitive, pricing should still be
set at a level that customers will pay but which also provides a satisfactory profit.
This chapter also considers the profit-maximising price/output level and a range of different
pricing strategies.
10
Exam questions on pricing in Section C are likely to be a mixture of calculation and discussion and
the examining team will expect a practical application of pricing theories.
Chapter overview
Pricing decisions
Factors influencing price
Demand
Optimal pricing
Relationship between
price and volume
Estimating the demand equation
Estimating marginal revenue
Profit maximisation
Decisions to increase
production and sales
Pricing
strategies
Cost plus
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1 Factors influencing price
The price to be charged to customers for a business’ products or services is an important business
decision. Where there is not a prevailing market price, a business will have to select its chosen
selling price using techniques and strategies that we will cover in this chapter.
Historically, the cost of a product would have had a large influence on the selling price set for that
product. Today, there are many factors that will influence that price.
These factors include:
(a) Demand
(b) Quality
(c) Competitors
(d) Substitutes
(e) Inflation
(f) Age of product
(g) Disposable incomes
Essential reading
See Chapter 10 Section 1 of the Essential reading for more detail on influences on price.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2 Demand
2.1 Relationship between price and volume
Price impacts volume sold, since a higher price will normally lower the volume sold.
Despite this, organisations may consider increasing revenue if the fall in volume sold (as a
percentage) is lower than the increase in the price (as a percentage).
Where this is the case, demand is said to be unresponsive to price changes or is price-inelastic.
KEY
TERM
Price elasticity of demand (PED): Price elasticity of demand (PED): measures the extent of the
change in market demand for a product or service in response to a change in its price.
Formula to learn
PED =
% change in demand
% change in price
The value of elasticity may be anything from zero to infinity.
KEY
TERM
Value of elasticity: If the result of the formula, in absolute terms, is less than one, the demand
is inelastic. If the result of the formula in absolute terms is greater than one, the demand is
elastic.
Demand is referred to as inelastic if the percentage change in demand is lower than the
percentage change in price. This gives an absolute value of less than one (ignoring the negative
sign, which is normal because PED is expected to be negative since demand will fall if price rises
and vice versa).
Demand is referred to as elastic if the percentage change in demand is higher than the
percentage change in price. This gives an absolute value of more than one (ignoring the negative
sign).
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Where demand is inelastic, prices can be raised without significantly affecting demand. If
demand is elastic, a decrease in price will result in an increase in volume.
Illustration 1: Price elasticity of demand
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research
indicates that an increase in price of 10 cents per unit will result in a fall in annual demand of
75,000 units.
1 Required
What is the price elasticity of demand? (Ignore the negative sign and work to three decimal
places.)
Annual demand at $1.20 per unit is 800,000 units.
Annual demand at $1.30 per unit is 725,000 units.
% change in demand = (75,000/800,000) × 100% = 9.375%
% change in price = ($0.10/ $1.20) × 100% = 8.333%
Price elasticity of demand = (–9.375/8.333) = –1.125 or 1.125 ignoring the negative sign
Since the demand goes up when the price falls, and goes down when the price rises, the elasticity
has a negative value, but it is usual to ignore the minus sign.
Ignoring the minus sign, price elasticity is 1.125.
The demand for this good, at a price of $1.20 per unit, would be referred to as elastic because the
price elasticity of demand is greater than one.
Solution
1 The correct answer is:
A price rise will therefore cause a fall in revenue.
Revenue before the price rise = $1.20 × 800,000 = $960,000
Revenue after the price rise = $1.30 × 725,000 = $942,500
2.1.1 Factors determining price elasticity of demand
Factor
How it might act to reduce elasticity
Income
If a good takes up a low percentage of customer income,
customers will be less sensitive to price rises.
Degree of necessity
An essential item (eg medicine) will still have to be bought
even if the price rises.
Availability of alternative
products
If there are few alternative substitute goods or services,
there will be a smaller fall in demand if price rises.
Activity 1: PED
1 A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Required
Determine the PED if ticket price increases from $12 to $13.
Solution
1
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3 Optimal pricing
It is possible to try to estimate the ‘optimal’ selling price by combining an analysis of both costs
and demand factors. This selling price is designed to maximise short-term profitability.
3.1 Estimating the demand equation
The demand equation shows the relationship between the price charged for a product and the
subsequent demand for that product.
An examination question may indicate that the demand curve for a product can be stated as a
straight line equation: P = a – bQ.
In practice, a linear relationship is most unlikely to happen, but it is an assumption made in
pricing theory that you need to understand.
Formula provided
When demand is linear, the equation for demand is P = a – bQ
Where P
= the selling price
Q
= the quantity demanded at that price
a
= theoretical maximum price. If price is set at ‘a’ or above, demand will be zero.
b
= the change in price required to change demand by unit
Illustration 2: Deriving the demand equation
1 The current price of a product is $12. At this price, the company sells 60 items a month. One
month, the company decides to raise the price to $15, but only 45 items are sold at this price.
Determine the demand equation, which is assumed to be a straight line equation.
Solution
1 The correct answer is:
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Step 1 Calculate b
change in price
$15−$12
3
b = change in quantity = 60−45 = 15 = 0.2
Step 2 Substitute the known value for ‘b’ into the demand function to find ‘a’
P = a - (0.2Q)
12 = a - (0.2 x 60)
12 = a - 12
a = 24
The demand equation is therefore P = 24 – 0.2Q
Step 3 Check your equation
We can check this by finding Q when P is $15.
15 = 24 - (0.2Q)
0.2Q = 24 – 15
0.2Q = 9
9
Q = 0.2 = 45
Activity 2: Deriving and using a demand equation
A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Assume attendance to be purely price dependent.
Required
Derive the demand equation and calculate the ticket price to ensure a full house with capacity
being 25,000.
 $6.40
 $8.40
 $13
 $18.40
Solution
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3.2 Estimating marginal revenue
It is worthwhile for a company to sell further units when the increase in revenue gained from the
sale of the next unit (marginal revenue) is greater than the cost of making it (marginal cost).
Marginal revenue (MR) is determined by the demand curve and can be expressed as an equation
that is similar to the demand equation that we have seen already.
Formula provided
MR = a - 2bQ
Where MR
= the marginal revenue
Q
= the quantity demanded
a
= the price at which demand would be nil
b
= change in price / change in quantity
Economic theory suggests that in order to sell more, the selling price will need to be reduced. As a
result, the marginal (extra) revenue generated by selling another unit will continually fall as output
rises. Marginal revenue may not be the same as the price charged for all units up to that demand
level, as to increase volumes the price may have to be reduced.
3.3 Profit maximisation
As economic theory suggests, that marginal (extra) revenue generated by selling another unit will
continually fall as output rises, there will be a point at which it is not worth cutting the price any
further because the revenue generated by selling another unit (MR) is below the marginal cost
(MC) of producing it. Profits will continue to be maximised only up to the output level where
marginal cost has risen to be exactly equal to the marginal revenue. At this point, the selling price
is said to be ‘optimal’ because it is the price at which profits are maximised.
Formula to learn
Profit is maximised at the level of output where MR = MC
3.3.1 Determining the optimal price using equations
You could be required to use the equation for marginal revenue to determine the optimal price.
Remember, marginal cost is the extra cost of producing one extra unit; marginal revenue is the
extra revenue from selling one extra unit.
The following approach should be used:
Step 1 – Determine the demand function.
Step 2 – Make the MR equation given equal to the value of MC.
Step 3 – Substitute the values for a and b in Step 1 into the MR formulae and solve to find Q.
Step 4 – Take the quantity in Step 3 and put this into the demand function to find the price to
charge.
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Illustration 3: MC = MR
1 AB 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 five units
for every $1 fall/rise in the selling price.
The marginal cost of Product G is $80
Calculate the profit-maximising selling price for Product G (to the nearest $).
Solution
1 The correct answer is:
Step 1 – Determine the demand function.
P = a - bQ
1
b = 5 = 0.2
Rearrange P = a – bQ to get: a = P + bQ
Therefore, a = $250 + (12,000 × 0.2) = $2,650
So, P = 2,650 – 0.2Q
Step 2 – Make the MR equation given equal to the value of MC
MR = MC
Step 3 - Substitute the values found for a and b in Step 1 into the MR formulae and solve to find Q.
Profits are maximised when MC = MR, ie when 80 = a – 2bQ
80 = 2,650 – 0.4Q, so 0.4Q = 2,650 – 80, so Q = (2,650 – 80) / 0.4, therefore Q = 6,425
Profit-maximising demand = 6,425
Step 4 – Take the quantity found in Step 3 and put this into the demand function to find the price
that should be charged.
Profit-maximising price: P = 2,650 – 0.2Q
= $2,650 – 0.2 × 1,285
= $1,365
Activity 3: Calculating the optimum selling price
A firm charges $18 per unit for its product. At this price it sells 17,000 units.
Research has shown that when prices were changed by $1 per unit sales changed by 2,000 units.
The product has a constant variable cost per unit of $5.
The demand function is given by P = a – bQ. The marginal revenue will be MR = a – 2bQ.
Required
Determine the price to be charged to maximise profit.
 $8.50
 $15.75
 $21.50
 $26.50
Solution
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3.3.2 Tabular approach
One approach to determining the profit maximising production plan is to calculate the extra
(marginal) costs and revenues at different combinations of output and selling price.
Activity 4: Tabular approach
Output
Total cost
(Units)
10
20
30
40
50
60
$
10
25
45
70
100
135
MC Selling price
$
10
15
20
25
5.00
4.50
4.00
3.50
3.00
2.50
Total
revenue
$
50
90
120
MR
Profit
$
50
40
$
40
65
Required
Complete the table above to determine the selling price per unit that will maximise profit.
 $2.50
 $3.00
 $3.50
 $4.00
Solution
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A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units can be
sold, not, say, 35. The use of equations can solve this problem.
4 Decisions to increase production and sales
If you are required to evaluate a decision to increase production and sales levels, you will need to
consider incremental costs, incremental revenues and other factors.
KEY
TERM
Incremental costs and revenues: Incremental costs and revenues are the difference between
costs and revenues for the corresponding items under each alternative being considered.
Illustration 4: A decision to increase production
1 George 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 – 1kg 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
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) George 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.
George would not be able to fulfil any new orders without him.
Required
Evaluate whether George should accept the new order.
Solution
1 The correct answer is:
Current production = 350,000/10 = 35,000 units
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Current cost per unit of Material A
=
$25,000 / 35,000 = $0.71
Current cost per unit of Material B
=
$50,000 / 35,000 = $1.43
Current cost of labour
$75,000 / 35,000 = $2.14
=
$
Incremental revenue (5,000 × $9)
Incremental costs
Material A (1.05 × $0.71 × 5,000)
Material B (1.03 × $1.43 × 5,000)
Labour [(1,000 × $2.14) + (4,000 × $3.50)]
Fixed overhead
$
45,000
3,728
7,365
16,140
5,000
32,233
12,767
Incremental profit
The new order would produce an additional $12,767 so is probably worthwhile but other factors
may need to be considered; for example, the effect of a price cut on existing customer
expectations and whether the workforce and production manager will be able to fulfil the new
order with the same labour efficiency
4.1 Volume based discounts
Volume based discount: A volume-based discount is a discount given for buying in bulk.
KEY
TERM
An organisation may wish to consider offering a volume-based discount to customers for
purchases above a certain quantity. The intention may be that, by offering the sale price
discount, customers will buy more of the product.
To decide whether a volume-based discount on selling prices is financially worthwhile, a
calculation is needed.
By reducing the selling price with a volume-based discount and reducing the price from P1 to P2,
sales volume may be expected to increase from Q1 to Q2. Assume that the variable cost of sale is
$V per unit, and fixed costs will be unaffected by a change in sales volume.
Total sales revenue at discounted price
Total sales revenue at non-discounted price
Increase in sales revenue
Increase in costs
$
(Q2 × P2)
(Q1 × P1)
Difference
(Q2 – Q1) × V
Change in profit = (Q2 × P2) – (Q1 × P1) – [(Q2 – Q1) × V]
For example, suppose that a company sells a product at a price of $10 per unit. The unit variable
cost is $4. The sales manager believes that, by offering a customer a discount of 5% for buying at
least 5,000 units a year, the customer will increase purchases from their current level of 4,000
units to a level of 5,000 units per year.
The effect on profits each year would be calculated as follows:
Total sales revenue at discounted price: 5,000 × $10 × 95%
Total sales revenue at non-discounted price: 4,000 × $10
$
47,500
40,000
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Increase in sales revenue
Increase in costs (1,000 units × $4)
Increase in annual profit from volume-based price discounting
$
7,500
4,000
3,500
5 Pricing strategies
5.1 Cost plus
The price of the product is calculated by adding an appropriate profit mark up to the product’s
cost. This cost could be:
• Absorption / full cost (including ABC)
• Marginal cost
• Relevant cost (Chapter 11)
• Standard cost
Advantages
(a) Readily understood / easy to apply
(b) Readily determined
(c) Doesn’t require / assume a linear and stable price/quantity relationship
Disadvantages
(a) Because it ignores the impact that the price will have on quantity demanded, it will not
maximise profit.
(b) If the basis of absorbing overheads changes, the price of the product will change. Thus,
absorption costing methods require accurate overhead and activity levels.
(c) Price may need to be adjusted to reflect market conditions.
Activity 5: Full cost plus method
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 year.
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 (to two decimal places)?
$
Solution
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5.2 Market penetration
KEY
TERM
Penetration pricing: 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.
Useful if:
(a) The firm wants to discourage new entrants into the market.
(b) The firm wishes to shorten the initial period of the product’s life cycle.
(c) There are significant economies of scale to be achieved.
(d) Demand is highly elastic and so would respond well to low prices.
5.3 Market skimming
KEY
TERM
Price skimming: Price skimming involves charging high prices when a new product is first
launched on the market, in order to maximise short-term profitability.
Initially there is heavy spending on advertising and sales promotion to obtain sales. As the
product moves into the later stages of its life cycle (growth, maturity and decline), progressively
lower prices will be charged. The aim of market skimming is to gain high unit profits early in the
product’s life.
Useful if:
(a) The product is new and different, so that early adopters are prepared to pay high prices to
be seen to own the latest products.
(b) The strength of demand and the sensitivity of demand to price are unknown.
(c) High prices in the early stages of a product’s life might generate high initial cash outflows. A
firm with liquidity problems may prefer market skimming for this reason.
(d) The product has a short life cycle and needs to recover development costs and make a profit
quickly.
Exam focus point
An exam question could ask you to explain why a particular pricing method might or might
not be suitable for a specific business. Make sure you know the features and relevant
situations for each pricing method.
5.4 Price discrimination
KEY
TERM
Price 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.
When a company can sell into two or more separate markets, it might be able to charge a
different price in each market. To be successful, the company must prevent the transfer of goods
from the cheap market to the more expensive one.
There are a number of bases on which such discriminating prices can be set.
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(a) By market segment. Items such as cinema tickets and hairdressing services are often
available at lower prices to over 60s, students or juveniles.
(b) By product version. For example, some car models have ‘add on’ extras.
(c) By place. Theatre seats are usually sold according to the type of seat and its location in the
theatre auditorium.
(d) By time. This is perhaps the most popular type of price discrimination, eg off-peak travel
bargains, hotel prices. Railway companies are successful price discriminators, charging more
to rush hour rail commuters whose demand is inelastic at certain times of the day.
Price discrimination can only be effective if a number of conditions hold:
(a) The market must be segmentable in price terms, and different sectors must show different
intensities of demand.
(b) 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 priced segment).
(c) There must be little or no chance that competitors can and will undercut the firm’s prices in
the higher priced (and/or most profitable) market segments.
(d) The cost of segmenting and administering the arrangements should not exceed the extra
revenue derived from the price discrimination strategy.
5.5 Product-line pricing
KEY
TERM
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.
Most organisations sell not just one product but a range of products. For example, a company
may manufacture a range of hygiene and skincare products, such as soaps, shower gels and
bath oils, under the same brand name.
Focus is placed on the profit from the whole range rather than the profit on each single product.
There is a range of product line pricing strategies.
(a) Set prices proportional to full or marginal cost with the same percentage profit margin for all
products. This means that prices are dependent on cost and ignore demand.
(b) Set prices reflecting the demand relationships between the products so that an overall
required rate of return is achieved.
(c) Set prices that reflect customer opinion about the quality of the products, and how they
compare with similar products of competitor organisations.
5.6 Complementary product pricing
KEY
TERM
Complementary products: 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.
One product would tend to be priced competitively which attracts demand for the
complementary product, for example, an electric toothbrush and replacement toothbrush heads.
The electric toothbrush may be priced competitively to attract demand but the replacement
heads can be relatively expensive.
5.7 Volume discounts
KEY
TERM
Volume discount: A volume discount is a reduction in price given for larger than average
purchases.
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These are given in order to increase sales volume without reducing prices permanently. They also
allow differentiation between customers, ie wholesale v retail. The reduced costs of a large order
will hopefully compensate for the loss of revenue from offering the discount.
5.8 Relevant cost pricing
Special orders may require a relevant cost approach to the calculation of the price. A relevant
cost approach is to identify a price at which the organisation 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.
A special order is a one-off revenue-earning opportunity. These may arise in the following
situations:
(a) When a business has a regular source of income but also has some spare capacity, allowing
it to take on extra work if demanded. 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.
(b) When a business has no regular source of income and relies exclusively on its ability to
respond to demand. A building firm is a typical example, as are many types of
subcontractors. In the service sector, consultants often work on this basis.
The reason for making the distinction is that in the case of (a), a firm would normally attempt to
cover its longer-term running costs in its prices for its regular product. Pricing for special orders
therefore does not need to consider unavoidable fixed costs, which will be incurred anyway. This
is clearly not the case for a firm in (b)’s position, where special orders are the only source of
income for the foreseeable future.
Relevant costing is covered in the next chapter and so relevant cost pricing will mean more to you
once you understand relevant costs.
Activity 6: Pricing strategies
1 The Q organisation is a large, worldwide respected manufacturer of consumer electrical and
electronic goods. Q constantly develops new products that are in high demand as they represent
the latest technology and are ‘must haves’ for those consumers that want to own the latest
consumer gadgets. Recently, Q has developed a new handheld digital DVD recorder and seeks
your advice as to the price it should charge for such a technologically advanced product.
Required
Suggest pricing policies that would be suitable for each stage of the product life cycle of the DVD
recorder.
Solution
1
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6 Other considerations
Bear in mind that pricing decisions should not be based on financial factors alone. Non-financial
considerations should also be made.
These might include:
• Company objectives – sales, market share, long- term or short-term
• Competition and markets – competing products and reaction of competitors
• Production capacity – demand may exceed supply
• Product life cycle – introduction, growth, maturity, decline
• Superior innovation, technology or quality – may set higher prices
• Customers’ buying power
• Other products in range – displacing or supplementary
• Availability of resources
• Impact on staff
• Impact on customers
• Competitors’ reactions
• Opportunity costs
• Impact on other products
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Chapter summary
Pricing decisions
Factors influencing price
• Demand
• Quality
• Competitors/substitutes
• Disposable incomes
• Cost
Demand
Optimal pricing
Relationship between price and
volume
Estimating the demand equation
• PED = % change in quantity/ %
change in demand
• PED>1 = elastic demand (small
change in price = large change
in demand)
• PED<1 = inelastic demand
(large change in price ≠ large
change in demand)
• Demand function: P = a – bQ
• P = selling price
• Q = quantity demanded at that
price
• a = theoretical maximum price
• b = change in price/change in
quantity
Estimating marginal revenue
Formula provided: MR = a – 2bQ
Profit maximisation
• Maximised at output level
where MR = MC
1 Determine demand function
2 Let MR = MC
3 Substitute the values found for
a and b in Step 1 into the MR
formulae and solve to
find Q
4 Take the quantity found in Step
3 and put this into the demand
function to find the price that
should be charged
Decisions to increase
production and sales
Consider incremental costs and
revenues
Pricing
strategies
Cost plus
• Full cost
• Marginal cost
• Relevant cost
• Standard cost
• Cost plus
• Market penetration
• Market skimming
• Price discrimination
• Product-line pricing
• Complementary product
pricing
• Volume discounts
• Relevant cost pricing
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Knowledge diagnostic
1. Demand
PED measures the responsiveness of demand to a change in price. PED > 1 = elastic demand. PED
< 1 = inelastic demand.
Price can be determined using the demand function:
P = a – bQ.
2. Optimal pricing
The output level to maximise profit is found when MR = MC.
The output level to maximise revenue is where MR = 0.
Prices at these output levels can then be determined from the demand function.
3. Decisions to increase production and sales
Consider incremental costs and revenues
4. Pricing strategies
There are several strategies that can be applied to a product. These strategies may be changed
depending upon the stage in the product life cycle.
5. Other considerations
The pricing strategy should be chosen bearing in mind both financial and non-financial factors.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q25
Examination
2
4 mins
Section A Q26
Examination
2
4 mins
Section A Q27
Examination
2
4 mins
Section A Q28
Examination
2
4 mins
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Activity answers
Activity 1: PED
1 The correct answer is:
% change in price
= $1 / $12
= 8.3% increase
% change in demand
= 2,500 / 16,000
= 15.6% decrease
PED
= -15.6% / 8.3 %
= 1.9
Demand is elastic
Activity 2: Deriving and using a demand equation
The correct answer is:
$8.40
P=a–bQ
b = $1/2,500 = 0.0004
12 = a – (0.0004 × 16,000)
a = 18.4
P = 18.4 – 0.0004Q
Therefore, to sell 25,000 tickets:
P = 18.4 – 25,000 × 0.0004 = $8.40 per ticket
Activity 3: Calculating the optimum selling price
The correct answer is:
$15.75
(a) Determine the demand function:
P = a - bQ
b = $1 / 2,000 = 0.0005
18 = a – (0.0005 × 17,000)
a = 26.50
P = 26.50 – 0.0005Q
(b) Make the MR equation given equal to the value of MC
MR = MC
3. Substitute the values found for a and b in Step 1 into the MR formulae and solve to find Q
MR = a – 2bx = 26.50 – 0.001Q
MC = 5
Therefore, 26.50 – 0.001Q = 5
Therefore, Q = 21,500 units
4. Take the quantity found in Step 3 and put this into the demand function to find the price that
should be charged
P = 26.50 - (0.0005 × 21,500)
= 15.75 per unit
Activity 4: Tabular approach
The correct answer is:
$4.00
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Output
(units)
10
20
30
40
50
60
Total cost
$
10
25
45
70
100
135
MC Selling price
$
$
10
15
20
25
30
35
Total revenue
$
MR
$
Profit
$
50
90
120
140
150
150
50
40
30
20
10
0
40
65
75
70
50
15
5.00
4.50
4.00
3.50
3.00
2.50
Profit is maximised at an output level of 30 units with a selling price of $4 per unit.
Activity 5: Full cost plus method
The correct answer is:
$9.80
Full cost per unit = variable cost + fixed cost
Variable cost = $4 per unit
$60,000
Fixed cost = 20,000 = $3 per unit
Full cost per unit = $(4 + 3) = $7
 Selling price using full cost-plus pricing method = $7.00 × 140%/100 = $9.80
Activity 6: Pricing strategies
1 The correct answer is:
The product life cycle comprises five stages:
• Development
• Introduction
• Growth
• Maturity
• Decline
In the introduction stage, the company needs to price the product to achieve its market strategy
using either penetration or skimming pricing policies.
A penetration policy is used with the objective of achieving a high level of demand very quickly by
using a low price that is affordable to a large number of potential customers.
A skimming policy is particularly appropriate to a product that has a novelty value or that is
technologically advanced such as the DVD recorder. Such a policy uses a price that is high and
this restricts the volume of sales since only high worth customers can afford the product, but the
high unit profitability enables the initial supplier to recover their development costs.
Competitors will be attracted to the product by its high price and will seek to compete with it by
introducing their own version of the product at much lower development costs (by reverse
engineering Q’s product) so it is important for Q to reduce the price during the growth stage of
the product’s life cycle. There may be many price reductions during this phase so that the product
gradually becomes more affordable to lower social economic groups.
As the product enters the maturity stage, the price will need to be lowered further, though a
profitable contribution ratio would continue to be earned. Competition is often found in this stage,
but contribution ratio would continue to be earned. Competition is often found in this stage but,
provided Q has gained market share and survived until this stage, the opportunity to make profit
and cash surpluses should exist. However, in this type of market the price will tend to be set by the
market and Q will have to accept that price. Thus, Q will need to focus on the control of its costs
to ensure that the product will remain profitable.
When the product enters the decline phase, a loyal group of customers may continue to be
prepared to pay a reasonable price and at this price the product will continue to be profitable,
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especially as costs continue to reduce. Eventually, the price will be lowered to marginal cost or
even lower in order to sell off inventories of what is now an obsolete product as it has been
replaced by a more technologically advanced item.
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Short-term decisions
11
11
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain the concept of relevant costing.
C1 (a)
Identify and calculate relevant costs for
specific decision situations from given data.
C1 (b)
Explain and apply the concept of opportunity
costs.
C1 (c)
Explain the issues surrounding make vs buy
and outsourcing decisions.
C5 (a)
Calculate and compare ‘make’ costs with
‘buy-in’ costs.
C5 (b)
Compare in-house costs and outsource costs
of completing tasks and consider other issues
surrounding this decision.
C5 (c)
Apply relevant costing principles in situations
involving shutdown, one-off contracts and the
further processing of joint products.
C5 (d)
11
Exam context
The concept of relevant cost was briefly touched on in its use in one-off contracts to identify a
minimum price in the previous chapter.
In this chapter, we look in greater depth at relevant costs and at how they should be applied in
decision-making situations.
We look at a variety of common short-run business decisions and consider how they can be dealt
with using relevant costs as appropriate.
11
The ability to recognise relevant costs and revenues is a key skill for the Performance
Management (PM) exam, and questions are likely to be based on practical scenarios.
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Chapter overview
Short-term decisions
Decision-making
scenarios
Relevant costs
Non-relevant costs
Relevant cost of
materials
Relevant cost of
machinery
Relevant cost of labour
and variable overheads
Minimum price
decisions
Accept or reject
decisions
Make or
buy decisions
Outsourcing
decisions
Make or buy decisions
with a limiting factor
Shutdown
decisions
The further
processing decision
Qualitative factors
Assumptions in
relevant costing
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Other factors
to consider
1 Decision-making scenarios
You need to be able to apply relevant costing principles to a range of short-term decisions that a
business may have to make. There are lots of types of decisions including:
(a) Minimum price of an order/job/contract
(b) Accept or reject
(c) Make or buy
(d) Outsource
(e) Shutdown
(f) Further processing decisions
The calculations are important, but so too are the non-financial factors involved. For example,
when deciding whether to shut down a business segment, there is more to consider than the
financial implication alone.
2 Relevant costs
The costs that should be used for decision-making are referred to as relevant costs.
KEY
TERM
Relevant costs: These are “Costs appropriate to specific management decisions these are
represented by future cash flows whose magnitude will vary depending upon the outcome of
the management decision made” (CIMA Official Terminology).
Relevant
costs
Future
Cash
Incremental/
Specific
Opportunity cost
Relevant costs must be:
(a) Future. They must occur in the future.
(b) Incremental. For example, suppose a company decides to accept a contract from a
customer. An existing supervisor currently earning $1,000 per month is given an extra $100
per month for taking on the extra responsibility associated with this contract. The
incremental cost is the additional salary paid to the supervisor ($100) – the original salary of
$1,000 was being paid anyway.
(c) Cash flow. This means that costs or charges which do not reflect additional cash spending,
should be ignored for the purpose of decision-making. These are outlined in the non-relevant
costs section below.
Relevant costs may also be:
Opportunity costs. 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 potential benefit forgone
from the best rejected course of action. Opportunity costs are relevant for decision-making and
are likely to arise when there are a number of possible uses of a scarce resource.
Avoidable costs. These are the specific costs of an activity or sector of a business that would be
avoided if that activity or sector did not exist. Avoidable costs are usually associated with
shutdown decisions.
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2.1 Non-relevant costs
Non-relevant
costs
Sunk costs
Committed costs
Notional costs
Fixed costs
(a) Sunk costs are costs already incurred. They are not relevant in decision-making and are
therefore ignored.
(b) Committed costs have already been committed to and so are not relevant to the decision.
Examples might include the cost of materials under a long-term contract.
(c) Notional costs are non-cash items or accountancy entries.
(d) Fixed costs are allocated, and general fixed costs are not specific to a decision. Avoidable
fixed costs would be relevant.
Activity 1: Relevant cost
A Co is preparing a tender for a new contract to build a bridge. The contracts manager has spent
40 hours researching the contract and preparing the tender. She is paid a fixed annual salary of
$96,000 per year for working 48 weeks of 40 hours each.
1 Required
How much should be included in the relevant cost of building the bridge for the contracts
manager’s time (to the nearest whole number)?
Solution
1
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2.2 Relevant cost of materials
In inventory
Not in inventory
Have to buy it
In continual use
No other use
Scarce
If taken from
inventory will be
replaced
If taken from
inventory won't
be replaced
If taken from
inventory can't
replace it
Relevant cost is…
Current
replacement cost
Current
replacement cost
Current
resale value
Opportunity
cost
Activity 2: Relevant materials cost
X Co intends to print a catalogue for a one-off special promotion. The catalogue requires 120
boxes of a particular type of paper that is not regularly used by X Co although a limited amount
remains in X Co’s inventory from a similar job.
The cost when X Co bought the paper two years ago was $17 per box and there are 50 boxes in
inventory. The boxes could be sold for $14 each or could be purchased in the market for $22 each.
1 Required
What is the relevant cost of the paper to be used in printing the catalogue (to the nearest whole
number)?
Solution
1
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2.3 Relevant cost of labour and variable overheads
Current labour force
Spare capacity
Full capacity
Additional work
can be
undertaken
Additional work
cannot be
undertaken
Hire
more staff
Cannot hire
more staff
Relevant cost is…
Nil
Current rate
of pay
Variable cost and
lost contribution
Activity 3: Relevant cost of labour
A Co is deciding whether to undertake a new contract.
15 hours of labour are required for the contract. Labour is currently at full capacity producing X.
Cost card for X
$ per unit
Direct materials
(10kg @ $2)
20
Direct labour
(5 hours @ $6)
30
50
Selling price
75
Contribution
25
1 Required
What is the cost of using 15 hours of labour for the contract (to the nearest whole number)?
Solution
1
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2.4 Relevant cost of machinery
•
•
•
Repair costs arising from use
Hire charges
Fall in resale value arising from use
Activity 4: Relevant cost of machinery
J Co was intending to sell one of its production machines for $10,000 as it no longer has a use for
it. The machine is being depreciated at $2,000 per annum. The variable running costs for the
machine are $500 per annum.
The company has been approached by a new customer and asked to manufacture one million
components for a one-off order. These components can only be manufactured on this machine
and production will take place over the coming year.
It has been estimated that the machine could be sold for $6,000 in one year’s time.
1 Required
What is the relevant cost of using the machine to produce the components (to the nearest whole
number)?
Solution
1
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Activity 5: Relevant cost pricing
Ennerdale has been asked to quote a price for a one-off contract. The following information is
available:
Materials
The contract requires 3,000kg of Material K, which is a material used regularly by the company in
other production. The company has 2,000kg of Material K currently in stock which had been
purchased last month for a total cost of $19,600. Since then, the price per kilogram for Material K
has increased by 5%.
The contract also requires 200kg of Material L. There are 250kg of Material L in stock which are
not required for normal production. This material originally cost a total of $3,125. If not used on
this contract, the stock of Material L would be sold for $11 per kg.
Labour
The contract requires 800 hours of skilled labour. Skilled labour is paid $9.50 per hour. There is a
shortage of skilled labour and all the available skilled labour is fully employed in the company in
the manufacture of Product P. The following information relates to Product P:
$ per unit
Selling price
Less:
Skilled labour
Other variable costs
$ per unit
100
38
22
(60)
40
1 Required
Prepare, on a relevant cost basis, the lowest cost estimate that could be used as the basis for a
quotation.
Solution
1
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3 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.
Illustration 1: Minimum price
LB Co has been approached by a customer to manufacture a specialised machine. This would be
a one-off order which LB Co would undertake in addition to its normal budgeted production.
The assistant accountant has prepared the following quotation:
Notes
$
Direct materials:
Aluminium plating (20m2 @ $10 per m2)
Rivets (100 @ $1 each)
Direct labour:
Skilled (50 hours @ $16 per hour)
Semi-skilled (20 hours @ $10 per hour)
Overheads
1
2
200
100
3
4
5
Administration overhead @ 10% of production cost
6
Profit 20% of total cost
Selling price
7
800
200
100
1,400
140
1,540
308
1,848
Notes
1) The aluminium 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.
2) Rivets are currently held in inventory and cost $1 each although the company has no further
use for them. They could be sold to a scrap merchant for $0.50 each.
3) Skilled labourers are paid $16 per hour and are currently fully utilised on other work. If the job
was undertaken it would be necessary to work a maximum of 40 hours of overtime (paid at time
and a half) and/or reduce the production of another product which earns contribution of $20 per
hour.
4) There is currently 100 hours of idle semi-skilled labour time available.
5) Overheads represent an apportionment to cover factory fixed costs.
6) It is policy to add 10% to the production cost of each job to cover the administration cost of
orders accepted.
7) Profit of 20% of total cost is added to each job as part of the standard pricing policy.
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Required
Prepare, on a relevant cost basis, the minimum price which should be quoted for the job (to the
nearest whole $).
$
Solution
The correct answer is:
$1,610
Relevant costing statement
Notes
$
Aluminium plating
1
240
Rivets
2
50
Skilled
3
1,320
Semi-skilled
4
0
5
0
Direct materials:
Direct labour:
Overheads
1,610
Administration overhead
6
Total relevant cost
0
1,610
Profit 20% of total cost
7
Minimum price
0
1,610
Notes
1) Aluminium is in regular use therefore it needs to be replaced. Value at current purchase price:
Relevant cost = 20 m2 × $12 = $240.
2) Rivets = opportunity cost is lost scrap proceeds, 100 × $0.5 = $50.
3) Skilled labour.
Cheaper to work overtime as $24/hr is less than $36/hr (16 + 20)
$
960
360
1,320
40 hours @ $24 =
10 hours @ $36 =
4) Semi-skilled labour
Relevant cost = nil (spare capacity)
5) Overheads – relevant cost is nil
Incurred anyway regardless of this job
6) Administration costs will be incurred regardless of whether or not the job is accepted and are,
therefore, not relevant.
7) Profit mark up is not relevant as question asks for a minimum price. A minimum price is one
which just covers the total of the relevant costs.
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4 Accept or reject decisions
Occasionally, a company may be given a proposal to provide a product or a service for a stated
price, and they have to decide whether they should accept or reject it. Accept or reject decisions
use exactly the same principles as minimum price decisions. A project with a positive return on a
relevant cost basis should be accepted; a negative return should be rejected.
Activity 6: Accept or reject
Make Co makes a range of different products. It has been approached by a new customer to
manufacture 12,000 units of T over 12 months at a selling price of $3 per unit. This would be in
addition to normal budgeted production.
The following statement has been prepared:
$
Sales revenue
Costs: Material X at historical cost
Material Z at contract price
Skilled manufacturing labour
Semi-skilled manufacturing labour
Depreciation of machine
Variable overheads @ 30c per unit
Fixed overheads
(absorbed @ 60% of skilled manufacturing labour)
$
36,000
5,000
9,000
10,000
2,000
4,000
3,600
6,000
(39,600)
(3,600)
1
A quotation now needs to be prepared on a relevant cost basis so that Make Co can decide
whether to accept the proposal.
Material X cannot be used or sold for any other product. It would cost $200 to dispose of the
existing inventories.
Each unit of new production uses two kilos of material Z. The company has entered into a
long‑term contract to buy 24,000 kilos at an average price of 37.5c per kilo. The current price is
17.5c per kilo. This material is regularly used in the manufacture of the company’s other products.
2
3
Required
What is the cost of the two materials which should be included in the quotation?
 Material X: $200 and Material Z: $9,000
 Material X: $5,000 and Material Z: $4,200
 Material X: ($200) and Material Z: $9,000
 Material X: ($200) and Material Z: $4,200
The new product requires the use of skilled labour, which is scarce. If product T were not made this
labour could be used on other activities, which would yield a contribution of $1,000. Semi-skilled
labour currently has spare capacity to undertake the additional work.
Required
What cost should be included in the quotation for skilled labour and semi-skilled labour?
 Skilled Labour: $1,000 and Semi-skilled labour: $2,000
 Skilled Labour: $10,000 and Semi-skilled labour: $2,000
 Skilled Labour: $10,000 and Semi-skilled labour: $0
 Skilled Labour: $11,000 and Semi-skilled labour: $0
The machine which would be used to manufacture T was bought new 3 years ago for $22,000. It
had an estimated life of 5 years with a scrap value of $2,000.
If the new product is not manufactured the machine could be sold immediately for $7,000. If it is
used for one year it is estimated that it could then be sold for $4,000.
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4
5
Required
What is the cost which should be included in the quotation for machine costs?
 $4,000
 $7,000
 $3,000
 $0
Required
Which statement correctly describes the treatment of the general fixed overheads when preparing
the quotation?
 The overheads should be included because they relate to production costs.
 The overheads should be included because all expenses should be recovered.
 The overheads should be excluded because they are a sunk cost.
 The overheads should be excluded because they are not an incremental cost.
Required
Which statement correctly describes the decision Make Co should reach regarding the proposal?
 Reject because the relevant costs exceed the relevant benefits
 Reject because it will decrease the company’s profits for the year
 Accept because the relevant benefits exceed the relevant costs
 Accept because it will increase the company’s profits for the year
Solution
1
2
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4
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5
5 Make or buy decisions
Organisations may need to decide to make components or provide services, themselves in-house
or alternatively, to buy them from an outside supplier. In-house production will provide greater
control over the work performed but will also use capacity which will give rise to opportunity costs.
Factors to consider:
• How can spare capacity freed up by subcontracting be used most profitably?
• Could the decision to use an outside supplier cause an industrial dispute?
• Would the subcontractor be reliable with delivery times and product quality?
• Does the company wish to be flexible and maintain better control over operations by making
everything itself?
Illustration 2: Make or buy
1 Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows:
Production (units)
Unit marginal costs
Direct materials
Direct labour
Variable production overheads
W
1,000
$
4
8
2
X
2,000
$
5
9
3
Y
4,000
$
2
4
1
Z
3,000
$
4
6
2
14
17
7
12
Directly attributable fixed costs per year and committed fixed costs:
Incurred as a direct consequence of making W
Incurred as a direct consequence of making X
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$
1,000
5,000
Incurred as a direct consequence of making Y
Incurred as a direct consequence of making Z
Other fixed costs (committed)
6,000
8,000
30,000
50,000
Directly attributable fixed costs are all items of cash expenditure that are incurred as a direct
consequence of making the product in-house.
A subcontractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Required
Calculate the relevant costs of buying each component from the subcontractor.
Solution
1 The correct answer is:
The relevant costs are the differential costs between making and buying, and they consist of
differences in unit variable costs plus differences in directly attributable fixed costs.
Subcontracting will result in some fixed cost savings.
W
$
14
12
(2)
X
$
17
21
4
Y
$
7
10
3
Z
$
12
14
2
1,000
$
(2,000)
(1,000)
(3,000)
2,000
$
8,000
(5,000)
3,000
4,000
$
12,000
(6,000)
6,000
3,000
$
6,000
(8,000)
(2,000)
Unit variable cost of making
Unit variable cost of buying
Annual requirements (units)
Extra variable cost of buying (per annum)
Fixed costs saved by buying
Extra total cost of buying
Activity 7: Make or buy
1 Mars Co makes units Pluto and Jupiter, for which costs in the forthcoming year are expected to
be as follows:
Production (units)
Direct materials
Direct labour
Variable production overheads
P
1,000
$
3
6
2
J
1,500
$
5
9
3
11
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)
$
1,500
3,000
10,000
14,500
Required
A sub-contractor has offered to supply units of P for $12 and J for $21.
(a) Should Mars make or buy the components?
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(b) What other factors should be considered before making a decision?
Solution
1
Remember decisions should not be purely based on financial factors.
Making the product gives the company more control whereas buying the product gives them
access to an organisation with specific expertise.
They will also need to consider what the impact will be on:
(a) The workforce
(b) Customers
(c) Competitors
5.1 Make or buy decisions with a limiting factor
A manufacturing organisation may want to produce items in-house but does not have sufficient
capacity to produce everything that it needs, due to a limiting factor on production, such as a
shortage of machine time or labour time.
In this situation, the decision is about which items to make internally and which to purchase
externally. The optimal decision, based on financial considerations alone, is to arrange internal
production and external purchasing in a way that minimises total costs. Total costs will be
minimised if those units bought from the subcontractor have the lowest extra variable cost per
unit of scarce resource saved by buying.
Make or buy decisions involving limiting factors were described in Chapter 8, Limiting factor
analysis.
6 Outsourcing decisions
KEY
TERM
Outsourcing: Outsourcing is the use of external suppliers for finished products, components or
services. This is also known as contract manufacturing or subcontracting.
Outsourcing scenarios are very similar to make or buy decisions and therefore you should
approach these in exactly the same way.
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Consideration of non-financial factors is particularly important here.
Advantages
Disadvantages
Cost savings
Loss of control
Access to expertise
Impact on quality
Releases capital
How flexible, reliable is supplier
Frees up capacity
Potential loss of confidential information
Loss of in-house skill
Impact on employees’ morale
7 Shutdown decisions
These decisions may involve the closure of:
(a) A division of a business that appears to be loss making
(b) A product of a business that appears to be loss making
(c) A department of a business that appears to be loss making
Shutdown decisions should focus on relevant costs rather than profitability under absorption
costing because absorption costing fails to consider whether overheads will change as a result of
the decision.
Shutdown decisions should focus on:
(a) Variable costs
(b) Avoidable costs (what constitutes an avoidable cost may be different depending upon the
timing of the decision)
(c) Directly attributable costs (and revenues) if the closure is made
(d) Timing
Illustration 3: Adding or deleting products
1 A company manufactures three products: Pawns, Rooks and Bishops. The present net annual
income from these is as follows:
Sales
Variable costs
Contribution
Fixed costs
Profit/loss
Pawns
$
50,000
30,000
20,000
17,000
Rooks
$
40,000
25,000
15,000
18,000
Bishops
$
60,000
35,000
25,000
20,000
Total
$
150,000
90,000
60,000
55,000
3,000
(3,000)
5,000
5,000
The company is concerned about its poor profit performance and is considering whether or not to
cease selling Rooks. $5,000 of the fixed costs of Rooks are direct fixed costs which would be saved
if production ceased (ie there are some attributable fixed costs). All other fixed costs, it is
considered, would remain the same.
By stopping production of Rooks, the consequences would be a $10,000 fall in profits.
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$
(15,000)
5,000
(10,000)
Loss of contribution
Savings in fixed costs
Incremental loss
Suppose, however, it were possible to use the resources realised by stopping production of Rooks
and switch to producing a new item, Crowners, which would sell for $50,000 and incur variable
costs of $30,000 and extra direct fixed costs of $6,000. A new decision is now required.
Rooks
$
40,000
25,000
15,000
5,000
10,000
Sales
Less: variable costs
Less: direct fixed costs
Contribution to shared fixed costs and profit
Crowners
$
50,000
30,000
20,000
6,000
14,000
Solution
1 The correct answer is:
It would be more profitable to shut down production of Rooks and switch resources to making
Crowners, in order to boost profits by $4,000 to $9,000.
Activity 8: Shutdown decisions
Lewis Co manufactures three products: K, L and G. Forecast statements of profit or loss for next
year are as follows:
Sales
Cost of
production
Materials
Labour
Variable overhead
Fixed overhead
Gross margin
Selling costs
Net margin
K
$’000
600
L
$’000
300
G
$’000
200
Total
$’000
1,100
200
95
75
200
30
40
(10)
60
20
10
50
160
20
140
30
10
5
80
75
15
60
290
125
90
330
265
75
190
The directors are considering the closure of the K product line, due to the losses incurred. You
obtain the following information:
(a) Fixed production overheads consist of an apportionment of general factory overheads, based
on 80% of direct materials cost. The remaining overheads are specific to the product
concerned.
(b) Selling costs are based on commission paid to sales staff.
1 Required
Should the K production line be closed down?
Solution
1
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8 The further processing decision
8.1 Processes and joint costs
In certain circumstances more than one product may be produced from a single process. These
products may sell in their current state or may need further, separate processing before they can
be sold.
The costs of the process will need to be apportioned between the products created by the
process in order to:
• Value inventory
• Prepare financial accounts
These costs are not relevant when deciding whether to process any product further because they
are:
• Sunk
• Arbitrarily apportioned
The total joint cost may be relevant for decisions regarding the viability of the process as a whole.
Joint costs can be apportioned between products based on the following:
• Physical quantity
• Relative sales value
• Net realisable value
Illustration 4: Further processing decisions
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.
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1 Required
Should the company sell Alash or Alashplus?
• Alash
• Alashplus
Solution
1 The correct answer is:
The only relevant costs/incomes are those which compare the sale of Alash against the sale of
Alashplus. Every other cost is irrelevant: they will be incurred regardless of what the decision is.
Alash
Alashplus
Selling price per unit
$1.25
$3.25
Total sales
$125,000
$195,000
Incremental post-separation
processing costs
0
Fixed
$20,000
0
Variable
$30,000
Sales minus post-separation
(further processing) costs
$50,000
$125,000
$145,000
It is $20,000 more profitable to convert Alash into Alashplus.
Activity 9: Further processing
Product
Output
Selling price
at separation
Selling price
after further
processing
Postseparation
costs
Units
$
$
$
X
2,500
3
5
10,000
Y
1,500
5
10
8,000
Z
2,000
8
15
12,000
Joint processing costs are £20,000.
Which products should be processed further?
 X, Y and Z
 X and Y
 X only
 Z only
Solution
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9 Qualitative factors
9.1 Assumptions in relevant costing
(a)
(b)
(c)
(d)
Cost behaviour patterns are known with certainty.
Costs, prices and volumes are known with certainty.
Objective is to maximise profit/contribution.
Information is complete and reliable.
9.2 Other factors to consider
Exam questions may require a discussion of other factors, aside from the financial calculation,
that should be taken into account when making any decision.
Timescale can also be relevant. Many fixed costs can be varied, but only in the long-term.
Essential reading
See Chapter 11 Section 1 of the Essential reading for more detail on other (non-financial) factors to
consider.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Short-term decisions
Decision-making
scenarios
Relevant costing
principles
Relevant costs
• Future
• Incremental (specific
to decision)
• Cash flow
• Opportunity cost
Relevant cost of
materials
Relevant cost of
machinery
• Current replacement
cost or
• Current resale value or
• Opportunity cost
• Repair costs arising
from use
• Hire charges
• Fall in resale value
arising from use
Non-relevant costs
• Sunk costs
• Committed costs
• Notional costs
• Fixed costs
Minimum price
decisions
• Total relevant cost
• Does not include
general overheads
• Does not include profit
mark-up
Accept or reject
decisions
Total relevant cost
Relevant cost of labour
and variable overheads
• Nil (if spare capacity)
or
• Current rate of pay or
• Variable cost and lost
contribution
Make or
buy decisions
Differential costs
between making and
buying
Make or buy decisions
with a limiting factor
Calculate lowest extra
variable cost of buying
per scarce resource
saved
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Outsourcing
decisions
• Similar to make or buy
• Consider advantages
and disadvantages
Shutdown
decisions
The further
processing decision
Focus on relevant costs
• Joint process costs are
not relevant to further
processing decision
• Joint process costs
may be relevant to
process viability as a
whole
• Joint costs can be
apportioned based on:
– Physical quantity
– Relative sales value
– Net realisable value
Qualitative factors
Assumptions in relevant
costing
Other factors to
consider
• Cost behaviour
patterns are known
with certainty
• Costs, prices and
volumes are known
with certainty
• Objective is to
maximise profit/
contribution
• Information is
complete and reliable
• Employees
• Customers
• Competitors
• Timing
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Knowledge diagnostic
1. Relevant costs
Decisions should be made on the basis of relevant costs.
Relevant costs must be future cash flows and specific to the decision. They may also be
opportunity costs.
2. Non-relevant costs
• Sunk costs
• Committed costs
• Notional costs
• Fixed costs
3. Make or buy
In a make or buy decision, the choice is between making items in-house or purchasing them from
an external supplier. When there are no limiting factors restricting the in-house production
capacity, the relevant costs are the differential costs between the two options.
4. Further processing
• A further processing decision often involves joint products from a common manufacturing
process. The decision is whether to sell the products at the split-off point, as soon as they
emerge from the common process, or whether they should be processed further before selling
them.
• A joint product should be processed further past the split-off point if the additional sales
revenue exceeds the relevant post-separation (further processing) costs.
5. Shutdown
Shutdown/discontinuance problems may sometimes be simplified into short-run relevant cost
decisions. A shutdown decision is whether to close down an operation or stop making and selling a
particular product or service.
6. Qualitative factors
Non-financial considerations should also be taken into account before making a final decision.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q29
Examination
2
4 mins
Section A Q30
Examination
2
4 mins
Section A Q31
Examination
2
4 mins
Section C ‘AB’
Examination
20
36 mins
Further reading
There is a technical article available on ACCA’s website, called Relevant costs.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Relevant cost
1 The correct answer is:
$0
There are two reasons why the contracts manager’s time is not a relevant cost.
(a) She is paid a fixed salary, ie not incrementally.
(b) It is a sunk cost; the time has already been spent, ie not a future cost.
Activity 2: Relevant materials cost
1 The correct answer is:
$2,240
Scrap proceeds forgone of
boxes held in inventory
Purchase price of remaining
boxes
Total
(50 × $14)
$
700
(70 × $22)
1,540
2,240
Activity 3: Relevant cost of labour
1 The correct answer is:
$165
$
Variable cost of labour
(15hrs @ $6)
90
Lost contribution from
product X
(15hrs × $25/5)
75
Total
165
Activity 4: Relevant cost of machinery
1 The correct answer is:
$4,500
Reduction in sales proceeds
of machine
Variable running costs of
machine
Total
($10,000 - $6,000)
$
4,000
500
4,500
Activity 5: Relevant cost pricing
1 The correct answer is:
$48,670
Relevant cost – Material K
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Since the material is regularly used by the company, the relevant cost of Material K is the current
price of the material.
Cost last month = $19,600 / 2,000kg
=$9.80
Revised cost (+5%) = $9.80 x 1.05
= $10.29
Relevant cost of Material K = 3,000kg x $10.29 per kg
= $30,870
Relevant cost – Material L
Since the material is not required for normal production, the relevant cost of this material is its net
realisable value if it were sold.
 Relevant cost of Material L = 200kg × $11 per kg
= $2,200
Relevant cost – Skilled labour
Skilled labour is in short supply and therefore the relevant cost of this labour will include both the
actual cost and the opportunity cost of the labour employed.
$
7,600
8,000
Cost of skilled labour (800 hours × $9.50)
Opportunity cost of skilled labour (see working)
Relevant cost – skilled labour
15,600
Working
Skilled labour cost per unit of Product P = $38
Cost per skilled labour hour = $9.50
Number of hours required per unit of Product P
= $38 / $9.50
= 4 hours
Contribution per unit of Product P
 Contribution per skilled labour hour
= $40
= $40 / 4hours
= $10 per hour
 Opportunity cost of skilled labour
= 800 hours × $10 per hour
= $8,000
The total relevant costs of this contract are therefore ($30,870 + $2,200 + $15,600) = $48,670
Activity 6: Accept or reject
1
The correct answer is:
Material X ($200) and Material Y $4,200
No other use for X in business, but $200 disposal costs are saved by using X to make Ts.
2
Z is used in the business and will have to be replaced for $0.175 × 2 × 12,000 = $4,200.
The correct answer is:
Skilled Labour: $11,000 and Semi-skilled labour: $0
3
Opportunity cost of using skilled labour
=
contribution foregone + cost of labour
=
=
$11,000
$1,000 + $10,000
The relevant cost of using semi-skilled labour is nil, since there is spare capacity.
The correct answer is:
$3,000
If the machine is used instead of scrapped, the business loses ($7,000 – $4,000) of scrap
proceeds.
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4
The correct answer is:
The overheads should be excluded because they are not an incremental cost.
5
The general fixed overheads should be excluded as they are not incremental, ie they are not
arising specifically as a result of this order.
The correct answer is:
Accept because the relevant benefits exceed the relevant costs
Conclusion: the proposal should be accepted as it makes a positive contribution of $14,400 based
on relevant costs.
$
Sales revenue
Costs
Material X
Material Z
Skilled labour
Semi-skilled labour
Variable overhead
Depreciation
Fixed overheads
Lost scrap proceeds
Non essential
Net relevant contributions
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
$
36,000
(200)
4,200
11,000
3,600
3,000
(21,600)
14,400
(1) Revenue earned as a result of producing and selling T.
(2) No other use for X in the business, but $200 disposal costs are saved by using X to make Ts.
(3) Z is used in the business and will have to be replaced for $0.175 × 2 × 12,000 = $4,200.
Assuming inventories can be bought at this price.
(4) Opportunity cost of using labour = contribution foregone + cost of labour = $1,000 + $10,000 =
$11,000
(5) Semi-skilled labour the relevant cost is nil since there is spare capacity.
(6) Variable overhead is only incurred when units are made.
 relevant cost = 12,000 × $0.30
(7) Depreciation is not a cash flow and therefore not relevant
(8) These fixed overheads will be incurred regardless of whether or not Ts are made; therefore,
cost is not relevant.
(9) If machine is used instead of scrapped, the business loses ($7,000 – $4,000) of scrap
proceeds.
However, the following non-financial factors also need to be considered:
(a) The likelihood of a more profitable proposal being received
(b) Whether repeat orders would be expected at the same price in future years
(c) Whether the company’s present customers can be differentiated from this special order price
Activity 7: Make or buy
1 The correct answer is:
(a)
P
1,000
$
Production (units)
J
1,500
$
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Variable cost of making
Variable cost of buying
Extra cost of buying / unit
Extra variable cost of buying (per annum)
Fixed costs saved by buying
Extra total cost of buying
11
12
17
21
1
$
1,000
(1,500)
4
$
6,000
(3,000)
(500)
3,000
The company would save $500 per year by sub-contracting component P but should make units
of J itself.
(b) Further considerations:
(i) If units of P are sub-contracted, the company will have spare capacity. How should that
spare capacity be profitably used? Are there hidden benefits to be obtained from subcontracting? Would the company’s workforce resent the loss of work to an outside
sub-contractor, and might such a decision cause an industrial dispute?
(ii) Would the sub-contractor be reliable with delivery times, and would they supply
components of the same quality as those manufactured internally?
(iii) Does the company wish to be flexible and maintain better control over operations by
making everything itself?
(iv) Are the estimates of fixed cost savings reliable?
Activity 8: Shutdown decisions
1 The correct answer is:
(a) If K were shut down the incremental costs and revenues would be:
$’000
600
Lost revenue
Saved
Materials
Labour
Variable overhead
Fixed overhead
$210 – (0.8 × $200)
Selling costs
Profit forgone
200
95
75
50
30
150
(b) Other factors
• Losing over 54% of company’s revenue – other costs likely to change
• Product interdependencies
• Possibility of changing sales commission or reducing expenses in place of closure
• Capital costs of closure not considered such as asset sales/write-offs
• Redundancy costs
Activity 9: Further processing
The correct answer is:
Z only
Product price
X
Increased
selling
2
Incremental
revenue
5,000
Further costs
Inc
benefit/(cost)
10,000
(5,000)
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Process
further?
No
Product price
Y
Z
Increased
selling
5
7
Incremental
revenue
7,500
14,000
Further costs
Inc
benefit/(cost)
8,000
(500)
12,000
2,000
Process
further?
No
Yes
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Skills checkpoint 2
Using the scenario
Chapter overview
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
ly sis
How to
approach
your PM
exam
Performance
management
questions
ti m
an a
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
r planning
Answe
an
cal
e ri
en
em
tn
ag
um
em
Effective
use of
spreadsheets
en
t
Effi
ci
Effe cti
ve writing
a nd p r
esentation
Introduction
Section C questions in the PM exam will be scenario-based. There may be several requirements,
including calculations and discussion elements, and they will be based on the scenario. The
scenarios are there for a reason! It is vital to spend time reading and absorbing the scenario as
part of your answer planning. It is important for you to use the information in the scenario to
validate that the discussion points that you are making in your answer are ‘relevant’. The
discussion parts of the question – applying your knowledge to the scenario – are the parts that
many students fail to score well on.
As you get into the habit of practising Section C questions and reading scenarios, you will be less
likely to make the mistake of including too much general theory in your answers. You are primarily
being tested on your ability to apply your knowledge to the scenario in question, not your ability
to simply recite it.
The skill of ‘using the scenario‘ is the most important skill you can learn for the discussion
elements of Section C questions. Overall, the mix of calculation and discussion elements is 50/50,
but it is not unreasonable to expect there to be a higher percentage of discussion marks in a
Section C question. In fact, some past Section C questions have been entirely discursive.
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Using the scenario
PM Skill: Using the scenario
A step-by-step technique for ensuring that your discussion points are relevant to the scenario is
outlined below. Each step will be explained in more detail in the following sections, and illustrated
by answering a requirement from a past exam question.
STEP 1:
Allow some of your allotted time for analysing the scenario and the requirements.
Don't rush into starting to write your answer.
STEP 2:
Prepare an answer plan using key words from the requirements as headings (eg a
bullet-pointed list). If you type your plan, you can then use these headings in your
answer and move them around as your answer develops. The software makes it
easy to change your mind.
STEP 3:
As you write your answer, explain what you mean in one (or two) sentence(s) and
then in the next sentence explain why it matters (in the given scenario). This should
results in a series of short punchy paragraphs containing points that address the
specific content of the scenario.
Exam success skills
The following illustration is based on an extract from a past ACCA exam question about a retail
store, called ‘Bits and Pieces’, selling spares and accessories for the car market. This extract was
worth eight marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in scenario-based
questions to feel overwhelming. To manage this, focus on the requirement first – noting the key
exam verbs to ensure you answer the question properly. Then read the rest of the question,
noting important and relevant information from the scenario.
• Correct interpretation of requirements. Parts (b) and (c) are looking for some common
(business) sense, based on the information in the scenario.
• Answer planning. Everyone will have a preferred style for an answer plan. For example, it may
be a mind map, bullet-pointed lists, or simply making notes. Choose the approach that you
feel most comfortable with or, if you are not sure, try out different approaches for different
questions until you have found your preferred style.
• Effective writing and presentation. It is often helpful to use key words from the requirement as
headings in your answer. You may also wish to use sub-headings in your answer; you could
use a separate sub-heading for each paragraph from the scenario in the question that
contains an issue for discussion. Underline or embolden your headings and sub-headings, and
use full sentences, ensuring your style is professional.
Skill activity
STEP 1
Allow some of your allotted time for analysing the scenario and requirements; don’t rush into starting to
write your answer.
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Start by analysing the requirements so that you know what you are looking for when you read the scenario.
(a) Discuss whether the manager’s pay deal (time off and bonus) is likely to motivate him.(4
marks)
(b) Briefly discuss whether offering substantial price discounts and promotions on Sunday is a
good suggestion.(4 marks)
The first key action verb is ‘discuss’. This is defined by the ACCA as: ‘Consider and debate/argue
about the pros and cons of an issue. Examine in detail by using arguments in favour or against’
and means ‘write about any conflict, compare and contrast’.
These requirements are worth eight marks and at 1.8 minutes a mark, they should take 14.4
minutes.
Now move on to reading the scenario, and identifying the key pieces of information provided in it.
From reading the requirements, you should know the key issues or clues you are looking for in the
scenario.
Bits and pieces (8 marks)
Bits and Pieces (B&P) operates a retail store selling spares and accessories for the car market. The
store has previously only opened for six days per week for the 50 working weeks in the year, but
B&P is now considering also opening on Sundays.
The sales of the business on Monday through to Saturday averages at $10,000 per day with
average gross profit of 70% earned.
B&P expects that the gross profit % earned on a Sunday will be 20 percentage points lower than
the average earned on the other days in the week. This is because they plan to offer substantial
discounts and promotions on a Sunday to attract customers. Given the price reduction, Sunday
sales revenues are expected to be 60% more than the average daily sales revenues for the other
days. These Sunday sales estimates are for new customers only, with no allowance being made
for those customers that may transfer from other days.
B&P buys all its goods from one supplier. This supplier gives a 5% discount on all purchases if
annual spend exceeds $1,000,000.
It has been agreed to pay time and a half to sales assistants who work on Sundays. The normal
hourly rate is $20 per hour. In total, five sales assistants will be needed for the six hours that the
store will be open on a Sunday. They will also be able to take a half-day off (four hours) during
the week. Staffing levels will be allowed to reduce slightly during the week to avoid extra costs
being incurred.
The staff will have to be supervised by a manager, currently employed by the company and paid
an annual salary of $80,000. If they work on a Sunday, they will take the equivalent time off
during the week when the assistant manager is available to cover for them at no extra cost to B&P.
They will also be paid a bonus of 1% of the extra sales generated on the Sunday project.
The store will have to be lit at a cost of $30 per hour and heated at a cost of $45 per hour. The
heating will come on two hours before the store opens in the 25 weeks of ‘winter’ to make sure it is
warm enough for customers to come in at opening time. The store is not heated in the other weeks.
The rent of the store amounts to $420,000 per annum.
(a) Discuss whether the manager’s pay deal (time off and bonus) is likely to motivate them.(4
marks)
(b) Briefly discuss whether offering substantial price discounts and promotions on Sunday is a
good suggestion.(4 marks)
STEP 2
Now you should be ready to prepare an answer plan using key words from the requirements as headings.
This could take the form of a bullet-pointed list.
Complete your answer plan by working through each paragraph of the question, identifying specific points
that are relevant to the scenario and requirement to make sure you generate enough points to score a pass
mark (ACCA marking guides typically allocate 1–2 marks per relevant well-explained point).
Completed answer plan
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Having worked through each paragraph, an answer plan can now be completed. A possible
answer plan is shown here. This uses the wording of the requirement and the initial ideas that have
been noted in the margins as shown earlier.
Part (b)
Ideas
Discuss*
As proposed:
Time off in week:
Sunday vs weekday
Conclusion re-motivation
Bonus
Calc value
Assumptions – estimated sales
Compared to sales assistants
Conclusion re motivation
(a) Time off
(b) Bonus
* There are two elements to evaluate. Ensure you conclude on how each would/would not motivate
the manager. Consider the bigger picture, eg how their reward compares to assistants. Main point
of the plan is to establish the structure of the answer.
Part (c)
Ideas
Briefly discuss
Promotion impact*:
Sunday sales rise, but
Sales on other days
Customer dissatisfaction
Reputational impact if lower price is perceived to mean
lower quality
* Think about how each could impact on the company positively or negatively.
STEP 3
As you write your answer, explain what you mean – in one (or two) sentence(s) – and then in the next
sentence explain why it matters in the given scenario. This should result in a series of short, punchy
paragraphs that address the specific context of the scenario.
Note, however, that addressing the specific context of the scenario does not simply mean repeating the
wording in the question. You should avoid doing this; and instead try to explain why your point matters.
Be concise (don’t waffle, given that any one point is normally unlikely to be worth more than two marks) and
especially avoid reciting theory at length (although briefly defining your terms is often an easy way of
scoring a mark).
Finally, write your answer in a time-efficient manner. If 25% of your time has been used for
planning/analysis this means that when you are writing the 1.8 minutes per mark becomes 1.8 × 0.75 = 1.35
minutes per mark of writing time. Here this would equate to 3.6 minutes planning and 10.8 minutes writing.
Suggested solution
(a) Manager’s pay deal
Time off
If1 the manager works on a Sunday they will take the
equivalent time off2 during the week. They are not
entitled to extra pay in the same way the sales
assistants are, and this seems unfair. Weekend working
is disruptive to most people’s family and social life and it
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1
Firstly, make the point – using
information from the scenario.
2
Secondly explain why this is relevant to
your answer.
is reasonable to expect extra reward for giving up time
at weekends. It is unlikely that time off in lieu during the
week will motivate3 the manager.
3
Bonus
Finally apply judgement and in this
case explain why it is unlikely to
motivate.
The bonus4 has been calculated as $8,000 which
4
equates to an extra $160 per day of extra work. The
Repeat the same approach (make a
point, explain the point, apply the point)
when discussing the bonus
sales assistants will be paid $180 per day (6 × $20 × 1.5)
so again the manager is not getting a fair offer.
The bonus is based on estimated sales so could be
higher if sales are higher than predicted. However, there
is a risk that sales and therefore the bonus could be
lower. It is therefore again unlikely that this bonus will
motivate the manager.
(b) Price discounts and promotions
B&P plans to offer substantial discounts and promotions
on a Sunday to attract customers. This may indeed be a
good marketing strategy5 to attract people to shop on
a Sunday, but it is not necessarily good for the
5
Try to think about the bigger picture
and apply common business sense.
business.
Customer buying pattern
B&P wants to attract new customers on a Sunday but
customers may simply change the day they do their
shopping in order to take advantage of the discounts
and promotions. The effect of this would be to reduce
the margin earned from customer purchases and not
increase revenue.
Customer dissatisfaction
Customers who buy goods at full price and then see
their purchases for sale at lower prices on a Sunday
may be disgruntled. They could then complain or switch
their custom to another shop.
The reputation of B&P could be damaged by this
marketing policy, especially if customers associate
lower prices with lower quality.
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Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the B&P activity to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Managing information
Did you identify the impact that the time off and bonus could
have on the manager and therefore on their motivation?
Correct interpretation of
requirements
Did you identify that part (b) was about the manager’s
motivation only?
Did you identify that part (c) concerned the wider impact on
sales?
Answer planning
Did you draw up an answer plan using your preferred approach
(eg mind map, bullet-pointed list)?
Did your plan help to create a structure for your answer?
Effective writing and
presentation
Did you use headings (key words from requirements)?
Did you use full sentences?
And most importantly – did you explain why your points related
to the scenario?
Most important action points to apply to your next question
Summary
Section C questions in the PM exam are scenario-based. It is therefore essential that you try to
create a practical answer that is relevant to the scenario, and/or addresses the issues identified in
the scenario, instead of simply repeating rote-learned, technical knowledge.
As you move into practising questions as part of your final revision, you will need to practise
taking in information from a scenario quickly (using active reading), accurately understanding the
requirements, and creating an answer plan and a final answer that addresses the requirements in
the context of the scenario.
This is not to suggest that theoretical knowledge is unimportant, because often scenario-based
questions will involve applying your knowledge to the scenario. In order to pass the exam, you
need to develop a sound knowledge of PM, but equally you need to apply this knowledge to the
question scenarios (for example to address problems or issues raised in the scenario). Simply
reciting your knowledge will not be sufficient to gain full marks, you must use the information
given to you in the scenario.
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Risk and uncertainty
12
12
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Suggest research techniques to reduce
uncertainty, eg focus groups, market
research.
C6 (a)
Explain the use of simulation, expected values
and sensitivity.
C6 (b)
Apply expected values and sensitivity to
decision-making problems.
C6 (c)
Apply the techniques of maximax, maximin,
and minimax regret to decision-making
problems, including the production of profit
tables.
C6 (d)
Interpret a decision tree and use it to solve a
multi-stage decision problem.
C6 (e)
Calculate the value of perfect and imperfect
information.
C6 (f)
12
Exam context
Management accounting exams have increasingly required a good understanding of risk and
uncertainty in decision-making. In an ideal world, a decision-maker would know with certainty
what the future consequences would be for each choice facing them. As this is not possible, it is
useful to incorporate risk and uncertainty into the decisions made. The techniques to allow this
are covered in this chapter.
12
Section C questions are likely to be a mixture of calculations and explanation.
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Chapter overview
Risk and uncertainty
Risk and
uncertainty
Allowing for
uncertainty
Attitudes to risk
Probabilities and
expected values (EV)
Other decision
rules
Pay-off tables
(profit tables)
Maximin decision rule
Maximax decision rule
Limitations of EV
Minimax regret
decision rule
Decision
trees
Evaluating a decision
tree
Benefits of using a
decision tree
The
value of
information
Techniques for
dealing
with uncertainty
Limitations of using
perfect information
Sensitivity analysis
Problems of using a
decision tree
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Simulation
1 Risk and uncertainty
When there is a strong element of risk or uncertainty in a decision, the decision that is taken may
be affected by the extent of the risk or uncertainty.
Risk: Risk involves situations or events that may or may not occur, but whose probability of
occurrence can be calculated statistically and the frequency of their occurrence predicted
from past records. Thus, insurance deals with risk.
KEY
TERM
Uncertain events: Uncertain events are those whose outcome cannot be predicted with
statistical confidence.
Making decisions now affects future outcomes. This means that managers preparing and
implementing budgets will need to estimate figures upon which to make decisions and set targets.
Risk exists where a decision-maker has knowledge that several different future outcomes are
possible, usually due to past experience. This past experience enables a decision-maker to
estimate the probability of the likely occurrence of each potential future outcome.
1.1 Attitudes to risk
Decisions should be taken with reference to the risks involved and the investor’s attitude to risk.
Individuals’ risk attitudes have an impact on decision-making in the short-term.
Risk seeker: A risk seeker is a decision maker who is interested in the best outcomes no matter
how small the chance that they may occur.
KEY
TERM
Risk neutral: A risk neutral decision-maker is concerned with what will be the most likely
outcome. This involves using expected values (EV) and selecting the strategy with the highest
EV.
Risk averse: A risk averse decision maker acts on the assumption that the worst outcome might
occur.
Activity 1: Attitudes to risk
Investment
Expected profit
Highest possible profit
Lowest possible profit
A
$10,000
$25,000
$(10,000)
B
$10,000
$11,000
$9,000
1 Required
Which investment would be chosen by a decision-maker who is:
(a) Risk seeking?
(b) Risk neutral?
(c) Risk averse?
Solution
1
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2 Allowing for uncertainty
One approach to dealing with uncertainty is to obtain more information about the effects of the
decision. Reliable information can reduce uncertainty.
Methods for obtaining more information include:
• Market research
• Focus groups
KEY
TERM
Market research: 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.
A focus group may be used to obtain qualitative views and opinions from a small group of
individuals. The group is asked about their opinions and attitudes towards a product or service,
and members of the group are encouraged to share their views with each other as well as with the
person leading the group.
Real life example
Retailers use focus groups of customers from their target market to help understand why that
target market behaves in a certain way and to establish what their barriers to purchasing are.
Essential reading
See Chapter 12 Sections 1 and 2 of the Essential reading for more detail on market research and
focus groups.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
3 Probabilities and expected values (EV)
When the final outcome of a decision is unknown and a range of possible future outcomes have
been quantified (eg best, worst and most likely) probabilities can be assigned to these outcomes
and a weighted average (expected value) of those outcomes calculated.
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Formula to learn
EV = ∑𝑝𝑥
where p is the probability of the outcome occurring and x is the value of the outcome (profit or
cost).
When faced with a number of alternative decisions, the one with the highest expected value (EV)
should be chosen.
Illustration 1: Expected values
1 Suppose a manager has to choose between options A and B. The options are mutually exclusive
(meaning that only one option can be chosen) and the probable outcomes of each option are as
follows:
Option A
Probability
Profit
$
5,000
6,000
0.8
0.2
Option B
Probability
Profit
0.1
0.2
0.6
0.1
(2,000)
5,000
7,000
8,000
Solution
1 The correct answer is:
The EV of profit for each option would be measured as follows:
Option A
Prob
p
0.8
0.2
×
×
Profit
x
$
5,000
6,000
EV
EV of profit
px
$
=
4,000
=
1,200
=
5,200
Option B
Prob
p
0.1
0.2
0.6
0.1
×
×
×
×
Profit
x
$
(2,000)
5,000
7,000
8,000
EV
EV of profit
px
$
=
(200)
=
1,000
=
4,200
=
800
=
5,800
In this example, since it offers a higher EV of profit, option B would be selected in preference to A,
unless further risk analysis is carried out.
3.1 Pay-off tables (profit tables)
Pay-off tables identify and record all possible outcomes (or pay-offs) in situations where there
are several decision options and the outcome from each decision depends on the eventual
circumstances that arise (for example, ‘worst possible’, ‘most likely’ or ‘best possible’).
Illustration 2: Expected values with pay-off tables (profit tables)
1 IB Newsagents stocks a weekly lifestyle magazine. The owner buys the magazines at the
beginning of each week for $0.30 each and sells them at the retail price of $0.50 each.
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At the end of the week, unsold magazines are obsolete and have no value, so they are discarded
as recycled waste. The estimated probability distribution for weekly demand is as follows:
Weekly demand in units
20
30
40
Probability
0.20
0.55
0.25
1.00
The actual demand in each week does not affect the actual demand in the following week.
Required
If the owner is to order a fixed quantity of magazines per week, how many should that be?
Since the outcomes occur every week, many times over, the EV decision rule is considered
appropriate here.
Assume no seasonal variations in demand.
Solution
1 The correct answer is:
Start by identifying the different decision options. These are assumed here to be the different
buying decisions, with three options: buy 20 per week, buy 30 per week or buy 40 per week.
The different possible outcomes are the three possibilities for actual demand: 20 units, 30 units or
40 units.
The next step is to set up a decision matrix of possible strategies (numbers bought) and possible
demand.
The ‘pay-off’ from each combination of action and outcome is then computed.
No sale = cost of $0.30 per magazine
Sale = profit of $0.20 per magazine ($0.50 – $0.30)
Probability
Outcome (number
demanded)
0.20
0.55
0.25
20
30
40
20
$
4.00
4.00
4.00
Decision (number
bought)
30
$
1.00*
6.00
6.00
40
$
**(2.00)
*** 3.00
8.00
* Buying 30 and selling only 20 gives a profit of (20 × $0.5) – (30 × $0.3) = $1
** Buying 40 and selling only 20 gives a loss of (20 × $0.5) – (40 × $0.3) = $(2)
*** Buying 40 and selling 30 gives a profit of (30 × $0.5) – (40 × $0.3) = $3
We can now calculate the EV of each decision option, as the weighted average value of the
different possible outcomes for each option.
Decision option
Buy 20
Buy 30
Buy 40
($4 × 0.20) + ($4 × 0.55) + ($4 × 0.25) =
($1 × 0.20) + ($6 × 0.55) + ($6 × 0.25) =
($(2) × 0.20) + ($3 × 0.55) + ($8 × 0.25) =
EV of weekly profit
$4.00
$5.00
$3.25
The strategy which gives the highest expected value of pay-off is to stock 30 magazines each
week.
Note. The expected value of weekly demand in this example is (20 × 0.20) + (30 × 0.55) + (40 ×
0.25) = 30.5 copies, but this does not help with the calculation of the expected value of profit,
because the profit is dependent on the purchase quantity as well as the sales demand quantity.)
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Activity 2: Table
1 Jaitinder must decide how best to use a monthly factory capacity of 1,200 units. Demand from
regular customers is risky and could be either 400, 500 or 700 units per month.
Regular customers generate contribution of $5 per unit. Jaitinder has the opportunity to enter a
special contract which will generate contribution of only $3 per unit. For the special contract, she
must enter a binding agreement now at a level of 900, 700 or 500 units.
Required
Display all possible contributions in the table below.
Special contract
Demand (units)
900
700
500
400
500
700
Solution
1
3.2 Limitations of EV
(a) EV is a long-term average, so will not be reached in the short term and is therefore not
suitable for one off decisions.
(b) The results are dependent on the accuracy of the probability estimates.
(c) The EV itself may not represent a single possible outcome.
(d) It ignores the range of possible outcomes.
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3.3 Two unknowns and joint probability
Illustration 3: Joint probabilities
Estimates of levels of demand and unit variable costs, with associated probabilities, for Product B
are shown below. Unit selling price is fixed at $100.
Levels of demand
Pessimistic
Probability of 0.4
10,000 units
Most likely
Probability of 0.5
12,500 units
Optimistic
Probability of 0.1
13,000 units
Optimistic
Probability of 0.3
$20
Most likely
Probability of 0.4
$30
Pessimistic
Probability of 0.3
$35
Unit variable costs
1 Required
Produce a two-way table showing levels of contribution that incorporates information about both
the variables and the associated probabilities.
Solution
1 The correct answer is:
Table of total contributions
The bold, shaded area on this table shows the possible total contributions and the associated joint
probabilities.
Demand
10,000
12,500
13,000
Probability
0.4
0.5
0.1
$800,000
$1,000,000
$1,040,000
0.12*
0.15**
0.03
$700,000
$875,000
$910,000
0.16
0.20
0.04
$650,000
$812,500
$845,000
0.12
0.15
0.03
Unit variable
cost
$20
$30
$35
Probability
Unit contribution
0.3
$80
0.4
0.3
$70
$65
* Joint probability: 0.3 × 0.4 = 0.12
**Joint probability: 0.3 × 0.5 = 0.15 etc
4 Other decisions
The expected value rule is just one possible ‘rule’ or criterion on which to base a decision. There
are other rules that a decision-maker may prefer to use.
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4.1 Maximin decision rule
Maximin decision rule: The maximin decision rule is that a decision-maker should select the
alternative that offers the least unattractive worst outcome. This would mean choosing the
alternative that maximises the minimum profits.
KEY
TERM
Maximin decisions:
• Maximise the minimum return of each decision.
• Apply to a risk averse decision maker.
Limitations of maximin:
• Does not consider the probability of each outcome occurring
• Is conservative (does not try to maximise profit)
Illustration 4: Maximin
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 (a conditional profit
table):
Net profit if outcome turns out to be
Project
I
II
III
A
$50,000
$65,000
$80,000
B
$70,000
$60,000
$75,000
C
$90,000
$80,000
$55,000
Probability
0.2
0.6
0.2
1 Required
Which project would be chosen using EV and which project would be chosen under maximin?
EV: Project
Maximin: Project
Solution
1 The correct answer is:
If the project with the highest EV of profit were chosen, this would be Project C.
Outcome
Probability
Project A
EV
Project B
EV
Project C
EV
$
$
$
I
0.2
10,000
14,000
18,000
II
0.6
39,000
36,000
48,000
III
0.2
16,000
15,000
11,000
65,000
65,000
77,000
However, if the maximin criterion were applied, the assessment would be as follows:
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Project selected
The worst outcome that
could happen
Profit
$
A
I
50,000
B
II
60,000
C
III
55,000
By choosing B, we are ‘guaranteed’ a profit of at least $60,000, which is more than we would get
from Projects A or C if the worst outcome were to occur for them. (We want the maximum of the
minimum achievable profits.)
The decision would therefore be to choose Project B.
4.2 Maximax decision rule
Maximax criterion: The maximax criterion looks at the best possible results. Maximax means
‘maximise the maximum profit’. The decision with this rule is to choose the option that could
provide the maximum possible profit.
KEY
TERM
Maximax decisions:
• Aim for the best possible return.
• Apply to a risk seeking decision-maker.
Limitations of maximax:
• Does not consider the probability of each outcome occurring
• Is overly optimistic
Activity 3: Maximin, maximax
Jaitinder must decide how best to use a monthly factory capacity of 1,200 units. Demand from
regular customers is risky and as follows.
Monthly demand (units)
400
500
700
Probability
0.2
0.6
0.2
1.0
Regular customers generate contribution of $5 per unit. Jaitinder has the opportunity to enter a
special contract which will generate contribution of only $3 per unit. For the special contract, she
must enter a binding agreement now at a level of 900, 700 or 500 units.
Profit table:
Demand (units)
400
500
700
1
P
0.2
0.6
0.2
900
4,200
4,200
4,200
Special contract (units)
700
500
4,100
3,500
4,600
4,000
4,600
5,000
Required
Using the profit table and expected values, what is the optimal level of special contract to commit
to every month?
 400 units
 500 units
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2
3
 700 units
 900 units
Required
Using the profit table and assuming a totally risk averse attitude to decision making, what is the
optimal level of special contract to commit to every month?
 400 units
 500 units
 700 units
 900 units
Required
Using the profit table, what is the optimal level of special contract to commit to every month,
assuming a risk seeking attitude to decision making?
 400 units
 500 units
 700 units
 900 units
Solution
1
2
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3
4.3 Minimax regret decision rule
KEY
TERM
Minimax regret rule: The minimax regret rule aims to minimise the regret from making the
wrong decision. Regret is the opportunity lost through making the wrong decision.
The decision rule chooses the option which minimises the maximum opportunity cost from
making the wrong decision.
Illustration 5: Minimax regret
A manager is trying to decide which of three mutually exclusive projects to undertake. Each of the
projects could lead to varying net costs which the manager calls outcomes I, II and III. The
following payoff table or matrix has been constructed:
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Outcomes (not profit)
Project
I (Worst)
II (Most likely)
III (Best)
A
50
85
130
B
70
75
140
C
90
100
110
1 Required
Which project should be undertaken under minimax regret rules?
Solution
1 The correct answer is:
A table of regrets can be compiled, as follows, showing the amount of profit that might be forgone
for each project, depending on whether the outcome is I, II or III:
Outcome I
Outcome II
Outcome III
Maximum
Project A
40*
15***
10
40
Project B
20**
25
0
25
Project C
0
0
30
30
*90 – 50
**90 – 70
***100 – 85 etc
The maximum regret is 40 with Project A, 25 with B and 30 with C. The lowest of these three
maximum regrets is 25 with B, and so Project B would be selected if the minimax regret rule is
used.
Activity 4: Minimax regret
1 Required
Using the minimax regret rule, what decisions would be taken using the data table in Activity 3?
Special contract (units)
Demand (units)
900
700
500
400
4,200
4,100
3,500
500
4,200
4,600
4,000
700
4,200
4,600
5,000
Opportunity cost table
Special contract (units)
Demand (units)
900
700
500
400
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500
700
Maximum regret
Solution
1
5 Decision trees
A decision tree is a pictorial method of showing a sequence of interrelated decisions and their
expected outcomes. Decision trees can incorporate both the probabilities and value of expected
outcomes and are used in decision- making.
Decision trees are most useful when there are several decisions and ranges of outcome.
5.1 Evaluating a decision tree
Once drawn, the optimal decision can be calculated using rollback analysis.
Evaluate the tree from right to left.
(a) Calculate expected values at outcome points. (Denoted by a circle on the tree.)
(b) Take highest benefit at decision points. (Denoted by a square on the tree.)
Illustration 6: Decision trees
Beeth Co has a new wonder product, the vylin, of which it expects great things. At the moment,
the company has two courses of action open to it, to test market the product or abandon it.
If the company test markets it, the cost will be $100,000 and the market response could be
positive or negative, with probabilities of 0.60 and 0.40.
If the response is positive, the company could either abandon the product or market it full scale.
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If it markets the vylin full scale, the outcome might be low, medium or high demand, and the
respective net gains/(losses) would be (200), 200 or 1,000 in units of $1,000 (the result could
range from a net loss of $200,000 to a gain of $1,000,000). These outcomes have probabilities of
0.20, 0.50 and 0.30, respectively.
If the result of the test marketing is negative and the company goes ahead and markets the
product, estimated losses would be $600,000.
If, at any point, the company abandons the product, there would be a net gain of $50,000 from
the sale of scrap. All the financial values have been discounted to the present.
High 0.3
Market
C
0.6
Abandon
B
Negative
Market
D
0.4
A
Abandon
Abandon
1
Medium 0.5
Low 0.2
Positive
Test -100
E
+ 1,000
+ 200
- 200
+ 50
- 600
+ 50
+ 50
Required
Based on the decision tree, evaluate whether the company should test the product or abandon it.
▼ and should not
The company should
▼
Pick list:
abandon
test
1
Solution
The correct answer is:
The company should test and should not abandon
Rollback analysis evaluates the EV of each decision option. You have to work from right to left and
calculate EVs at each outcome point.
The EV of each decision option can be evaluated, using the decision tree to help with keeping the
logic on track. The basic rules are as follows:
(a) We start on the right hand side of the tree and work back towards the left hand side and the
current decision under consideration. This is sometimes known as the ‘rollback’ technique or
‘rollback analysis’.
(b) Working from right to left, we calculate the EV of revenue, cost, contribution or profit at each
outcome point on the tree.
In the above example, the right hand most outcome point is point E, and the EV is as follows:
Profit
x
Probability
p
px
$’000
$’000
$’000
High
1000
0.3
300
Medium
200
0.5
100
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Low
Profit
x
Probability
p
px
$’000
$’000
$’000
(200)
0.2
(40)
EV:
360
This is the EV of the decision to market the product if the test shows a positive response.
(a) At decision point C, the choice is as follows:
(i) Market, EV = +360 (the EV at point E)
(ii) Abandon, value = +50
The choice would be to market the product, and so the EV at decision point C is +360.
(b) At decision point D, the choice is as follows:
(i) Market, value = – 600
(ii) Abandon, value = +50
The choice would be to abandon, and so the EV at decision point D is +50.
The second-stage decisions have therefore been made. If the original decision is to test the
market, the company will market the product if the test shows a positive customer response, and
will abandon the product if the test results are negative.
The evaluation of the decision tree is completed as follows:
(a) Calculate the EV at outcome point B.
0.6 × 360 (EV at C)
+ 0.4 × 50 (EV at D)
= 216 + 20 = 236
(b) Compare the options at point A, which are as follows:
(i) Test: EV = EV at B minus test marketing cost = 236 – 100 = 136
(ii) Abandon: value = 50
The choice would be to test market the product, because it has a higher EV of profit.
Activity 5: Decisions trees
Captain plc runs its business through a number of centres. One of its centres is suffering from
declining sales and management has a range of options:
(a) To shut down the site and sell it for $5 million
(b) To undertake a major refurbishment
(c) To undertake a cheaper refurbishment
In the past, two-thirds of such refurbishments have achieved good results, the other one-third
being less successful, achieving poor results.
The major refurbishment will cost $4,000,000 now. Estimates of the outcomes are as follows:
(a) Good results
PV =
$13,500,000
(b) Poor results
PV =
$6,500,000
The cheaper refurbishment, costing $2,000,000 now, would have the following outcomes:
(a) Good results PV = $8,500,000
(b) Poor results PV = $4,000,000
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Sell
5,000
Good
A
Major
(4,000)
B
Poor
Good
Cheap
(2,000)
1
13,500
6,500
8,500
C
Poor
4,000
Required
Calculate the expected value at Points B and C (to the nearest whole $’000). Recommend what
action should be taken.
 Captain plc should sell the site
 Captain plc should undertake a major refurbishment
 Captain plc should undertake a cheaper refurbishment
Solution
1
5.2 Benefit of using a decision tree
Clearly shows all the decisions and uncertain events and how they are interrelated.
5.3 Problems of using a decision tree
•
•
•
Based on EV, so suffers from same disadvantages as all EV techniques
Heavily dependent on the probabilities used
Oversimplification of reality
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6 The value of information
Information about uncertain variables may be available, for example, from market research. If this
information is guaranteed to predict the future with certainty, it is defined as perfect information.
Perfect information removes risk and is therefore valuable.
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.
KEY
TERM
Formula to learn
Value of perfect information (VOPI)
EV (with perfect information)
EV (without perfect information)
VOPI
X
(X)
X
Illustration 7: Perfect information
The management of Ivor Co must choose whether to go ahead with either of two mutually
exclusive projects: A or B. The expected profits are as follows:
1
2
Profit if there is strong
demand
Profit/(loss) if there is
weak demand
Option A
$4,000
$(1,000)
Option B
$1,500
$500
Probability of demand
0.3
0.7
Required
Ascertain what the decision would be, based on expected values, if no information about demand
were available.
Project
Required
Calculate the value of perfect information about demand.
$
1
Solution
The correct answer is:
Project B
Step 1 If there were no information to help with the decision, the project with the higher EV of
profit would be selected.
Probability
Project A
Profit
$
Project A
EV
$
Project B
Profit
$
Project B
EV
$
0.3
4,000
1,200
1,500
450
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Probability
Project A
Profit
$
Project A
EV
$
Project B
Profit
$
Project B
EV
$
0.7
(1,000)
(700)
500
350
500
800
Project B would be selected.
2
This is clearly the better option if demand turns out to be weak. However, if demand were to turn
out to be strong, Project A would be more profitable. There is a 30% chance that this could
happen.
The correct answer is:
$750
Step 2 Perfect information will indicate for certain whether demand will be weak or strong. If
demand is forecast ‘weak’, Project B would be selected. If demand is forecast as ‘strong’, Project A
would be selected, and perfect information would improve the profit from $1,500, which would
have been earned by selecting B, to $4,000.
Forecast
demand
Probability
Project
chosen
Profit
$
EV if profit
$
Weak
0.7
B
500
350
Strong
0.3
A
4,000
1,200
EV of profit with
Perfect
information:
1,550
Step 3
$
EV of profit without perfect information (ie if Project B is always chosen)
800
EV of profit with perfect information
1,550
Value of perfect information
750
Provided that the information does not cost more than $750 to collect, it would be worth having.
Activity 6: Perfect information
Jaitinder has been contacted by a market research company, which guarantees that the results
of its survey will be 100% correct.
These results will enable Jaitinder to ascertain the demand from her regular customers every
month, in advance of accepting the special order.
Without this information, Jaitinder would choose to order the special contract of 700 units which,
based on the expected value calculations, will give an average profit of $4,500.
Required
What is the maximum amount that Jaitinder should pay for the survey?
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Demand (units)
400
500
900




P
0.2
0.6
0.2
900
4,200
4,200
4,200
Special contract
(units)
700
4,100
4,600
4,600
500
3,500
4,000
5,000
$0
$100
$400
Impossible to know
Solution
6.1 Limitations of using perfect information
In practice, useful information is never perfect, market research findings can be reasonably
accurate, but could still be wrong and it is not until after the decision has been made that this
would be known. This is known as imperfect information, which while not as valuable as perfect
information, is still better than nothing.
7 Techniques for dealing with uncertainty
Sensitivity analysis is a method of analysing the uncertainty in a situation or decision. It
measures the effect of changes in the estimated value of an item (‘key factor’) on the future
outcome. It can therefore be used to assess the sensitivity of the expected outcome to variations
or changes in the value of the item (‘key factor’).
KEY
TERM
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 two approaches to sensitivity analysis:
• Calculating the maximum percentage change in a variable before the decision would change
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•
Assessing if the decision would change if a variable changed by x% of estimate
Sensitivity analysis concentrates management attention on variables that are the most important
for the decision under review.
Strengths of sensitivity analysis
• Easy to understand
• Highlights key variables which are crucial to the success of the project, once identified these
can be closely monitored
Limitations of sensitivity analysis
• Assumes that all changes are independent; in reality, multiple variables are likely to chance
simultaneously
• Only identifies the amount of change required in one variable, it does not assess the
probability of that change occurring
• Does not offer a clear decision rule; appropriate management judgement is still required
Illustration 8: Sensitivity analysis
SS has estimated the following sales and profits for a new product that it may launch on to the
market:
$
Sales (2,000 units)
Variable costs:
Materials
Labour
Contribution
Less incremental fixed costs
Profit
$
4,000
2,000
1,000
3,000
1,000
(800)
200
1 Required
What are the percentages changes that would result in a loss (to the nearest whole percent)?
More than
% increase in incremental fixed costs
More than
% increase in unit cost of materials
More than
% increase in unit labour costs
More than
% drop in unit selling price
Solution
1 The correct answer is:
The margin of safety
= ((budgeted sales – breakeven sales)/budgeted sales) × 100%
The breakeven point
= fixed costs/contribution per unit
= $800 / ($1,000/2,000 units) = 1,600 units
Margin of safety
= ((2,000 – 1,600)/2,000) × 100% = 20%
If any of the costs increase by more than $200, the profit will disappear and there will be a loss.
Changes in variables that would result in a loss
More than ((200/800) × 100%) 25% increase in incremental fixed costs
More than ((200/2,000) × 100%) 10% increase in unit cost of materials
More than ((200/1,000) × 100%) 20% increase in unit labour costs
More than ((200/4,000) × 100%) 5% drop in unit selling price
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Management would now be able to judge more clearly whether the product is likely to be
profitable. The items to which profitability is most sensitive in this example are the selling price
(5%) and material costs (10%). Sensitivity analysis can help to concentrate management
attention on the most important forecasts.
Activity 7: Margin of safety
Columbus makes and sells a single product, the Raleigh.
Financial data concerning this product is as follows:
$/unit
Selling price
120
Direct materials
30
Direct labour
25
Fixed costs
40
Anticipated sales and production are forecast to be 750 units.
Some uncertainty has now arisen over the level of likely cost expected in the production of the
Raleigh.
Required
What is the impact on the margin of safety if material costs increase by 5%?
 4% increase
 4% decrease
 63% increase
 63% decrease
Solution
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8 Simulation
Sensitivity analysis can only be used to assess changes in one variable at a time. In practice,
many variables may be uncertain.
Simulation models can be created using computers and random numbers. These numbers are
linked to probability distributions so that the number chosen would occur with the same
probability that the real-life event would occur.
Simulation can be used for estimating queues in shops, as this depends on two uncertainties;
arrival of customers at the shop and service time. Two sets of probabilities and random numbers
will be required.
Essential reading
See Chapter 12 Section 3 of the Essential reading for more detail on simulation. Section 4 of the
Essential reading is on standard deviation which is a measure of risk. Standard deviation is not
specifically mentioned in the PM syllabus but it is mentioned in the technical article on the ACCA
website.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Risk and uncertainty
Risk and
uncertainty
Allowing for
uncertainty
• Risk seeker = optimist
• Risk averse = pessimist
• Market research
• Focus groups
EV = ∑px
• Risk = past experience
• Risk – can estimate
probabilities
• Uncertainty = no past
experience
• Uncertainty – cannot
predict probabilities
Benefits of using a
decision tree
• From right to left
• Calculate EVs at
outcome points
(circles)
• Take highest benefit at
decision points
(squares)
Clearly shows decisions
and how they are
interrelated
Problems of using a
decision tree
• Based on EV (suffers
same problems as EV)
• Heavily dependent on
probabilities used
• Oversimplification of
reality
Maximax decision rule
Risk seeker
Limitations of EV
Minimax regret decision
rule
The
value of
information
Evaluating a decision
tree
Maximin decision rule
Record all outcomes
(pay-offs)
• Long term average
• Ignores risk
• May not represent a
possible outcome
• Inappropriate for one
off decisions
Decision
trees
Other decision
rules
Risk averse
Pay-off tables (profit
tables)
Attitudes to risk
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Probabilities and
expected values (EV)
• Perfect information
(PI) removes risk
• Value of PI = EV with
PI – EV without PI
Limitations of using
perfect information
• Information is never
perfect
• Imperfect information
is better than nothing
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Minimise maximum
opportunity cost
Techniques for
dealing
with uncertainty
Sensitivity analysis
• Highlights variables
crucial to success
• Assumes all changes
are independent
• Does not offer clear
decision rule
Simulation
Models created using
computers and random
numbers
Knowledge diagnostic
1. Risk and uncertainty
Risk is where a decision maker has past experience. With uncertainty, there is no past
experience.
2. Attitudes to risk
There are three types of risk preference:
• Risk seeker
• Risk averse
• Risk neutral
3. Probabilities and expected values
EVs are calculated as
∑𝑝𝑥
4. Other decision rules
Maximin - maximise the minimum return
Maximax - maximise the maximum return
Maximax regret - minimise the opportunity cost from making the wrong decision
5. Decision trees
Decision trees can be used to illustrate the choices and possible outcomes of a decision.
6. The value of information
Perfect information is guaranteed to predict the future with 100% accuracy. Imperfect information
is valuable even though it may incorrectly predict future events.
The value of perfect information is calculated as:
$
X
(X)
X
EV with perfect information
EV without perfect information
Value of information
7. Sensitivity analysis and simulation
Sensitivity analysis
An alternative way of assessing risk in which variables are assessed in
isolation.
Simulation
A method of assessing risk where there are several uncertain variables
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q32
Examination
2
4 mins
Section A Q33
Examination
2
4 mins
Section A Q34
Examination
2
4 mins
Section C ‘Stow Health
Centre’
Examination
20
36 mins
Further reading
There are two technical articles available on ACCA’s website, called The risks of uncertainty and
Decision trees.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Attitudes to risk
1 The correct answer is:
(a) Risk-seeker chooses A as it gives a chance of earning the best profit of $25,000.
(b) Risk-neutral decision-maker is indifferent between A and B as they give the same expected
profit.
(c) Risk-averse decision-maker chooses B to avoid the chance of the loss of $(10,000) with
investment
Activity 2: Table
1 The correct answer is:
Special contract
Demand units
900
700
500
400
4,200 (W1)
4,100 (W2)
3,500 (W3)
500
4,200
4,600 (W4)
4,000 (W5)
700
4,200
4,600 (W6)
5,000 (W7)
(a) Factory capacity = 1,200 units. As such, if Jaitinder enters into the special contract for 900
units then she can only make an additional 1,200 - 900 = 300 units for regular customers.
Therefore, the total contribution = (900 × $3) + (300 × $5) = $4,200.
(b) If Jaitinder enters into the special contract for 700 units then she can make an additional
1,200 - 700 = 500 units for regular customers. If demand is 400 units then:
Total contribution = (700 × $3) + (400 × $5) = $4,100
(c) If Jaitinder enters into the special contract for 500 units then she can make an additional
1,200 - 500 = 700 units for regular customers. If demand is 400 units then:
Total contribution = (500 × $3) + (400 × $5) = $3,500
(d) If Jaitinder enters into the special contract for 700 units then she can make an additional
1,200 - 700 = 500 units for regular customers.
Total contribution = (700 × $3) + (500 × $5) = $4,600
(e) Total contribution = (500 × $3) + (500 × $5) = $4,000
(f) Total contribution = (700 × $3) + (500 × $5) = $4,600
(g) Total contribution = (500 × $3) + (700 × $5) = $5,000
Activity 3: Maximin, maximax
1
The correct answer is:
700 units
EV(900) = 4,200
EV(700) = (4,100 × 0.2) + (4,600 × 0.8) = 4,500
EV(500) = (3,500× 0.2) + (4,000 × 0.6) + (5,000 × 0.2) = 4,100
2
 to maximise profits over the long-term choose 700 for special contract.
The correct answer is:
900 units
Maximin rule:
Maximise the possible minimum return that the decision maker could get.
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Contract
Minimum achievable contribution
900
$4,200
700
$4,100
500
$3,500
We want the maximum of the minimum achievable contributions, therefore 900 units would be
chosen.
The correct answer is:
500 units
Maximax rule:
Choose the option giving the highest possible return.
Maximum contribution = $5,000 under a contract of 500 units.
Activity 4: Minimax regret
1 The correct answer is:
900
700
500
Demand
400
500
700
0
400
800
100
0
400
700
600
0
Maximum regret
$800
$400
$700
Decision – set order level for special contract at 700 units.
Activity 5: Decisions trees
1
The correct answer is:
EV at B = $11,167
EV at C = $7,000
EV at B = (2/3 × $13,500) + (1/3 × $6,500) = $11,167
EV at C = (2/3 × $8,500) + (1/3 × $4,000) = $7,000
Captain plc should undertake a major refurbishment
The expected values of the options are:
Sell: $5,000,000
Major refurb: $7,167,000 (11,167,000 - 4,000,000)
Cheaper refurb: $5,000,000 (7,000,000 - 2,000,000)
Captain plc should undertake the major refurbishment, which will result in the highest EV of
$7,167,000.
Activity 6: Perfect information
The correct answer is:
$100
EV with perfect information
Demand
Contract
(units)
(units)
Contribution
P
$
400
900
$4,200
0.2
840
500
700
$4,600
0.6
2,760
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700
500
$5,000
0.2
1,000
4,600
VOPI = EV with PI – EV without PI
=
$4,600 – $4,500
=
$100
This is the maximum Jaitinder would be willing to pay each month for the survey.
Activity 7: Margin of safety
The correct answer is:
4% decrease
Current breakeven point = $30,000 / ($120 - £30 - $25_ = 462 units
Current margin of safety = 750 - 462 = 288 units
Materials increase by 5% = $31.5
Revised breakeven point = $30,000 / ($120 - £31.5 - $25) = 473 units
Revised margin of safety = 750 - 473 = 277 units
Therefore, change in margin of safety = drop of 11 units (ie a fall of 3.8%)
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Budgetary systems
13
13
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain how budgetary systems fit within the
performance hierarchy.
D1 (a)
Select and explain appropriate budgetary
systems for an organisation, including topdown, bottom-up, rolling, zero base, activity
base, incremental and feed-forward control.
D1 (b)
Describe the information used in budget
systems and the sources of the information
needed.
D1 (c)
Indicate the usefulness and problems with
different budget types (including fixed,
flexible, zero based, activity based,
incremental, rolling, top-down, bottom up,
master, functional).
D1 (d)
Prepare flexed budgets, rolling budgets and
activity based budgets.
D1 (e)
Explain the beyond budgeting model,
including the benefits and problems that may
be faced if it is adopted in an organisation.
D1 (f)
Explain the difficulties of changing a
budgetary system or type of budget used.
D1 (i)
Explain how budget systems can deal with
uncertainty in the environment.
D1 (j)
13
Exam context
This chapter looks at the budgeting system and methods of preparing budgets. We look at how
the budget is used in the planning and control process.
We then go on to look at the traditional approach to budget preparation – incremental
budgeting – as well as alternative approaches to budget preparation: zero based budgeting,
rolling budgets and activity based budgeting. You are expected to be aware of the problems of
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traditional budgeting systems and why organisations may be reluctant to change to more
appropriate systems.
Chapter overview
Budgetary systems
Planning and control in
the performance hierarchy
Control
Budget systems
Fixed budgets
Zero-based budgeting
Flexible budget
Rolling budgets
Flexed budget
Activity-based budgeting
Purpose of flexible/flexed
budgets
Beyond budgeting
Incremental budgeting
Information used in
budget systems
Changing
budgetary systems
Sales budget information
Probabilistic budgeting
Production budget information
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1 Planning and control in the performance hierarchy
PER alert
One of the competencies needed to fulfil performance objective 13 of the PER is the ability to
contribute to setting objectives for the planning and control of business activities. You can
apply the knowledge you obtain from this chapter to help demonstrate this competence.
Long-term strategic plans are broken down into short-term plans and targets. This is generally
done in the form of a budget or forecast.
KEY
TERM
Budget: A budget: is a quantified plan of action for a forthcoming accounting period. Note
that a budget is a plan of what the organisation is aiming to achieve and what it has set as a
target, whereas a forecast is an estimate of what is likely to occur in the future.
Essential reading
See Chapter 13 Section 1 of the Essential reading for more detail on budgeting systems including
knowledge brought forward from earlier studies.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Planning and control occurs at all levels of the performance hierarchy to different degrees. The
performance hierarchy refers to the system by which performance is measured and controlled at
different levels of management within the organisation.
1.1 Control
Consider how the activities of planning and control are interrelated.
(a) Plans set the targets
(b) Control involves two main processes
(i) Measure actual results against plan
(ii) Take action to adjust actual performance to achieve the plan or to change the plan
altogether
Control is therefore impossible without planning.
The essence of control is the measurement of results and comparing them with the original plan.
Any deviation from the plan indicates that control action is required to make the results conform
more closely with the plan.
1.1.1 Feedback
KEY
TERM
Feedback: Feedback occurs when the results (outputs) 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.
A business organisation uses feedback for control.
(a) Negative feedback indicates that results or activities must be brought back on course, as
they are deviating from the plan.
(b) Positive feedback results in control action continuing the current course. You would normally
assume that positive feedback means that results are going according to plan and that no
corrective action is necessary: but it is best to be sure that the control system itself is not
picking up the wrong information.
(c) Feedforward control is control based on forecast results: in other words, if the forecast is
bad, control action is taken well in advance of actual results.
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These are two types of feedback:
• Single loop feedback is control, like a thermostat, which regulates the output of a system. For
example, if sales targets are not reached, control action will be taken to ensure that targets will
be reached soon. The plan or target itself is not changed, even though the resources needed to
achieve it might have to be reviewed.
• Double loop feedback is of a different order. It is information used to change the plan itself.
For example, if sales targets are not reached, the company may need to change the plan.
1.1.2 Controls at different levels
Performance hierarchy
Features
Strategic performance reports
•
•
•
Produced periodically (three, six or twelve months)
Compare strategic position vs overall business plan
Use information from outside and inside organisation
Management control (standard
costing and budgetary control)
performance reports
•
•
May be monthly (eg variance report)
Compare actual performance vs planned
performance in budget
Formal feedback systems for reporting
Based on feedback from within organisation
•
•
Operational level
•
•
•
Control measures reported regularly (often day-today basis)
Compare actual performance vs standard
Sometimes non-financial, eg standard times to
complete task, wastage rates etc
1.1.3 Top-down and bottom-up budgeting
‘Top-down’ and ‘bottom-up’ are two different approaches to budget preparation.
KEY
TERM
Top down budgeting: Top-down budgeting is when budget targets are set at senior
management level for the organisation as a whole and for each major department or activity
within the organisation.
(a) With top-down budgeting, the departmental budget targets are given to the departmental
managers, who are required to prepare a budget that conforms to the targets that have been
imposed on them from above.
(b) Similarly, when budgets have been set at departmental level, targets are then given to
managers lower down the organisation hierarchy; these managers are then required to
prepare budgets that meet the targets that have been imposed on them for their area of
operations.
KEY
TERM
Bottom-up budgeting: Bottom-up budgeting is when the budgeting process starts at a
relatively low level of management.
(c) With bottom-up budgeting, managers are required to draft a budget for their area of
operations. These are submitted to their superior, who combines the lower-level budgets into
a combined budget for the department as a whole. Departmental budgets are then
submitted to senior management, where they are combined into a co-ordinated budget for
the organisation as a whole.
(d) Top-down budgeting takes much less time and planning effort than bottom-up budgeting
and senior management can use top-down budgets to impose their views.
(e) Bottom-up budgeting is much more time consuming, and draft budgets may have to be
revised many times until they are properly co-ordinated.
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However, bottom-up budgeting has two potential advantages:
• It reflects the views and expectations of managers who are closer to operations and who may
therefore have a better understanding of what is and what is not achievable.
• Bottom-up budgeting is a form of participative budgeting process, which can have
behavioural and motivational advantages. These are considered further in a later chapter.
2 Budget systems
PER alert
One of the competencies needed to fulfil performance objective 13 is to coordinate, prepare
and use budgets, selecting suitable budgeting models. You can apply the knowledge you
obtain from this chapter to help to demonstrate this competence.
2.1 Fixed budgets
KEY
TERM
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.
The fixed budget is the master budget prepared before the beginning of the budget period.
It is based on budgeted volumes and costs/revenues and as such is often unrealistic as the actual
level of activity will be almost certainly different from the level of activity originally planned.
The major purpose of a fixed budget is for planning. It is prepared at the planning stage, when it
is used to define the objectives and targets of the organisation for the budget period (financial
year).
2.2 Flexible budget
KEY
TERM
Flexible budget: A flexible budget is a budget which, by recognising different cost behaviour
patterns, is changed as the volume of output and sales changes. It recognises cost behaviour
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.
It is useful at the planning stage to show different results from various possible activity levels
(what-if analysis) allowing better planning for uncertainty in the future.
2.3 Flexed budgets
Used at the control stage, budgets need to be flexed to reflect the actual activity level achieved in
a given period before the budget can meaningfully be compared with actual results and variance
analysis performed.
Note that a flexible budget is designed at the planning stage to vary with activity levels, whereas
a flexed budget is a revised budget that reflects the actual activity levels achieved in the budget
period. A flexed budget is therefore used retrospectively to compare actual results achieved with
what results should have been under the circumstances.
2.4 Purpose of flexible/flexed budgets
(a) Designed to cope with different activity levels to keep the budget meaningful and hence
preserve the relevance of variances for effective control.
(b) Useful at planning stage to show different results from possible activity levels.
(c) Necessary as control device because we can meaningfully compare actual results with
relevant flexible budget, ie budgetary control.
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Illustration 1: Preparing a flexible budget
1 Required
Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
department flexed at the activity levels of 80%, 90% and 100%, using the information listed below.
(a) The direct labour hourly rate is expected to be $3.75.
(b) 100% activity represents 60,000 direct labour hours.
(c) Variable costs
Indirect labour
$0.75 per direct labour hour
Consumable supplies
$0.375 per direct labour hour
Canteen and other
6% of direct and indirect labour costs
welfare services
(d) Semi variable costs are expected to relate to the direct labour hours in the same manner as
for the last five years.
Direct labour hours
Year
20X1
20X2
20X3
20X4
20X5
64,000
59,000
53,000
49,000
40,000 (estimate)
Semi-variable costs
$
20,800
19,800
18,600
17,800
16,000 (estimate)
(e) Fixed costs
$
18,000
10,000
4,000
15,000
25,000
Depreciation
Maintenance
Insurance
Rates
Management salaries
(f)
Inflation is to be ignored
2 Required
Calculate the budget cost allowance (ie expected expenditure) for 20X6 assuming that 57,000
direct labour hours are worked.
Solution
1 The correct answer is:
Direct labour
Other variable costs
Indirect labour
Consumable supplies
Canteen etc
Total variable costs ($5.145 per hour)
Semi‑variable costs (W)
Fixed costs
284
80% level
48,000 hrs
$’000
180.00
90% level
54,000 hrs
$’000
202.50
100% level
60,000 hrs
$’000
225.0
36.00
18.00
12.96
246.96
17.60
40.50
20.25
14.58
277.83
18.80
45.0
22.5
16.2
308.7
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Depreciation
Maintenance
Insurance
Rates
Management salaries
Budgeted costs
18.00
10.00
4.00
15.00
25.00
18.00
10.00
4.00
15.00
25.00
18.0
10.0
4.0
15.0
25.0
336.56
368.63
400.7
Using the high/low method:
$
20,800
16,000
4,800
$0.20
Total cost of 64,000 hours
Total cost of 40,000 hours
Variable cost of 24,000 hours
Variable cost per hour ($4,800/24,000)
$
20,800
12,800
Total cost of 64,000 hours
Variable cost of 64,000 hours (× $0.20)
Fixed costs
8,000
Semi‑variable costs are calculated as follows.
60,000 hours
54,000 hours
48,000 hours
(60,000 × $0.20) + $8,000
(54,000 × $0.20) + $8,000
(48,000 × $0.20) + $8,000
$
20,000
18,800
17,600
=
=
=
2 The correct answer is:
The budget cost allowance for 57,000 direct labour hours of work would be as follows:
Variable costs
Semi‑variable costs
Fixed costs
$
293,265
19,400
72,000
(57,000 × $5.145)
($8,000 + (57,000 × $0.20))
384,665
Activity 1: Flexible budget
Chateau Larnaque has a bottling plant for its drinks and has prepared flexible budgets:
Bottles:
Production costs:
Materials
Labour
Overhead
10,000
$
30,000
27,000
20,000
12,000
$
36,000
31,000
20,000
Flexible budgets
14,000
$
42,000
35,000
20,000
Actual production was 12,350 bottles and the production costs incurred totalled $90,000.
Required
What is the meaningful total variance for performance evaluation purposes?
 $0
 $350 Adverse
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 $1,250 Adverse
 $1,650 Adverse
Solution
2.5 Incremental budgeting
Incremental budgeting: This is where the budget is based on the current year’s budget (or
results) plus an extra amount for estimated growth or inflation.
KEY
TERM
This method will be sufficient if current operations are as efficient, effective and economical as
they can be, without any alternative courses of action available to the organisation.
Activity 2: Incremental budgeting
CP produces two products, X and Y. In the year ending 30 April 20X1, it produced 4,520 X and
11,750 Y and incurred costs of $1,217,200.
The costs incurred are such that 60% are variable. 70% of these variable costs vary with the
number of X produced, with the remainder varying with the output of Y.
The budget for the three months to 31 October 20X1 is being prepared using an incremental
approach based on the following:
• All costs will be 5% higher than the average paid in the year ended 30 April 20X1.
• Efficiency levels will be unchanged.
• Expected output:
X
1,210 units
Y
3,950 units
Required
What is the budgeted cost for the output of X (to the nearest $100) for the 3 months ending 31
October 20X1?
 $100
 $127,100
 $136,900
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 $143,700
Solution
2.5.1 Advantages of incremental budgeting
(a) It is simple and cheap.
(b) It is relatively quick to administer.
2.5.2 Limitations of incremental budgeting
(a) It does not identify inefficient operations meaning inefficiencies will continue.
(b) Budgetary slack, (ie deliberately overestimating costs or underestimating revenues), once
introduced, will be protected/carried forward into future periods.
(c) It is not suitable for changing environments, as it is based on the past and assumes that
activities will continue to be the same.
(d) It encourages managers to spend up to the budget because if they do not, the budget is
likely to be cut in the next period.
(e) It does not produce challenging performance targets or encourage managers to find ways of
improving the business.
2.6 Zero-based budgeting (ZBB)
KEY
TERM
Zero-based budgeting: This is a method of budgeting that requires each cost element to be
specifically justified, as though the activities to which the budget relates were being
undertaken for the first time.
Zero based budgeting (ZBB) is a technique used to allocate resources more efficiently, thus
reducing waste and increasing efficiency.
The process of ZBB starts from the basic premise that next year’s budget is zero; every process, or
item of expenditure, or intended activity (referred to as a ‘decision package‘) must be justified in
its entirety before it can be included in the budget.
The incremental cost and incremental benefit of each decision package will be considered and
priority given to those packages providing the most added value to the organisation’s key
objectives (note that ZBB is sometimes known as ‘priority-based budgeting’).
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ZBB is not particularly suitable for direct manufacturing costs but lends itself very well to support
expenses or discretionary costs.
ZBB is particularly useful in public sector organisations where funding (income) is fixed, and the
best possible service for the available budget needs to be achieved.
There is a three-step approach to implementing a zero-based budget:
Step 1 - Define the decision packages
There are two types of decision packages:
(a) Mutually exclusive packages, which
contain alternative methods of getting
the same job done
(b) Incremental packages, which divide one
aspect of an activity into different levels
of effort (the base package being the
minimum amount of work to carry out the
activity)
Step 2 - Evaluate and rank each activity
(decision package)
On the basis of its benefit to the organisation.
This can be a lengthy process.
Minimum work requirements and work that
meets legal obligations will be given high
priority.
Step 3 - Allocate resources
According to funds available and the
evaluation in Step 2.
2.6.1 Package examples
Suppose that a cost centre manager is preparing a budget for maintenance costs. She might first
consider two mutually exclusive packages. Package A might be to keep a maintenance team of
two people per shift for two shifts each day at a cost of $60,000 per annum, whereas Package B
might be to obtain a maintenance service from an outside contractor at a cost of $50,000. A
cost‑benefit analysis will be conducted because the quicker repairs provided by an in‑house
maintenance service might justify its extra cost. If we now suppose that Package A is preferred,
the budget analysis must be completed by describing the incremental variations in this chosen
alternative.
(a) The ‘base’ package would describe the minimum requirement for the maintenance work. This
might be to pay for one person per shift for two shifts each day at a cost of $30,000.
(b) Incremental package 1 might be to pay for two people on the early shift and one person on
the late shift, at a cost of $45,000. The extra cost of $15,000 would need to be justified, for
example by savings in lost production time, or by more efficient machinery.
(c) Incremental package 2 might be the original preference, for two people on each shift at a
cost of $60,000. The cost‑benefit analysis would compare its advantages, if any, over
incremental package 1; and so on.
Activity 3: ZBB
Required
Which THREE of the following would be base packages for the accounting department of a listed
manufacturing company, assuming that all are performed to the minimum requirements?
 Operate payroll
 Aged receivables report
 Operate payables ledger
 Publish statutory accounts
 Oversee end of year inventory count
 Enter trainee accountants for their ACCA exams
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Solution
2.6.2 Advantages of ZBB
(a) It is possible to identify and remove inefficient or obsolete operations.
(b) It necessitates close examination of organisation’s operations
(c) It results in a more efficient allocation of resources and challenges the status quo
(d) It responds to changes in the business environment
2.6.3 Disadvantages of ZBB
The major disadvantage of ZBB is the volume of extra paperwork created. The assumptions about
costs and benefits in each package must be continually updated and new packages developed as
soon as new activities emerge. The following problems might also occur:
(a) Short‑term benefits might be emphasised to the detriment of long‑term benefits.
(b) It may give the impression that all decisions have to be made in the budget. Management
must be able to meet unforeseen opportunities and threats at all times, however, and must
not feel restricted from carrying out new ideas simply because they were not approved by a
decision package, cost-benefit analysis and the ranking process.
(c) It may call for management skills in both constructing decision packages and the ranking
process that the organisation does not possess. Managers may therefore have to be trained
in ZBB techniques.
(d) The organisation’s information systems may not be capable of providing suitable information.
(e) The ranking process can be difficult. Managers face three common problems:
(i) A large number of packages may have to be ranked.
(ii) It can be difficult to rank packages that appear to be equally vital, for legal or
operational reasons.
(iii) It is difficult to rank activities that have qualitative rather than quantitative benefits –
such as spending on staff welfare and working conditions.
One way of obtaining the benefits of ZBB while overcoming the drawbacks is to apply it selectively
on a rolling basis throughout the organisation. For example, this year it could be applied to the
finance department and next year, the marketing department until all departments have been
appraised. In this way, all activities will be thoroughly scrutinised over a period of time.
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2.6.4 Using ZBB
ZBB does not work well for direct manufacturing costs, which are usually budgeted using
standard costing, work study and other management planning and control techniques.
ZBB is best applied to support expenses; that is, expenditure incurred in departments that exist to
support the essential production function. These expenses can make up a large proportion of the
total expenditure and are less easily quantifiable by conventional methods and are more
discretionary in nature.
ZBB can also be successfully applied to service industries and not-for-profit organisations such
as local and central government, educational establishments and hospitals, and in any
organisation where alternative levels of provision for each activity are possible, and costs and
benefits are separately identifiable.
2.7 Rolling budgets
KEY
TERM
Rolling budget: This is defined as “A budget continuously updated by adding a further
accounting period (month or quarter) when the earliest accounting period has expired. Its use
is particularly beneficial where future costs and/or activities cannot be forecast accurately”
(CIMA Official Terminology).
They are particularly useful when an organisation is facing a period of uncertainty, making it
difficult to prepare accurate forecasts.
Rolling budgets are an attempt to prepare targets and plans that are more realistic and certain,
particularly with regard to price levels, by shortening the period between preparing budgets.
Instead of preparing a periodic budget annually for the full budget period, budgets would be
prepared, say, every 1, 2 or 3 months (4, 6, or even 12 budgets each year). Each of these budgets
would plan for the next 12 months so that the current budget is extended by an extra period as
the current period ends: hence the name rolling budgets. Cash budgets are usually prepared on a
rolling basis.
2.7.1 Advantages of rolling budgets
(a) Uncertainty is reduced. Rolling budgets focus detailed planning and control on short-term
prospects where the degree of uncertainty is much smaller, especially in times of change.
(b) Managers have to regularly reassess the budget, which means they should be more realistic.
(c) Planning and control will be based on a more recent plan.
(d) The budget is continuous and will always extend a number of months ahead, encouraging
managers to think about the future. This is not the case with fixed periodic budgets.
(e) A realistic budget that takes account of recent performance and market conditions is likely to
have a better motivational influence on managers.
2.7.2 Disadvantages of rolling budgets
(a) Effort and expense are required to continuously update the budget.
(b) May demotivate managers if they cannot see the benefit of regular revisions
(c) Each revised budget may require revision of standards or inventory valuations, which could
put additional pressure on the accounts department each time a rolling budget is prepared.
Illustration 2: Preparing a rolling budget
A company uses a system of rolling budgets. The sales budget is displayed below.
Sales
290
Jan–Mar
$
78,480
Apr–Jun
$
86,120
Jul–Sep
$
91,800
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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.
1 Required
Update the budget as appropriate.
Solution
1 The correct answer is:
Step 1
Using the actual sales figure for January–March, update the budget for the next four quarters
(including a figure for January–March of the following year), incorporating a sales growth rate of
2.5%.
Apr–Jun = $74,640 × 1.025 = $76,506
Jul–Sept = $76,506 × 1.025 = $78,419
Oct–Dec = $78,419 × 1.025 = $80,379
Jan–Mar = $80,379 × 1.025 = $82,389
Step 2 Revised budget
Sales
Apr–Jun
$
76,506
Jul–Sep
$
78,419
Oct–Dec
$
80,379
Jan–Mar
$
82,398
Total
$
317,692
Activity 4: Rolling budgets
Bay Co uses a system of rolling budgets. The sales budget for the year to 31 December 20X3 is as
follows:
Sales
Q1
$
122,000
Q2
$
131,760
Q3
$
142,301
Q4
$
153,685
Total
$
549,746
Actual sales for Q1 were 117,879. 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 5% per
quarter.
Required
Applying the principles of rolling budgets, what would the forecast for Q4’s sales be?
 $123,773
 $129,962
 $136,460
 $143,283
Solution
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2.8 Activity-based budgeting (ABB)
KEY
TERM
Activity based budgeting: Uses the costs determined using activity based costing (ABC) as a
basis for preparing budgets.
For example, if an organisation expects to place 500 orders and the rate per order is $100, the
budgeted cost of the ordering activity will be 500 × $100 = $50,000.
Implementing ABC leads to the realisation that the business as a whole needs to be managed
with far more reference to the behaviour of activities and cost drivers identified.
Activity based budgeting recognises the following:
(a) Activities drive costs
(b) The causes (drivers) of the cost should be controlled rather than the cost itself
(c) Not all activities are value-adding
(d) Demand and decisions beyond the control of a department’s manager drive many
departmental activities.
ABB can only be used in organisations which use ABC, therefore the advantages and
disadvantages of using this budgeting technique are the same as using the ABC for costing.
2.8.1 Advantages of ABB
(a) Different activity levels will provide a foundation for the base package and incremental
packages of ZBB.
(b) The organisation’s overall strategy and any actual or likely changes in that strategy will be
taken into account because ABB attempts to manage the business as the sum of its
interrelated parts.
(c) Critical success factors (an activity in which a business must perform well if it is to succeed)
will be identified and key metrics devised to monitor progress towards them.
(d) The focus is on the whole of an activity, not just its separate parts, and so there is more
likelihood of getting it right first time. For example, what is the use of being able to produce
goods in time for their despatch date if the budget provides insufficient resources for the
distribution manager who has to deliver them?
(e) Traditional accounting tends to focus on the nature of the costs being incurred (the input
side) and traditional budgeting tends to mirror this. ABB emphasises the activities that are
being achieved (the outputs).
Activity 5: Activity based budget
1 The production department of EFG Co has four major activities: receiving deliveries, material
handling, production runs and quality tests.
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Each of these activities has an identifiable cost driver. These are provided below along with
estimated volumes for the coming period:
Number of deliveries
300
Number of movements of material
400
Number of production runs
800
Number of quality tests
600
Two other activities that occur in the department are administration and supervision. While these
activities are non-volume related, they are necessary functions and should not be ignored in the
budgeting process.
Budgeted costs for the coming period are displayed below.
Total
$’000
Attributable to
$’000
Management salary
50
Supervision $45; Administration $5
Basic wages
30
Receiving deliveries $7; Production runs $5;
Administration $6; Material handling $7; Quality
tests $5
Overtime
15
Receiving deliveries $6; Quality tests $1; Production
runs $8
Factory overheads
12
Receiving deliveries $3; Production runs $2;
Administration $1.5; Material handling $2; Quality
tests $1.5; Supervision $2
Other costs
4
Receiving deliveries $1; Supervision $1;
Administration $2
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(a) Total cost for each activity
(b) Total cost for the production department
(c) Cost per activity unit
Solution
1
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2.9 Beyond Budgeting
Beyond Budgeting is a budgeting model which proposes that traditional budgeting should be
abandoned in favour of two fundamental concepts:
(a) Use adaptive management processes rather than the more rigid annual budget. Traditional
annual plans tie managers to predetermined actions that are not responsive to current
situations. Instead 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.
(b) Move towards devolved networks rather than centralised hierarchies. The emphasis is on
encouraging a culture of personal responsibility by delegating decision-making and
performance accountability to line managers.
2.9.1 Principles of Beyond Budgeting
The Beyond Budgeting Institute has suggested that Beyond Budgeting can be distinguished from
the ‘traditional’ management model for budgeting through 12 guiding principles.
The first six of these principles relate to the leadership model in an organisation and, in particular,
the devolution of responsibility to local managers and front-line staff, enabling them to respond
quickly to emerging events, and making them accountable for continuously improving
performance.
The remaining principles (ie numbers 7-12) relate to the performance management systems which
enable front-line teams to be more responsive to the competitive environment and to customer
needs.
The 12 key guiding principles are shown in the table below.
Principle
Comment
Governance and
transparency
1. Values
Bind people to a common cause, not a central plan.
2. Governance
Govern through shared values and sound judgement, not
detailed rules and regulations.
3. Transparency
Make information open and transparent, do not restrict and
control it.
Accountable teams
4. Teams
Organise around a seamless network of accountable teams,
not around centralised functions.
5. Trust
Trust teams to regulate their performance, do not micromanage them.
6. Accountability
Base accountability on holistic criteria and peer reviews, not
on hierarchical relationships.
Goals and rewards
7. Goals
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Set ambitious medium-term goals, not short-term fixed
targets.
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Principle
Comment
8. Rewards
Base rewards on relative performance, not on meeting fixed
targets.
Planning and controls
9. Planning
Make planning a continuous and inclusive process, not a topdown annual event.
10. Co-ordination
Co-ordinate interactions dynamically, not through annual
budgets.
11. Resources
Make resources available just-in-time, not just-in-case.
12. Controls
Base controls on fast, frequent feedback, not budget
variances.
(Source: Beyond Budgeting Institute; www.bbrt.org)
Hope & Fraser (co-founders of the Beyond Budgeting Round Table) argue that ‘traditional’
budgeting processes do not meet the purposes of performance management. The table below
illustrates the ways in which Hope & Fraser feel ‘beyond budgeting’ differs from ‘traditional’
budgeting, and also how ‘beyond budgeting’ meets the purposes of performance management
better.
Purposes of performance
management
Traditional budgeting
processes
‘Beyond budgeting’
processes
Goals – to balance the need
for short-term and long-term
profitability
Short-term focus: Fixed
annual targets drive shortterm actions with a view to
meeting annual targets.
Longer-term focus: KPIs and
aspirational goals focus on
sustained competitive
success.
Rewards – to provide an
effective basis for motivating
and rewarding performance
Individual departments or
divisions have to meet their
own targets in order to gain
rewards.
This focus on individual
incentives means
departments are not willing to
share expertise, skills and
information with others,
preferring to defend their
‘own turf’ instead.
Recognition of team-based
success is important, but the
organisation needs to be
viewed as one team, thereby
breaking down barriers and
encouraging people to share
resources and knowledge.
There is an emphasis on
learning and continual
innovation.
Plans – to direct actions to
maximise market
opportunities
Planning is based on a
premise of ‘predict and
control‘ and is highly
deterministic. This means
plans are difficult to change
even if the assumption on
which the plans were based
become unrealistic.
Organisations adopt a
‘company led‘ rather than
‘customer led’ approach to
strategic management.
The future is inherently
unpredictable, so plans need
to be continuously updated
to adapt to events as they
happen.
Organisations adopt a
‘customer led‘ approach to
strategic management.
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Purposes of performance
management
Traditional budgeting
processes
‘Beyond budgeting’
processes
Resources – to ensure that
resources are available to
support agreed actions
Budgets are seen as a way of
enabling senior managers to
allocate resources to
operating units. The process
is centralised, and the ‘head
office’ exerts control over the
operating units or cost
centres.
But head offices are usually
risk averse and prefer to
allocate resources to existing
products and businesses
rather than to new ideas and
opportunities.
Resources are available on
demand, to enable a fast
response to new
opportunities.
Resources are allocated to
strategic initiatives rather
than to departmental
budgets.
Co-ordination – to harmonise
actions across the business
Leaders attempt to coordinate plans by linking one
functional budget to another.
But these centrally linked
budgets provide slow
solutions that often fail to
meet customer needs.
Co-ordination should focus
around a dynamic linking of
customer demands in order to
provide fast, seamless
solutions that meet customer
needs.
Controls – to provide relevant
information for strategic
decision making and controls
Performance reports are
based primarily on financial
indicators, and usually
contain lagging indicators
(connected with past
performance and past
events).
But financial indicators give
little insight into the root
causes of performance, and
provide a poor basis for
learning.
Strategic decisions are based
on multifaceted and multilevel information, which gives
insight into future
performance as well as into
past performance.
Information systems need to
be able to provide fast,
transparent information for
multi-level control.
2.9.2 Advantages of Beyond Budgeting
(a) Encourages innovation
(b) Increases motivation
(c) Allows faster responses to threats and opportunities
2.9.3 Disadvantages of Beyond Budgeting
(a) May be resistance to change from employees or management in adopting the Beyond
Budgeting culture
(b) Need to plan, even if there are lots of uncertainties in the future
3 Information used in budget systems
Information used in budgeting comes from a wide variety of sources.
Past data may be used as a starting point for the preparation of budgets but other information
from a wide variety of sources will also be used.
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3.1 Sales budget information
For many organisations, the principal budget factor is sales volume. The sales budget is therefore
often the primary budget from which the majority of the other budgets are derived. Before the
sales budget can be prepared a sales forecast has to be made. Sales forecasting information
may come from:
• Past sales patterns
• The economic environment
• Results of market research
• Anticipated advertising
• Competition
• Changing consumer taste
• Distribution
• Pricing policies and discounts offered
• Legislation
• Environmental factors
3.2 Production budget information
Sources of information for the production budget will include:
(a) Labour costs including idle time, overtime and standard output rates per hour
(b) Raw material costs including allowances for losses during production
(c) Machine hours including expected idle time and expected output rates per machine hour
This information will come from the production department and a large part of the traditional
work of cost accounting involves attributing costs to the physical information produced.
4 Changing budgetary systems
Although the business environment may dictate that a change in budgetary system is necessary,
the change will not be without its problems. The following need to be borne in mind:
(a) Resistance by employees. Employees will be familiar with the current system and may have
built in slack so will not easily accept new targets. New control systems that threaten to alter
existing power relationships may be thwarted by those affected.
(b) Loss of control. Senior management may take time to adapt to the new system and
understand the implications of results.
(c) Costs of implementation. Any new system or process requires careful implementation which
will have cost implications. For example, the procedures for preparing budgets will have to be
rewritten in a new budget manual. Establishing a system of zero based budgeting, for
example, will require the design and documentation of a large number of decision packages.
(d) Training. In order to prepare and implement budgets under the new system, managers will
need to be fully trained. This is time consuming and expensive.
(e) Lack of accounting information. The organisation may not have the systems in place to
obtain and analyse the necessary information for preparing the new style budget. For
example, an organisation needs a system of activity based costing if it is to implement
activity based budgeting.
5 Budgeting and uncertainty
Preparing a budget involves forecasting which is open to risk and uncertainty.
Causes of uncertainty in the budgeting process include:
(a) Customers. They may decide to buy less than forecast, or they may buy more.
(b) Products/services. In the modern business environment, organisations need to respond to
customers’ rapidly changing requirements.
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(c) Inflation and movements in interest and exchange rates. 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.
(d) Materials. The cost of raw materials may change unexpectedly.
(e) Competitors. They may steal some of an organisation’s expected customers, or some
competitors’ customers may change their buying allegiance.
(f) Employees. They may not work as hard as was hoped, or they may work harder.
(g) Machines. They may break down unexpectedly.
(h) Unrest or disaster. There may be political unrest (eg terrorist activity), social unrest (eg public
transport strikes) or minor or major natural disasters (eg storms, floods).
Some of the tools we have seen will help to deal with this. Examples include:
• Flexible budgeting
• Rolling budgets
• Probabilistic budgeting
• Sensitivity analysis
5.1 Probabilistic budgeting
You have already come across expected values when dealing with risk and uncertainty.
Budgets are subject to risk and uncertainty and, as such, expected values may be incorporated
into the budget.
Activity 6: Probabilistic budgeting
Orchard has made the following predictions for the profitability of its product the Russet for the
upcoming financial year:
Profit/(loss)
$’000
400
200
(150)
Best
Most likely
Worst
Required
Calculate the expected value that would be included in the budget.
 $0
 $190
 $200
 $450
Solution
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Probability
0.3
0.5
0.2
Obviously, the problems discussed earlier about expected values (EVs) still hold, ie:
(a) The results are dependent on the accuracy of the probability distribution.
(b) EV takes no account of the risk associated with a decision.
(c) The EV itself may not represent a single possible outcome.
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Chapter summary
Budgetary systems
Planning and control in
the performance hierarchy
Budget systems
Control
Fixed budgets
Zero-based budgeting
• Feedback control involves
taking action after the event
• Feedforward control involves
taking action during the event
• Top down budgets are set at
senior management level
• Bottom up budgets are set by
low level of management
• Budgets set in advance
• Do not change
• Build up budgets from scratch
• Allocates resources effectively
• Suitable for discretionary
spend
Flexible budget
• Budget set for several activity
levels
• Good planning tool enabling
'what if' scenarios
Flexed budget
Re-state budget based on actual
volumes
Rolling budgets
• Always look at 12 months of
budget
• Complete 1st quarter, remove
from budget and add another
quarter on the end
• Useful in times of uncertainty
Activity-based budgeting
Purpose of flexible/flexed
budgets
Builds up budgets by activity
rather than by department
• Useful for control
• Like for like comparison and
meaningful variances
Beyond budgeting
Incremental budgeting
• Based on current year
• Builds in slack & inefficiencies
Information used in
budget systems
Sales budget information
• Produce sales forecast first
• Sales forecast information from
past patterns, competition,
pricing policy etc
Changing
budgetary systems
• Has various implications
– Resistance
– Costly
– Training needs
– Learning curve
Production budget information
• Labour costs
• Raw material costs
• Machine hours
• Use adaptive management
processes
• Move towards devolved
networks rather than
centralised hierarchies
Budgeting and
uncertainty
• Budgets are estimates and
therefore subject to risk and
uncertainty. Suitable tools
may be:
– Flexible budgets
– Rolling budgets
– Probabilistic budgeting
– Sensitivity analysis
Probabilistic budgeting
Expected values incorporated
into budget
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Knowledge diagnostic
1. Budgetary control
Budgeting is part of the planning and control process.
Control can be feedback or feedforward – comparison of past results or forecast results to plan
2. Budget systems
• Flexible budgets are ideal for planning.
• Flexed budgets are the best budget for control as they allow you to compare like for like.
• Incremental budgets tend to build in slack and inefficiency.
• ZBB results in efficient resource allocation and is suitable for discretionary spend.
• Rolling budgets are useful in times of uncertainty.
• ABB ensures the causes of cost are managed.
3. Changing budgetary systems
Changes to the budgetary system will meet with resistance due to the learning curve, loss of
control, cost and training required.
4. Budgeting and uncertainty
Probabilistic budgeting incorporates expected values.
Flexible and rolling budgets can also be used.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q35
Examination
2
4 mins
Section A Q36
Examination
2
4 mins
Section A Q37
Examination
2
4 mins
Section C ‘NYE Co’
Examination
20
36 mins
Further reading
There are two technical articles available on ACCA’s website, called Comparing budgeting
techniques and All about budgeting.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Flexible budget
The correct answer is:
$1,250 Adverse
Materials:
Variable cost = $3/unit
Overhead:
Fixed cost = $20,000
Labour:
Output
14,000
10,000
4,000
(High-low method)
 VC/unit = $2
Cost
35,000
27,000
8,000
By substitution into high output:
Total VC
Total FC
= $28,000
= $35,000 – $28,000
= $7,000
... Flexed budgeted cost:
Materials (12,350 × 3)
Labour (7,000 + 2 × 12,350)
Overhead
$
37,050
31,700
20,000
88,750
... $1,250 (A)
Actual costs – Flexed budgeted cost
Activity 2: Incremental budgeting
The correct answer is:
$143,700
Proportion of actual annual costs related to X = $1,217,200 × 0.6 × 0.7 = $511,224
Per unit of X $511,224/4,520 = $113.10
Cost for 1,210 units = 1,210 × $113.10 = $136,854
Inflated cost = $136,854 × 1.05 = $143,697
$100 is the budgeted cost per X. If you selected $127,100 you forgot to adjust the quantity. If you
selected $136,900, you forgot to inflate the cost.
Activity 3: ZBB
The correct answers are:
•
Operate payroll
•
Operate payables ledger
•
Publish statutory accounts
All of these are essential for the operation of the business; employees will not work and suppliers
will not supply goods on credit if they are not paid the correct amounts on time. Additionally, the
statutory accounts must legally be prepared.
All of these are essential for the operation of the business; employees will not work and suppliers
will not supply goods on credit if they are not paid the correct amounts on time. Additionally, the
statutory accounts must legally be prepared.
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The year-end inventory count needs to happen for inclusion in the statutory accounts, but it is not
essential that it is observed by a member of the accounting team, although this may be desirable.
Aged receivables reports and chasing of outstanding payments will aid credit collection and cash
flow, so it is very desirable, but it is not essential.
Offering support with ACCA training and exams will improve employee motivation and enhance
their skills but, again, is not essential to running an accounting department.
Activity 4: Rolling budgets
The correct answer is:
$136,460
20X3 Q2
$
123,773
Sales
20X3 Q3
$
129,962
20X3 Q4
$
136,460
20X4 Q1
$
143,283
Total
$
533,478
The revised budget should incorporate 5% growth, starting from Q1’s actual figure.
Q2: $117,879 × 1.05 = $123,773
Q3: $123,773 × 1.05 = $129,962
Q4: $129,962 × 1.05 = $136,460
Q1: $136,460 × 1.05 = $143,283
Activity 5: Activity based budget
1 The correct answer is:
Activity based budget
Receivin
g
deliveries
Material
handling
Producti
on
runs
Quality
tests
Cost
driver
No of
deliveries
No of
moveme
nts of
material
No of
producti
on runs
Number
of
quality
tests
Volume
300
400
800
600
$’000
$’000
$’000
$’000
Manage
ment
salary
Basic
wages
7
Overtime
6
Factory
overhea
ds
3
Other
1
Total
17
7
2
9
5
5
8
1
2
1.5
15
7.5
Admin
S’vision
Total
$’000
$’000
$’000
5
45
50
6
30
15
1.5
2
12
2
1
4
14.5
48
111
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Cost per
activity
unit
$56.67
$22.50
$18.75
$12.50
Activity 6: Probabilistic budgeting
The correct answer is:
$190
Expected values are calculated as
∑𝑝𝑥
Best
Most likely
Worst
Profit/(loss)
$’000
400
200
(150)
Probability
Expected value (EV)
0.3
0.5
0.2
120
100
(30)
190
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Quantitative analysis in
budgeting
14
14
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Analyse fixed and variable cost elements from
total cost data using the high/low method.
D2 (a)
Estimate the learning rate and learning effect.
D2 (b)
Apply the learning curve to a budgetary
problem, including calculations on steady
states.
D2 (c)
Discuss the reservations with the learning
curve.
D2 (d)
14
Exam context
The success of a budget is largely dependent on the degree of accuracy in estimating the
revenues and costs for the budget period.
This chapter looks at the quantitative techniques involved in budgeting, including the high-low
method and the concept of the learning curve.
14
The quantitative techniques covered in this chapter could form the calculation part of a
budgeting question in Section C. Techniques may also be examined regularly in short Section A
objective test questions, as well as featuring in Section B questions.
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Chapter overview
Quantitative analysis in budgeting
High low
method
Learning curve theory
Conditions required
308
Method 2 - The
algebraic approach
Uses of learning curve
theory
Learning rate and
learning effect
Steady state
Problems with learning
curve theory
Method 1 - The tabular
approach
Cessation of learning
effect
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1 High-low method
PER alert
One of the competencies needed to fulfil performance objective 13 of the PER is the ability to
prepare and use budgets, selecting suitable budgeting models. You can apply the knowledge
you obtain from this chapter of the text to help demonstrate this competence.
In order to prepare budgets, forecasts of costs and revenues will need to be undertaken.
You will have seen in your earlier studies the use of the high-low method and linear regression to
analyse total costs into their fixed and variable elements.
Illustration 1: High low method
Number of units
Overhead cost ($)
10,000
27,000
12,000
31,000
14,000
35,000
Required
Calculate the variable cost per unit and the fixed overhead cost.
Solution
1 The correct answer is:
Variable cost per unit = $2 and fixed costs = $7,000
Step 1 - Take the highest and lowest output levels
Output
Cost
$
Highest
14,000
35,000
Lowest
10,000
27,000
4,000
8,000
Step 2 - Find the difference
Step 3 - Calculate the variable cost/unit
Variable cost/unit = $8,000/4,000 = $2
Step 4 - Calculate the fixed cost
Substituting the variable cost into the high output:
Fixed cost = $35,000 – (14,000 × $2) = $7,000
Activity 1: High low method
1 A department in a large organisation wishes to develop a method of predicting its total costs in a
period. The following data has been recorded:
Month
January
February
March
Activity level (X)
Units
1,600
2,300
1,900
Cost
$
28,200
29,600
28,800
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April
May
June
1,800
1,500
1,700
28,600
28,000
28,400
Required
The total cost model for a period could be represented by what equation?
Solution
1
2 Learning curve theory
KEY
TERM
Learning curve theory: 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.
When new working practices or products are introduced, the theory is that as a workforce gains
experience in a task, it will come to perform that task quicker.
This means that labour costs and variable overheads (if labour hour driven) will be lower in later
periods of production than when the new product or production technique is introduced.
2.1 Conditions required
The theory of learning curves will only hold if the following conditions apply:
(a) There must be a significant manual element in the task being considered.
(b) The task must be repetitive.
(c) Production must be at an early stage so that there is room for improvement.
(d) There must be consistency in the workforce.
(e) There must not be extensive breaks in production, or workers will ‘forget’ the skill.
(f) Workforce must be motivated.
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2.2 Learning rate and learning effect
Where a learning curve applies, there is a learning rate and a learning effect.
The learning rate is expressed as a percentage value, such as an 80% learning curve or a 70%
learning curve.
The 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.
Specifically, every time that the cumulative output of the product doubles, the average time to
make all the units produced to date is a proportion of what it was before. This proportion is the
learning rate.
There are two methods that can be used to deal with a learning curve scenario. Be prepared to
use either or both in the exam.
• Method 1. The tabular approach
• Method 2. The algebraic approach
2.3 Method 1 - The tabular approach: cumulative average time and the
learning rate
The rule to remember is that every time that cumulative output doubles the average production
time is x% of what is was before, where x is the learning rate.
The approach is best explained with a numerical example.
Example
Tabular approach - 80% learning curve
For example, 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. The
production times would be as follows:
Cumulative
number of units
1
2*
4*
8*
Cumulative
average time
per unit (hours)
100.0
80.0
64.0
51.2
Cumulative
total time
(hours)
100.0
160.0
256.0
409.6
Incremental Incremental total
number of units
time (hours)
–
1
2
4
–
60.0
96.0
153.6
*Output is being doubled each time.
The cost of the additional time can be calculated by applying the labour hour rate to the number
of labour hours (and variable overhead rate, where variable overheads vary with the number of
labour hours). The learning effect does not affect material costs.
Activity 2: Learning rate
A firm’s workforce experiences a 75% learning rate.
The budgeted time for the first batch is 100 hours.
Required
What is the total time to produce eight batches in total?
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



42.19 hours
337.5 hours
600 hours
800 hours
Solution
2.4 Method 2 - The algebraic approach
The learning curve formula can be used to solve all learning curve scenarios.
Formula provided
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
Exam focus point
This formula is provided in the exam. It refers to time rather than labour cost. The formula can
also be used to calculate the labour cost per unit. The labour times are calculated using the
curve formula and then converted to cost.
It is essential to understand how to apply the learning curve formula. You need a calculator that
includes a function for calculating logarithms. Logarithms are the value of any number to the
power of 10. For example, the logarithm of 3 is 0.4771213 because 100.4771213 = 3. Using a calculator,
it is a simple process to obtain the log value of any number.
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Illustration 2: Using the formula
1 Suppose that an 80% learning curve applies to production of a new product item ABC. To date (30
June) 30 units of ABC have been produced. Budgeted production in July is five units. The time to
make the very first unit of ABC in January was 120 hours. The labour cost is $10 per hour.
(a) Calculate the time required to make the 31st unit
(b) Calculate the budgeted total labour cost for July
Solution
1 The correct answer is:
To solve this problem, we need to calculate the following.
(a) The cumulative total labour cost so far to produce 30 units of ABC
(b) The cumulative total labour cost to produce 31 units of ABC
(c) The cumulative total labour cost to produce 35 units of ABC; that is, adding on the extra 5
units for production in July
(d) The time taken to produce the 31st unit is the difference between (b) and (a). The cost of
production of 5 units of ABC in July, as the difference between (c) and (a)
Time to produce the first 30 units
Y = axb
b = log 0.8/log 2 = –0.09691/0.30103 = –0.3219281
Y = 120 × (1/300.3219281) = 120 × 0.3345594 = 40.147 hours
Total time for first 30 units = 30 × 40.147 hours = 1,204.41 hours
Time to produce the first 31 units
Y = 120 × (1/310.3219281) = 120 × 0.3310463 = 39.726 hours
Total time for first 31 units = 31 × 39.726 hours = 1,231.51 hours
Time to produce the 31st unit = (1,231.51 – 1,204.41) = 27.1 hours
Time to produce the first 35 units
Y = 120 × (1/350.3219281) = 120 × 0.3183619 = 38.203 hours
Total time for first 35 units = 35 × 38.203 hours = 1,337.11 hours
Budgeted labour cost in July = (1,337.11 – 1,204.41) hours × $10 per hour = $1,327
Exam focus point
The examining team has stated that you should not round ‘b’ to less than three decimal
places. Ideally, you should keep the long number in your calculator and use that!
Activity 3: Using the formula
1 A firm’s workforce experiences a 75% learning rate.
The budgeted time for the first batch is 100 hours.
Using the formula Y= aXb, calculate the time to produce:
(a) The first 10 batches in total
(b) The 10th batch only
Solution
1
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Essential reading
See Chapter 14 Section 1 of the Essential reading for an illustration on deriving the learning rate.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2.5 Steady state
Eventually, the time per unit will reach a steady state where no further improvement can be made.
When a steady state is reached, a standard time and standard labour cost for the product can be
established.
Illustration 3: Learning curves and standard costs
1 A company needs to calculate a new standard cost for one of its products. When the product was
first manufactured, the standard variable cost of the first unit was as follows.
Direct material
Direct labour
Variable overhead
Total
10 kg @ $4 per kg
10 hours @ $9 per hour
10 hours @ $1 per hour
Cost per unit
$
40
90
10
140
During the following year, a 90% learning curve was observed in making the product. The
cumulative production at the end of the third quarter was 50 units. After producing 50 units, the
learning effect ended, and all subsequent units took the same time to make.
Required
What is the standard cost per unit for the fourth quarter assuming the learning curve had
reached a steady state, ie peak efficiency was reached after the 50th unit was produced?
Solution
1 The correct answer is:
Y = axb where b = log 0.9/log 2.
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b = –0.0457575/0.30103 = –0.1520031
So Y = ax-0.1520031
For 49 cumulative units Y = 10 x (49-0.1520031) = 10 × 0.55346 hours = 5.5346 hours.
Total time for first 49 units = 49 × 5.5346 hours = 271.2 hours.
For 50 cumulative units Y = 10 x (50-0.1520031) = 10 × 0.55176 hours = 5.5176 hours.
Total time for first 50 units = 50 × 5.5176 hours = 275.88 hours.
Time for 50th unit = (275.88 – 271.2) = 4.68 hours
This is the standard time for the product when the steady state has been reached.
Standard cost
Direct material
Direct labour
Variable overhead
Total
10 kg @ $4 per kg
4.68 hours @ $9 per hour
4.68 hours @ $1 per hour
Cost per unit
$
40.00
42.12
4.68
86.80
In practice, the standard time may be rounded to a more convenient number, such as 4.5 hours or
5.0 hours.
2.6 Cessation of learning effect
Practical reasons for the learning effect to cease are:
(a) When machine efficiency restricts any further improvement.
(b) The workforce reach their physical limits.
(c) There is a ‘go slow’ agreement among the workforce.
Activity 4: Learning curve
Flogel Co has just produced the first full batch of a new product taking 200 hours.
1
2
3
Flogel has predicted a learning curve effect of 85%. b = –0.2345
Required
How long will it take to produce the next 15 batches?
 1,470 hours
 1,590 hours
 1,670 hours
 3,000 hours
Flogel expects that after the 30th batch has been produced, the learning effect will cease. From
the 31st batch onwards, each batch will take the same time as the 30th batch.
Required
What is the long-run steady state time per unit?
 30 hours
 31 hours
 69 hours
 90 hours
The first 8 units have now been produced. The first unit took 200 hours to make and the total time
for the first 8 units was 819.2.
Required
What was the actual rate of learning which occurred?
 85%
 80%
 72%
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 50%
Solution
1
2
3
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2.7 Uses of learning curve theory
The learning curve theory can be used in the business for:
• Forecasting labour hours required
• Cash forecasting
• Standard setting
• Cost calculation
• Price setting
Essential reading
See Chapter 14 Section 2 of the Essential reading for more detail on the relevance of learning
curve effects in management accounting.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2.8 Problems with learning curve theory
Although it seems a useful and easy to apply technique, learning curve theory is not without
problems:
• We may not be able to calculate a rate.
• We may not know when production has reached a steady state.
• The rate may not necessarily be constant.
Essential reading
See Chapter 14 Section 3 of the Essential reading for more detail on the limitations of learning
curve theory.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Quantitative analysis in budgeting
High low
method
• Use to calculate
amount of variable
and fixed cost within a
semi variable cost
• Step 1 – Take the
highest and lowest
output levels
• Step 2 – Find the
difference
• Step 3 – Calculate the
variable cost/unit
• Step 4 – Calculate the
fixed cost
Learning curve theory
Conditions required
• Significant manual
element
• Repetitive task
• Early stage of
production
• Consistent workforce
• No breaks in
production
• Motivated workforce
Learning rate and
learning effect
As cumulative output
doubles the average
time to produce a unit
falls by a given rate
Method 1 - The tabular
approach
318
Method 2 - The
algebraic approach
Uses of learning curve
theory
Y = axb
• Forecasting labour
hours required
• Cash forecasting
• Standard setting
• Cost calculation
• Price setting
Steady state
• Reached when no
further improvements
can be made
• The time taken per
unit is constant
Cessation of learning
effect
• When machine
efficiency restricts any
further improvement
• The workforce reach
their physical limits
• There is a 'go slow'
agreement among
the workforce
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Problems with learning
curve theory
• How to calculate the
rate?
• Is the rate really
constant?
• When will production
reach the steady
state?
Knowledge diagnostic
1. High-low method
This can be used to determine the amount of fixed and variable cost which can then be used to
forecast for different levels of output.
2. Learning curve theory
The amount of time needed for production may reduce when the product is new, repetitive and
has a significant manual element.
Learning curve theory states that as cumulative output doubles, the cumulative average time per
unit falls to a given percentage of the previous cumulative average time per unit.
The time/cost for production of units can be calculated if the rate of learning is known using the
formula Y= aXb.
Eventually a consistent time to produce a unit will be reached from which it is not possible to
improve any further. This is known as steady state.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q38
Examination
2
4 mins
Section A Q39
Examination
2
4 mins
Section A Q40
Examination
2
4 mins
Section B ‘Bench Co’
Examination
10
18 mins
Further reading
There is a technical article available on ACCA’s website, called The learning rate and learning
effect.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: High low method
1 The correct answer is:
Total costs = 25,000 + 2x where x is the volume of activity in units
The highest activity level is in February and the lowest in May.
Step 1 – Take the highest and lowest output levels
Activity level
Cost
$
Highest
2,300
29,600
Lowest
1,500
28,000
800
1,600
Step 2 - Find the difference
Step 3 - Calculate the variable cost/unit
Variable cost/unit = $1,600/800 = $2
Step 4 - Calculate the fixed cost
Substituting the variable cost into the high output:
Fixed cost = $29,600 – (2,300 × $2) = $25,000
Total costs = 25,000 + 2x where x is the volume of activity in units
Activity 2: Learning rate
The correct answer is:
337.5 hours
Output
Total time (hrs) Cumulative average
time (hrs)
100
100
150
75
225
56.25
337.5
42.1875
1
2
4
8
Activity 3: Using the formula
1 The correct answer is:
(a) Y = aXb
a = 100
X = 10
b = log 0.75/log 2 = –0.125/0.301 = –0.415
Y
= 10 × 10–0.415
= 38.459 hrs
Total time taken to produce 10 batches: 10 × 38.459 = 384.59 hrs
(b) Y = aXb
a = 100
X=9
b = -0.415
Y = 100 × 9-0.415
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= 40.1781 hrs
Total time to produce 9 batches =
9 × 40.1781 = 361.60 hrs
 Time to produce 10th batch
= 384.59 – 361.60
= 22.99 hrs
Activity 4: Learning curve
1
The correct answer is:
1,470 hours
b = log 0.85/log 2 = –0.2345
To produce the next 15 batches:
find time to produce 16 and deduct time to make 1:
y = 200 × 16–0.2345 = 104.4 hours = average time per batch, thus 16 batches will take
16 × 104.4 = 1,670.4 hours
Hours
200.0
1,470.4
less time for first batch
time for the next 15 batches
2
The correct answer is:
69 hours
Time for 30 batches:
y = 200 × 30-0.2345 = 90.08 × 30 = 2,702
Time for 29 batches:
y = 200 × 29-0.2345 = 90.80 × 29 = 2,633
3
Time for 30th batch = 2,702 – 2,633 = 69 hours, so this should be the budgeted hours once the
steady state has been achieved.
The correct answer is:
Let r be the rate of learning which actually occurred.
If the total time for 8 units was 819.2 hours, then the cumulative average time per unit must be
102.4.
200 × r3 = 102.4
r3 = 102.4/200 = 0.512
r = 0.8
Therefore, the rate of learning is 80%.
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Budgeting and standard
costing
15
15
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Explain the use of standard costs.
D3 (a)
Outline the methods used to derive standard
costs and discuss the different types of cost
possible.
D3 (b)
Explain and illustrate the importance of flexing
budgets in performance management.
D3 (c)
Explain and apply the principle of
controllability in the performance
management system.
D3 (d)
15
Exam context
In this chapter, we will be looking at standard costs and standard costing.
You will have studied standard costing before and have learned about the principles involved and
how to calculate a number of cost and sales variances. We look at the topic in more depth for
your studies of this syllabus.
15
The contents of this chapter are likely to be examined in conjunction with variance analysis,
covered in the next two chapters.
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Chapter overview
Budgeting and standard costing
Standards
Standards and
budgets
Purposes of standards
Deriving standards
Where standard costing
should be used
Types of standard
Criticisms of
standard costing
Flexible
budgets
Revision of standards
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The principle of
controllability
Controllable costs
1 Standards
Standard cost: A standard cost is an estimated unit cost.
KEY
TERM
A standard is prepared by management in advance and details their expectations of the future.
Standards are not just for items of production in manufacturing businesses. They exist in many
different spheres. Standard times for repairing cars, standard punctualities for train companies
and standard response times for ambulances are just some of the many examples encountered.
You will have come across standard costs before as part of costing. When trying to establish the
cost of a unit, be it under absorption or marginal costing, the cost card was derived using
standard costs.
As a reminder:
Example of a standard cost card for a cost unit
$/unit
Direct costs:
Direct materials
Direct labour
(5 kg @ $3/kg)
(3 hrs @ $6/hr)
Indirect costs:
Variable overheads
Fixed overheads
Full product cost
15.00
18.00
33.00
2.00
3.00
38.00
The costs in the cost card are built up using, for example, the expected amount of material at the
expected price of the material.
2 Purposes of standards
KEY
TERM
Standard costing: 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.
The uses of standard costing are as follows:
(a) Prediction of costs and times for decision making, eg for allocating resources.
(b) Standard costing is used in setting budgets – an accurate standard will increase the
accuracy of the budget.
(c) Variance analysis is a control technique which compares actual with standard costs and
revenues.
(d) Performance evaluation systems make use of standards as motivators and as a basis for
assessment.
(e) Inventory valuation – this is often less time consuming than alternative valuation methods
such as first in, first out (FIFO) or weighted average.
(f) To enable the principle of ‘management by exception‘ to be practised (a standard cost, when
established, is an average expected unit cost and because it is only an average, actual
results will vary to some extent above and below the average; only significant differences
between actual and standard should be reported).
Although the other uses of standard costing should not be overlooked, we will be concentrating on
variance reporting and the control aspect.
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2.1 Where standard costing should be used
Although standard costing can be used in a variety of costing situations including service
industries, its greatest benefit can be gained if there is a large amount of repetition in the
production process so the average or expected usage of resources can be determined. It is
therefore most suited to mass production and repetitive assembly work. It is not well suited to
production systems where items are manufactured to customer demand and specifications.
3 Deriving standards
The responsibility for deriving standard costs should be shared between managers who are able
to provide the necessary information about levels of expected efficiency, prices and overhead
costs.
The standard cost of materials will be estimated by the purchasing department.
Activity 1: Deriving standards
(a) The forecast sales levels
(b) The amount of wastage expected
Required
Which of the above factors does the purchasing department need to consider when establishing
the standard cost of materials?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
Setting standards for other elements on the cost card will undergo a similar process.
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Essential reading
See Chapter 15 Section 1 of the Essential reading for more detail on deriving standards.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
3.1 Types of standard
KEY
TERM
Ideal standard: An ideal standard is a standard which can be attained under perfect
operating conditions: no wastage, no inefficiencies, no idle time, no breakdowns.
Attainable standard: An attainable standard is 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.
Current standard: A current standard is a standard based on current working conditions
(current wastage, current inefficiencies).
Basic standard: A basic standard is a long-term standard which remains unchanged over the
years and is used to show trends.
Activity 2: Types of standard
The following statements have been made about different types of standards in standard costing
systems:
(a) Current standards provide the best basis for budgeting because they represent an
achievable level of productivity.
(b) Ideal standards provide a useful short-term target for standard setting, because they lead to
improvement in performance.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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3.1.1 The impact on employee behaviour of the type of standard set
The type of standard set can have an impact on the behaviour of the employees trying to achieve
those standards.
Type of
standard
Impact on behaviour
Ideal
Some say that they provide employees with an incentive to be more
efficient even though it is highly unlikely that the standard will be
achieved. Others argue that they are likely to have an unfavourable effect
on employee motivation because the differences between standards and
actual results will always be adverse. The employees may feel that the
goals are unattainable and so they will not work so hard.
Attainable
Might be an incentive to work harder as they provide a realistic but
challenging target of efficiency
Current
Will not motivate employees to do anything more than they are currently
doing
Basic
This may have an unfavourable impact on the motivation of employees.
Over time, they will discover that they are easily able to achieve the
standards. They may become bored and lose interest in what they are
doing if they have nothing to aim for.
4 Standards and budgets
Similarities:
• Standards and budgets are very similar in terms of their impacts on employees’ motivation
• Standards generally form the basis for the budget
• Both are used for control
Differences:
Standards
Budgets
By unit
In total
For areas of repetition
All areas
Financial and non-financial targets
Financial targets
5 Criticisms of standard costing
Standard costing has some disadvantages and, arguably, is less relevant in the modern
environment than previously when manufacturing was mainly of standard, mass-produced
products.
(a) Standard costing works best in a stable environment; the modern business environment is
rapidly changing.
(b) Regular revisions to the standard are required. This process is expensive and time consuming.
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(c) Meeting the standard should not necessarily be accepted as satisfactory if further
improvements could be made.
(d) Techniques associated with standard costing (such as variance analysis) are less useful in a
modern environment of customised products.
5.1 Revision of standards
Standards should be reviewed regularly and revised when there is a change in the basis upon
which they were set. This ensures that they remain useful as a performance measure.
6 Flexible budgets
We covered flexible budgets in Chapter 13. Remember that comparison of a fixed budget with the
actual results for a different level of activity is of little use for control purposes. Flexible budgets
should be used to show what cost and revenues should have been for the actual level of activity.
Budgetary control involves drawing up budgets for the areas of responsibility for individual
managers (production managers, purchasing managers, and so on) and regularly comparing
actual results against expected results. The differences between actual results and expected
results are reported as variances and these are used to provide a guideline for control action by
individual managers.
Note that individual managers are held responsible for investigating differences between
budgeted and actual results, and are then expected to take corrective action or amend the plan in
the light of actual events.
Essential reading
See Chapter 15 Section 2 of the Essential reading for more detail on flexible budgets.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
7 The principle of controllability
The principle of controllability means that managers of responsibility centres should only be held
accountable for costs over which they have some influence.
Exam focus point
The principle of controllability is extremely important for performance management.
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.
Budgetary control and budget centres are therefore part of the overall system of responsibility
accounting within an organisation.
KEY
TERM
Responsibility accounting: 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 organisation.
7.1 Controllable costs
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span. Care must be taken to distinguish between controllable costs and
uncontrollable costs in variance reporting. From a motivation point of view, this is important
because it can be very demoralising for managers who feel that their performance is being
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judged on the basis of something over which they have no influence. It is also important from a
control point of view in that control reports should ensure that information on costs is reported to
the manager who is able to take action to control them.
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the
managers most capable of controlling them. As a system of accounting, it therefore distinguishes
between controllable and uncontrollable costs.
Most variable costs within a department are thought to be controllable in the short term because
managers can influence the efficiency with which resources are used, even if they cannot do
anything to raise or lower price levels.
7.1.1 The controllability of fixed costs
It is often assumed that all fixed costs are non-controllable in the short run. This is not so.
(a) Committed fixed costs are those costs arising from the possession of plant, equipment,
buildings and an administration department to support the long-term needs of the business.
These costs (depreciation, rent, administration salaries) are largely non-controllable in the
short term because they have been committed to by longer-term decisions affecting longerterm needs. When a company decides to cut production drastically, the long-term committed
fixed costs will be reduced, but only after redundancy terms have been settled and assets
sold.
(b) Discretionary fixed costs, such as advertising and research and development costs, are
incurred as a result of a top management decision, but could be raised or lowered at fairly
short notice (irrespective of the actual volume of production and sales).
7.1.2 Controllability and apportioned costs
This may seem quite straightforward in theory, but it is not always so easy in practice to
distinguish controllable from uncontrollable costs. Apportioned overhead costs provide a good
example.
Suppose that a manager of a production department in a manufacturing company is made
responsible for the costs of their department. These costs include directly attributable overhead
items, such as the costs of indirect labour and indirect materials consumed in the department.
The department’s overhead costs also include an apportionment of costs from other cost centres,
such as rent and rates for the building it shares with other departments, and a share of the costs
of the maintenance department.
Should the production manager be held accountable for any of these apportioned costs?
(a) Managers should not be held accountable for costs over which they have no control. In this
example, apportioned rent and rates costs would not be controllable by the production
department manager.
(b) Managers should be held accountable for costs over which they have some influence. In this
example, it is the responsibility of the maintenance department manager to keep
maintenance costs within budget. However, their costs will be partly variable and partly fixed,
and the variable cost element will depend on the volume of demand for their services. If the
production department’s staff treat their equipment badly we might expect higher repair
costs, and the production department manager should therefore be made accountable for
the repair costs that their department makes the maintenance department incur on its
behalf.
(c) Charging the production department with some of the costs of the maintenance department
prevents the production department from viewing the maintenance services as ‘free services’.
Overuse would be discouraged and the production manager is more likely to question the
activities of the maintenance department, possibly resulting in a reduction in maintenance
costs or the provision of more efficient maintenance services.
7.1.3 Controllability and dual responsibility
Quite often, a particular cost might be the responsibility of two or more managers. For example,
the costs of raw materials might be the responsibility of the purchasing manager (prices) and the
production manager (usage). A reporting system must allocate responsibility appropriately. The
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purchasing manager must be responsible for any increase in the prices of raw materials, whereas
the production manager should be responsible for any increase in the usage of raw materials.
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Chapter summary
Budgeting and standard costing
Standards
Purposes of standards
A standard cost is an estimated
unit cost
• Decision making
• Budgeting
• Control
• Performance evaluation
• Inventory valuation
Deriving standards
Based on expected prices and
expected usage or time and
wastage
Types of standard
Where standard costing should
be used
• Large amounts of repetition
• Mass production
• Can be used in services
• Ideal
• Attainable
• Current
• Basic
Standards and
budgets
Criticisms of
standard costing
Flexible
budgets
• Standards: by unit
Budgets: In total
• Standards: areas of
repetitions Budgets:
All areas
• Standards: financial
and non financial
targets Budgets:
financial targets
• Needs a stable
environment
• Needs regular revision
• No incentive to do
better than standard
• Less appropriate for
customised products
Flexible budgets should
be used to show what
cost and revenues
should have been for the
actual level of activity
Managers of
responsibility centres
should only be held
accountable for costs
over which they have
some influence
Controllable costs
Revision of standards
Changed when there is
a change in the basis on
which they were set
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Controllable costs are
items of expenditure
which can be directly
influenced by a given
manager within a given
time span
Knowledge diagnostic
1. Standards
A standard is prepared in advance based upon expectations of the future.
2. Purposes of standards
Standard costs have many uses in performance management. These include:
• Performance evaluation
• Control
• Decision making
• Budgeting
• Inventory valuation
3. Types of standard
The four bases are:
• Ideal
• Attainable
• Current
• Basic
Standards should be set to an attainable level to drive the best performance.
4. Deriving standards
Standards take into account future price rises, efficiencies etc, when prepared.
5. Standards and budgets
Standards are set for a unit, whereas budgets encompass the whole business.
6. Flexed budgets
Comparison of a fixed budget with the actual results for a different level of activity is of little use
for control purposes. Flexed budgets should be used to show what cost and revenues should have
been for the actual level of activity.
7. Principle of controllability
The principle of controllability means managers of responsibility centres should only be held
accountable for costs over which they have some influence. Controllable costs are items of
expenditure which can be directly influenced by a given manager within a given time span.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate Time
Section A Q41
Examination
2
4 mins
Section A Q42
Examination
2
4 mins
Section A Q43
Examination
2
4 mins
Section C ‘McDreamy’
Examination
20
36 mins
Further reading
N/A
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Activity answers
Activity 1: Deriving standards
The correct answer is:
(a) only
The quantity will be relevant, as purchasing larger amounts will often mean that bulk quantity
discounts are available. The expected wastage levels are not directly relevant to the purchase
price per kg. Instead, they will affect the standard quantity used per unit.
Activity 2: Types of standard
The correct answer is:
Neither (a) nor (b)
Current standards are not ideal as they do not include an incentive to make improvements from
the current position. Ideal standards are not achievable in the short-term, but may be useful for
longer-term targets.
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Skills checkpoint 3
How to approach your PM
exam
Chapter overview
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
l y si s
How to
approach
your PM
exam
Performance
management
questions
ti m
ana
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
r planning
Answe
c al
e ri
an
en
en
em
tn
ag
um
em
Effective
use of
spreadsheets
t
Effi
ci
Effe cti
ve writing
a nd p r
esentation
Introduction
You can answer your PM exam in whatever order you prefer. It is important that you adopt a
strategy that works best for you. We would suggest that you decide on your preferred approach
and practise it by doing a timed mock exam before your real exam.
Remember your PM exam will be structured as follows:
Section A – 15 individual OT questions worth two marks each. Questions in Section A can come
from any syllabus area. There will be a mix of numerical and discursive style questions and you
may find that some questions are easier than others.
Section B – Three OT case questions worth 10 marks each. Each case question will consist of five
individual OT questions worth two marks each. There will normally be a mix of numerical and
discursive questions. You do not have to answer these questions in order as the answer from one
will not be required for subsequent questions. Again, questions in Section B can come from any
syllabus area. Each individual case does however tend to focus on a particular syllabus area and
at least one is likely to come from the syllabus area ‘Specialist cost and management accounting
techniques’.
Section C - Section C will contain two, 20-mark questions which will be scenario based and may
contain both discursive and computational elements. Section C questions will mainly focus on the
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following syllabus areas, but a minority of marks can be drawn from any other area of the
syllabus.
• Decision-making techniques (syllabus area C)
• Budgeting and control (syllabus area D)
• Performance measurement and control (syllabus area E)
This Skills Checkpoint will provide you with one suggested approach for tackling your PM exam.
Good luck!
How to approach your PM exam
We would suggest the following approach for tackling your PM exam. It is important that you
adopt an approach that works best for you and practise it by completing a mock exam to time
prior to your real exam.
Complete Section A first - allocated time 54 minutes
• Tackle any easier OT questions first. Often discursive style questions can be answered quickly,
saving more time for calculations. Do not leave any questions unanswered. Even if you are
unsure, make a reasoned guess. Skills Checkpoint 1 covers how to approach OT questions in
more detail.
• If you do not feel that you need the full 54 minutes to complete Section A, you can carry this
time forward to your Section C questions which tend to be more time pressured. With practice,
it may be possible for you to complete Section A up to 10 minutes quicker than the allocated
time of 54 minutes.
Complete Section B next - allocated time 54 minutes
• You will have 18 mins of exam time to allocate to each of the three OT case questions in Section
B. Use the same approach to OT questions as discussed for Section A.
• Each individual case tends to focus on a specific syllabus area. Start with the OT case
question you feel most confident with.
• There will normally be two discussion type and three numerical questions within each case.
Again, it is better to tackle the discussion type questions first as they tend to be less time
consuming.
• If you do not feel that you need the full 54 minutes to complete section B you can carry this
time forward to your Section C questions which tend to be more time sensitive. With practice, it
may be possible for you to complete Section B approximately five minutes quicker than the
allocated time of 54 minutes.
Finally, complete Section C – allocated time 72 minutes
• Section C will contain two, 20-mark questions which will be scenario based and will contain
both discursive and computational elements. Allocate at least 36 minutes to each question
(remembering to split your time between each of the sub requirements) but you may have up
to 15 minutes of extra time if you have completed Sections A and B of the exam in less than the
allotted time.
• Start with the question you feel most confident with. The first sub-requirement will normally
involve some detailed calculations and these tend to be very time sensitive. If possible, answer
the discursive sub-requirements first. This will ensure that you don’t spend too much time on
the calculations and then lose out on the easier discursive marks. Make it clear to your marker
which sub-requirement you are answering.
• Skills Checkpoints 2, 4 and 5 look specifically at the techniques you should use answering the
scenario-based questions in Section C. It is very likely that you will get a performance
management question in Section C so make sure you are confident using the techniques
covered in Skills Checkpoint 5.
• You must practise written questions in full to time, as this is the only way to acquire the
necessary skills to tackle discussion questions. Continuous effort in practising these skills will
lead to an increased chance of success in your exam.
Set some time aside to practise this approach through the completion of a mock exam to time.
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Variance analysis
16
16
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Calculate, identify the cause of, and explain
mixand yield variances.
D4 (a)
Explain the wider issues involved in changing
material mix, eg cost, quality and
performance measurement issues.
D4 (b)
Identify and explain the relationship of the
material usage variance with the material mix
and yield variances.
D4 (c)
Suggest and justify alternative methods of
controlling production processes.
D4 (d)
Calculate, identify the cause of, and explain
sales mix and quantity variances.
D5 (a)
Identify and explain the relationship of the
sales volume variances with the sales mix and
quantity variances.
D5 (a)
16
Exam context
16
The actual results achieved by an organisation will usually differ from the expected results (the
expected results being the standard costs and revenues which we looked at in the previous
chapter). These differences are variances. You should have learned basic variances in your
previous studies but the PM exam requires some more advanced knowledge of variances including
materials mix and yield variances and sales mix and quantity variances.
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Chapter overview
Variance analysis
Mix and yield variances
Materials and labour inputs
Changing the mix
Interrelationship between variances
Additional production control methods
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1 Mix and yield variances
PER alert
One of the competencies needed to fulfil performance objective 13 of the PER is to use
appropriate techniques to assess and to evaluate actual performance against plans. You can
apply the knowledge you obtain from this section of the text to help demonstrate this
competence.
In order to understand more advanced variances, you need to understand the basic variances
brought forward from your earlier studies.
Essential reading
See Chapter 16 Section 1 of the Essential reading for details on basic variances and operating
statements.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
1.1 Materials and labour inputs
Where inputs can be substituted for one another, the efficiency/usage variance can be
subdivided.
For example, manufacturing processes often require that a number of different materials are
combined to make a unit of finished product. When a product requires two or more raw materials
in its make-up, it is often possible to sub-analyse the materials usage variance into a materials
mix and a materials yield variance.
Adding a greater proportion of one material (therefore a smaller proportion of a different
material) might make the materials mix cheaper or more expensive.
Similarly, if more than one type of labour is used in a product, the labour efficiency variance can
be analysed further into a labour mix (team composition) variance and a labour yield (team
productivity or output) variance.
KEY
TERM
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.
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.
The mix variance represents the financial impact of using a different proportion of raw materials.
The yield variance represents the financial impact of the input yielding a different level of output
to the standard.
Note that 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.
Total materials variance
Material price variance
Material usage variance
Mix variance
Yield variance
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Illustration 1: Materials usage, mix and yield usage
1 A company manufactures a chemical, Dynamite, using two compounds: Flash and Bang. The
standard materials usage and cost of one unit of Dynamite are as follows:
Flash
Bang
$
10
30
40
5 kg at $2 per kg
10 kg at $3 per kg
In a particular period, 80 units of Dynamite were produced from 600 kg of Flash and 750 kg of
Bang.
Required
Calculate the materials usage, mix and yield variances.
Solution
1 The correct answer is:
(a) Usage variance
If we do not calculate a mix and yield variance, we would calculate a usage variance separately
for each material.
Flash
Bang
Standard usage for
actual output of 80 units
kg
400
800
1,200
Actual
usage
kg
600
750
1,350
Variance
kg
200 (A)
50 (F)
Standard
cost per kg
$
2
3
Variance
$
400 (A)
150 (F)
250 (A)
The total usage variance of $250 (A) can be analysed into a mix variance and a yield variance
and these may be reported instead of the usage variance.
(b) Mix variance
To calculate the mix variance, it is first necessary to decide how the total quantity of materials
used (600 kg + 750 kg) should have been divided between Flash and Bang. In other words, we
need to calculate the standard mix of the actual quantity of materials used.
Actual usage
Flash
Bang
Mix variance
kg
600
750
Actual total usage in
standard mix (5:10 or 1:2)
kg
450
900
1,350
1,350
0
kg
150 (A)
150 (F)
The mix variance in total quantities is always 0. This must always be the case since the expected
mix is based on the total quantity actually used; hence the difference between the total expected
and actual total is zero.
However, the actual mix uses:
• More of the cheaper material, Flash (= adverse variance, because actual usage of Flash in the
mix is more than the standard usage; therefore the cost for Flash is more); but
• Less of the more expensive material, Bang (= favourable variance, because actual usage of
Bang in the mix is less than the standard usage; therefore the cost for Bang is lower).
Taking both materials together, the actual mix of materials is cheaper than the standard mix, and
this will produce a favourable mix variance overall.
The mix variances in quantities are converted into a monetary value at the standard price of the
materials.
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Flash
Bang
Actual quantity
standard
mix
kg
450
900
Actual
usage/mix
Mix variance Standard price
kg
600
750
kg
150 (A)
150 (F)
1,350
1,350
0
$ per kg
2
3
Mix variance
$
300 (A)
450 (F)
150 (F)
The total mix variance is $150 (F).
(c) Yield variance
The yield variance can be calculated in total or for each individual material input.
Method 1
Flash
Bang
Standard
quantity
standard
mix
kg
400
800
Actual quantity
standard mix
Yield variance Standard price
kg
450
900
kg
50 (A)
100 (A)
1,200
1,350
150
$ per kg
2
3
Yield variance
$
100 (A)
300 (A)
400 (A)
Method 2
The weighted average cost per kilogram of materials = $40/15 kg = $2.67 per kg.
kg
1,200
1,350
80 units of product should use in total (× 15 kg)
They did use (600 + 750)
Yield variance in kg
150 (A)
$2.67
Weighted average price per kg
Yield variance in $
$400 (A)
Method 3
Units
90
80
1,350 kg of material should produce (÷ 15)
They did produce
Yield variance in units of output
10 (A)
$40
Standard material cost per unit
Yield variance in $
$400 (A)
The mix variance $150 (F) plus the yield variance $400 (A) add up to the usage variance $250 (A).
Exam focus point
In the exam, use whichever method you prefer.
Activity 1: Materials mix and yield variances
Brenda and Eddie are analysing the main ingredients to their basic pasta sauce.
The standard ingredients for one batch of tomato pasta sauce are:
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Onions
Tomatoes
5 kg
5 kg
@ $2/kg
@ $4/kg
$
10
20
30
During June, 100 batches of sauce were prepared, using the following ingredients:
Onions
Tomatoes
1
600 kg
900 kg
Required
Calculate the materials mix variance and determine whether it is adverse or favourable.
▼
2
 Adverse
 Favourable
Required
Calculate the materials yield variance and determine whether it is adverse or favourable.
 Adverse
 Favourable
▼
Solution
1
2
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1.2 Changing the mix
Exam focus point
Always consider the impact on quality and the related impact on sales of a change in the mix.
The materials mix variance indicates the cost of a change in the mix of materials, while the yield
variance indicates the productivity of the manufacturing process. A change in the mix can have
wider implications. For example, rising raw material prices may cause pressure to change the mix
of materials. Even if the yield is not affected by the change in the mix, the quality of the final
product may change. This can have an adverse effect on sales if customers do not accept the
change in quality.
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.
1.3 Interrelationship between variances
A favourable mix variance occurs when the actual mix of materials is cheaper than the standard
mix.
Using a cheaper mix of materials may result in an output/yield that is less than the standard
output. In other words, a favourable mix variance may result in an adverse yield variance.
For similar reasons, when there is an adverse mix variance because the actual mix of materials is
more expensive than the standard mix, there may possibly be an interrelated favourable yield
variance.
Activity 2: Implications of changing the mix
The following statements have been made about the implications of changing the mix of materials
used in the production of soup:
(a) Using proportionally more of the cheaper ingredients will always lead to lower yields.
(b) Altering the mix could affect the taste and therefore the number of units sold.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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Activity 3: Material yield
A company manufactures a fruit flavoured drink by mixing two liquids: A & J. The standard cost
for ten litres of the drink is shown below:
$
5 litres of liquid A at $16 per litre
80
6 litres of liquid J at $25 per litre
150
230
During August the company produced 4,800 litres of the drink. This was 200 litres below
budgeted production. The company purchased and used 2,200 litres of A for $18 per litre and
2,750 litres of J for $21 per litre.
Required
What is the material yield for August?
 $450 A
 $450 F
 $6,900 F
 $6,900 A
Solution
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1.4 Additional production control methods
In a modern manufacturing environment with an emphasis on quality management, using mix
and yield variances for control purposes may not be possible or may be inadequate. Other
control methods could be more useful, such as:
• Rates of wastage
• Average cost of input calculations
• Percentage of deliveries on time
• Customer satisfaction ratings
• Yield percentage calculations or output to input conversion rates
2 Sales mix and quantity variances
The sales volume profit variance can be analysed further into a sales mix variance and a sales
quantity variance.
Sales mix variance: The sales mix variance occurs when the proportions of the various
products sold are different from those in the budget.
KEY
TERM
Sales quantity variance: The sales quantity variance shows the difference in
contribution/profit because of a change in sales volume from the budgeted volume of sales.
Total sales variance
Sales price variance
Sales volume variance
Sales mix variance
Sales quantity variance
Illustration 2: Sales volume, mix and quantity variance
1 Just Desserts Co makes and sells two products, Chocolate Crunch and Strawberry Sundae. The
budgeted sales and profit are as follows:
Chocolate Crunch (CC)
Sales
Units
400
Revenue
$
8,000
Costs
$
6,000
Profit
$
2,000
Profit per unit
$
5
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$
300
Strawberry Sundae (SS)
$
12,000
$
11,100
$
900
$
3
2,900
Actual sales were 280 units of Chocolate Crunch and 630 units of Strawberry Sundae. The
company management is able to control the relative sales of each product through the allocation
of sales effort, advertising and sales promotion expenses.
Calculate the sales volume variance, the sales mix variance and the sales quantity variance.
Solution
1 The correct answer is:
(a) Sales volume variance
CC
SS
Budgeted sales
400 units
300 units
Actual sales
280 units
630 units
Sales volume variance in units
120 units (A)
330 units (F)
× standard profit per unit
× $5
× $3
Sales volume variance in $
$600 (A)
$990 (F)
Total sales volume variance
$390 (F)
The favourable sales volume variance indicates that profit was better than budget because on
balance more units were sold than budgeted. However, the favourable variance may be due to
selling a larger proportion of the more profitable product (sales mix variance) or selling more units
in total (sales quantity variance).
Now we will see how to analyse this favourable volume variance into its mix and quantity
elements.
(b) Sales mix variance
This is calculated in a similar way to the materials mix variance. Start with the total quantity of
products sold and calculate what sales of each product would have been if they had been sold in
the budgeted proportions.
Actual sales in
standard mix
(4:3)
Actual sales
in actual mix
Sales mix
variance
Standard profit
Sales mix
variance
Units
Units
Units
$ per unit
$
CC
520
280
(A) 240
5
1,200 (A)
SS
390
630
(F) 240
3
720 (F)
910
910
0
The total sales mix variance is $480 (A)
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480 (A)
(c) Sales quantity variance
Method 1
Standard
sales in
standard mix
Actual sales
in standard
mix
Sales mix
variance
Standard profit
Sales mix
variance
Units
Units
Units
$ per unit
$
CC
400
520
(F) 120
5
600 (F)
SS
300
390
(F) 90
3
270 (F)
700
910
30
870 (F)
Method 2
The standard weighted average profit per unit of sale, taken from the budget, is $2,900/700 =
$29/7
Units
700
910
Budgeted sales in total
Actual sales in total
Sales quantity variance in units
210 (F)
$29/7
Standard weighted average profit per unit
Sales quantity variance in $
$870 (F)
Sales mix variance $480 (A) + Sales quantity variance $870 (F) = Sales volume variance $390 (F).
The overall favourable sales volume variance was achieved by selling products in a cheaper sales
mix, but achieving a higher total quantity of sales units than budgeted.
Activity 4: Sales variances
Puddingsrus makes and sells two products: Sticky Toffee and Chocolate Goo. The budgeted sales
and profit are as follows:
1
2
Sales
Revenue
Costs
Profit
Profit per unit
Units
$
$
$
$
Sticky Toffee
800
5,600
2,400
3,200
4
Chocolate Goo
900
4,500
2,700
1,800
2
Actual sales in November were 600 units of Sticky Toffee and 1,200 units of Chocolate Goo. The
company management is able to control the relative sales of each product through the allocation
of sales effort, advertising and sales promotion expenses.
Required
What is the sales volume profit variance for Puddingsrus?
 $800 Adverse
 $800 Favourable
 $200 Adverse
 $200 Favourable
Required
What is the sales mix variance for Puddingsrus?
 $494 Adverse
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3
 $494 Favourable
 $247 Adverse
 $247 Favourable
Required
What is the sales quantity variance for Puddingsrus?
 $294 Adverse
 $294 Favourable
 $200 Adverse
 $800 Favourable
Solution
1
2
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Chapter summary
Variance analysis
Mix and yield variances
Materials and labour inputs
• Materials usage variance = materials mix variance
+ materials yield variance
• Mix = financial impact of using different
proportions from standard
• Yield = financial impact of input yielding different
output level from standard
Changing the mix
• Quality and its impact on sales
• How managers' performance is measured (eg
saving money at expense of quality)
Interrelationship between variances
Favourable mix may lead to adverse yield variance
Additional production control methods
• Quality control measures
• Customer satisfaction scores
• Wastage rates
• Number of late deliveries
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Knowledge diagnostic
1. Material mix and yield variations
A mix variance is the result of a different mix of materials to the standard being used.
A yield variance occurs when a different quantity from standard is input in order to achieve the
desired output.
However, 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.
2. Sales mix and quantity variance
A sales mix variance is the result of selling a different proportion of products to the standard.
A sales quantity variance occurs when a different volume of units is sold.
This may be useful for control purposes where management is in a position to control the sales
mix; for example, through the allocation of spending on advertising and sales promotion
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q44
Examination
2
4 mins
Section A Q45
Examination
2
4 mins
Section A Q46
Examination
2
4 mins
Section A Q47
Examination
2
4 mins
Section A Q48
Examination
2
4 mins
Further reading
There is a technical article available on ACCA’s website, called Material mix and yield variances.
You are strongly advised to read this article in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Materials mix and yield variances
1
The correct answer is:
Adverse
$300 Adverse
Total mix variance
Std mix
750
750
1,500
Onions
Tomatoes
2
Actual mix
600
900
1,500
Difference
150 (F)
150 (A)
× Std cost
$2
$4
Variance
300 (F)
600 (A)
300 (A)
Actual in std
mix
750
750
1,500
Difference
× Std cost
Variance
250 (A)
250 (A)
$2
$4
500 (A)
1,000 (A)
1,500 (A)
The correct answer is:
Adverse
$1,500 Adverse
Total yield variance
Std in std mix
Onions
Tomatoes
500
500
1,000
OR
Batches
150
1,500 kg of input should yield
1,500 / (5 + 5)
1,500 kg of input did yield
100
A 50
A $1,500
Value at std cost per batch ($30)
Activity 2: Implications of changing the mix
The correct answer is:
(b) only
Using cheaper ingredients in the mix could lead to lower yields, but this will not always be the
case. However, changing the recipe could have an impact on the taste and quality. For example,
increasing the water content in soup would increase the yield, but it may not taste as good.
Activity 3: Material yield
The correct answer is:
$6,900 F
Yield
Litres
4,500
4,800
F 6,900
4,950 litres should yield @ 10/11
Did yield
Valued at standard cost $230/10
Alternative yield calculations
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Proportion
A
J
Total
5/11
6/11
Should use for Should use in
actual
std mix
production
2,400
2,250
2,880
2,700
5,280 (W1)
4,950
Difference
Value
$
Variance
$
150
180
16
25
2,400 F
4,500 F
6,900 F
(W1) 4,800 adjusted for losses 4,800/0.909 = 5,280 litres.
Or
The weighted average cost per litre of ingredients is $230 / 11 litres = $20.91
4,800 litres of drink should use (× 11/10)
5,280 litres
But did use
4,950 litres
Yield variance in litres
330 litres(F)
Weighted average price per litre
× $20.91
Yield variance in $
$6,900(F)
Activity 4: Sales variances
1
The correct answer is:
$200 Adverse
Sales volume profit variance
Sticky Toffee
Budgeted sales
800 units
900 units
Actual sales
600 units
1,200 units
Sales volume variance in units
200 units (A)
300 units (F)
× standard margin per unit
× $4
× $2
Sales volume variance in $
$800 (A)
$600 (F)
Total sales volume variance
2
Chocolate Goo
$200 (A)
Profit is lower as a result of a lower sales volume compared with budget.
The correct answer is:
$494 Adverse
Sales mix variance
Units
1,800
847
953
Total quantity sold (600 + 1,200)
Budgeted mix for actual sales: 8/17 Sticky Toffee
9/17 Chocolate Goo
1,800
Sticky Toffee
‘Should’ mix
‘Did’ mix
Actual sales
Actual sales
Standard mix
Actual mix
847 units
600 units
× Standard
Difference
247 (A)
margin
Variance
$
$
×4
988 (A)
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Chocolate
Goo
3
953 units
1,200 units
247 (F)
1,800 units
1,800 units
–
×2
494 (F)
494 (A)
The profit would have been $494 higher if the 1,800 units had been sold in the budgeted mix of
8:9.
The correct answer is:
Sales quantity variance
Sticky Toffee
Chocolate
Goo
Standard sales
Standard mix
Actual sales
Standard mix
800 units
900 units
847 units
953 units
1,700 units
1,800 units
Difference × Standard
in units
profit
$
47 units (F)
×4
53 units (F)
×2
100 units
Variance
$
188 (F)
106 (F)
294 (F)
Summary
$
494 (A)
294 (F)
Sales mix variance
Sales quantity variance
Sales volume profit variance
200 (A)
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17
Planning and operational
variance analysis
17
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Calculate a revised budget.
D6 (a)
Identify and explain those factors that could
and could not be allowed to revise an original
budget.
D6 (b)
Calculate, identify the cause of and explain
planning and operational variances for:
D6 (c)
(a) Sales, including market size and market
share
(b) Materials
(c) Labour, including the effect of the
learning curve.
Explain and discuss the manipulation issues in
revising budgets.
D6 (d)
17
Exam context
In this chapter, we discuss the circumstances in which management may consider it appropriate
to revise the budget or the standard cost.
17
When a budget or standard cost is revised after the budget period has begun, the reporting of
variances should allow for this revision. One way of doing this is to present variances in the form
of planning variances and operational variances.
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Chapter overview
Planning and operational variance analysis
Revising a budget or standard cost
Reasons for revising a budget or
standard cost
Advantages of
revising the budget
Calculating a revised budget
Disadvantages of
revising the budget
Planning and operational
variances for materials
Revising budgets:
manipulation issues
Planning and operational
variances for labour
Planning and operational
variances for sales
Labour planning variances and
the learning curve
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The value of planning
and operational variances
1 Revising a budget or standard cost
PER alert
One of the competencies needed to fulfil performance objective 13 of the PER is to monitor
business activities. You can apply the knowledge you obtain from this section of the text to
help demonstrate this competence.
Occasionally, it may be appropriate to revise a budget or standard cost. When this happens,
variances should be reported in a way that distinguishes between variances caused by the
revision to the budget and variances that are the responsibility of operational management.
1.1 Reasons for revising a budget or standard cost
Assumption
Changes
Sales budget may be based on expectations
of the total size of the market for the
organisation’s product
But market size may be much larger or much
smaller than first assumed due to:
•
•
•
•
Unexpected change in economic
conditions
Unexpected technological change
Radical change in customer attitudes
Unexpected new regulations
Standard cost of materials may be based on
an assumption about what the market price
for the materials should be
Due to a major change in the market, the
available market price for the materials may
become much higher or much lower than
originally expected
Standard quantity of materials made may be
based on product specification
Standard quantity of materials may be
significantly altered due to 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
Standard labour rate may become unrealistic
due to an unexpected increase in pay rates
for employees
Standard time to produce a unit of product is
estimated
The standard time could be affected by a
change in the labour grade or upgraded
machinery
If the budget or standard cost is not revised in these circumstances, variances reported to
operational managers will be unrealistic. A large part of the variances will be due to changes that
are outside the control of the operational managers.
A budget revision should be allowed if something has happened which is beyond the control of
the organisation or individual manager and which makes the original budget unsuitable for use in
performance management.
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1.2 Calculating a revised budget
Illustration 1: Calculating a revised budget
1 A company produces Widgets and Splodgets which are fairly standardised products. The
following information relates to Period 1.
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.
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.
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.
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.
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.
Solution
1 The correct answer is:
Original budget for Period 1
Sales revenue ((2,000 × $50) + (500 × $100))
Material costs X (2,000 × 5 kg × $3)
Material costs Z (500 × $30 × 1.5)
Labour costs ((2,000 × 3 × $5) + (500 × 2 × $5))
Variable overheads ((2,000 × 3 × $3) + (500 × 2 × $3))
Fixed overheads
Profit
$
150,000
30,000
22,500
35,000
21,000
12,000
29,500
Revised budget for Period 1
Sales revenue ((2,000 × $50) + (500 × $100))
Material costs X (2,000 × 5 kg × $4.5)
Material costs Z (500 × $23 × 1.5)
Labour costs ((2,000 × 3 × $5) + (500 × 2 × $5)) × 0.95
Variable overheads ((2,000 × 3 × $3) + (500 × 2 × $3)) × 0.95
Fixed overheads
Profit
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$
150,000
45,000
17,250
33,250
19,950
12,000
22,550
1.3 Revising budgets: manipulation issues
Revisions to the budget or standard cost may be manipulated in such a way as to make operating
results seem much better than is really the case.
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
evidence (and verifiable evidence) that operational managers are not in a position to manipulate.
Change
Evidence
Total size of the market for the company’s
product
There should ideally be independent evidence
from an external source (such as a market
research firm) about the revised expectations of
the market size
Market price for materials
There should ideally be an official price index or
price benchmark for the material item
Standard material usage for a product
This should ideally be evidenced by a
documented change in the product specification
1.4 Advantages of revising the budget
(a) Highlights those variances which are controllable and those which are not
(b) Ensures that operational performance is appraised by reference to realistic targets
(c) Should ensure that future budgets are more realistic
1.5 Disadvantages of revising the budget
(a) Determination of revised budget
• May be biased
• May need external information
(b) Use of revised budget may undermine original budget as a target and as a motivator.
(c) Employees may use this system to their advantage by excusing operating problems as poor
planning if this method is used.
A budget should only be revised for items that are beyond the control of the organisation. Such
changes would render the original budget inappropriate as a performance management tool.
Budgets should not be revised for operational issues.
2 Planning and operational variances for materials
Total material price variance
(1) Actual materials should cost
(3) Actual materials did cost
Material price planning variance
(1) Actual materials should cost
(2) Actual materials should now cost
$
X
X
X
Material price operational variance
$
X
X
X
(1) Actual materials should now cost
(3) Actual materials did cost
$
X
X
X
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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).
Illustration 2: Material planning price and usage variances
1 The standard materials cost of a product is 5kg × $7.50 per kg = $37.50. Actual production of
10,000 units used 54,400kg at a cost of $410,000.
In retrospect, it was realised that the standard materials cost should have been 5.3kg per unit at a
cost of $8 per kg. The standard cost was revised to this amount.
Required
Calculate the materials planning and operational variances in as much detail as possible.
Solution
1 The correct answer is:
Original standard cost: 5kg × $7.50 per kg = $37.50 per unit of product
Revised standard cost: 5.3kg × $8 per kg = $42.40 per unit of product
In this example, both the material price and the material usage per unit have been revised. There
are planning variances for both material price and material usage.
Material price planning variance
This is the difference between the original standard price for Material M and the revised standard
price multiplied by the actual quantity of materials used.
Original standard price per kg
Revised standard price per kg
Material price planning variance
× actual quantity of materials used
Material price planning variance
$7.50
$8.00
$0.50 (A)
× 54,400 kg
$27,200 (A)
The planning variance is adverse because the change in the standard price increases the material
cost and this will result in lower profit.
Material usage planning variance
10,000 units of product X should use: original standard
10,000 units of product X should use: revised standard
Material usage planning variance in kg of material
Original standard price per kg of material
Material usage planning variance in $
kg
50,000
53,000
3,000 (A)
$7.50
$22,500 (A)
The planning variance is adverse because the revised standard is for a higher usage quantity (so
higher cost and lower profit).
Material price operational variance
This compares the actual price per kg of material with the revised standard price. It is calculated
using the actual quantity of materials used.
54,400kg of material should cost (revised standard $8)
They did cost
Material price operational variance
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$
435,200
410,000
25,200 (F)
Material usage operational variance
This variance is calculated by comparing the actual material usage with the standard usage in
the revised standard, but it is then converted into a monetary value by applying the original
standard price for the materials, not the revised standard price. This is an important rule.
kg
53,000
54,400
1,400 (A)
$7.50
$10,500 (A)
10,000 units of product X should use (× 5.3kg)
They did use
Material usage (operational) variance in kg of material
Original standard price per kg of Material M
Material usage (operational) variance in $
The variances may be summarised as follows:
$
10,000 units of product at original std cost ($37.50)
Actual material cost
Total material cost variance
Material price planning variance
Material usage planning variance
Material price operational variance
Material usage operational variance
Total of variances
$
375,000
410,000
35,000 (A)
27,200 (A)
22,500 (A)
25,200 (F)
10,500 (A)
35,000 (A)
Activity 1: Material planning and operational variances
Mason Co makes plastic patio furniture for sale to garden centres. One of its most popular
products is the recliner chair. The standard amount of plastic per chair is 4kg and the standard
cost per kg is $9. Budgeted production in June was 15,000 units. Actual production in June was
only 14,000 units, which used 54,000kg of plastic at a cost of $9.50 per kg.
1
2
At the end of May, it was agreed that in order to boost sales the quality of the chairs needed to be
improved. This meant purchasing better quality plastic at a standard cost of $9.30 per kg, whilst
reducing the standard kg per chair to 3.8kg due to less waste.
Required
Calculate the following variances for Mason Co.
(a) Material price planning variance
(b) Material price operational variance
(c) Material usage planning variance
(d) Material usage operational variance
Required
Assess the performance of the production manager for the month of June.
Solution
1
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2
3 Planning and operational variances for labour
Illustration 3: Labour planning and operational variances
1 A company makes a single product. At the beginning of the budget year, the standard labour cost
was established as $8 per unit, and the standard time to make each unit was 0.5 hours.
However, during the year, the standard labour cost was revised. A new quality control procedure
was introduced to the production process, adding 20% to the expected time to complete a unit. In
addition, due to severe financial difficulties facing the company, the workforce reluctantly agreed
to reduce the rate of pay to $15 per hour.
In the first month after revision of the standard cost, budgeted production was 15,000 units but
only 14,000 units were actually produced. These took 8,700 hours of labour time, which cost
$130,500.
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Required
Calculate the labour planning and operational variances in as much detail as possible.
Solution
1 The correct answer is:
Original standard cost = 0.5 hours × $16 per hour = $8 per unit
Revised standard = 0.6 hours × $15 per hour = $9 per unit
Planning and operational variances for labour are calculated in a similar way to planning and
operational variances for materials. We need to look at planning and operational variances for
labour rate and labour efficiency.
Labour rate planning variance
The following is the difference between the original standard rate per hour and the revised
standard rate per hour:
$ per hour
16
15
1 (A)
Original standard rate
Revised standard rate
Labour rate planning variance
The planning variance for labour rate is favourable, because the revised hourly rate is lower than
in the original standard. The variance is converted into a total monetary amount by multiplying
the planning variance per hour by the actual number of hours worked.
Labour rate planning variance = 8,700 hours × $1 (F) = $8,700 (F).
Labour efficiency planning variance
This is the difference between the original standard time per unit and the revised standard time,
for the quantity of units produced. The efficiency planning variance is converted into a total
monetary value by applying the original standard rate per hour, not the revised standard rate.
Hours
7,000
8,400
1,400
$16
$22,400 (A)
14,000 units of product should take: original standard (× 0.5)
14,000 units of product should take: revised standard (× 0.6)
Labour efficiency planning variance in hours
Original standard rate per hour
Labour efficiency planning variance in $
The planning variance is adverse because the revised standard is for a longer time per unit (so
higher cost and lower profit).
Labour rate operational variance
This is calculated using the actual number of hours worked and paid for.
$
130,500
130,500
0
8,700 hours should cost (revised standard $15)
They did cost
Labour rate operational variance
In this example, the workforce was paid exactly the revised rate of pay per hour.
Labour efficiency operational variance
This variance is calculated by comparing the actual time to make the output units with the
standard time in the revised standard. It is then converted into a monetary value by applying the
original standard rate per hour.
Hours
14,000 units of product should take (× 0.6 hours)
8,400
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They did take
8,700
Labour efficiency (operational variance in hours)
300 (A)
Original standard rate per hour
$16
Labour efficiency (operational variance in $)
$4,800 (A)
The variances may be summarised as follows:
$
14,000 units of product at original standard cost ($8)
Actual material cost
Total material cost variance
Labour rate planning variance
Labour efficiency planning variance
Labour rate operational variance
Labour efficiency operational variance
Total of variances
$
112,000
130,500
18,500 (A)
8,700 (F)
22,400 (A)
0
4,800 (A)
18,500 (A)
3.1 Labour planning variances and the learning curve
We looked at the learning curve in Chapter 14 and we said that a standard labour cost can only
be established when a ‘steady state’ is reached, ie production of each additional unit should take
the same amount of time. In principle, however, it would be possible to combine standard costing
with the learning curve, as follows.
(a) Establish an original standard labour cost per unit, even though a learning effect will apply to
production.
(b) At the end of the budget period, revise the standard time per unit. The revised standard time
could be calculated using the learning curve formula and applying this to the number of units
produced in the period.
(c) With the original standard cost and the revised standard cost, planning and operational
variances for labour can be calculated. Because of the learning effect, the labour efficiency
planning variance will always be favourable.
Essential reading
See Chapter 17 Section 1 of the Essential reading for an illustration on variances and the learning
curve.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
4 Planning and operational variances for sales
The sales volume variance can be reported as:
(a) A sales volume planning variance, or market size variance, which is caused by the difference
between the sales volume in the original budget and the sales volume in the revised budget.
(b) A sales volume operational variance, or market share variance, which is caused by the
difference between actual sales volume and the sales volume in the revised budget.
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Illustration 4: Market size and market share variance
1 Dimsek budgeted to make and sell 400 units of its product, the Role, in the four-week Period 8, as
follows:
$
40,000
24,000
16,000
10,000
6,000
Budgeted sales (100 units per week)
Variable costs (400 units × $60)
Contribution
Fixed costs
Profit
At the beginning of the second week, production came to a halt because inventories of raw
materials ran out, and a new supply was not received until the beginning of Week 3. As a
consequence, the company lost one week’s production and sales. Actual results in Period 8 were
as follows:
$
32,000
19,200
12,800
10,000
2,800
Sales (320 units)
Variable costs (320 units × $60)
Contribution
Fixed costs
Actual profit
In retrospect, it is decided that the optimum budget, given the loss of production facilities in the
third week, would have been to sell only 300 units in the period.
Required
Calculate appropriate planning and operational variances for sales volume.
Solution
1 The correct answer is:
The sales volume planning variance compares the revised budget with the original budget. It
may be called a market size variance.
Revised sales volume, given materials shortage
300 units
Original budgeted sales volume
400 units
Sales volume planning variance in units of sales
100 units (A)
× standard contribution per unit
× $40
Sales volume planning variance in $
$4,000 (A)
Arguably, running out of raw materials is an operational error and so the loss of sales volume
and contribution from the shortage of materials is an opportunity cost that could have been
avoided with better purchasing arrangements. Despite this, we are treating this as a planning
variance. The operational variances are variances calculated in the usual way, except that actual
results are compared with the revised standard or budget. There is a sales volume variance which
is an operational variance, as follows.
Actual sales volume
Revised sales volume
Operational sales volume variance in units
(possibly due to production efficiency or marketing efficiency)
× standard contribution per unit
Operational sales volume variance in $ contribution
320 units
300 units
20 units (F)
× $40
$800 (F)
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The operational variance for sales volume may be called a market share variance. These planning
and operational variances for sales volume can be used as control information to reconcile
budgeted and actual profit.
$
Operating statement, Period 8
Budgeted profit
Planning variance: sales volume
Operational variance: sales volume
$
6,000
4,000 (A)
800 (F)
3,200 (A)
Actual profit in Period 8
2,800
You may have noticed that, in this example, sales volume variances were valued at contribution
forgone. This is because it is assumed that a marginal costing system applies.
Activity 2: Market size and market share variances
A sales volume variance can be analysed into a market size variance and a market share variance.
The following statements have been made about these variances:
(a) In a competitive market, the market share variance is controllable by the sales management.
(b) In a competitive market, a market size variance is controllable by sales management.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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Activity 3: Sales planning and operational variances
Chianti Co manufactures and sells a single product, the Chil. The company uses a standard
costing system, and the standard cost per unit is $7.40 and the budgeted selling price is $16.00
per unit.
Budgeted production and sales for 20X8 were 5,000 units. The budgeted fixed overhead was
$20,000.
Actual production in 20X8 was 5,200 units, and 5,100 units were sold for $81,000.
You have discovered that industry sales of Chils were 10% lower than forecast.
Required
For the sales volume planning variance and the sales volume operational variance was there a
favourable or adverse result in 20X8?
 The sales volume planning variance was adverse and the sales volume operational variance
was favourable
 The sales volume planning variance was favourable and the sales volume operational variance
was adverse
 Both variances were adverse
 Both variances were favourable
Solution
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.
The planning variance is generally outside the control of sales management, but the operational
sales price variance is a sales management responsibility.
Illustration 5: Planning and operational variances for sales price
1 KSO budgeted to sell 10,000 units of a new product during 20X0. The budgeted sales price was
$10 per unit, and the variable cost $3 per unit.
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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.
Solution
1 The correct answer is:
The only variances are selling price variances.
Planning (selling price) variance
$ per unit
10.00
4.50
5.50 (A)
× 12,000
$66,000 (A)
Original budgeted sales price
Revised budgeted sales price
Sales price planning variance
× the actual number of units sold
Sales price planning variance
The planning variance is adverse because the revised sales price is lower than the sales price in
the original budget. As a result, actual profit will not achieve the budgeted profit level.
Operational (selling price) variance
The sales price operational variance is calculated in the same way as a ‘normal’ sales price
variance, except that the sales price in the revised budget is used, not the original budget.
$
60,000
54,000
6,000 (F)
12,000 units sold for (12,000 × $5)
They should have sold for (× $4.50)
Sales price operational variance
5 The value of planning and operational variances
Advantages of a system of planning and operational variances
• The analysis highlights those variances which are controllable (operational variances) and
those which are non-controllable (planning variances).
• Managers’ acceptance of the use of variances for performance measurement, and their
motivation, 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 more
accurate, relevant and appropriate.
• Operational variances will provide a more realistic and ‘fair’ reflection of actual performance.
Limitations of planning and operational variances, which must be overcome if they are to be
applied in practice
• It is difficult to decide in hindsight what the realistic standard should have been.
• It may become too easy to justify all the variances as being due to bad planning, so no
operational variances will be highlighted.
• Establishing realistic revised standards and analysing the total variance into planning and
operational variances can be a time-consuming task, even if a spreadsheet package is
devised.
• Even though the intention is to provide more meaningful information, managers may be
resistant to the very idea of variances and refuse to see the virtues of the approach. Careful
presentation and explanation will be required until managers are used to the concepts.
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Exam focus point
If you get a variance question in Section C of the exam, you should use the spreadsheet to do
your calculations. By all means check your answers on your calculator but try to avoid just
typing in your calculator answers into the spreadsheet. The spreadsheet has the functionality
to perform the calculations and using this makes it much easier for the marker to see what you
have done.
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Chapter summary
Planning and operational variance analysis
Revising a budget or standard cost
Reasons for revising a budget or
standard cost
Advantages of revising the
budget
• Changes to market size
• Change in market price
• Changes in quantities of
materials
• Change in labour rates
• Changes in production times
• Highlights variances that are
controllable
• Ensures operational
performance is appraised by
reference to realistic targets
• Should ensure future budgets
are more realistic
Planning and operational
variances for materials
• Incorrect standards (planning
variances)
• Within the manager's control
(operational variances)
• Price planning
• Usage planning
• Price operational
• Usage operational
Calculating a revised budget
Original budget and revised
budget to allow for controllable
factors
Revising budgets: manipulation
issues
Disadvantages of revising the
budget
• May be subjective
• May undermine use of original
budget as a target/motivator
• May be manipulated
• Rules should be applied
• Independent evidence should
be obtained
Planning and operational
variances for labour
Planning and operational
variances for sales
The value of planning
and operational variances
• Rate planning
• Efficiency planning
• Rate operational
• Efficiency operational
• Sales volume planning
(market size)
• Sales volume operational
(market share)
• Sales price planning
• Sales price operational
• Highlights those variances
which are controllable
• May increase manager
motivation
• Standard setting processes
should improve
• Can be difficult to decide with
hindsight
• Can be time consuming
Labour planning variances and
the learning curve
Because of the learning effect,
the labour efficiency planning
variance will always be
favourable
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Knowledge diagnostic
1. Planning variances
Planning variances represent the difference between the original and revised budget.
2. Operational variances
Operational variances are those items which were within a manager’s control. They are the
difference between the revised budget and the actual.
3. Market size variance
When the sales budget is revised, a sales volume planning variance may be reported. This is the
difference in profit caused by the difference between the original sales budget and the revised
sales budget. This planning variance is called a market size variance.
4. Market share variance
When the sales budget is revised, a sales volume operational variance may be reported, for
which operational sales managers should be held responsible. This is the difference in profit
caused by the difference between actual sales volume and the sales volume in the revised sales
budget. This operational variance is called a market share variance.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q49
Examination
2
4 mins
Section A Q50
Examination
2
4 mins
Section A Q51
Examination
2
4 mins
Section C ‘Truffle Co’
Examination
20
36 mins
Further reading
N/A
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Activity answers
Activity 1: Material planning and operational variances
1
The correct answer is:
(a) Material price planning variance
Original standard price per kg
Revised standard price per kg
Material price planning variance
× actual quantity of materials used
$9.00
$9.30
$0.30 (A)
× 54,000 kg
$16,200 (A)
(b) Material usage planning variance
$
502,200
(513,000)
(2) 54,000 kg should now cost @ $9.30
(3) 54,000 kg did cost @ $9.50
10,800 (A)
(c) Material usage operational variance
Kg
56,000
(53,200)
2,800
(1) 14,000 units should use @ 4kg
(2) 14,000 units should now use @ 3.8kg
Valued at original standard cost $9
$25,200 (F)
(d) Material usage operational variance
Kg
(2) 14,000 units should now use @ 3.8kg
53,200
(3) 14,000 units did use
(54,000)
(800)
@ original standard cost $9
2
($7,200) (A)
The correct answer is:
Only the material usage variances are relevant for consideration of the performance of the
production manager. There is a total favourable usage variance of $18,000 during the period. If
we only consider the total variance it would appear that the production manager had performed
well in managing to produce the recliners using less materials. However, we need to strip out the
impact of the decision to purchase better quality materials in order to appraise their true
performance.
The better quality materials accounted for the favourable variance; however, the material usage
operational variance was adverse. This means that the production manager was not able to stick
to the revised standard quantity of 3.8kg per chair. This could be because the standard was too
challenging or because of a lack of effort controlling efficiency. More information would be
needed to establish which was the case but, overall, the production manager has not been able to
achieve the efficiency savings anticipated.
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Activity 2: Market size and market share variances
The correct answer is:
(a) only
In a competitive market, the sales team are in a position to influence the market share, for
example through advertising, sales promotion and pricing policy. As it is controllable a change in
market share forms the operating variance. However, the size of the overall market is not going to
be controllable by one company and so this is part of the planning variance.
Activity 3: Sales planning and operational variances
The correct answer is:
The sales volume planning variance was adverse
The sales volume operational variance was favourable
Sales volume variances
Revised sales volume
4,500 units
Original budgeted sales volume
5,000 units
Sales volume planning variance in units of sales
500 units (A)
× standard contribution per unit
× $8.60
Sales volume planning variance in $
$4,300 (A)
Operational
(2) Should now
(3) Did
Revised budget sales
Actual sales
@ original standard contribution / unit $8.60
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Units
4,500
5,100
600 (F)
5,160 (F)
Skills checkpoint 4
Effective use of
spreadsheets
Chapter overview
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
ly sis
How to
approach
your PM
exam
Performance
management
questions
ti m
an a
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
r planning
Answe
an
en
cal
e ri
en
em
tn
ag
um
em
Effective
use of
spreadsheets
t
Effi
ci
Effe cti
ve writing
a nd p r
esentation
Introduction
The spreadsheet is one of the response options available in the constructed workspace for Section
C questions. The PM syllabus area ‘Budgetary control’ is commonly assessed through variance
calculations and you are likely to be provided with a spreadsheet for these questions. It is
imperative that you know how to use the spreadsheet functions to prepare accurate and easy to
follow variance calculations. Efficient use of the spreadsheets will save valuable time, which you
can then use to address the discursive elements. In the case of variance questions, there will
usually be marks for both calculation and discussion within a Section C question and both must
be answered within the allotted 36 minutes.
Effective use of spreadsheets
The key steps in applying this skill are outlined below and will be explained in more detail in the
following sections as the past exam question, ‘Kappa’ is answered.
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STEP 1:
Use standard variance calculation proformas. These will help the marker to
understand your workings and allocate the marks easily. It will also help you to
work through the figures in a methodical and time-efficient way, for example by
calculating total figures.
STEP 2:
Input easy numbers from the question directly onto your proformas. This will make
sure that you pick up as many easy marks as possible before dealing with more
complex figures. It will also enable you to score method marks if you make a minor
mistake.
STEP 3:
Always use formulae to perform calculations. Do not waste time doing calculations
manually when the spreadsheet can do them for you.
STEP 4:
Show clear workings for any complex calculations.
More complex calculations such as standard mix of actual sales will require a
separate working. Keep your workings as clear and simple as possible and ensure
they are cross-referenced to your proforma.
Exam success skills
The following question is an extract from a past exam question worth 11 marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in a Section C
question to feel over-whelming. Active reading is a useful technique to use to avoid this. This
involves focusing on the requirement first, on the basis that until you have done this, the detail
in the question will have little meaning.
This is especially important in variance questions where you need to clearly identify the ‘should‘
and the ‘did‘ amounts and in the case of planning and operational variances the ‘should now’ too.
• Correct interpretation of requirements. At first glance, it looks like part (i) of the following
question is just asking for the usage variance of each ingredient, but it also requires the total
usage variance.
• Efficient numerical analysis. The key to success here is applying a sensible proforma for
typical variance calculations, backed up by clear, referenced, workings wherever needed.
Learning a standard proforma layout will save time and reduce the amount of planning and
thinking required in the exam.
• Utilise the spreadsheet functionality. Do not waste time doing calculations manually when the
spreadsheet can do them for you.
Skill activity
Kappa Co produces Omega, an animal feed made by mixing and heating three ingredients:
Alpha, Beta and Gamma.
The company uses a standard costing system to monitor its costs.
The standard material cost for 100kg of Omega is as follows:
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Input
Kg
Alpha
Beta
Gamma
Total
40
60
20
120
Cost per kg
$
2.00
5.00
1.00
Cost per 100kg
of Omega
$
80.00
300.00
20.00
400.00
Notes
(a) The mixing and heating process is subject to a standard evaporation loss.
(b) Alpha, Beta and Gamma are agricultural products and their quality and price vary
significantly from year to year. Standard prices are set at the average market price over the
last five years. Kappa Co has a purchasing manager who is responsible for pricing and
supplier contracts.
(c) The standard mix is set by the finance department. The last time this was done was at the
product launch, which was five years ago. It has not changed since.
Last month 4,600kg of Omega was produced, using the following inputs:
Input
Alpha
Beta
Gamma
Kg
2,200
2,500
920
5,620
Cost per kg
$
1.80
6.00
1.00
Total cost
$
3,960
15,000
920
19,880
At the end of each month, the production manager receives a standard cost operating statement
from Kappa Co’s performance manager. The statement contains material price and usage
variances, labour rate and efficiency variances, and overhead expenditure and efficiency
variances for the previous month. No commentary on the variances is given and the production
manager receives no other feedback on the efficiency of the Omega process.
Required
Calculate the following variances for the last month:
(a) The material usage variance for each ingredient and in total (4 marks)
(b) The total material mix variance(4 marks)
(c) The total material yield variance(3 marks)
STEP 1
Use standard variance calculation proformas. These will help the marker to understand your workings and
allocate the marks easily. It will also help you to work through the figures in a methodical and time-efficient
way, for example by calculating total figures.
This is an 11-mark question and, at 1.8 minutes a mark, should take approximately 20 minutes.
Using a standard variance proforma will help you to work through the information in the question
in a methodical, time efficient way. Your proforma should look like this:
STEP 2
Input easy numbers from the question directly onto your proformas. This will make sure that you pick up as
many easy marks as possible before dealing with more complex figures. It will also enable you to score
method marks if you make a minor mistake.
There are some easy numbers from the question that you can put straight onto your proforma
such as the actual quantity of materials used and the standard cost per unit. Using the proforma
will ensure that you can quickly and efficiently organise your thoughts in the exam and extract
the right information from the scenario.
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STEP 3
Always use formulae to perform basic calculations. Do not waste time doing calculations manually when
the spreadsheet can do them for you.
For example, you can use the sum formula to give the total usage variance once you have
calculated the individual usage variances.
This will be quicker than adding the figures with a calculator.
Examples of the formulae you would use are shown below:
STEP 4
Show clear workings for any complex calculations.
More complex calculations such as standard mix of actual usage will require a separate working. Keep your
workings as clear and simple as possible and ensure they are cross-referenced to your proforma.
For example, you could prepare a working to show the actual usage in the standard mix. This
could look like the following:
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A
10
B
C
D
E
F
G
H
11
12
13
ii) Material mix variance
Actual
usage
14
15
16
17
18
19
20
Kg
Alpha
Beta
Gamma
21
A
Actual
Variance Std
$
usage in
cost/kg
std mix
Kg
Kg
2200 1,873.33
326.67
2
653.33 Adverse
2500 2,810.00 - 310.00
5 - 1,550.00 Favourable
920
936.67 16.67
1 16.67 Favourable
5620
5620
- 913.33 Favourable
22 Working - actual usage in std mix:
B
23
24 Alpha
25 Beta
26 Gamma
27
28
=(40/120)*C20
=(60/120)*C20
=(20/120)*C20
=SUM(B24:B26)
Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the ‘Kappa’ activity to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Managing information
Did you identify the correct standard cost per unit?
Correct interpretation of
requirements
You need to calculate six variances.
Did you remember to calculate the total usage variance?
Efficient numerical analysis
Did your answer present a neat set of variances in a proforma
that would have been easy for a marker to follow?
Good time management
Did you manage your time to ensure you completed the
variance calculations in the time available, leaving yourself
enough time to attempt the discursive elements?
Most important action points to apply to your next question
We have shown you an example of a variance question which uses a spreadsheet but there are
other types of question that may require you to use a spreadsheet too. Here are some general tips
on using the spreadsheet.
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(a) Label your numbers so that the examiner can see what you mean.
This is particularly important for variance questions. The examiner needs to know what you are
calculating!
A list of labels in a column with the numbers in the next column is generally better than a column
for each label and one row of numbers.
A
1
B
C
2 Number of rooms
3 Number of nights
4 Total room nights
5 Occupancy rate
6 Total nights occupied
7 Rate per night
8 Total room revenue
A
B
120
31
3720
50%
1860
70
130200
C
D
E
F
G
H
1 Number of Number of Total room Occupancy Total night Rate per n Total room revenue
2
120
3
31
3720
50%
1860
70
130200
(b) Ensure the numbers are in a separate cell from the label.
This makes the numbers easier to mark for the examiner as well as making it possible to use
spreadsheet formulae for any necessary calculations.
1
A
B
2 Total nights occupied
3 Rate per night
4 Total room revenue
386
C
1
1,860
70
130200
A
B
2 Total nights occupied 1,860
3 Rate per night 70
4 Total room revenue 130200
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(c) Always use formulae to perform calculations.
It is generally better to use a column to do this. Do not write out your working (eg 800700+400=600) in a single cell because it wastes time and you may make a mistake. Use the
spreadsheet functions instead! You can always double check your answer on your calculator.
1
A
2 Total nights occupied
3 Rate per night
4 Total room revenue
B
C
1860
70
=C2*C3
The total room revenue is showing as 130200
and when the examiner clicks on the cell C4,
they can see the formula as shown above.
1
A
B
C
2 Total nights occupied 1,860
3 Rate per night 70
4 Total room revenue = 1860*70=1302000
The student here has not used the
spreadsheet formula and has wasted time
typing 1860*70. They have then made a
mistake writing down the answer and have
added an extra zero.
(d) Make efficient use of the SUM function
If some of the numbers in a list need to be deducted, enter a minus sign for these and then use the
‘SUM’ formula to add all of the numbers together. Type ‘=sum(‘ then select the cells you want to
add together with your mouse and press return. This is quicker than entering = A1-A2+A3 and so
on, and you are less likely to make a mistake.
A
1 Incremental running
2
3 Less manager’s salary
4 Less chef’s salary
5
B
$
120000
-2500
-200
=SUM(B2:B4)
A
1 Incremental running
2
C
120000
3 Less manager’s salary 2500
4 Less chef’s salary
2000
=B2-B3+B4
Here, the student has wasted time trying to
add and deduct each cell instead of using the
SUM function. They have also made a mistake
and added B4 instead of deducting it.
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(e) Cross reference any workings using ‘=‘ rather than re-typing the numbers
A
B
1 Material mix variance
C
D
E
Variance
kg
Std cost
per kg
$
2
5
1
F
2
3
4
5
6 Alpha
7 Beta
8 Gamma
9
10
Std usage for
actual output
(W1)
=D14
=D15
=D16
=SUM(B6:B8)
Actual
usage
2200
=B6-C6
2500
=B7-C7
920
=B8-C8
=SUM(C6:C8)
=40/100
=60/100
=20/100
4600
4600
4600
Variance
$
=D6*E6
=D7*E7
=D8*E8
=SUM(F6:F8)
11
1 2 Workings
13 1
1 4 Alpha
1 5 Beta
1 6 Gamma
=B14*C14
=B15*C15
=B16*C16
Here, the student has worked out the standard usage for actual output in cells D14 to D16.
Then, instead of typing the standard usage into cells B6 to B8, they have used the spreadsheet
function ‘=‘ to pick up the numbers. This ensures that the examiner can see exactly where the
numbers have come from, and also reduces the chances of making a mistake.
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A
B
C
1 Material mix variance
D
E
F
G
2
3
Std usage for Actual Variance Std cost Variance
actual output usage kg
per kg $
(W1)
$
1840
2200
-360
2
-720 A
2760
2500
260
5
1300 F
9200
920
8280
1
8280
13800
5620
8860 F
4
5
6 Alpha
7 Beta
8 Gamma
9
10
11
1 2 Workings
13
1 4 Alpha
1 5 Beta
1 6 Gamma
1
0.4
0.6
0.2
4600
4600
4600
1840
2760
920
Here, the student has typed the standard usage into cells B6 to B8 and has made a mistake.
(f)
Does your answer look reasonable?
Have you used some numbers in thousands and some in hundreds? Take a moment to look at your
answers and see whether any of the numbers look odd. If they do, re-check your calculations. If
your calculations are correct, then it is likely that these ‘odd‘ numbers need to be discussed. For
example, in a performance management question, you may calculate a very high receivables
days ratio for one of the divisions. This implies that the division is not collecting its debts
efficiently.
Summary
Section C of the PM exam could contain a question that focuses on variance analysis and asks
you to perform mix and yield variance calculations or planning and operational variance
calculations.
This is a commonly examined type of calculation question and it is important that you know the
proformas so that you can quickly and accurately populate them so that you have sufficient time
to complete the discussion elements of the question too. You will get credit for discussion based on
your own numbers, even if they are incorrect, but it is obviously better if your numbers are
accurate.
You therefore need to ensure that you:
• Use clear, standard proformas to performance variance calculations.
• Use spreadsheet formulae to perform basic calculations.
• Score well on the easier parts of the question.
• Allow sufficient time for discussion elements.
Note that there is detailed commentary on the use of spreadsheets for the Mar/Jun 19 sample
question ‘Belton Park’, found on the ACCA website. You should read this to build on the skills
discussed in this Checkpoint.
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Performance analysis
and behavioural aspects
18
18
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Discuss the issues surrounding setting the
difficulty level for a budget.
D1 (g)
Explain the benefits and difficulties of the
participation of employees in the negotiations
of targets.
D1 (h)
Analyse and evaluate past performance using
the results of variance analysis.
D7 (a)
Use variance analysis to assess how future
performance of an organisation or business
can be improved.
D7 (b)
Identify the factors which influence behaviour.
D7 (c)
Discuss the effect that variances have on staff
motivation and action.
D7 (d)
Describe the dysfunctional nature of some
variances in the modern environment of justin-time (JIT) and total quality management
(TQM).
D7 (e)
Discuss the behavioural problems resulting
from using standard costs in rapidly changing
environments
D7 (f)
18
Exam context
In this chapter we discuss the effects of standard costing and variance reporting on management
and employee behaviour.
We also discuss the problems of using standard costing in the modern, rapidly changing business
environment.
18
The behavioural aspects of performance analysis and variances may form the discussion part of
a Section C question, but you should also be prepared for a Section A question, or Section B case
questions, on any of the topics in this chapter.
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Chapter overview
Performance analysis and behavioural aspects
Using variance analysis
Setting the difficulty level for a budget
The effect of reported variances on staff action
Participation
in budgeting
Standard costing in
the modern environment
Bottom-up budgeting
Just-in-time (JIT)
Top-down budgeting
Total quality management (TQM)
The modern business environment
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1 Using variance analysis
Variance analysis is used to analyse and evaluate past performance.
It is also used for 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.
The appropriate use of control information depends not only on the content of the information
itself but also the behaviour of its recipients. Problems can arise because of the following:
(a) The managers who set the budget or standards are often not the managers who are then
made responsible for achieving budget targets.
(b) The goals of the organisation as a whole, as expressed in a budget, may not coincide with
the personal aspirations of individual managers.
(c) 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.
Essential reading
See Chapter 15 Section 1 of the Essential reading for more detail on using variance analysis.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2 Setting the difficulty level for a budget
Budgets can motivate managers to achieve a high level of performance or they can demotivate
managers depending on the difficulty level.
(a) A demotivating effect is likely where an ideal standard of performance is set (all efficiency
variances will be adverse).
(b) A low standard of efficiency is also demotivating (no sense of achievement and no incentive
to try harder).
(c) A budgeted level of attainment could be the same as the level that has been achieved in the
past (but might encourage budgetary slack).
Individual aspirations might be much higher or much lower than the organisation’s aspirations.
The solution might be to have two budgets.
• A budget for planning and decision-making based on reasonable expectations
• A budget for motivational purposes, with more difficult targets of performance
These two budgets might be called an ‘expectations budget‘ and an ‘aspirations budget‘
respectively.
Similarly, the level of difficulty in a standard cost may vary.
Type of standard
Ideal
This is a standard of performance that
assumes the highest possible level of
achievement. This can be demotivating for the
managers responsible for performance.
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Type of standard
Target
This is a standard cost that sets performance
targets at a higher level than is currently
being achieved yet is realistic. Improvements
in performance will be needed to turn adverse
variances into favourable variances. An
incentive scheme may be needed to persuade
managers to ‘buy in’ to the target standard.
Currently attainable
This standard is based on levels of
performance that are currently being
achieved. They provide no incentive to
improve performance but may prevent
deterioration in performance.
Basic standard
This is an original standard that is unchanged
over a long period of time. It is used to
measure trends and changes in performance
standards over time. It is not useful for control
purposes.
2.1 The effect of reported variances on staff action
Reported variances, if significant and adverse, should prompt managers into taking control action
to improve performance. The success of a variance reporting system in achieving this objective
will depend on several factors.
(a) The manager who is considered responsible for the variance should agree and accept that
the cause of the variance is their responsibility. Variances should be reported to the
appropriate manager. The manager must believe that the cause of the variance is something
that they are in a position to control.
(b) The manager should consider the reported variance to be ‘fair’. Variances should be a
realistic measure. This is why separating planning variances from operational variances is
useful.
(c) The manager should want to do something to deal with the causes of the variance. Incentives
and motivation are important factors.
(d) Variances should be reported in a timely manner. If a reported variance relates to events that
occurred a long time ago, managers will be reluctant to investigate them ‘now’ because the
variance will seem out of date.
The control culture within the organisation may also affect the response of managers to
variances. If there is a ‘blame culture’, managers will be blamed for adverse variances and
accused of poor performance. This is likely to 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. Managers are not blamed for adverse variances, but
encouraged to look for suitable control measures whenever significant adverse variances occur.
3 Participation in budgeting
In Chapter 13 we briefly explained top-down budgeting (an imposed style of budgeting) and
bottom-up budgeting (a participative style of budgeting). You need to understand the benefits
and difficulties of participative budgeting.
3.1 Bottom-up budgeting
Participative budgets may be effective in the following circumstances:
• In well-established organisations
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•
•
•
•
In very large businesses
During periods of economic affluence
When operational managers have strong budgeting skills
When an organisation’s different units act autonomously
The advantages of participative budgets are as follows:
• They are based on information from employees most familiar with the department.
• Knowledge spread among several levels of management is pulled together.
• Morale and motivation are improved: employees feel more involved and that their opinions
matter to senior management.
• They increase operational managers’ commitment to organisational objectives.
• In general, they are more realistic.
• Co-ordination between units is improved.
• Specific resource requirements are included.
• Senior managers’ overview is mixed with operational level details.
There are, on the other hand, a number of disadvantages of participative budgets.
• They consume more time.
• When individuals are involved in negotiating their budget targets, they may want to set targets
that are easily attainable rather than targets that are challenging. In other words, an ability to
negotiate targets may tempt managers to introduce budgetary slack into their targets.
• Individuals may not properly understand the strategic and budgetary objectives of the
organisation, and they may argue for targets that are not in the best interests of the
organisation as a whole.
• Changes implemented by senior management may cause dissatisfaction if they seem to
ignore the opinions of employees who have been involved in negotiating targets.
• Budgets may be unachievable if managers are not sufficiently experienced or knowledgeable
to contribute usefully.
• They can support ‘empire building’ by subordinates.
• An earlier start to the budgeting process will be required, compared with top-down budgeting
and target setting.
3.2 Top down budgeting
The times when imposed budgets are effective are as follows.
• In newly formed organisations
• In very small businesses
• During periods of economic hardship
• When operational managers lack budgeting skills
• When an organisation’s different units require precise co-ordination
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
• Strategic plans are likely to be incorporated into planned activities.
• They enhance the co-ordination between the plans and objectives of divisions.
• They use senior management’s awareness of total resource availability.
• They decrease the input from inexperienced or uninformed lower-level employees.
• They decrease the period of time taken to draw up the budgets.
Disadvantages
• There may be dissatisfaction, defensiveness and low morale among employees.
• The feeling of team spirit may disappear.
• The acceptance of organisational goals and objectives could be limited.
• The feeling of the budget as a punitive device could arise.
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•
•
Unachievable budgets for overseas divisions could result if consideration is not given to local
operating and political environments.
Lower-level management initiative may be stifled.
4 Standard costing in the modern environment
Standard costing and variance analysis may sometimes be inappropriate in a production
environment based on just-in-time (JIT) methods or a total quality management (TQM) approach.
4.1 JIT
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 (WIP) and finished goods.
A JIT approach implies that if there are no sales orders, production resources should be kept idle.
In addition, as explained in the earlier chapter on the theory of constraints, 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.
(a) In JIT manufacturing, idle time should therefore be expected.
(b) In a system of standard costing, idle time is an adverse labour efficiency variance, and is
undesirable.
If 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.
4.2 Total quality management (TQM)
Total quality management (TQM) is a business philosophy aimed at improving quality.
4.2.1 Get it right, first time
The cost of preventing mistakes is less than the cost of correcting them if they occur.
4.2.2 Continuous improvement
Never be satisfied with current achievement. It is always possible to improve performance.
4.2.3 Goals of TQM
(a) To gain competitive advantage via continuously improved quality
(b) To continuously reduce the cost of providing enhanced quality
(c) Innovation
(d) Provide first class customer service
(e) To involve all employees
4.2.4 Design for quality
Design quality into an organisation’s products and operations from the outset.
(a) Reduce the number of parts in a product.
(b) Use components common to other products in the organisation.
(c) Improve physical characteristics to meet customers’ needs.
4.2.5 TQM and standard costing
(a) The philosophy in TQM of ‘right first time’ may be inconsistent with a standard cost that
includes an allowance for wastage. TQM is more consistent with environmental cost
accounting (material flow cost accounting) than a costing system that allows for normal loss
in the standard cost.
(b) 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. A standard cost is
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based on an assumption of a desirable steady state; this view is inconsistent with the
principle of continuous improvement.
4.3 The modern business environment
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.
Despite the criticisms and impacts, many businesses still operate with standard costing as it does
aid planning and control. Other non-financial measures should be used alongside it such as
punctual deliveries, customer satisfaction measures and so on.
Activity 1: TQM
The following statements have been made about the use of a TQM approach.
(a) Standard costing systems are not compatible with a TQM approach to operations.
(b) TQM can only be used in industries which operate in a rapidly changing environment.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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Chapter summary
Performance analysis and behavioural aspects
Using variance analysis
Setting the difficulty level for a budget
• Used to evaluate past performance
• Used to improve performance in the future
• Too difficult - demotivating
• Too easy - also demotivating and offers no
incentive
The effect of reported variances on staff action
• Managers need to accept and agree
responsibility
• Reported variance should be fair
• Should be an incentive to deal with cause of
variance
• Variances should be reported in a timely
manner
Participation
in budgeting
Standard costing in
the modern environment
Bottom-up budgeting
Just-in-time (JIT)
• Time consuming
• May not promote goal congruence
• Morale and motivation is improved
• Based on information from employees most
familiar with the department
• Production is managed on the principle that
items should not be produced until they are
required to meet sales orders
• Idle time should therefore be expected
Total quality management (TQM)
Top-down budgeting
• The acceptance of organisational goals and
objectives could be limited
• Lower-level management initiative may be
stifled
• Strategic plans are likely to be incorporated
into planned activities
• They use senior management's awareness of
total resource availability
• Get it right first time
• Continuous improvement
• Involve all employees
• Design for quality
The modern business environment
• Lower labour cost, higher overhead (than
traditional manufacturing)
• Rapidly changing environment/products
• Customised products
• Focus on quality
• JIT philosophy
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Knowledge diagnostic
1. Using variance analysis
Variance analysis is used to analyse and evaluate past performance. It is also used for 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.
Used correctly, a budgetary control and variance reporting system can motivate managers and
employees to improve performance, but it may also produce undesirable negative reactions.
2. Setting the difficulty level for a budget
The level of difficulty in a standard cost may range from very challenging to fairly undemanding:
standard costs may be ideal, or may establish either a target or a currently attainable level of
performance.
3. Participative budgeting
A budget can be set from the top down (imposed budget) or from the bottom up (participatory
budget).
4. Standard costing in the modern business environment
Standard costing and variance analysis may sometimes be inappropriate in a production
environment based on just-in-time (JIT) methods or a total quality management (TQM) approach.
The role of standards and variances in the rapidly changing modern business environment is
open to question.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q52
Examination
2
4 mins
Section A Q53
Examination
2
4 mins
Section A Q54
Examination
2
4 mins
Further reading
N/A
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Activity answers
Activity 1: TQM
The correct answer is:
(a) only
Standard costing systems are not compatible with a TQM approach to operations, as with
standard costing the aim is to achieve a standard cost, whereas with TQM the overriding
philosophy is ‘continuous improvement’. This means that reaching the standard would not be
sufficient in a TQM environment. TQM is not exclusively used in a rapidly changing environment; it
can also be applied to improve performance in a stable industry.
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Performance
measurement
19
19
Learning objectives
On completion of this chapter, you should be able to:
Syllabus reference no.
Describe, calculate and interpret financial
performance indicators (FPIs) for profitability,
liquidity and risk in both manufacturing and
service businesses. Suggest methods to
improve these measures.
E1 (a)
Describe, calculate and interpret non-financial
performance indicators (NFPIs) and suggest
methods to improve the performance
indicated.
E1 (b)
Analyse past performance and suggest ways
for improving financial and non-financial
performance.
E1 (c)
Explain the causes and problems created by
short-termism and financial manipulation of
results and suggest methods to encourage a
long-term view.
E1 (d)
Explain and interpret the balanced scorecard,
and the Building Block model proposed by
Fitzgerald and Moon.
E1 (e)
Discuss the difficulties of target setting in
qualitative areas.
E1 (f)
Performance analysis in not for profit
organisations and the public sector
E3
Describe, calculate and interpret non-financial
performance indicators (NFPIs) and suggest
methods to improve the performance
indicated.
E3(e)
Discuss the difficulties of target setting in
qualitative areas.
E3 (f)
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Syllabus reference no.
Analyse past performance and suggest ways
for improving financial and non-financial
performance.
E3 (g)
Explain the causes and problems created by
short-termism and financial manipulation of
results and suggest methods to encourage a
long-term view.
E3 (h)
19
Exam context
This chapter begins by introducing the term performance measurement and then describes
various performance measures that are used by organisations (other than variances).
It is important that the performance of an organisation is monitored; this is most commonly done
by calculating a number of ratios.
The chapter concludes by considering alternative views of performance measurement, such as
the balanced scorecard and building blocks, which offer a contrast to the more traditional
approaches to performance measurement.
19
You must be able to explain as well as calculate performance indicators and apply your analysis
to the organisation in the question. The organisations may be profit seeking or non-profit seeking.
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Chapter overview
Performance measurement
Performance
measurement
Ratios
Financial performance indicators
Profitability ratios
Limitations and
strengths of ratios
Gearing ratios
Non-financial performance
indicators (NFPIs)
Short-termism
Value of NFPIs
Improving
performance
Linking reasons for poor
performance with improving
performance
Problems with NFPIs
The balanced
scorecard
Building
block model
Target setting in
qualitative areas
Dimensions
Standards
Rewards
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1 Performance measurement
Performance measurement is a vital part of the planning and control process.
Performance measurement aims to establish how well something or somebody is doing in relation
to a plan.
Performance measures may be divided into two types:
• Financial performance indicators
• Non-financial performance indicators
1.1 Financial performance indicators
Analysis and interpretation of a company’s accounts will give an indication of the company’s
performance.
The aims would be to:
• Assess the company’s performance and financial position (in comparison with other
companies in the same industry)
• Try to assess the potential future performance or to identify weakness
1.1.1 Company performance assessment
This would usually involve:
(a) Ratio analysis
(b) Review of the accounts to highlight issues not disclosed by ratio analysis (eg contingent
liabilities)
(c) Review of the benefits/wealth from the point of view of the other stakeholders
(d) Analysis of other financial and non-financial information from external sources
1.1.2 Areas for analysis
(a) Profitability – how well a company performs, given its asset base
(b) Liquidity – short-term financial position
(c) Gearing – measure of risk
These areas can all be assessed using ratios but when presented with a set of accounts, you
should start by looking at obvious trends or changes in figures (you will normally be given figures
with some sort of comparative data).
Details of these ratios are provided in Section 2 of this chapter. You must ensure that you learn
these; however, the focus for PM is application.
1.1.3 Basis for comparison
(a) Over time
(b) With other companies
(c) With industry averages
(d) With other performance measures
Exam focus point
You need to be prepared for 20-mark Section C questions that provide you with data and ask
you to discuss ‘the organisation’s financial and non-financial performance‘. You will need to
calculate ratios and discuss what they mean, relating your answer to the scenario.
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2 Ratios
PER alert
One of the competencies needed to fulfil performance objective 14 of the PER is to identify and
use appropriate performance measurement techniques to assess aspects of performance
within the organisation. You can apply the knowledge you obtain from this section of the text
to help to demonstrate this competence.
2.1 Profitability ratios
Formula to learn
Return on capital employed (ROCE) = (profit before interest and tax / capital employed) ×
100%
Capital employed = total assets less current liabilities
ROCE
=
PBIT
Sales
×
Sales
Capital employed
Net profit
margin
Asset turnover
ROCE states profit as a percentage of capital employed and shows how well the business utilises
the funds invested in it.
There are three comparisons that can be made:
(a) The change in ROCE from year to year
(b) Comparison to other similar businesses
(c) Comparison to the market borrowing rate
Note. ROCE should be increasing. If it is static or reducing, it is important to determine whether
this is due to a reduced profit margin or asset turnover. If both profit margin and asset turnover
are deteriorating, the company has a profitability problem.
To improve a ratio, the company would need to investigate each element of the calculation to see
whether increasing or reducing the numbers would improve the result. For example, to improve
ROCE a company could look at the elements which make up the profit figure and look at ways to
increase sales revenue or reduce costs. Alternatively, they could look to improve the capital
employed figure by selling unused assets.
Net profit margin
Net profit
Sales × 100%
A high profit margin indicates that either sales prices are high or total costs are being kept well
under control.
This ratio could be improved by increasing the selling price (as long as sales volumes were not
compromised) or looking at ways to reduce costs.
Gross profit margin
(Sales− cost of sales)
× 100%
Sales
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A high gross profit margin also indicates that either sales prices are high or production costs are
being kept well under control.
Again, this ratio could be improved by increasing the selling price (as long as sales volumes were
not compromised) or looking at ways to reduce cost of sales.
Asset turnover
The ratio of sales turnover to the amount of capital employed
Sales
(Total assets−current liabilities)
This shows the turnover that is generated from each $1 worth of assets employed.
This ratio could be improved by increasing sales or reducing total assets or increasing current
liabilities.
2.1.1 Liquidity
A company can be profitable but at the same time get into cash flow problems. Liquidity ratios
(current and quick) and working capital turnover ratios give some idea of a company’s liquidity
and ability to generate cash from its business operations.
KEY
TERM
Liquidity: Liquidity is the amount of cash a company can obtain quickly to settle its debts
(and possibly to meet other unforeseen demands for cash payments too).
The current ratio is the standard test of liquidity, calculated by dividing the most liquid assets in
the business (receivables, inventories and cash) by the business’s payables.
Current assets
Current ratio = Current liabilities
A ratio comfortably in excess of one should be expected, but what is ‘comfortable’ varies between
different types of business.
The current ratio can be amended by excluding the inventory from the current assets. This gives
the quick ratio or acid test.
Formula to learn
Quick ratio =
Current assets−inventories
Current liabilities
For businesses with a fast inventory turnover, a quick ratio can be less than one without
suggesting that the company is in cash flow difficulties.
Do not forget the other side of the coin. The current ratio and the quick ratio can be bigger than
they should be. A company that has large volumes of inventories and receivables might be
overinvesting in working capital, and so tying up more funds in the business than it needs to. This
would suggest poor management of receivables or inventories by the company.
By calculating the following ratios, we can see how long a company holds inventory for, the length
of time it takes them to pay their suppliers, and the length of time it takes them to receive cash
from their customers:
1
Receivables period
Average receivables
Credit sales
× 365
=
days
2
Inventory period
Average finished goods
Cost of sales
× 365
=
days
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Payables period
Average payables
Credit purchases
× 365
=
days
Note. If average data is not available year-end values should be used.
The receivables period is a rough measure of the average length of time it takes for a company’s
accounts receivable to pay what they owe.
A lengthening inventory turnover period indicates:
(a) A slowdown in trading; or
(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive.
2.2 Gearing ratios
Formula to learn
Long - term debt
Gearing ratio = Long - term debt + equity (shareholders' funds)
Gearing measures the financial risk of a company.
Business risk refers to the variability in earnings which is due to the business activities of the
organisation. This can result from the organisation’s products, customers, suppliers or cost
structure.
Operating gearing is a ratio which is calculated to quantify business risk. It looks specifically at
the operating cost structure of the organisation.
Formula to learn
Contribution
Operating gearing = Profit before interest and tax (PBIT)
If operating gearing is high this indicates that a large proportion of the organisation’s operating
costs are fixed. Fixed costs make profit more volatile as PBIT becomes more vulnerable to
downturns in business volume.
Activity 1: Financial performance
1 Preston Financial Services is an accounting practice specialising in providing accounting and
taxation work for dentists and doctors. The clients are mainly wealthy, self-employed and have an
average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and
aggressive sole-practitioner. He feels that promotion of new products to his clients would be likely
to upset the conservative nature of his dentists and doctors and, as a result, the business has
been managed with similar products year on year.
You have been provided with financial information relating to the practice.
Financial information
Turnover ($’000)
Net profit ($’000)
Average cash balances ($’000)
Average trade receivables days (industry average 30 days)
Inflation rate (%)
Current year Previous year
945
900
187
180
21
20
18 days
22 days
3
3
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Required
Using the financial information above only, comment on the financial performance of the business
(briefly consider growth, profitability, liquidity and credit management).
Solution
1
3 Limitations and strengths of ratios
Limitations:
(a) Not useful on their own – need to be compared to yardstick
(b) Must be carefully defined
(c) Inflation needs to be adjusted for – often forgotten
(d) Different basis of calculating between companies
(e) Based on historical costs – but is this an accurate reflection of future?
Strengths:
(a) Easier to understand than absolute measures
(b) Easier to look at changes over time
(c) Puts performance into context
(d) Can be used as targets
(e) Summarise results
3.1 Other problems with financial performance indicators
(a) Focus only on variables which can be expressed in monetary terms ignoring other important
variables which cannot be expressed in monetary terms
(b) Focus on past
(c) Do not convey the full picture of a company’s performance in a modern business
environment, eg quality, customer satisfaction
(d) Focus on the short-term
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4 Non-financial performance indicators (NFPIs)
Non-financial performance indicators (NFPIs) are measures of performance based on nonfinancial information which operating departments use to monitor and control their activities.
Examples of NFPIs are summarised in the following table:
Area Assessed
Performance measures
Service Quality
Number of complaints
Proportion of repeat bookings
On-time deliveries
Customer waiting time
Personnel
Staff turnover
Days lost through absenteeism
Days lost through accidents/sickness
Training time per employee
Different industries will place a different weighting on each area depending on those most critical
to their success.
Essential reading
See Chapter 19 Section 1 of the Essential reading for more detail on NFPIs.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
4.1 Value of NFPIs
(a) Information can be provided quickly for managers (eg per shift, daily or hourly) unlike
traditional financial performance reports.
(b) Anything can be measured/compared if it is meaningful to do so.
(c) Easy to calculate and easier for non-financial managers to understand and use effectively
(d) Less likely to be manipulated than traditional profit related measures
(e) Can be quantitative or qualitative
(f) Provide information about key areas such as quality, customer satisfaction etc
(g) Better indicator of future prospects than financial indicators which focus on the short term
4.2 Problems with NFPIs
(a) Too many measures can lead to information overload for managers, providing information
which is not truly useful.
(b) May lead managers to pursue detailed operational goals at the expense of overall corporate
strategy
(c) Need to be linked with financial measures
(d) Need to be developed and refined over time to ensure remain relevant
Exam focus point
Note that many NFPIs can be used in not-for -profit and public sector organisations, too.
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5 Short-termism
KEY
TERM
Short-termism: Short-termism is when there is a bias towards short-term rather than longterm performance.
If a manager’s performance is measured on a short-term basis or a company is under pressure to
report positive growth, short-termism may occur.
Activity 2: Short-termism
The following are all decisions a manager could make:
(a) Postpone repairs/maintenance expenditure until the following year
(b) Reduce R&D expenditure
(c) Postpone recruitment of new staff
(d) Train staff to complete work faster
Required
Which of the above decisions are consequences of a bonus based on short-term profits?
 (a) and (b)
 (a) and (c)
 (a), (b) and (c)
 All of the above
Solution
Activity 3: Encouraging a long-term view
Required
Which of the following could be used to encourage managers to take decisions in the long-term
interests of the company?
(a) Link bonus to share price
(b) Link bonus to profit
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(c) Award bonus in shares rather than cash
 (a) and (b)
 (a) and (c)
 (b) and (c)
 (a) only
Solution
Essential reading
See Chapter 19 Section 2 of the Essential reading for more detail on methods to encourage a
long-term view.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
6 Improving performance
PER alert
One of the competencies needed to fulfil performance objective 14 of the PER is to advise on
appropriate ways to maintain and improve performance. You can apply the knowledge you
obtain from this section of the text to help to demonstrate this competence.
When performance is measured, the objectives should be to:
(a) Identify aspects of performance that may be a cause for concern
(b) Explain differences between actual performance and the plan or expectation, or
deteriorating performance over time
(c) Consider ways of taking control measures to improve performance
In an exam question on performance measurement, it is highly likely that you will be required to
do all three of these things in your answer.
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Essential reading
See Chapter 19 Section 3 of the Essential reading for more detail on objectives (a) and (b).
The Essential reading is available as an Appendix of the digital edition of the Workbook.
6.1 Linking reasons for poor performance with improving performance
Having identified reasons for poor performance, whether financial or non-financial, the final step
is to consider and implement methods of improving performance. Methods of improving
performance should be linked to the possible reasons for the poor performance.
The aim of corrective measures should be to tackle the problems that are the cause of the poor
performance.
Illustrative control measures are shown in the following table:
Aspect of performance
Possible reasons
Possible measures to
improve performance
Increase in rejection rates for
faulty products
Using relatively inexperienced
staff to do the work
Using cheaper materials (to
save money)
Hire more experienced staff
Provide training
Switch back to better-quality
materials
Increase in time between
taking a customer order and
delivering the product to the
customer
Administrative delays in
processing customer orders
Review procedures and
remove any unnecessary
administrative tasks such as
duplication of paperwork
Increase in frequency of
machine breakdowns
Reduction on amount of
routine maintenance work
Increase routine maintenance
of machines
Customer dissatisfaction with
online sales service
Poor website design
Redesign the website. Hire
web design specialists if
necessary
Longer average time to
answer customer calls in a
call centre
Reduction in number of call
centre staff
Employ more staff
Declining labour productivity
Failure to train staff
Increase in complexity of the
work
Use of inexperienced staff
Hire more experienced staff
Provide training
Give the most complex tasks
to specialist staff
Some structured approaches to performance measurement have been developed, which combine
measurements of financial and non-financial performance. Two of these are described in the next
sections.
Activity 4: Improving performance (ACCA 6/08 amended)
1 Bridgewater Co provides training courses for many of the mainstream software packages on the
market.
The business has many divisions within Waterland, the one country in which it operates. The
senior managers of Bridgewater Co have very clear objectives for the divisions and these are
communicated to divisional managers on appointment and subsequently in quarterly and annual
reviews. These are:
• Each quarter, sales should grow and annual sales should exceed budget
• Trainer (lecture staff) costs should not exceed $180 per teaching day
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• Room hire costs should not exceed $90 per teaching day
• Each division should meet its budget for profit per quarter and annually
It is known that managers will be promoted based on their ability to meet these targets. A member
of the senior management is to retire after Quarter 2 of the current financial year, which has just
begun. The divisional managers anticipate that one of them may be promoted at the beginning of
Quarter 3 if their performance is good enough.
The current quarterly forecasts, along with the original budgeted profit for the Northwest division,
are as follows:
Sales
Less:
Trainers
Room hire
Staff training
Other costs
Forecast new
profit
Original
budgeted
profit
Annual sales
budget
Teaching days
Q1
$’000
40.0
Q2
$’000
36.0
Q3
$’000
50.0
Q4
$’000
60.0
Q5
$’000
186.0
8.0
4.0
1.0
3.0
24.0
7.2
3.6
1.0
1.7
22.5
10.0
5.0
1.0
6.0
28.0
12.0
6.0
1.0
7.0
34.0
37.2
18.6
4.0
17.7
108.5
25.0
26.0
27.0
28.0
106.0
180.0
40
36
50
60
The manager of the Northwest division has been considering a few steps to improve the
performance of his division.
Voucher scheme
As a sales promotion, vouchers will be sold for $125 each, a substantial discount on normal prices.
These vouchers will entitle the holder to attend four training sessions on software of their choice.
They can attend when they want to but are advised that one training session per quarter is
sensible. The manager is confident that if the promotion took place immediately, he could sell 80
vouchers and that customers would follow the advice given to attend one session per quarter. All
voucher holders would attend planned existing courses and all will be new customers.
Software upgrade
A new important software programme has recently been launched for which there could be a
market for training courses. Demonstration programs can be bought for $1,800 in Quarter 1. Staff
training would be needed, costing $500 in each of Quarters 1 and 2 but in Quarters 3 and 4 extra
courses could be offered selling this training.
Assuming similar class sizes and the usual sales prices, extra sales revenue amounting to 20% of
normal sales are expected (measured before the voucher promotion above). The manager is keen
to run these courses at the same tutorial and room standards as he normally provides. Software
expenditure is written off in the income statement as incurred.
Delaying payments to trainers
The manager is considering delaying payment to the trainers. He intends to delay payment on
50% of all invoices received from the trainers in the first two quarters, paying them one month
later than is usual.
The revised forecast would be:
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Revised forecasts
Existing sales
Voucher sales
($125 ×
80/4)
Software
training
Less:
Existing trainer
costs
Additional
training
costs ($200
× teaching
days)
Room hire
Additional
room hire
($100 ×
teaching
days)
Staff training
Additional
staff
training
Other costs
Software
Forecast net
profit
Original
budget
profit
Q1
$’000
40.0
2.5
Q2
$’000
36.0
2.5
Q3
$’000
50.0
2.5
Q4
$’000
60.0
2.5
Total
$’000
186.0
10.0
10.0
12.0
22.0
42.5
38.5
62.5
74.5
218.0
8.0
7.2
10.0
12.0
37.2
2.0
2.4
4.4
4.0
3.6
5.0
1.0
6.0
1.2
18.6
2.2
1.0
0.5
1.0
0.5
1.0
1.0
4.0
1
3.0
1.8
1.7
6.0
7.0
17.7
1.8
24.2
24.5
37.5
44.9
131.1
25.0
26.0
27.0
28.0
106.0
Required
Comment on whether each of the proposed steps by the manager will improve the manager’s
chances of promotion.
Solution
1
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7 The balanced scorecard
A popular approach in current management thinking to performance measurement (for service
and non-service organisations) is the use of a ‘balanced scorecard’, consisting of a variety of
indicators, both financial and non-financial. It is commonly used in not for profit organisations
and the public sector.
The balanced scorecard focuses on four different perspectives and aims to establish goals for
each together with measures which can be used to evaluate whether these goals have been
achieved.
How do we create value for our shareholders?
Financial
perspective
Goals
Measures
How do customers see us?
What must we excel at?
Customer
perspective
Internal business
perspective
Goals
Measures
Goals
Measures
Innovation and
learning perspective
Goals
Measures
Can we continue to improve
and create value?
Features:
(a) Traditional measures are mainly inward looking and narrow in focus with over emphasis on
financial measures and short-term goals.
(b) The balanced scorecard focuses on both internal and external factors and links performance
measures to key elements of a company’s strategy.
(c) It requires a balanced consideration of both financial and non-financial measures and goals
to prevent improvements being made in one area at the expense of another.
(d) It attempts to identify the needs and concerns of customers. This information can then be
used to identify new products and markets. Comparison with competitors can be made in
order to establish best practice.
Activity 5: Balanced scorecard
The following statements have been made about the use of the balanced scorecard:
(a) Percentage of customers ordering a dessert could be used as a measure of customer
satisfaction for a restaurant.
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(b) Percentage of revenue from meals sold from the specials board could be used as a measure
of innovation for a restaurant.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
Activity 6: Analysing performance
1 Preston Financial Services is an accounting practice. The business specialises in providing
accounting and taxation work for dentists and doctors. The clients are mainly wealthy, selfemployed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and
aggressive sole practitioner. He feels that promotion of new products to his clients would be likely
to upset the conservative nature of his dentists and doctors and, as a result, the business has
been managed with similar products year on year.
You have been provided with financial information relating to the practice.
Financial information
Turnover ($’000)
Net profit ($’000)
Average cash balances ($’000)
Average trade receivables days (industry average 30 days)
Inflation rate (%)
Current year Previous year
945
900
187
180
21
20
18 days
22 days
3
3
You have also been provided with non-financial information which is based on the balanced
scorecard format.
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Balanced scorecard (extract)
Internal business processes
Error rates in jobs done
Average job completion time
Current year
16%
7 weeks
Previous year
10%
10 weeks
Current year
1,220
775
14%
Previous year
1,500
600
20%
Customer knowledge
Number of customers
Average fee levels ($)
Market share
Learning and growth
Percentage of revenue from non-core work
Industry average of the proportion of revenue from non-core
work in accounting practices
Employee retention rate
Current year Previous year
4%
5%
30%
25%
60%
80%
Notes
(a) Error rates measure the number of jobs with mistakes made by staff as a proportion of the
number of clients serviced.
(b) Core work is defined as accountancy and taxation. Non-core work is defined primarily as
pension advice and business consultancy. Non-core work traditionally has a high margin.
Required
Using the data given in the balanced scorecard, extract comment on the performance of the
business. Include comments on internal business processes, customer knowledge and
learning/growth, separately, and provide a concluding comment on the overall performance of
the business.
Solution
1
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Essential reading
See Chapter 19 Section 4 of the Essential reading for more detail on the balanced scorecard.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
8 Building block model
Performance measurement in service businesses has sometimes been perceived as more difficult
than in manufacturing businesses.
Fitzgerald and Moon (1996) suggest that a performance management system in a service
organisation can be analysed as a combination of three building blocks.
• Dimensions of performance
• Standards
• Rewards
Dimensions of performance
Profit
Competitiveness
Quality
Resource utilisation
Flexibility
Innovation
Standards
Rewards
Ownership
Achievability
Equity
Clarity
Motivation
Controllability
This framework is also known as the results and determinants framework.
PER alert
One of the competencies needed to fulfil performance objective 14 of the PER is to use review
and reward systems to monitor and assess performance. You can apply the knowledge you
obtain from this section of the text to help to demonstrate this competence.
8.1 Dimensions
Performance of the organisation is viewed over six dimensions, the first two listed on the diagram;
Profit and Competitiveness are the results of the other four determinants:
(a) Quality – being reliability, courtesy, competence and availability
(b) Flexibility – the ability to deliver at the right time, response to customer requirements and
changes in demand
(c) Resourceutilisation – best use of inputs to create outputs. This is usually measured in terms
of productivity
(d) Innovation – ability to develop new products or services, move into new markets and
continuous improvement
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8.2 Standards
The second part of Fitzgerald and Moon’s framework for performance measurement concerns
setting the standards or targets of performance, once the measures for the dimensions of
performance have been selected.
There are three aspects to setting standards of performance:
• Individuals need to feel that they ‘own’ the standards and targets for which they will be made
responsible.
• Individuals also need to feel that the targets or standards are realistic and achievable.
• The standards and targets should be seen as ‘fair’ and equitable for all the managers in the
organisation.
8.3 Rewards
The third aspect of Fitzgerald and Moon’s performance measurement framework is rewards. This
refers to the structure of the rewards system, and how individuals will be rewarded for the
successful achievement of performance targets.
There are three aspects to consider in a reward system:
• The system of setting targets and rewarding individuals for achieving the targets should be
clear. Clarity will improve motivation to achieve the targets.
• Achievement of performance targets should be suitably rewarded.
• Individuals should be made responsible only for aspects of performance that they are in a
position to control.
Essential reading
See Chapter 19 Section 5 of the Essential reading for more detail on Fitzgerald and Moon’s
building blocks.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Activity 7: Performance measures
The following statements have been made about performance measurements:
(a) Non-financial performance measures are important because they can provide a good
indication of future financial prospects.
(b) A problem with using multiple measures of performance is that the organisation may lose
sight of its overall aim.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
Solution
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9 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. This presumes that all key non-financial aspects of performance can be measured
and quantified.
In practice, this is not necessarily the case. There are several problems with qualitative nonfinancial performance targets.
(a) Difficulties selecting a suitable performance measure
For example, an important objective for an organisation may be winning and retaining customer
loyalty. But how is a reliable target for customer loyalty decided?
• Opinion research by a market research firm and setting a ‘target score for loyalty’?
• The percentage of customers who make a repeat order within x months?
Similarly, a performance objective may be to deliver a high standard of service to a customer, but
how is service quality defined? Having defined service quality, how is it measured?
(b) Qualitative data is not quantified
At best, qualitative measures are converted into quantitative measures using a subjective scoring
system. When performance is not quantified, it is difficult to target and monitor.
(c) Lack of information system
An organisation may have a well-established system for measuring quantitative data, especially
in the areas of accounting and sales statistics. It is much less likely to have a reliable and
comprehensive system for collecting data about qualitative aspects of performance.
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Chapter summary
Performance measurement
Performance
measurement
Ratios
Limitations and
strengths of ratios
Profitability ratios
Financial performance indicators
• Ratio analysis
• Profitability
• Liquidity
• Gearing
• ROCE = (PBIT/Capital
employed) × 100%
• Net profit margin = (Net profit/
Sales) × 100%
• Gross profit margin = [(Sales –
cost of sales)/ sales] × 100%
• Asset turnover = (Sales/total
assets – current liabilities)
• Liquidity ratios
– Current ratio = current
assets/current liabilities
– Quick ratio = current assets inventories/current liabilities
• Working capital ratios
– Receivables period =
(Average receivables/credit
sales) x 365 days
– Inventory period = (Average
finished goods/cost of sales)
x 365 days
– Payables period = (Average
payables/credit purchases) x
365 days
• Not useful on their own – need
to be compared to yardstick
• Focus on past
• Focus on the short term
• Ignore important variables
which cannot be expressed in
monetary terms
• Easier to understand than
absolute measures
• Easier to look at changes over
time
• Can be used as targets
Gearing ratios
• Gearing ratio = Long-term
debt/(Long term debt + equity)
• Operating gearing ratio =
Contribution/ PBIT
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Non-financial performance
indicators (NFPIs)
Value of NFPIs
• Can measure anything
• Quantitative and qualitative
• Gather information on key
areas eg quality, customers,
employees
• Good indicator of future
prospects
Short-termism
Improving
performance
Focus on short term goals at the
expense of long term goals
• Identify aspects of
performance that may be a
cause for concern
• Explain differences between
actual performance and the
plan or expectation, or
deteriorating performance over
time
• Consider ways of taking
control measures to improve
performance
Problems with NFPIs
• Can provide too much
information
• Can forget overall goal
Linking reasons for poor
performance with improving
performance
Methods of improving
performance should be linked to
the possible reasons for the poor
performance
The balanced
scorecard
• Enables focus on both internal
and external factors and on
key elements of business
strategy
• Four dimensions are:
– Customer
– Internal business
– Financial
– Innovation and learning
Building
block model
Dimensions
• Profit
• Competitiveness
• Quality
• Resource utilisation
• Flexibility
• Innovation
Standards
• Ownership
• Achievability
• Equity
Rewards
• Clarity
• Motivation
• Controllability
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Target setting in
qualitative areas
• Problems with qualitative
non-financial performance
targets:
– Difficulties selecting a
suitable performance
measure
– Qualitative data is not
quantified
– Lack of information system
Knowledge diagnostic
1. Performance measurement
Performance of a business can be evaluated by financial indicators.
Financial indicators focus on the past and are short-term measures; as such, non-financial
indicators also need to be used. A balance is needed between both.
2. Limitations and strengths of ratios
Whilst ratios are very helpful as a target and a means of assessing performance, they should not
be used on their own. They only focus on the past and monetary measures and are very often
short term.
3. Non-financial performance indicators
These measures when used in conjunction with financial measures enable the whole picture to be
seen. They can be quantitative or qualitative. Anything that is important to the business can be
measured and these ratios are not easily manipulated.
4. The balanced scorecard
Tools such as the balanced scorecard help to evaluate a business by looking at all key areas using
a variety of financial and non-financial indicators.
The four key areas are:
• Customer
• Financial
• Internal
• Innovation and learning
5. Building block model
Fitzgerald and Moon’s building blocks for dimensions, standards and rewards attempt to
overcome the problems associated with performance measurement of service businesses.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q55
Examination
2
4 mins
Section A Q56
Examination
2
4 mins
Section A Q57
Examination
2
4 mins
Further reading
There are two technical articles available on ACCA’s website, called Tackling performance
evaluation questions and Building blocks of performance management.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Financial performance
1 The correct answer is:
Turnover has increased by 5%, which is higher than the 3% rate of inflation, indicating that the
business has grown in real terms.
Net profits have risen by 3.9% (($187 – $180)/$180 × 100%) and net profits of $187,000 for a sole
practitioner look very healthy.
Net profit margin has however fallen from 20% ($180/$900 × 100%) to 19.8% ($187/$945 × 100%).
This suggests either that costs have risen disproportionately or that the profit margin on fees
charged has declined, perhaps due to increased competition.
Average cash balances have increased by 5% (($21 – $20)/$20 × 100%) indicating that liquidity
has improved and the business has a healthy cash balance.
Average trade receivables days have fallen by four days indicating that the business has become
more efficient at collecting amounts owing from customers. The industry average is 30 days so the
working capital management must be particularly effective. However, Richard Preston is
apparently dominant and aggressive and the methods used to collect debts may upset customers
and lose business.
In conclusion, the business is healthy and successful with just some minor concerns over margins
and low growth.
Activity 2: Short-termism
The correct answer is:
(a), (b) and (c)
Postponing repair/maintenance expenditure until the following year, not recruiting new staff and
cutting back on R&D will all increase short-term profits, but potentially have a detrimental longterm effect. Investing in staff training will actually reduce profits in the short term; the benefits
would usually take time to filter through to profits
Activity 3: Encouraging a long-term view
The correct answer is:
(a) and (c)
Linking bonuses to share price and awarding bonuses in shares should ensure that employees are
committed to increasing the wealth of shareholders, rather than just maximising short-term
profits.
Activity 4: Improving performance (ACCA 6/08 amended)
1 The correct answer is:
Voucher scheme
The voucher scheme looks like a good idea as the manager is confident that the take-up would be
good and customers would follow his advice to attend one session per quarter. This will increase
revenue without incurring additional costs as customers would attend existing planned courses.
However, some additional unforeseen costs may still be incurred.
The additional revenue and profit will help, but targets for Quarters 1 and 2 will still not be met so
the voucher scheme will not necessarily improve the manager’s promotion prospects.
There is always the danger with offering a discount that existing customers will be disgruntled,
particularly if they have already paid a higher price for a course that is now being offered at a
discount. The vouchers are however only being offered to new customers so the manager should
be able to offer this promotion without upsetting existing customers.
Software upgrade
It is essential that a software training company uses the latest software technology on its
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courses. The investment in software and staff training is therefore a necessity and cannot be
avoided.
The courses will generate extra revenue but not until Quarters 3 and 4. This software upgrade will
therefore further damage the achievement of targets in Quarters 1 and 2, as costs will rise but the
extra revenue will be too late for the promotion assessment.
It is to be hoped that the senior managers will recognise the essential long-term planning being
undertaken.
Delaying payments to trainers
This is not a good idea. None of the performance targets will be affected, as the plan will not
affect costs or profits. The only positive impact will be on cash flow. The worrying aspect is the
negative impact it may have on relationships with trainers. Software training is a competitive
market and good trainers will be in demand by a number of training providers. If the company is
to offer quality training, it must have the best trainers and this is not the way to retain them.
In conclusion, if all the proposals were taken together, they will not improve the manager’s chance
of promotion as any benefits will accrue after Quarter 2.
Activity 5: Balanced scorecard
The correct answer is:
Both (a) and (b)
Both of these performance measures would be suitable for a restaurant and it should be possible
to get the information.
Activity 6: Analysing performance
1 The correct answer is:
Internal business processes
Error rates in jobs done have increased from 10% to 16%, possibly as a result of the reduction in
the average job completion time. This is unacceptable as accuracy is a primary concern for clients
of an accounting practice. Such errors could cause clients to have problems with the tax
authorities, banks etc and the clients may well sue Mr Preston for negligence.
Customer knowledge
The number of customers has fallen dramatically by 18.7% ((1,500 – 1,220)/1,500 × 100%) and this
is a serious cause for concern. Existing clients are obviously not happy with the service that has
been provided and the repeat work that an accountancy practice relies on has suffered.
Average fees have increased dramatically by 29% ((775 – 600)/600 × 100%) and this could explain
why clients have been lost. It does also explain the increase in the turnover figure.
Market share has fallen from 20% to 14% so competitors are offering a better service and taking
clients from Preston Financial Services.
Learning and growth
The percentage of revenue from non-core work is considerably lower than the industry average
and has fallen from 5% to 4% compared to a growth in the industry average from 25% to 30%. It
would appear that clients are wanting a wider range of services from their accountants which Mr
Preston is failing to provide.
The employee retention rate has fallen indicating that staff have become more dissatisfied and
have left the business. Clients of accountancy practices like to have continuity of service and may
resent having to deal with different people each year, especially as information is often private
and confidential. Staff may be leaving more frequently as they have been put under pressure to
complete jobs more quickly or because they want to develop their knowledge and experience in
non-core work.
Conclusion
The non-financial information indicates that there are fundamental problems with the business
which need to be addressed. Future prospects for growth do not look good unless Mr Preston
responds to changes in his business environment. In particular, he needs to improve the quality of
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the work being done and offer a wider range of services to clients.
Activity 7: Performance measures
The correct answer is:
Both (a) and (b)
Although it is useful to consider a range of performance measures, the organisation must ensure
that it does not become too focused on achieving one objective. For example, customer
satisfaction is clearly important, but if achieving top results in feedback surveys means that the
company cannot operate profitably, this is not going to be good news in the long run.
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Divisional performance
and transfer pricing
20
20
Learning objectives
On competition of this chapter, you should be able to:
Syllabus reference
no.
Explain and illustrate the basis for setting a transfer price using variable
cost, full cost and the principles behind allowing for intermediate
markets.
E2 (a)
Explain how transfer prices can distort the performance assessment of
divisions and decisions made.
E2 (b)
Explain the meaning of, and calculate, return on investment (ROI) and
residual income (RI), and discuss their shortcomings.
E2 (c)
Compare divisional performance and recognise the problems of doing
so.
E2 (d)
20
Exam context
This chapter looks at divisional performance and transfer pricing which is a system of charging
other divisions of your organisation when you provide them with your division’s goods or services.
In a divisionalised organisation structure of any kind, if one division does work that is used by
another division, transfer pricing may be required. Do not be misled by the term ‘price’: there is
not necessarily any suggestion of profit as there usually is with an external selling price. But as we
shall see, transfer pricing is particularly appropriate where divisions are designated as profit
centres.
20
You may be required to calculate transfer prices in this exam. You must be able to explain how
and why they are used and the problems they can create. You must also be able to calculate
return on investment (ROI) and residual income (RI) and compare performance of divisions.
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Chapter overview
Divisional performance and transfer pricing
Divisionalisation
Investment centres
Transfer pricing
Decentralisation
Return on investment (ROI)
Different approaches to transfer
pricing
Conditions for a good
performance measure
Residual income (RI)
Cost-based approaches to
transfer pricing
Responsibility accounting
What to look for in
exam questions
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1 Divisionalisation
Divisionalisation is a term for the separation of an organisation into divisions. Each divisional
manager is responsible for the performance of the division. A division may be a cost centre
(responsible for its costs only), a profit centre (responsible for revenues and costs) or an
investment centre or Strategic Business Unit (responsible for costs, revenues and assets).
1.1 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.
Advantages of decentralisation can include:
(a) Decisions made more quickly
(b) Increased motivation of management
(c) Increased quality of decisions due to local knowledge
(d) Reduced head office bureaucracy
(e) Better training for all levels of management
Disadvantages of decentralisation include:
(a) Potential for dysfunctional decision making, ie not in the interests of the whole organisation
(b) Duplication amongst divisions leading to greater cost
(c) Senior management loss of control
Appropriate performance evaluation methods are therefore needed in order to counteract the
possible disadvantages.
1.2 Conditions for a good performance measure
A good performance measure should:
(a) Provide incentive to the divisional manager to make decisions which are in the best interests
of the overall company (goal congruence)
(b) Only include factors for which the manager (division) can be held accountable
(c) Recognise the long-term objectives as well as short-term objectives of the organisation
1.3 Responsibility accounting
Responsibility accounting is used to measure performance of decentralised units.
Responsibility structure
Manager’s area of
responsibility
Typical financial
performance measure
Cost centre
Decisions over costs
Standard costing variances
Revenue centre
Revenues only
Revenues
Profit centre
Decisions over costs and
revenues
Controllable profit
Investment centre
Decisions over costs,
revenues, and assets
Return on investment and
residual income
So far, we have seen many of the performance measures dealing with the first three of these
responsibility centres.
Activity 1: Investment centres
The following are some of the areas which require control within a division:
(a) Generation of revenues
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(b) Investment in non-current assets
(c) Apportioned head office costs
(d) Salary costs
Required
Which of the above does the manager have control of in an investment centre?
 All of the above
 (a) and (b)
 (b) and (d)
 (a), (b) and (d)
Solution
2 Investment centres
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.
The performance of an investment centre is usually monitored using either or both ROI and RI.
2.1 Return on investment (ROI)
KEY
TERM
Return on investment (ROI): ROI shows how much profit has been made in relation to the
amount of capital invested and is calculated as (profit/capital employed) × 100%.
Formula to learn
ROI = (divisional profit (PBIT) / divisional investment) × 100
or
(Divisional controllable PBIT / divisional net controllable assets) × 100
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Profit should be before interest and tax (PBIT). It may also be helpful in measuring performance to
calculate ROI based on controllable profit.
For the investment, use opening book value of total assets less current liabilities. Alternatively, an
average book value may be used.
ROI enables performance in different divisions to be compared.
Similarly, new investments can also be appraised using ROI.
Decision rule
Only projects which increase the existing ROI should be undertaken.
2.1.1 Problems with ROI
• Dysfunctional behaviour – only projects which increase ROI will be accepted; this could be at
the expense of growth in corporate profits
• The ratio will be distorted by the age of the assets
• Profit can be manipulated
2.1.2 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).
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.
Essential reading
See Chapter 20 Section 1 of the Essential reading for more detail on ROI and new investments.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Exam focus point
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. 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’. As such, make sure you understand the relationship between
ROI, investments and bonuses.
2.2 Residual income
KEY
TERM
Residual income: Residual income is a measure of the centre’s profits after deducting a
notional or imputed interest cost.
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Formula to learn
Traditionally the main alternative to ROI, RI provides a hurdle figure for profit based on the
company’s minimum required percentage return from a division.
$
X
(X)
X
PBIT (or controllable profit)
Less ‘imputed interest’ (= divisional investment × cost of capital)
Residual income
The result is an absolute figure.
2.2.1 Advantages of residual income
The advantages of using RI
(a) Residual income will increase when investments earning above the cost of capital are
undertaken and investments earning below the cost of capital are eliminated.
(b) Residual income is more flexible since a different cost of capital can be applied to
investments with different risk characteristics.
The weakness of RI is that it does not facilitate comparisons between investment centres, nor
does it relate the size of a centre’s income to the size of the investment. If a company has two
identical divisions but one is four years older than the other, the older division will have suffered
more depreciation and will therefore have a lower capital employed. RI will favour the older
division because the imputed interest (capital employed multiplied by cost of capital) for the older
division will be smaller.
Essential reading
See Chapter 20 Section 2 of the Essential reading for more detail on RI versus ROI.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
Activity 2: Measuring performance
Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorio’s
$
90,000
500,000
Profits
Investment
Dugaldo’s
$
135,000
750,000
Required
Which of the following statements would explain why profit or ROI would be more equitable for
comparing Vittorio’s and Dugaldo’s forecast performance?
 Profit because this relates to shareholder wealth
 Profit because maximising profit is the overriding objective of all companies
 ROI because it takes into consideration the fact that Dugaldo has more investment than
Vittorio
 ROI because it is based on prior results which are historical information
Solution
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Activity 3: ROI and RI
Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorio’s
$
90,000
500,000
Profits
Investment
Dugaldo’s
$
135,000
750,000
Vittorio is considering investing in a labour-saving piece of equipment which will cost $8,000. This
will generate an increase in net profit of $1,200 each year for 10 years, after which time the
equipment is expected to have no resale value. Vittorio uses straight-line depreciation.
Dugaldo has been offered a replacement oven for one of his existing ones. The existing one is
written down in the books to an NBV of $2,000 and is very inefficient. Total costs are $25,000,
including maintenance and depreciation.
The replacement will cost $75,000, will have no downtime and negligible maintenance costs in its
early years. Depreciation will be 20% p.a. straight-line.
Each oven is estimated to generate $60,000 per year before these costs are considered.
1
2
The directors demand a minimum return on capital employed of 12%.
Required
What is the current ROI of each division?
 Vittorio 18% and Dugaldo 8%
 Vittorio 18% and Dugaldo 18%
 Vittorio 15% and Dugaldo 8%
 Vittorio 15% and Dugaldo 18%
Required
What is the ROI of the new labour-saving equipment Vittorio is considering?
 18%
 17.95%
 15.00%
 5.00%
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3
4
5
6
Required
What decision would the manager and the company reach regarding the new equipment?
 Manager: Accept and Company: Reject
 Manager: Accept and Company: Accept
 Manager: Reject and Company: Accept
 Manager: Reject and Company: Reject
Required
What is the ROI of the new oven?
 1750%
 60%
 18%
 15%
Required
What decision would the manager and the company reach regarding the new oven?
 Manager: Accept and Company: Reject
 Manager: Accept and Company: Accept
 Manager: Reject and Company: Accept
 Manager: Reject and Company: Reject
Required
What is the RI of each investment?
 Vittorio $240 and Dugaldo $1,000
 Vittorio $960 and Dugaldo $9,000
 Vittorio $240 and Dugaldo $9,000
 Vittorio $960 and Dugaldo $1,000
Solution
1
2
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4
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5
6
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3 Transfer pricing
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.
KEY
TERM
Transfer price: 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.
The transfer pricing policy will have a significant impact on responsibility accounting and
performance measurement.
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’
If so, the price charged should ensure that the transfer satisfies the company, the supplying
division and the receiving division.
The goals of a transfer pricing system are:
(a) Goal congruence
(b) Equitable performance measurement
(c) Retained divisional autonomy
(d) Motivated divisional managers
(e) Optimum resource allocation
The diagram below shows how two divisions of a company could make decisions that are not in
the best interests of the whole company. For example, 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 which satisfies both divisions.
External sale of intermediate
product by Supply
Whole company
Costs incurred
by Supply
Division
Supply
Division
Receive
Transfer?
Revenue earned
by Receive
Alternative suppliers to Receive
Essential reading
See Chapter 20 Section 3 of the Essential reading for more detail on the problems with transfer
pricing.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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3.1 Different approaches to transfer pricing
Method
Impact on selling
division
Impact on buying
division
Impact on
company
Market based
•
•
Goal congruent
behaviour should
arise
•
Earns same profit
as external sales
Equitable
performance
management
•
Happy to accept
transfer (cannot
buy cheaper
elsewhere)
Equitable
performance
management
Full cost
No incentive to
transfer unless spare
capacity
Happy to accept (if
less than market
price)
May lead to
dysfunctional
behaviour
Variable cost
No incentive to
transfer
Happy to accept
May lead to
dysfunctional
behaviour
Full cost plus %
Covers all costs and
makes a contribution
to profit so happy to
sell
May not accept as
price could be higher
than market price
May lead to
dysfunctional
behaviour
Variable cost plus %
May not cover all
fixed costs
Will accept if lower
than market price
May lead to
dysfunctional
behaviour
Head office
intervention
Lack of autonomy so
demotivating
Lack of autonomy so
demotivating
Goal congruent
behaviour should
arise
3.2 Cost-based approaches to transfer pricing
Problems arise with the use of cost-based transfer prices because one party or the other is liable
to perceive them as unfair.
Cost-based approaches to transfer pricing are often used in practice, because in practice the
following conditions are common:
(a) There is no external market for the product that is being transferred.
(b) Alternatively, 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 because 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.
3.2.1 Transfer prices based on full cost
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. The obvious
drawback to this is that the division supplying the product makes no profit on its work so is not
motivated to supply internally. In addition, there are a number of alternative ways in which fixed
costs can be accounted for. If a full cost-plus approach is used, a profit margin is also included in
this transfer price. The supplying division will therefore gain some profit at the expense of the
buying division.
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3.2.2 Example: Transfer prices based on full cost
Suppose a company has two profit centres: A and B. A can only sell half its maximum output of
800 units 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
$
8,000
13,000
External sales
Costs of production in the division
Profit
B
$
24,000
10,000
Total
$
32,000
23,000
9,000
Division A’s costs include fixed production overheads of $4,800 and fixed selling and
administration costs of $1,000.
There are no opening or closing inventories. It does not matter, for this illustration, whether
marginal costing or absorption costing is used.
If the transfer price is at full cost, A in our example would have ‘sales’ to B of $6,000 (($13,000 –
$1,000) x 50%). Selling and administration costs are not included, as these are not incurred on the
internal transfers. This would be a cost to B, as follows:
A
$
Open market sales
Transfer sales
Total sales, inc transfers
Transfer costs
Own costs
Total costs, inc transfers
Profit
$
8,000
6,000
14,000
$
B
$
24,000
–
24,000
Company as a
whole
6,000
10,000
13,000
$
32,000
13,000
16,000
23,000
_–
1,000
8,000
9,000
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 $9,000
between A and B.
By setting the transfer price at cost, Division A makes no profit on the products they have made,
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 this would be in the best interests of
the company as a whole. Division A needs a profit on its transfers to be motivated to supply B;
therefore, transfer pricing at cost is inconsistent with the use of a profit centre accounting system.
KEY
TERM
Intermediate product: An intermediate product is one used as a component in another
product; for example, car headlights or food additives.
3.2.3 Transfer price at variable 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 problem is that with a transfer price at marginal cost, the supplying division does not cover
its fixed costs.
Activity 4: Transfer pricing approaches
The Fruity Bakers specialise in making delicious cakes. Their trademark fruit cake is made in
Division A (the supplying division) and sold to external customers for them to decorate, or it can be
enjoyed plain. It is also transferred to Division B (the receiving division) where it is iced and
decorated to be sold as a luxury wedding cake. Fruity Bakers are currently trying to decide what
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the optimum price to sell the cakes from Division A to B should be in order to motivate the
managers of both divisions. The following data shows the costs incurred by Division A to make a
fruit cake and by Division B to ice and decorate the wedding cake:
1
2
3
Division A
Variable costs
Fixed overhead
Division B
Variable costs
Fixed overhead
• Plain fruit cakes can be sold and purchased externally for $30.
• Wedding cakes can be sold for $100.
Required
Should the company make the fruit cakes internally or buy them in?
Required
What non-financial factors should also be taken into consideration?
Required
What would be the implication of using the following transfer pricing policies?
(a) Full cost plus 10%
(b) Variable cost plus 55%
(c) Variable cost only
(d) The external market price
Solution
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2
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$/unit
20.00
8.00
28.00
40.00
5.00
45.00
3
An opportunity cost based approach is the optimum approach to setting transfer prices.
Minimum transfer price
Maximum transfer price
Variable cost
Lower of:
+
External market price
or
Divisional new revenue
Opportunity cost
Where the supplying division has spare capacity, the opportunity cost of transferring units
internally is nil as there is no external market for the additional units.
Where the supplying division is at full capacity, the opportunity cost will be the lost contribution
from the other sales.
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Opportunity cost based approaches should always result in goal congruent behaviour with both
buyer and seller happy to transfer when it is in the group’s best interest to do so.
Activity 5: Spare and full capacity
1 It has now been identified that Division A also makes excellent sponge cakes. These are sold
externally only. The bakers can make either 100 fruit cakes per month or 800 sponge cakes per
month or any combination of the two. The following information is available:
Fruit cake
$/Unit
30
(20)
(8)
2
2
Selling price
Variable costs
Fixed overheads
Profit
Labour hours per cake
Sponge cake
$/Unit
10
(6)
(2)
2
0.25
Required
Using the above information, provide advice on the determination of an appropriate transfer price
and provide a reasoned recommendation of a policy. The Fruity Bakers should adopt for the
transfer of fruit cakes from Division A to Division B in the following conditions:
(a) When Division A has spare capacity and limited external demand for sponge cakes
(b) When Division A is operating at full capacity with unsatisfied external demand for sponge
cakes
Solution
1
Illustration 1: Minimum and maximum transfer prices
Division X produces three products: A, B and C. Each product has an external market, but B can
also be transferred to Division Y.
After incurring extra costs of $60, Division Y then sells the unit for $300.
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The maximum quantity that might be required for transfer is 150 units of B.
Information on the products is as follows:
A
$150
$86
4
2,000
External market price per unit
Variable production cost per unit
Labour hours required per unit
Maximum external sales, in units
B
$200
$95
6
1,250
C
$140
$83
3
2,400
In the current period, labour hours in division X are limited to 20,000, and this is insufficient to
satisfy maximum external demand.
Therefore, using limiting factor analysis, the optimal production plan has been calculated as:
A
$64
4
$16
3rd
Contribution per unit
Labour hours required
Contribution per hour
Ranking
Optimal Production Plan
Product
C
B
A (balance)
Units
2,400
1,250
1,325
Hours/unit
3
6
4
B
$105
6
$17.50
2nd
$57
3
$19
1st
Hours
7,200
7,500
5,300
20,000
Required
Given that Division X is operating at full capacity, what are the minimum and maximum transfer
prices that could be used for Product B?
 Minimum $191 - Maximum $200
 Minimum $105 - Maximum $200
 Minimum $191 - Maximum $210
 Minimum $105 - Maximum $210
Solution
The correct answer is:
Minimum $191 - Maximum $200
If labour is diverted for the transfer, hours will come from Product A which is earning contribution
of $16 per hour.
Minimum transfer price:
$
95
96
191
Variable unit cost of Product B
Opportunity cost of Product A 6 hrs × $16
Maximum transfer price:
Maximum transfer price:
Lower of : external market price
: divisional net revenue
$
200
240
$200
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3.3 What to look for in exam questions
Checklist of things to look out for in exam questions:
• Impact on both divisions and the company as a whole
• Capacity issues
• Opportunity costs
• Remember the current situation does not always result in goal congruent behaviour!
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Chapter summary
Divisional performance and transfer pricing
Divisionalisation
Investment centres
Decentralisation
Return on investment (ROI)
• Decisions taken more quickly
• Increased motivation of
management
• Increased quality of decisions
due to local knowledge
• Potential for dysfunctional
decision making
• Duplication amongst divisions
leading to greater cost
• ROI = divisional profit (PBIT)/
divisional investment
• Only projects which increase
the existing ROI should be
undertaken
• Problems with ROI
– Dysfunctional behaviour
– The ratio will be distorted by
the age of the assets
– Profit can be manipulated
Conditions for a good
performance measure
• Must produce goal congruence
• Only include factors for which
manager can be held
accountable
• Recognise long-term objectives
as well as short-term
Responsibility accounting
• Cost centre
• Revenue centre
• Profit centre
• Investment centre (ROI and RI)
Residual income (RI)
• RI = divisional profit (PBIT) imputed interest
• Imputed interest = divisional
investment × cost of capital
• Projects with a positive residual
income should be undertaken
• Problems with RI
– The ratio will be distorted by
the age of the assets
– Profit can be manipulated
– Gives an absolute number
Transfer pricing
Different approaches to transfer
pricing
• Market based
– Selling division gets same
profit on internal and
external sales
– Buying division pays a
commercial price (possibly
less savings in selling and
distribution)
– Equitable performance
measurement for both
divisions
• Opportunity cost
– Minimum acceptable to
seller: Marginal cost +
opportunity cost
– Maximum payable by buyer:
External market price
• Cost based
Cost-based approaches to
transfer pricing
• Full cost plus
– Covers all costs
– Seller encouraged to make
transfer
– Buyer may wish to buy
externally
• Variable cost plus
– Selling division does not
cover all costs
– Buyer encouraged to make
transfer
What to look for in exam
questions
• Impact on both divisions and
the company as a whole
• Capacity issues
• Opportunity costs
• Remember the current
situation does not always
result in goal congruent
behaviour
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Knowledge diagnostic
1. Divisionalisation
A good performance measure should be one that drives goal congruence, measures managers
only on those items that they can control and recognises long-term as well as short-term
objectives.
2. Investment centres
Performance measures need to reflect not just profit but also the investment made to generate
that profit.
ROI is the most commonly used measure within a decentralised business but can result in
dysfunctional behaviour.
3. Transfer pricing
Within a decentralised business it may be necessary to set transfer prices when goods are
transferred between divisions. Transfer prices can be set on the basis of cost, market price or
opportunity cost.
Cost based transfer prices are most likely to result in dysfunctional behaviour.
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Further study guidance
Question practice
Now try the following from the Further question practice bank [available in the digital edition of
the Workbook]:
Number
Level
Marks
Approximate time
Section A Q58
Examination
2
4 mins
Section A Q59
Examination
2
4 mins
Section C ‘Divisional
performance measures’
Examination
20
36 mins
Further reading
There are two technical articles available on ACCA’s website, called Transfer pricing and
Decentralisation and the need for performance measurement.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Investment centres
The correct answer is:
(a), (b) and (d)
The manager of an investment centre will have control over all the income and expenditure and
investment decisions within that division; they will not however be able to control expenses
incurred centrally.
Activity 2: Measuring performance
The correct answer is:
ROI because it takes into consideration the fact that Dugaldo has more investment than Vittorio
ROI would be more equitable as it is a relative measure, and takes into consideration the differing
sizes of the alternative investments.
Activity 3: ROI and RI
1
The correct answer is:
Vittorio 18% and Dugaldo 18%
Vittorio: Current ROI = 90,000 / 500,000 = 18%
2
Dugaldo: Current ROI = 135,000 / 750,000 = 18%
The correct answer is:
3
ROI of new equipment = 1,200 / 8,000 = 15%
The correct answer is:
Manager: Reject and Company: Accept
The return of the labour-saving equipment is less than current (18%) so the manager would turn it
down.
However, 15% is better than the company’s minimum required return of 12% so the company would
want to accept it.
4
This is an example of dysfunctional decision-making caused by the chosen performance measure.
The correct answer is:
60%
5
ROI of replacement oven = (60,000 - 15,000) / 75,000 = 60%
The correct answer is:
Manager: Reject and Company: Accept
ROI of current oven = (60,000 - 25,000) / 2,000 = 1750%
Replacement is not as good as current so Dugaldo’s manager would reject it.
6
Since 60% > 12%, the company would want to accept the replacement oven. Again, this is another
example of dysfunctional decision-making.
The correct answer is:
Vittorio $240 and Dugaldo $1,000
Vittorio:
Cost saving (profit) of proposal
Imputed interest = 12% × 8,000
Residual income
=
=
$
1,200
(960)
(Positive so accept) 240
Dugaldo:
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Profit from proposal = (60,000 – 15,000)
Existing profit = (60,000 – 25,000)
=
Incremental profit
Imputed interest = 12% × 75,000
Incremental RI
=
45,000
35,000
10,000
(9,000)
(Positive so accept) 1,000
Activity 4: Transfer pricing approaches
1
The correct answer is:
Cost to buy in $30.
Variable cost to make internally $20.
2
Therefore, it is $10 cheaper for the company to make the fruit cakes internally.
The correct answer is:
3
Non-financial factors:
• Quality/taste/appearance of bought cakes
• Unsatisfied customer demand due to capacity constraints
The correct answer is:
Transfer price
Division A (selling)
Division B
(receiving)
Result
(i)
Full cost plus
10% – $30.80
Happy to supply
as covers all costs
and makes
contribution to
profit
Would prefer to
buy externally as
can be purchased
for $30.
Dysfunctional
behaviour may arise
(ii)
Variable cost
plus 55% –
$31
Happy to supply
as covers all costs
and makes
contribution to
profit
Would prefer to
buy externally as
can be purchased
for $30.
Dysfunctional
behaviour may arise
(iii)
Variable cost
only – $20
No incentive to
transfer
Happy to buy as
cannot source
cheaper
Dysfunctional
behaviour may arise
(iv)
External
market price –
$30
Happy to supply
Happy to buy
Cheaper to transfer
internally than buy
externally (part (a)).
There may even be
savings from
transferring internally.
Activity 5: Spare and full capacity
1 The correct answer is:
(a) Spare capacity = no opportunity cost
The minimum transfer price is variable cost + lost contribution $20 + $0 and the maximum transfer
price is $30.
(b)
Contribution $
Hours
Fruit cake
10
2
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Sponge cake
4
0.25
Contribution/hr $
Rank
5
2
16
1
Variable cost + lost contribution
$20 + (2 × $16) = $52
The company can buy fruit cakes in for $30 or make them internally at a cost of $52. Thus, the
optimal policy is to buy the fruit cakes externally for $30 from the external market and use the
capacity in Division A to make sponge cakes to sell externally.
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Skills checkpoint 5
Performance management
questions
Chapter overview
cess skills
Exam suc
C
c PM skills
Specifi
Approach to
objective test
(OT) questions
Using the
scenario
o
Go od
ly sis
How to
approach
your PM
exam
Performance
management
questions
ti m
an a
n
tio
tion
reta
erp ents
nt
t i rem
ec ui
rr req
of
Man
agi
ng
inf
or
m
a
r planning
Answe
an
cal
e ri
en
em
tn
ag
um
em
Effective
use of
spreadsheets
en
t
Effi
ci
Effe cti
ve writing
a nd p r
esentation
1
Introduction
The exam name is Performance Management. It therefore makes sense that applying the
concepts of performance management to a business is likely to feature in a scenario-based
(Section C) question. Sometimes the requirements in these questions can seem vague, for
example: ‘appraise the performance of the company’. In the performance management
questions, you need to ensure that you apply your answer to the scenario (Skill 2). Like the other
syllabus scenario-based questions, you must relate your answer to the scenario, and we
recommend using the PEA approach. This involves making a point, P, explaining why it is relevant,
E, and applying it to the scenario, A. It is important to spend time digesting the requirement and
planning your answer before you start your writing.
When you are assessing the financial performance, you must ensure that you do more than
calculate ratios.
Performance management questions
A step-by-step technique for ensuring that your performance management questions are
answered in a way that makes reference to the scenario and the relevant theory is outlined below.
Each step will be explained in more detail in the following sections and illustrated by answering a
requirement from a past exam question.
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STEP 1:
Allow some of your allotted time for analysing the scenario and the requirements.
Don't rush into starting to write your answer.
STEP 2:
Prepare an answer plan using key words from the requirements as headings (eg a
bullet-pointed list).You can then use these headings in your answer.
STEP 3:
As you write your answer, use the PEA approach. Firstly, make your point, secondly
explain what you mean and why it is relevant and finally apply it to the scenario.
Start each explanation in a new paragraph.
Exam success skills
The following illustration is based on an extract from a past exam question, about a hairdressing
salon, called ‘Oliver’s Salon’. This extract was worth 17 marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in scenario-based
questions to feel overwhelming. To manage this, focus on the requirement first – noting the key
exam verbs to ensure you answer the question properly. Then read the rest of the question,
noting important and relevant information from the scenario.
• Correct interpretation of requirements. Parts (b) and (c) are looking for an assessment of the
performance of the company, from both financial and non-financial perspectives.
• Answer planning. Everyone will have a preferred style for an answer plan. For example, it may
be a mind map, bullet-pointed lists, or simply making notes. Choose the approach that you
feel most comfortable with or, if you are not sure, try out different approaches for different
questions until you have found your preferred style.
• Effective writing and presentation. It is often helpful to use key words from the requirement as
headings in your answer. You may also wish to use sub-headings in your answer. You could use
a separate sub-heading for each paragraph from the scenario that contains an issue for
discussion. Underline or embolden your headings and sub-headings, and use full sentences,
ensuring your style is professional.
Skill activity
STEP 1
Allow some of your allotted time for analysing the scenario and requirements; don’t rush into starting to
write your answer.
Start by analysing the requirements so that you know what you are looking for when you read the scenario.
(a) Assess the financial performance of the salon using the data above. (11 marks)
(b) Analyse and comment on the non-financial performance of Oliver’s business, under the
headings of quality and resource utilisation. (6 marks)
The first key action verb is ‘assess’. This is defined by the ACCA as: ‘Judge the worth, importance,
evaluate or estimate the nature, quality, ability, extent or significance’. This means that you must
determine the strengths, weaknesses, importance, significance and ability to contribute.
These requirements are worth 17 marks and at 1.8 minutes a mark, they should take 30.6 minutes.
Part (b) appears vague, but these requirements are common in PM exams, so you need to be
prepared for such requirements and a have a plan about how to approach them.
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Oliver’s salon (17 marks)
Oliver is the owner and manager of Oliver’s Salon which is a quality hairdresser that experiences
high levels of competition. The salon traditionally provided a range of hair services to female
clients only, including cuts, colouring and straightening.
A year ago, at the start of his 20X9 financial year, Oliver decided to expand his operations to
include the hairdressing needs of male clients. Male hairdressing prices are lower, the work simpler
(mainly haircuts only) and so the time taken per male client is much less.
The prices for the female clients were not increased during the whole of 20X8 and 20X9 and the
mix of services provided for female clients in the two years was the same.
The latest financial results are as follows:
$
Sales
Less cost of sales:
Hairdressing staff costs
Hair products – female
Hair products – male
Gross profit
Less expenses:
Rent
Administration salaries
Electricity
Advertising
Total expenses
Profit
20X8
$
200,000
65,000
29,000
$
20X9
$
238,500
91,000
27,000
8,000
94,000
106,000
10,000
9,000
7,000
2,000
126,000
112,500
10,000
9,500
8,000
5,000
28,000
32,500
78,000
80,000
Oliver is disappointed with his financial results. He thinks the salon is much busier than a year ago
and was expecting more profit. He has noted the following extra information.
Some female clients complained about the change in atmosphere following the introduction of
male services, which created tension in the salon.
Two new staff were recruited at the start of 20X9. The first was a junior hairdresser to support the
specialist hairdressers for the female clients. She was appointed on a salary of $9,000 per annum.
The second new staff member was a specialist hairdresser for the male clients. There were no
increases in pay for existing staff at the start of 20X9 after a big rise at the start of 20X8 which
was designed to cover two years’ worth of increases.
Oliver introduced some non-financial measures of success two years ago.
20X8
12
0
8,000
4
0
Number of complaints
Number of male client visits
Number of female client visits
Number of specialist hairdressers for female clients
Number of specialist hairdressers for male clients
STEP 2
20X9
46
3,425
6,800
5
1
Now you should be ready to prepare an answer plan using key words from the requirements as headings.
This could take the form of a bullet-pointed list.
Complete your answer plan by working through each paragraph of the scenario identifying specific points
that are relevant to the requirement to make sure you generate enough points to score a pass mark (ACCA
marking guides typically allocate 1–2 marks per relevant well-explained point).
Completed answer plan
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Having worked through each paragraph, an answer plan can now be completed. A possible
answer plan is shown here.
Part (b)
Ideas
Assess financial performance.
Use the information in the
financial results to form the
structure of the answer. You will
need to make a judgment as to
which are most significant and
therefore require the most detail.
Financial results:
Sales: Growth %
Male vs female revenue stream
Gross margin
Margin vs prior year
Reason
Male vs female revenue stream
Rent:
No change
Advertising spend:
% change
Impact
Staff costs:
% change compared to sales growth
Electricity:
% change
Reasons
Net profit:
% increase compared to increase in sales
Comment
Part (c)
Ideas
Analyse and comment on non-financial
performance measures
Quality*:
Complaints – number and per visit
Suggest reasons for changes
Resource utilisation:
Salon
Staff
Relate to complaints
* These headings were given in the requirement - make sure you use them in your answer.
STEP 3
As you write your answer, use the PEA approach. Firstly, make your point, secondly explain what you mean
and why it is relevant and finally apply it to the scenario. Start each explanation in a new paragraph.
Ensure that you do more than just calculate ratios to assess performance.
Required
Suggested solution
(a) Financial measures1
1
Use the headings in the financial
information to give your answer
structure.
Financial performance
Sales growth
Sales have grown2 by 19.25% (($238,500 –
$200,000)/$200,000 × 100%) from 20X8 to 20X9. This is
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2
Make the point - Sales have grown.
particularly impressive as Oliver’s Salon experiences
high levels of competition.
This3 growth has come from the new male hairdressing
3
part of the business, as female sales have fallen by 15%
from
scenario that supports the point.
Apply back to information
(($200,000 – $170,000)/$200,000 × 100%). There was
no price increase during this time, so this fall is due to
fewer female client visits.
Gross profit
The gross profit margin in 20X8 was 53%
($106,000/$200,000 × 100%) and in 20X9 had fallen to
47.2% ($112,500/$238,500 × 100%). This is
predominantly due to a 40% increase (($91,000 –
$65,000)/$65,000 × 100%) in staff costs as a result of
the recruitment of two new staff.
The new specialist hairdresser for male clients is on a
salary of $17,000 ($91,000 – $65,000 – $9,000) whereas
the female hairdressers were paid an average of
$16,250 ($65,000/4) in 20X8.
However4, it is the female client business which has
4
Numbers can be used to support
answer, but will not be sufficient to score
enough marks to pass.
been responsible for the drop in gross profit margin.
20X8
Female
$
200,000
20X9
Female
$
170,000
20X9
Male
$
68,500
Sales
Less cost of sales:
Hairdressing staff
(65,000)
(74,000)
(17,000)
Hair products –
(29,000)
(27,000)
female
Hair products – male
(8,000)
Gross profit
106,000
69,000
43,500
Gross profit margin 106/200 × 100% = 53% 69/170 × 100% = 40.6% 43.5/68.5 × 100% = 63.5%
The gross profit margin from male clients is higher than
for female clients.
Rent
This has not changed so is a fixed cost at the moment5.
5
Can still earn marks for obvious
statements if explain what it means/why
it is important.
Administration salaries
These have increased by only 5.6% (($9,500 –
$9,000)/$9,000 × 100%) which is impressive given the
expansion in the business.
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This has increased by 14.3% (($8,000 – $7,000)/$7,000 ×
100%. More clients would involve more electricity, so it is
a semi-variable cost. There may also have been a
general increase in electricity prices, which would be
beyond the control of Oliver.
Advertising
This has increased by 150% (($5,000 – $2,000)/$2,000
× 100%) which could be expected at the launch of a new
service. Provided the advertising has generated new
clients, it should not be a cause for concern.
Net profit
Net profit has only increased by 2.6% (($80,000 –
$78,000/$78,000 × 100%) which is disappointing
compared to a 19.25% increase in sales.
(b) Non-financial performance
Quality
has increased significantly by 283% ((46 – 12)/12 ×
100%). This is not just due to the increase in client
numbers.
Complaints per customer visit have increased from
0.15% (12/8,000 × 100%) to 0.44%. This is a cause for
concern in a service business, especially as many
customers will not actually complain but will just not
come back.
The complaints could be from the new male clients who
are not happy with the new hairdresser, or they could
be from female clients who do not like having men in the
salon. More information is needed and action to be
taken to reduce the complaints.
Resource utilisation
The resources6 in Oliver’s Salon are the salon itself and
the staff. The salon is being utilised more as a result of
the increase in clients from 8,000 in 20X8 to 10,225
(6,800 + 3,425) in 20X9. This is a 27.8% ((10,225 –
8,000)/8,000 × 100%) increase. This increase in
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Consider what the resources are and
how changes in sales would affect them.
utilisation has not however resulted in a proportionate
increase in profit.
The female specialist hairdressers served 2,000
(8,000/4) clients per specialist in 20X8 and this fell to
1,360 (6,800/5) in 20X9, following the recruitment of two
new staff. Oliver may be prepared to accept this
reduction in resource utilisation in order to boost service
levels and reduce complaints.
This contrasts with the higher figure of 3,425 clients per
male specialist in 20X9. The time taken per male client is
much less, so this should be expected.
Exam success skills diagnostic
Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the Oliver’s Salon activity to give you an idea of how to complete the diagnostic.
Exam success skills
Your reflections/observations
Managing information
Did you identify the relevant financial information to include in
your assessment of the financial performance of Oliver’s Salon in
part (b)?
Correct interpretation of
requirements
Did you identify that part (b) was about financial performance
only?
Did you identify that part (c) was about non-financial
performance only and should consider both quality and resource
utilisation?
Answer planning
Did you draw up an answer plan using your preferred approach
(eg mind map, bullet-pointed list)?
Did your plan help to create a structure for your answer?
Effective writing and
presentation
Did you use headings (key words from requirements)?
Did you use full sentences?
And most importantly – did you explain why your points related
to the scenario?
Most important action points to apply to your next question
The exam is called Performance Measurement and it is therefore likely that you will have to assess
the performance of an organisation. Although you cannot prepare for every organisation, you
can equip yourself with the skills to attempt performance management questions, by using the
information given in the question to guide the structure of your answer. A key skill is then applying
this back to the given scenario. You will not be able to pass these questions by just calculating
ratios from a list. It is therefore essential that you try to create a practical answer that is relevant
to the scenario, and/or addresses the issues identified in the scenario, instead of simply
calculating rote-learned ratios.
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As you move into practising questions as part of your final revision, you will need to practise
taking in information from a scenario quickly (using active reading), accurately understanding the
requirements, and creating an answer plan and a final answer that addresses the requirements in
the context of the scenario.
Performance management question preparation is like preparing for your driving test. You cannot
practise on every road, but you can equip yourself with the skills to deal with any road layout you
face in your test through lots of practice.
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Further aspects of
performance management
21
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Learning objectives
On competition of this chapter, you should be able to:
Syllabus reference
no.
Comment on the problems of having non-quantifiable objectives in
performance management.
E3 (a)
Comment on the problems of having multiple objectives in this sector.
E3 (b)
Explain how performance could be measured in this sector.
E3 (c)
Outline value for money (VFM) as a public sector objective.
E3 (d)
Describe, calculate and interpret non-financial performance indicators
(NFPIs) and suggest methods to improve the performance indicated.
E3 (e)
Discuss the difficulties of target setting in qualitative areas.
E3 (f)
Analyse past performance and suggest ways for improving financial
and non-financial performance
E3 (g)
Explain the causes and problems created by short-termism and
financial manipulation of results and suggest methods to encourage a
long-term view.
E3 (h)
Explain the need to allow for external considerations in performance
management, including stakeholders, market conditions and allowance
for competitors.
E4 (a)
Suggest ways in which external considerations could be allowed for in
performance management.
E4 (b)
Interpret performance in the light of external considerations.
E4 (c)
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Exam context
This final chapter on performance measurement looks at performance analysis in not for profit
organisations and the public sector. The problems of having non-quantifiable and multiple
objectives are discussed. We then go on to consider how external considerations are allowed for in
performance measurement.
21
Scenarios in your exam may relate to not for profit organisations and the public sector and you
need to understand their particular needs and issues. Always apply your answers to the specific
organisation.
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Chapter overview
Further aspects of performance management
Objectives
Evaluation of
performance in not for
profit organisations
Other
factors
Profit seeking
organisations
Value for money
Non-financial
performance indicators
(NFPIs)
Not for profit
organisations
Target setting in
qualitative areas
Short-termism
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Performance
measurement and
external factors
1 Objectives
1.1 Profit seeking organisations
Primary objective
• Maximise the wealth of owners (shareholders) of the business - (equity)
Secondary objectives might be
• Ensure survival
• Provide a quality product/service (customer satisfaction)
• Be a good corporate citizen (health and safety/environment)
• Create wealth/benefits for management/employees
• Secure competitive advantage and grow market share
The objective of profit or wealth maximisation is thus modified to meet the needs of different
interest groups (stakeholders).
1.2 Not for profit organisations (NFPOs)
A major problem with many not for profit organisations (NFPOs), particularly government bodies,
is that it is extremely difficult to define their objectives at all. In addition, they tend to have
multiple objectives, so that even if they could all be clearly identified it is impossible to say which
is the overriding objective.
Public sector organisations
Primary objective might be:
• Provision of a quality product/service within a value for money framework
Secondary objectives might be:
• Be a good corporate citizen (health and safety/environment)
• Adopt an ethical social stance in decision-making
• Create wealth/benefit for management/employees
• Earn sufficient profits to provide for future capital investment and perhaps provide a surplus
for the exchequer
Other NFPOs
Primary objective might be:
• Provision of a social or community service for the wellbeing of society
Secondary objectives might be:
• Be a good corporate citizen (health and safety/environment)
• Adopt an ethical social stance in decision-making
• Increase wealth/benefit for management/employees
Activity 1: Objectives
1 Required
What objectives might the following NFPOs have?
(a) An army
(b) A local council
(c) A charity
(d) A political party
(e) A college
Solution
1
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More general objectives for NFPOs include:
• Surplus maximisation (equivalent to profit maximisation)
• Revenue maximisation (as for a commercial business)
• Usage maximisation (as in leisure centre swimming pool usage)
• Usage targeting (matching the capacity available)
• Full/partial cost recovery (minimising subsidy)
• Budget maximisation (maximising what is offered)
• Producer satisfaction maximisation (satisfying the wants of staff and volunteers)
• Client satisfaction maximisation (the police generating the support of the public)
1.2.1 Non-quantifiable objectives
It is difficult to judge whether non-quantifiable objectives have been met. For example, assessing
whether a charity has improved the situation of those benefiting from its activities is difficult to
research.
Essential reading
See Chapter 21 Section 1 of the Essential reading for more detail on the problems with
performance measurement of NFPOs.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
2 Evaluation of performance in not for profit organisations
NFPOs and public sector organisations will not have wealth maximisation as a primary objective.
However, they will still have strategic objectives (albeit non-financial) and stakeholders (clients,
members etc), who will wish to measure their performance.
Activity 2: Suitable performance measures
Required
Which THREE of the following would be suitable performance measures for ensuring that a
hospital is achieving its objectives?
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




Incidents of abuse against staff
Death rates
Re-admission rates
Use of agency staff
Number of cases of flu reported
Solution
2.1 Value for money
One of the ways that performance can be measured in public sector organisations is to prove that
they operate economically, efficiently and effectively and achieve value for money as part of the
continuing process of good management.
Value for money (VFM): Value for money (VFM) means providing a service in a way which is
economical, efficient and effective.
KEY
TERM
•
•
•
Economy (spending money frugally)
Efficiency (getting out as much as possible for what goes in)
Effectiveness (getting done, by means of the above, what was supposed to be done)
These are sometimes referred to as the 3Es. More formal definitions are as follows:
KEY
TERM
Economy: Economy is attaining the appropriate quantity and quality of inputs at the lowest
cost.
Efficiency: Efficiency is the relationship between inputs and outputs.
Effectiveness: Effectiveness is the relationship between an organisation’s outputs and its
objectives.
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Illustration 1: Value for money
1 Imagine a bottle of washing up liquid for cleaning dishes. We’ll call it Angeldishes. The advertising
says Angeldishes is good ‘value for money’ because it washes twice as many plates as any other
washing up liquid. Bottle for bottle it may be more expensive, but plate for plate it is cheaper. Not
only this, but Angeldishes gets plates ‘squeaky’ clean. To summarise, Angeldishes gives us VFM
because it exhibits the following characteristics:
• Economy (more clean plates per $ spent)
• Efficiency (more clean plates per squirt)
• Effectiveness (plates as clean as they should be)
Solution
1 The correct answer is:
Activity 3: Effectiveness
Required
Which TWO of the following performance measures would be appropriate for measuring
effectiveness for a public sector higher education college?
 Teaching hours per student
 Sourcing lecturers of appropriate quality at an acceptable cost
 Percentage of graduates employed within 12 months of the course ending
 Percentage of students achieving target pass rates
Solution
Essential reading
See Chapter 21 Section 2 of the Essential reading for more detail on the 3Es.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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3 Other factors
3.1 Non-financial performance indicators (NFPIs)
In Chapter 19 Section 4, we covered NFPIs and their value. These aspects can be applied to the
public sector also. As with profit-seeking businesses, NFPOs can measure quality, efficiency,
delivery, reliability, customer satisfaction and innovation. VFM and the 3Es include performance
measures which are non-financial.
Exam focus point
Performance management questions regularly appear as a constructed response question in
the exam. Therefore, you must be comfortable discussing this area and applying your
knowledge to the scenario in the question. You may be given numbers relating to financial or
non-financial indicators and you must be able to talk about them. The examining team have
said that subtracting one number from another is not enough to earn a calculation mark. For
example, if the number of complaints received one year was 50 and the next year was 60, it
would not be sufficient to simply say that there were 10 more complaints in the second year.
You must state the percentage increase in complaints in order to earn marks, which is this case
would be a 20% increase ([(60-50)/50] × 100) (ACCA, 2017).
3.2 Target setting in qualitative areas
In Chapter 19 Section 9 we discussed the difficulties of measuring non-financial aspects of
performance. The same problems arise for not for profit and public sector organisations. Problems
include:
• Selecting a suitable measure for performance,
• Having data which by its very nature is not quantified
• A lack of system for collecting data about qualitative areas
3.3 Short-termism and manipulation
In Chapter 19 Section 5 we discussed how organisations often make a trade-off between shortterm and long-term objectives. This applies to not for profit and public sector organisations too.
4 Performance measurement and external factors
When devising performance measures for any organisation, consideration needs to be given to
three key external factors:
• Stakeholders
• Economic environment
• Competition
KEY
TERM
Stakeholders: Stakeholders are groups of people or individuals who have a legitimate interest
in the activities of an organisation. They include customers, employees, the community,
shareholders, suppliers and lenders.
Stakeholders can be broken down into three key groups:
• Internal
– such as employees
• Connected – shareholders, customers, suppliers
• External
– community and the Government
There will often be a conflict between the stakeholder objectives. For example, shareholders want
larger returns whereas employees want pay rises. Performance measures need to be considered
carefully. A suitable measure in this case might be performance related pay.
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Essential reading
See Chapter 21 Section 3 of the Essential reading for more detail on stakeholders, the economic
environment and competition.
The Essential reading is available as an Appendix of the digital edition of the Workbook.
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Chapter summary
Further aspects of performance management
Objectives
Profit seeking
organisations
Maximise shareholder
wealth
Not for profit
organisations
• Difficult to define
objectives
• Tend to have multiple
objectives
• Difficult to judge
whether
non-quantifiable
objectives have been
met
Evaluation of
performance in not for
profit organisations
Value for money
• Providing a service in
a way which is
economical, efficient
and effective
• Economy (spending
money frugally)
• Efficiency (getting out
as much as possible
for what goes in)
• Effectiveness (getting
done, by means of the
above, what was
supposed to be done)
Other
factors
Performance
measurement and
external factors
Non-financial
performance indicators
(NFPIs)
• Stakeholders
• Economic environment
• Competition
Quality, efficiency,
delivery, reliability,
customer satisfaction,
innovation
Target setting in
qualitative areas
• Problems include:
– Difficulty selecting a
suitable measure for
performance
– Having data which
by its very nature is
not quantified
– A lack of system for
collecting data
about qualitative
areas
Short-termism
A bias towards
short-term rather than
long-term performance
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Knowledge diagnostic
1. Objectives
Performance measurement in public sector or not for profit (NFP) organisations can be difficult as
they often have multiple objectives and these are often hard to quantify and measure
2. Value for money
There are a range of problems in measuring the performance of NFP organisations.
Performance is judged in terms of inputs and outputs, hence the value for money criteria of
economy, efficiency and effectiveness.
3. Other factors
NFPIs can usefully be applied to employees and product/service quality.
Short-termism is when there is a bias towards short-term rather than long-term performance. It is
often due to the fact that managers’ performance is measured on short-term results.
4. External considerations
Performance management needs to allow for external considerations including stakeholders,
market conditions and allowance for competitors.
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Further study guidance
Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
Number
Level
Marks
Approximate time
Section A Q60
Examination
2
4 mins
Section A Q61
Examination
2
4 mins
Section A Q62
Examination
2
4 mins
Section C ‘Non profit
seeking organisations’
Examination
20
36 mins
Further reading
There is a two-part technical article available on ACCA’s website, called Not for profit
organisations.
You are strongly advised to read these articles in full as part of your preparation for the PM exam.
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Activity answers
Activity 1: Objectives
1 The correct answer is:
Here are some suggestions:
(a) To defend a country
(b) To provide services for local people (such as the elderly)
(c) To help others/protect the environment
(d) To gain power/enact legislation
(e) To provide education
Activity 2: Suitable performance measures
The correct answers are:
•
Death rates
•
Re-admission rates
•
Use of agency staff
Whilst a hospital management team would be concerned about abuse against staff it is not
directly linked to its primary objective. The primary objective will be centred around improving
health and life expectancy as efficiently as possible; therefore the other measures would be
appropriate. The numbers of cases of flu reported is not within the hospital’s control and would
therefore not be an appropriate performance measure.
Activity 3: Effectiveness
The correct answers are:
•
Percentage of graduates employed within 12 months of the course ending
•
Percentage of students achieving target pass rates
Securing appropriate staff who represent good value for money would be an economy measure,
whilst teaching hours per student would be an efficiency measure. Pass rates are only part of the
story regarding effectiveness as employability following the course will also be important to
students and potential students.
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Managing information
Essential reading
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1 The role of an information system
The role of an information system encompasses more than just activity automation. Information
systems can be used to improve processes within organisations as well as externally with suppliers
and customers. Organisations need information systems to enable them to capture and generate
the information that managers need for planning, control and decision-making purposes. We
shall consider the needs of management further in Chapter 2 when we look at the types of
information system.
Information systems also have more general roles to play within an organisation. For example,
they improve communication, allow better operations and manufacturing, enhance products and
services provided, and supply opportunities to reduce costs.
1.1 Recording transactions
Information about each business transaction or event is required for a number of reasons.
Documentation of transactions can be used as evidence in a case of dispute. There may be a
legal requirement to record transactions, for example for accounting and audit purposes.
Detailed information on production costs can be built up allowing for a better assessment of
profitability.
1.2 Decision-making
Information is stored and organised within information systems and this enables informed
decisions to be made. This information could be classified as internal and external.
1.3 Planning
Planning requires knowledge of, among other things, available resources, possible timescales for
implementation and the likely outcome under alternative scenarios. Information systems can
provide a number of planning tools.
1.4 Performance measurement
Just as individual operations need to be controlled, overall performance must be measured in
order to enable comparisons against budget or plan to be made. This may involve the collection
of information on, for example, costs, revenues, volumes, timescales and profitability. The
collection, analysis and presentation of such data can be performed by information systems.
1.5 Control
Once a plan is implemented, its actual performance must be controlled. Information is required to
assess whether it is proceeding as expected or whether there is some unexpected deviation from
the plan. It may consequently be necessary to take some form of corrective action. Information
systems can be used to monitor and control the outcomes of plans.
2 Communication
2.1 Intranets
Intranets are used for many purposes. The following list is not exhaustive and there may be
industry-specific or company-specific use.
(a) Performance data: linked to sales, inventory, job progress and other database and reporting
systems, enabling employees to process and analyse data to fulfil their work objectives.
(b) Employment information: online policy and procedures manuals (health and safety,
disciplinary and grievance), training and induction material, internal contacts for help and
information.
(c) Employee support/information: advice on first aid, healthy working at computer terminals,
training courses offered and resources held in the corporate library and so on.
(d) Communication: notice boards for the posting of messages to and from employees, notice of
meetings, events, trade union activities, bulletins or newsletters, details of product launches
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and marketing campaigns, staff moves, changes in company policy, links to relevant
databases or departmental home pages.
(e) Departmental home pages: information and news about each department’s personnel and
activities to aid identification and cross-functional understanding.
(f) Email facilities for the exchange of messages between employees in different locations.
(g) Upward communication: suggestion schemes, feedback, questionnaires.
2.2 Wireless technology
Wi-Fi networks are created through an array of hundreds and even thousands of local ‘hotspots’
throughout metropolitan areas. Initially, hotspots were rare but can now be found in most major
airports, hotels, bookstores, cafes, shopping centres and even car dealerships.
Mobile devices also have certain drawbacks. Laptops, netbooks and smartphones have security
issues (eg they are easy to steal or lose). When using mobile devices, it is important to ensure that
employees are aware of their responsibilities and the need to keep both mobile devices and
business information secure. If using public Wi-Fi to access the internet, it may not always be
possible to find a secure and available network. This may prevent access to business information
when required.
There are costs involved in setting up the equipment and training required to make use of mobile
devices. Mobile IT devices can expose valuable data to unauthorised people if the proper
precautions are not taken to ensure that the devices, and the data they can access, are kept safe.
3 Security and confidential information
Disaffected employees have the potential to do deliberate damage to valuable corporate data or
systems, especially if the information system is networked, because they may have access to
parts of the system that they should not really be authorised to use.
If the organisation is linked to an external network, people outside the company (hackers) may
also be able to get into the company’s internal network, either to steal data or to damage the
system.
Various procedures are therefore necessary to ensure the security of highly confidential
information that is not for external consumption.
3.1 Passwords
Passwords are a set of characters allocated to a person, terminal or facility which must be keyed
into the system before further access is permitted.
In order to access a system, the user first needs to enter a string of characters. If what is entered
matches a password issued to an authorised user, or valid for that particular terminal, the system
permits access. Otherwise, the system shuts down and may record the attempted unauthorised
access.
Keeping track of these attempts can alert managers to repeated efforts to break into the system.
In these cases, the culprits can potentially be caught, particularly if there is an apparent pattern
to their efforts.
The restriction of access to a system with passwords is effective and widely used but the
widespread and growing use of PCs and networks is making physical isolation virtually
impossible. The wider use of information systems requires that access to the system becomes
equally widespread and easy. Requirements for system security must be balanced by the
operational requirements for access: rigidly enforced isolation of the system may significantly
reduce the value of the system.
3.2 Logical access systems
While physical access control (doors, locks, and so on) is concerned with the prevention of
unauthorised persons gaining access to the hardware, logical access control is concerned with
preventing those who already have access to a terminal or a computer from gaining access to
data or software.
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In a logical access system, data and software or individual computer systems will be classified
according to the sensitivity and confidentiality of data.
(a) Payroll data or details of the draft corporate budget for the coming year may thus be
perceived as highly sensitive and made available to identified individuals only.
(b) Other financial information may be made available to certain groups of staff only; for
example, members of the finance function or a certain grade of management.
(c) Other data may be unrestricted.
A logical access system performs three operations when access is requested.
(a) Identification of the user
(b) Authentication of user identity
(c) Check on user authority
3.3 Database controls
Databases present a particular problem for computer security. In theory, the database can be
accessed by large numbers of people, and so the possibility of alteration, unauthorised
disclosure or fraud is so much greater than with application-specific files.
It is possible to construct complicated password systems, and the system can be programmed to
give a limited view of its contents to specific users or restrict the disclosure of certain types of
information to particular times of day. It is possible to build a set of privileges into the system,
allowing authorised users with a particular password to access more information.
There are problems ensuring that individuals do not circumvent the database by means of
inference, however. If you ask enough questions, you should be able to infer from the replies the
information you are really seeking.
For example, the database forbids you to ask if John is employee Category A. However, if you
know there are only three employee categories (A, B, and C), and there is no prohibition on asking
about categories B and C, you can work out the members of category A by process of elimination
(ie neither B, nor C, therefore A).
These so-called inference controls exist to make this difficult by limiting the number of queries, or
by controlling the overlap between questions.
3.4 Firewalls
Systems can have firewalls to prevent unauthorised access into company systems. Firewalls can
be implemented in both hardware and software, or a combination of both. Firewalls are
frequently used to prevent unauthorised internet users from accessing private networks
connected to the internet, especially intranets.
As well as preventing unauthorised access onto company systems, firewalls can also be used to
help protect a company’s data from corruption by viruses.
3.5 Encryption
Information transmitted from one part of an organisation to another may be intercepted. Data
can be encrypted (scrambled) in an attempt to make it unintelligible to eavesdroppers.
3.6 Other safety measures
Authentication is a technique for making sure that a message has come from an authorised
sender.
Dial back security operates by requiring the person wanting access to the network to dial into it
and identify themselves first. The system then dials the person back on their authorised number
before allowing them access.
All attempted violations of security should be automatically logged and the log checked regularly.
In a multi-user system, the terminal attempting the violation may be automatically disconnected.
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3.7 Personal data
In recent years, there has been a growing popular fear that information about individuals which
is stored in computer files and processed by computers can be misused.
In particular, it is felt that an individual could easily be harmed by the existence of computerised
data about themselves which was inaccurate or misleading, and which could be transferred to
unauthorised third parties at high speed and little cost.
As a result, most countries have introduced legislation designed to protect the individual. In the
UK, the current legislation is the Data Protection Act 2018.
3.8 Personnel security planning
Certain employees will always be placed in a position of trust; for example, senior systems
analysts, the database administrator and the computer security officer. With the growth of
networks, almost all employees may be in a position to do damage to a computer system.
Although most employees are honest and well intentioned, it may be relatively easy for individuals
to compromise the security of an organisation if they wish to do so. The following types of
measure are therefore necessary.
(a) Careful recruitment
(b) Job rotation
(c) Supervision and observation by a superior
(d) Review of computer usage (eg via systems logs)
(e) Enforced vacations
The key is that security should depend on the minimum possible number of personnel. Although
this is a weakness, it is also a strength.
3.9 Anti-virus and anti-spyware software
The growth of the internet has led to increased exposure to security risks. Two particular risks
derive from exposure to computer viruses and to spyware.
Computer viruses typically arrive by email and are triggered when the user opens an attachment
in an email. The virus is a self-replicating computer program that infiltrates and then damages a
computer system.
Spyware is a type of program that watches what users do with their computer and then sends
that information over the internet to a third party. Customers of online bank accounts have
experienced problems with spyware when their personal financial data has been captured by
keylogging software (ie software that records the keys pressed).
Software has been developed to counteract these risks. Anti-virus software works to achieve this
by:
(a) Scanning files to look for known viruses
(b) Identifying suspicious behaviour, which might indicate infection, from any computer
program
Anti-spyware software combats spyware in two ways:
(a) Real-time protection which prevents the installation of spyware by blocking software and
activities known to represent spyware
(b) Detection and removal of spyware by scanning software and removing files and entries that
match known spyware
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4 Internal sources of information
4.1 Sources of monetary and non-monetary information
4.1.1 The financial accounting records
You are by now very familiar with the idea of a system of sales ledgers and purchase ledgers,
general ledgers, cash books, and so on. These records provide a history of an organisation’s
monetary transactions.
Some of this information is of great value outside the accounts department – most obviously, for
example, sales information for the marketing function. Other information, like cheque numbers, is
of purely administrative value within the accounts department.
You will also be aware that, to maintain the integrity of its financial accounting records, an
organisation of any size will have systems for and controls over transactions. These also give rise
to valuable information.
An inventory control system is the classic example: besides actually recording the monetary value
of purchases and inventory in hand for external financial reporting purposes, the system will
include purchase orders, goods received notes, goods returned notes, and so on, which can be
analysed to provide management information about speed of delivery, say, or the quality of
supplies.
4.1.2 Other internal sources
Much information that is not strictly part of the financial accounting records nevertheless is
closely tied to the accounting system.
(a) Information about personnel will be linked to the payroll system. Additional information may
be obtained from this source if, say, a project is being costed and it is necessary to ascertain
the availability and rate of pay of different levels of staff.
(b) Much information will be produced by a production department about machine capacity,
movement of materials and work in progress, set up times, maintenance requirements, and so
on.
(c) Many service businesses, notably accountants and solicitors, need to keep detailed records of
the time spent on various activities, both to justify fees to clients and to assess the efficiency
of operations.
Staff themselves are one of the primary sources of internal information. Information may be
obtained either informally in the course of day-to-day business or formally through meetings,
interviews or questionnaires.
5 External sources of information
5.1 External sources of information
Capturing information from outside the organisation might be carried out formally and entrusted
to particular individuals, or might be ‘informal’.
5.2 Formal collection of data from outside sources
(a) A company’s tax specialists will be expected to gather information about changes in tax law
and how this will affect the company.
(b) Obtaining information about any new legislation on health and safety at work, or
employment regulations, must be the responsibility of a particular person; for example, the
company’s legal expert or company secretary, who must then pass on the information to
other managers affected by it.
(c) Research and development work often relies on information about other R&D work being done
by other companies or by government institutions. An R&D official might be made responsible
for finding out about R&D work outside the company.
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(d) Marketing managers need to know about the opinions and buying attitudes of potential
customers. To obtain this information, they might carry out market research exercises.
Informal gathering of information from the environment goes on all the time, consciously or
unconsciously, because the employees of an organisation learn what is going on in the world
around them – perhaps from the media, meetings with business associates or the trade press.
Organisations hold external information, such as invoices and advertisements, from customers
and suppliers. However, there are many occasions when an active search outside the organisation
is necessary.
5.3 Specific external sources
Secondary data, such as government statistics or data provided by online databases, is not
collected by or intended for the user. Primary data, which is more expensive than secondary data,
is more tailored to the user’s exact needs. Market research is an example.
5.3.1 Directories
Examples (of business directories) include the following (although there are many others):
(a) Kompass Register (Kompass)
(b) Who owns Whom (Dun & Bradstreet)
(c) Key British Enterprises (Dun & Bradstreet)
5.3.2 Associations
There are associations in almost every field of business and leisure activity, and ACCA itself is an
association. Associations collect and publish data for their members that can be of great interest
to other users. For example, although the services of the Road Haulage Association (RHA) are
geared towards transport businesses, their analysis of fuel price rises could be useful to all
motorists.
5.3.3 Government agencies
The Government is a major source of economic information and information about industry and
population trends. Examples of UK Government publications are as follows. Most of these are
available online and can be downloaded for free.
(a) National Statistics, divided into 12 separate themes such as economy, health and labour
(b) The Digest of UK Energy Statistics (annual)
(c) Housing and Construction Statistics (quarterly)
(d) Financial Statistics (monthly)
(e) Economic Trends now published with Labour Market Trends in the Economic Labour Market
Review
(f) Public Sector Employment Trends (annual) gives details of employment in the public sector in
the UK.
(g) A variety of publications on the Department for Business, Innovation and Skills website give
data on industrial and commercial trends at home and overseas.
(h) Social Trends (annual)
Official statistics are also published by other government bodies, such as the European Union, the
United Nations and local authorities.
5.3.4 Other published sources
This group includes all other publications, including some digests and pocket books and
periodicals (often available in public libraries).
5.3.5 Syndicated services
The sources of secondary data we have looked at so far have generally been free because they
are in the public domain. Inexpensiveness is an advantage that can be offset by the fact that the
information is unspecific and needs considerable analysis before being useable. A middle step
between adapting secondary data and commissioning primary research is the purchase of data
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collected by market research companies. The data tends to be expensive but less costly than
primary research.
5.3.6 Consumer panels
A form of continuous research which results in secondary data, often bought in by marketers, is
research generated by consumer panels. These constitute a representative sample of individuals
and households whose buying activity in a defined area is monitored either continuously (every
day, with results aggregated) or at regular intervals, over a period of time. There are panels set
up to monitor purchases of groceries, consumer durables, cars, baby products and many others.
5.4 Information from customers
Customers can provide useful information.
(a) Firms send out satisfaction questionnaires and market research.
(b) Customer comments and complaints sent voluntarily can suggest improvements.
5.5 Information from suppliers
Supplier information comes in several categories.
Information
Comment
‘Bid’ information
A supplier pitching for a product will detail
products, services and prices. This is before a
deal is done.
Operational information
If a firm has placed a particular job or
contract with a supplier, the supplier may
provide details of the stages in the
manufacturing process, eg the delivery time
Pricing information
Component prices vary from industry to
industry; some are volatile.
Technology
Technological developments in the supplier’s
industry can affect the type of input
components, their cost and their availability.
5.6 The internet
The internet offers efficient, fast and cost-effective email, and massive information search and
retrieval facilities. There is a great deal of financial information available and users can also
access publications and news releases issued by the Treasury and other government
departments.
Businesses are also using it to provide information (cheaply) about their own products and
services and to conduct research into their competitors’ activities.
The internet offers a speedy and impersonal way of getting to know the basics (or even the
details) of the services that a company provides.
The internet is commonly used to access information about suppliers.
(a) A firm can visit a supplier’s website for details of products and services.
(b) The user can search a number of websites through a browser. Note that the internet may not
contain every supplier; arguably it should not be relied on as the sole source.
(c) A number of business-to-business (B2B) sites have been opened. Participating members offer
their services, as well as quotes for those services. A lot of the communication search problem
is avoided.
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5.7 Database information
A management information system or database should provide managers with a useful flow of
relevant information which is easy to use and easy to access. Information is an important
corporate resource. Managed and used effectively, it can provide considerable competitive
advantage and so is a worthwhile investment.
It is now possible to access large volumes of generally available information through databases
held by public bodies and businesses.
(a) Some companies, such as LexisNexis, charge users a subscription fee to access their
electronic database. LexisNexis’ clients come primarily from within the legal and accountancy
profession, who use the service to access legal and public records related information.
(b) Public databases are also available for inspection.
Dun & Bradstreet provides general business information. AC Nielsen operates online information
regarding products and market share.
Developments in information technology allow businesses to have access to the databases of
external organisations. Reuters, for example, provides an online information system for money
market interest rates and foreign exchange rates to firms involved in money market and foreign
exchange dealings, and to the treasury departments of a large number of companies. The
growing adoption of technology at point of sale provides a potentially invaluable source of data
to both retailer and manufacturer.
5.7.1 Online databases
Most external databases are online databases, which are very large computer files of information
supplied by database providers and managed by ‘host’ companies whose business revenue is
generated through charges made to users. Access to such databases is open to anyone prepared
to pay and who is equipped with a PC plus internet access and communication software. These
days there are an increasing number of companies offering free internet access. Most databases
can be accessed around the clock.
5.8 Data warehouses
A data warehouse contains data from a range of internal (for instance sales order processing
system, nominal ledger) and external sources. One reason for including individual transaction
data in a data warehouse is that the user can drill down to access transaction-level detail if
necessary. Data is increasingly obtained from newer channels, such as customer care systems,
outside agencies or websites.
The warehouse provides a coherent set of information to be used across the organisation for
management analysis and decision-making. The reporting and query tools available within the
warehouse should facilitate management reporting and analysis. This analysis can be enhanced
through using data mining software to identify trends and patterns in the data.
6 Information for control
Information is used to supply management with data for control.
For instance, payroll records give information on the total cost of staff, as well as a breakdown
into cost by function, role, bonuses, taxes, and so on which can show management how different
cost areas are performing. As payroll is often a large cost and to some extent discretionary or
variable, it is important to monitor and control.
Equally, information on wage payments will also be relevant to an organisation’s cash flow
planning. As far as possible, organisations like to keep their cash balances within certain limits.
So, by knowing the amount and timing of wages and salary payments, the organisation can
make any adjustments to ensure cash balances remain within the desired limits.
Information about inventory levels can also be instructive. For example, some lines of inventory
may be slow moving, but management will need to establish why this is. Has a competitor
introduced a rival product, or reduced its prices? Have there been any quality issues with the
product which have damaged its reputation in the marketplace? Is the product in a long-term
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decline and should production of it be discontinued? In this respect, information about quantities
of a product sold compared with quantities produced could also be very useful. For example, if a
product is selling very well, production may need to be increased so that demand can be satisfied
and any stock-outs avoided.
Customer data is vital in any business that strives to focus on customers. Thus, data on buying
habits, where customers shop, what they buy and who the main customers are all give feedback
for control purposes.
Equally, data from customer sales accounts can provide useful information on how customer
debts are aged. A report on the ageing of debt can provide management with information on how
successful its control policy is on receivables . Management’s response will be different if half the
customer debt has been outstanding for more than say, 60 days, compared with only 5% of the
debt being outstanding for the same period of time.
External data is useful for benchmarking, provided the correct or appropriate benchmarks are
selected.
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Information systems
and data analytics
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1 Strategic planning, control and decision-making
The important fact which distinguishes strategic management accounting from other
management accounting activities is its external orientation, towards customers and competitors,
suppliers and perhaps other stakeholders.
Much strategic planning is uncertain.
(a) Strategic plans may cover a long period into the future, perhaps five to ten years ahead or
even longer.
(b) Many strategic plans involve big changes and new ventures, such as capacity expansion
decisions, decisions to develop into new product areas and new markets, and so on.
The challenge lies in providing relevant information for strategic planning, control and decisionmaking. Traditional management accounting systems may not always provide this.
(a) Historical costs are not necessarily the best guide to decision-making. One of the criticisms
of management accounting is that management accounting information is biased towards
the past rather than the future.
(b) Strategic issues are not easily detected by management accounting systems.
(c) Financial models of some sophistication are needed to enable management accountants to
provide useful information.
2 Management control
Management control is concerned with:
(a) Resources (which can be categorised as a series of ‘M’s): money, manpower (meaning staff,
although this term is admittedly outdated), machinery, methods, markets, management, and
management information.
(b) Efficiency in the use of resources means that optimum output is achieved from the input
resources used. It relates to the combinations of staff, land and capital (eg how much
production work should be automated) and to the productivity of labour, or material usage.
(c) Effectiveness in the use of resources means that the outputs obtained are in line with the
intended objectives or targets.
The time horizon involved in management control will be shorter than at the strategic decisions
level, there will be much greater precision and the focus of information will be narrower.
Management control activities are short-term non-strategic activities.
2.1 Examples of management (or tactical) planning activities
(a)
(b)
(c)
(d)
(e)
Preparing budgets for the next year for sales, production, inventory levels, and so on
Establishing measures of performance by which profit centres can be gauged
Developing a product for launching in the market
Planning advertising and marketing campaigns
Establishing a line of authority structure for the organisation
2.2 Examples of management control activities
(a) Ensuring that budget targets are reached, or improved on
(b) Ensuring that other measures of performance are satisfactory, or even better than planned
(c) Where appropriate, changing the budget because circumstances have altered
2.3 Sources of information
A large proportion of this information will be generated from within the organisation and it will
often have an accounting emphasis. Tactical information is usually prepared regularly; perhaps
weekly or monthly.
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2.4 Management control and strategic planning compared
The dividing line between strategic planning and management control is not a clear one; many
decisions include issues ranging from strategic to tactical. Nevertheless, there is a basic
distinction between the two levels of decision.
(a) The decision to launch a new brand of calorie-controlled frozen foods is a strategic plan
(business strategy), but the choice of ingredients for the frozen meals involves a management
control decision.
(b) The decision to make the market share for a product 25% is a strategic plan (competitive
strategy), but the selection of a sales price of $2 per unit, supported by other marketing
decisions about sales promotion and direct sales effort to achieve the required market share,
would be a series of management control decisions.
Management control tends to be carried out in a series of regular planning and comparison
procedures (annually, monthly, weekly). For example, a budget is usually prepared annually, and
control reports issued every month or four weeks. Strategic planning, in contrast, might be
irregular and occur when opportunities arise or are identified.
2.5 Operational control
The third and lowest tier in Anthony’s hierarchy of decision-making consists of operational control
decisions. Just as ‘management control’ plans are set within the guidelines of strategic plans, so
too are ‘operational control’ plans set within the guidelines of both strategic planning and
management control.
2.6 Example: Link between strategic plans and operational/management
control decisions
(a) Senior management may decide that the company should increase sales by 5% per annum
for at least five years – a strategic plan.
(b) The sales director and senior sales managers will make plans to increase sales by 5% in the
next year, with some provisional planning for future years. This involves planning direct sales
resources, advertising, sales promotion, and so on. Sales quotas are assigned to each sales
territory – a tactical management control decision.
(c) The manager of a sales territory specifies the weekly sales targets for each sales
representative. This is an operational control decision: individuals are given tasks which they
are expected to achieve.
Operational control decisions are therefore much more narrowly focused and have a shorter time
frame than tactical or strategic decisions.
2.7 Operational control activities
Although we have used an example of selling tasks to describe operational control, it is important
to remember that this level of decision-making occurs in all aspects of an organisation’s
activities, even when the activities cannot be scheduled nor properly estimated because they are
non-standard activities (such as repair work and answering customer complaints).
The scheduling of unexpected or ‘ad hoc’ work must be done at short notice, which is a feature of
much operational decision-making. In the repairs department, for example, routine preventive
maintenance can be scheduled, but breakdowns occur unexpectedly, and repair work must be
scheduled and controlled ‘on the spot’ by a repairs department supervisor.
Operational control activities can also be described as short-term non-strategic activities.
3 ERP systems
Example: ERP
Say you are running a bicycle shop. Once you make a sale, you enter the order on the ERP
system. The system then updates the inventory of bicycles in the shop, incorporates the sale into
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the financial ledgers, prints out an invoice, and can prompt you to purchase more bikes to replace
the ones that you have sold. The ERP system can also handle repair orders and manage the spare
parts inventory. It can also provide automated tools to help you forecast future sales and to plan
activities over the next few weeks. There may also be data query tools present to enable
sophisticated management reports and graphs to be generated. In addition, the system may
handle the return of defective items from unhappy customers, the sending out of regular account
statements to customers and the management of payments to suppliers.
ERP systems can assist with the scheduling and deployment of all sorts of resources, physical,
monetary and human. A water company might use their ERP system to schedule a customer
repair job, deploy staff to the job, verify that it was completed, and subsequently bill the
customer. An oil company might use it to ensure that their tankers are loaded, that a shipping
itinerary is prepared and completed on schedule, and that all the equipment and people required
for loading and unloading the cargo in each port are present at the right times. A bus company
might use its system to manage customer bookings, record receipts and plan preventive
maintenance activities for their fleet.
4 Big data
4.1 Making use of big data
The following example, about big data in the logistics industry, illustrates some of the ways big
data can help an organisation.
Real world example
Logistics providers, such as DHL, manage a massive flow of goods around the globe, and at the
same time create vast data sets; for example, from recording the origin and destination, size and
weight of millions of shipments every day, and then from tracking their location across global
delivery networks.
Big data can also provide a number of potential benefits to logistics providers, and this case
example highlights three of these (DHL, 2013).
Last-mile optimisation
A major constraint on the levels of operational efficiency in a distribution network is the so-called
‘last mile’ – the final stage of a supply chain in which goods are handed over to the recipient. This
final stage can often be one of the most expensive in the supply chain (for example, if a delivery
driver becomes stuck in a traffic jam, or if a recipient is not present when a courier attempts to
deliver their package, the delivery has to be rearranged).
Analysis of big data can help to increase last-mile efficiency through route optimisation, aimed at
saving time in the delivery process. Rapid processing of real-time information assists route
optimisation in a number of ways.
When the delivery vehicle is loaded and unloaded, sensors detect the destinations of the
packages and the optimal delivery sequence is then calculated for the driver.
Once the delivery vehicle has begun its journey, telematics databases are used to automatically
change delivery routes according to current traffic conditions. For example, if heavy traffic is
causing delays on the route originally scheduled, a revised route is generated for the driver to
avoid those delays.
In addition, routing intelligence makes use of availability and location information posted by
recipients in order to avoid unsuccessful delivery attempts.
The ‘big data’ aspects of this scenario are that the driver’s control systems make use of a number
of different optimisation procedures, fed by correlated streams of real-time events, to dynamically
re-route vehicles while they are on the road. As a result, each driver receives instant driving
direction updates from their onboard navigation system, guiding them to the next best point of
delivery.
Determining capacity
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Effective capacity planning can be an important competitive advantage. Too much capacity
reduces profitability, while capacity shortages affect service quality and potentially jeopardise
customer satisfaction (eg by increasing delivery times).
Big data can support capacity planning by analysing data about the historical capacity and
utilisation rates of transit points and transportation routes. In addition, it can take account of
seasonal factors and emerging freight flow trends (which are affected by external economic
information, such as industry or regional growth forecasts).
As well as identifying potential under-capacity, planners can expose any potential overcapacity,
and identifying this should provide a trigger to try to increase sales volumes.
Risk evaluation
Logistics providers need to be aware of forces which could affect the performance of the supply
chain – for example, local developments in politics, economy or events in the natural environment.
Data on these environmental factors can come from a number of sources (eg weather forecasts,
new sites, social media and blogs) but must then be aggregated and analysed. Much of this data
stream is unstructured and continuously updating, so the power of big data analytics in dealing
with velocity and variability could be invaluable in detecting supply chain risks. For example, if
there is a tornado warning in the region where a transhipment point is located, the logistics
company will need to alert its customer to this risk, as well as suggesting suitable countermeasures to mitigate against potential disruption (eg either re-planning the transport route, or
else increasing substitute supplies from another area).
(Based on DHL, 2013)
The DHL case study illustrates some of the ways big data can help an organisation but, more
generally, one of the main ways in which big data can create value for organisations is through
improving operational efficiency. Data can be used to make better decisions, to optimise resource
consumption and to improve process quality and performance.
McKinsey’s Big Data report (McKinsey, 2011) highlights ways in which big data can benefit
organisations:
(a) Creating transparency
Making data more easily accessible to relevant stakeholders, in a timely manner, can create value
in its own right (eg by revealing insights from data which had previously been too costly or
complex to process).
This transparency could relate to data within an organisation (eg through better integration and
analysis of data produced by different parts of an organisation) but in many cases it relates to
external data. For example, analysing shoppers’ transactions, alongside social and geographical
data, can reveal peer influence among customers (ie the extent to which shoppers’ choices are
shaped by their friends and neighbours as well as by the marketing efforts of a company itself).
Another important context in which transparency can be valuable for organisations is in relation
to fraud. For example, having real-time information available from a variety of sources could help
them expose fraud and irregular business practices among customers, employees, suppliers or
other partners more quickly than they would otherwise have been able to do so.
(b) Performance improvement
As organisations create, and store, more transaction data in digital form, they can collect more
accurate and detailed performance information. This enables them to identify variations in
performance (eg around sales of different products) and then to assess the reasons for those (eg
monitoring customer comments on social media could help to identify changes to products which
are needed to meet customers’ needs more effectively, and thereby to increase sales).
Detailed performance data can also be useful for controlling and cutting costs as well as boosting
revenue. Having a complete picture of operational activities, and a detailed picture of costs, can
help organisations identify patterns that indicate wasteful or inefficient processes. Similarly,
understanding the dynamics of the supply chain in more detail could help organisations optimise
its costs, capacity and inventory levels, as well as the service they provides customers (for
example, through improved product availability).
(c) Decision making
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The sophisticated analytics tools which are used to uncover previously hidden patterns and trends
in data could also be used to improve decision making. For example, trends identified by a retailer
in online and in-store sales, in real time, could be used to manage inventories and pricing. In some
cases, decisions will be made by managers in store (based on analytics from the data sets) but in
other cases the decisions themselves could even become automated. So, for example, a retailer
could use algorithms to optimise decisions about inventory levels and pricing in response to
current and predicted sales data.
(d) New products and services
Entities can use data about social trends and consumer behaviours to create new products and
services to meet customers’ needs, or to enhance existing products and services so that they meet
customers’ needs more exactly. The emergence of real-time location data from traffic light
sensors and satellite navigation systems, for example, could enable insurance companies to refine
the pricing of their insurance policies according to where and how people drive their cars. Equally,
manufacturers can use data from sensors embedded in products to offer innovative after-sales
service offerings, such as proactive maintenance (preventative measures, that take place before a
failure occurs or is even noticed).
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Activity based costing
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1 Costing
Cost accounting is used to determine the cost of products, jobs or services. Such costs have to be
built up using a process known as cost accumulation.
In your earlier studies you will have learnt how to accumulate the various cost elements which
make up total cost.
Absorption costing cost accumulation system
Direct costs
Materials
Labour
Indirect costs/overheads
Expenses
Production
Absorbed
overhead
Non-production
Under/over-absorbed
overhead
Production cost
Total cost
1.1 The problem of overheads
If a company manufactures a product, the cost of the product will include the cost of the raw
materials and components used in it and the cost of the labour effort required to make it. These
are direct costs of the product. The company would, however, incur many other costs in making
the product which are not directly attributable to a single product, but are instead incurred
generally in the process of manufacturing a large number of product units. These are indirect
costs or overheads. Such costs include the following:
• Factory rent and rates
• Machine depreciation
• Supervision costs
• Heating and lighting
KEY
TERM
Direct cost: A direct cost is a cost that can be traced in full to the product, service or
department that is being costed.
Indirect cost or overhead: An indirect cost or 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 or exclusively to the product, service or department.
In some companies, total overhead costs may be substantially greater than the total of direct
production costs.
It might seem unreasonable to ignore indirect costs entirely when accumulating the costs of
making a product, and yet there cannot be a completely satisfactory way of sharing out indirect
costs between the many different items of production which benefit from them.
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1.2 Using absorption costing
Traditionally, the view has been that a fair share of overheads should be added to the cost of units
produced to obtain a full unit cost of production and sales. This fair share should include a
portion of production overhead expenditure and possibly administration and marketing
overheads too. This is the view embodied in the principles of absorption costing.
Practical reasons for using absorption costing:
(a) Inventory valuations
Inventory in hand must be valued for two reasons:
• For the closing inventory figure in the statement of financial position
• To calculate the cost of sales figure in the statement of profit or loss
The valuation of inventories will affect profitability during a period because of the way in which
the cost of sales is calculated.
Cost of goods sold = cost of goods produced + opening inventory value – closing inventory value
(b) Pricing decisions
Many companies attempt to set selling prices by calculating the full cost of production or sales
of each product, and then adding a margin for profit. ‘Full cost plus pricing’ can be particularly
useful for companies which do jobbing or contract work, where each job or contract is different,
so that a standard unit sales price cannot be fixed. Without using absorption costing, it may be
difficult to decide what the price should be in order to earn a satisfactory profit.
(c) Establishing the profitability of different products
This argument in favour of absorption costing states that, if a company sells more than one
product, it will be difficult to judge how profitable each individual product is, unless overhead
costs are shared on a fair basis and charged to the cost of sales of each product.
1.3 Revision of absorption costing
Absorption costing is a traditional approach to dealing with overheads, involving three stages:
allocation, apportionment and absorption.
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.
KEY
TERM
•
•
•
•
•
Product costs are built up using absorption costing by a process of allocation, apportionment
and overhead absorption.
Allocation is the process by which whole cost items are charged directly to a cost unit or cost
centre. Direct costs are allocated directly to cost units. Overheads clearly identifiable with cost
centres are allocated to those cost centres but costs which cannot be identified with a
particular cost centre are allocated to general overhead cost centres. The cost of a warehouse
security guard would therefore be charged to the warehouse cost centre but heating and
lighting costs would be charged to a general overhead cost centre.
The first stage of overhead apportionment involves sharing out (or apportioning) the
overheads within general overhead cost centres between the other cost centres using a fair
basis of apportionment (such as floor area occupied by each cost centre for heating and
lighting costs).
The second stage of overhead apportionment is to apportion the costs of service cost centres
(both directly allocated and apportioned costs) to production cost centres.
After the apportionment of production overheads, all the overhead costs have been divided or
shared between the production departments. The final stage in absorption costing is the
absorption into product costs (using overhead absorption rates) of the overheads that have
been allocated and apportioned to the production cost centres.
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•
An overhead absorption rate is calculated for each production department (or for production
activity as a whole). Typically, this is an absorption rate per direct labour hour worked or an
absorption rate per machine hour worked
1.4 Overhead absorption
Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add
them to, or absorb them into, the cost of production or sales.
Overhead costs are absorbed using a predetermined rate based on budgeted figures.
1.5 Use of predetermined absorption rate
Step 1 The overhead likely to be incurred during the coming year is estimated.
Step 2 The total hours, units or direct costs on which the overhead absorption rates are based
(activity levels) are estimated.
Step 3 Absorption rate = estimated overhead / budgeted activity level
Formula to learn
Overhead absorption rate (OAR) = Budgeted production overheads / Budgeted level of activity
1.6 Choosing the appropriate absorption base
The choice of an absorption basis is a matter of judgement and common sense. There are no
strict rules or formulae involved. However, the basis should realistically reflect the characteristics
of a given production centre, avoid undue anomalies and be ‘fair’. The choice will be significant in
determining the cost of individual products, but the total cost of production overheads is the
budgeted overhead expenditure, no matter what basis of absorption is selected. It is the relative
share of overhead costs borne by individual products and jobs which is affected.
1.7 Over- and under-absorption of overheads
The rate of overhead absorption is based on estimates in the budget, of both the numerator
(budgeted expenditure) and denominator (budgeted activity level), and it is quite likely that what
actually occurs will differ from either one or both of these estimates. As a consequence, actual
overheads incurred will probably be either greater than or less than overheads absorbed into the
cost of production, and so it is almost inevitable that at the end of the accounting year there will
have been an over-absorption or under-absorption of the overhead actually incurred.
• Over-absorption means that the overheads charged to the cost of production or sales are
greater than the overheads actually incurred.
• Under-absorption means that insufficient overheads have been included in the cost of
production or sales.
Under-absorption may also be called under-recovery of overheads; over-absorption may be
called over-recovery.
Suppose that the budgeted overhead in a production department is $80,000 and the budgeted
activity is 40,000 direct labour hours. The overhead recovery rate (using a direct labour hour
basis) would be $2 per direct labour hour.
Suppose that actual overheads in the period are $84,000 and 45,000 direct labour hours are
worked.
$
84,000
90,000
Overhead incurred (actual)
Overhead absorbed (45,000 × $2)
Over-absorption of overhead
6,000
In this example, the cost of production has been charged with $6,000 more than was actually
spent and so the recorded cost of production will be too high. The over-absorbed overhead will be
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an adjustment to profit at the end of the accounting period to reconcile the overheads charged to
the actual overhead.
1.8 Illustrations
Illustration 1: Overhead absorption basis
Mars Co has two production departments, mixing and stirring, in which it makes a variety of
products.
Mixing
Stirring
Direct labour hours
20,000
5,000
Direct machine hours
2,000
60,000
Required
Based on the above information, what are the most appropriate overhead absorption bases for
the mixing and stirring departments?
 Both departments’ OAR should be based on labour hours
 Both departments’ OAR should be based on machine hours
 The mixing department’s OAR should be based on labour hours and the stirring department’s
OAR should be based on machine hours
 The mixing department’s OAR should be based on machine hours and the stirring
department’s OAR should be based on labour hours
Solution
The correct answer is:
The mixing department’s OAR should be based on labour hours and the stirring department’s OAR
should be based on machine hours
Mixing department is labour intensive, therefore a suitable OAR would be budgeted direct labour
hours.
Stirring department is machine intensive, therefore a suitable OAR would be budgeted direct
machine hours.
Illustration 2: Overhead absorption rates 1
Budgeted information for department A is as follows:
Department A
Budgeted overheads
$40,000
Direct machine hours
2,000
Calculate the budgeted overhead absorption rate per machine hour for department A?
Budgeted OAR = $
per machine hour
Solution
The correct answer is:
Budgeted OAR = $20 per machine hour
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Budgeted OAR =
= Budgeted overheads / budgeted machine hours
= $40,000 /2,000 hours
= $20 per machine hour
Illustration 3: Under- and over-absorption
Co A has budgeted fixed production overheads of $20,000 and budgeted activity of 20,000 units.
Required
What would the under absorption be if actual overhead expenditure was $21,000 and exactly
20,000 units were produced?
$
Solution
The correct answer is:
$1000
The OAR is 20,000 (budgeted overhead) / 20,000 (budgeted activity in units) = $1 per unit.
Actual overhead expenditure
Amount of overhead absorbed ($1 × 20,000)
Under/(over) absorption
$21,000
($20,000)
$1,000 under absorbed
Activity 1: Overhead absorption rates 2
Pumpkin Co provides you with the following budgeted information for its painting division.
Total overheads: $400,000.
Total budgeted direct labour hours: 3,200
1
Total budgeted machine hours: 10,000
Required
Calculate the budgeted fixed overhead absorption rate using a direct labour hours basis.
2
OAR = $
per direct labour hour
Required
Calculate the budgeted fixed overhead absorption rate using a machine hours basis.
3
OAR = $
per direct labour hour
The painting manager informs you that the painting division is highly automated and operates
with expensive machinery which is run whenever possible on a 24 hour a day, 7 days a week
basis.
4
Required
Which of the two OARs calculated above would be the most appropriate for absorption?
 $40 per machine hour
 $125 per direct labour hour
At the end of the accounting period, the painting manager provides you with the following actual
data for the painting division:
Total overheads = $521,262
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Total direct labour hours = 4,100
Total machine hours = 12,562
Required
Calculate the amount of overheads over- or under-absorbed for the period using the basis chosen
in the previous question.
$
Solution
1
2
3
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2 Marginal costing
KEY
TERM
Marginal cost: Marginal cost is the cost of one unit of a product/service which could be
avoided if that unit were not produced/provided.
Contribution: Contribution is the difference between sales revenue and variable (marginal)
cost of sales.
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Marginal costing: Marginal costing is an alternative to absorption costing. Only variable costs
(marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are
charged in full against the profit of the period in which they are incurred.
In marginal costing, closing inventories are valued at marginal (variable) production cost
whereas, in absorption costing, inventories are valued at their full production cost which includes
absorbed fixed production overhead.
If the opening and closing inventory levels differ in an accounting period, the profit reported for
the period will differ between absorption costing and marginal costing.
But in the long run, total profit for a company will be the same whichever costing method is used
because, in the long run, total costs will be the same by either method of accounting. The
different costing methods merely affect the reported profit for individual accounting periods.
Activity 2: Absorption and marginal costing
1 A company 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 is $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
Prepare profit statements for each period and for the two periods in total using both absorption
costing and marginal costing.
Solution
1
2.1 Absorption costing and marginal costing compared
If opening and closing inventory levels differ, the profit reported under the two methods will be
different.
In the long run, total profit will be the same whichever method is used.
The difference in profits reported under the two costing systems is due to the different inventory
valuation methods used.
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If inventory levels increase between the beginning and end of a period, absorption costing will
report the higher profit because some of the fixed production overhead incurred during the period
will be carried forward in closing inventory (which reduces cost of sales) to be set against sales
revenue in the following period, instead of being written off in full against profit in the period
concerned.
If inventory levels decrease, absorption costing will report the lower profit because, as well as
the fixed overhead incurred, fixed production overhead which had been carried forward in
opening inventory is released and is also included in cost of sales.
The profits reported for Period 1 in the activity above would be reconciled as follows:
$
Marginal costing profit
400
Adjust for fixed overhead in inventory (inventory increase of 300 units × $1 per unit)
300
Absorption costing profit
700
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Activity answers
Activity 1: Overhead absorption rates 2
1
The correct answer is:
OAR = $125 per direct labour hour
OAR = budgeted overheads/ budgeted labour hours = $400,000 / 3,200 hours
2
=$125 per labour hour
The correct answer is:
OAR = $40 per direct labour hour
OAR = budgeted overheads/budgeted machine hours = $400,000 / 10,000
3
= $40 per machine hour
The correct answer is:
$40 per machine hour
4
As the painting division is machine intensive, a machine hour based OAR is more appropriate for
calculations ($40 per machine hour).
The correct answer is:
$18,782
Over/under absorbed overheads
= $40 × 12,562 machine hours
= $502,480
Overheads actually incurred
= $521,262
Therefore, overheads were under-absorbed by $521,362 – $502,480 = $18,782
Activity 2: Absorption and marginal costing
1 The correct answer is:
It is important to note that although production and sales volumes in each period are different,
over the full period, total production volume equals sales volume. The total cost of sales is the
same and therefore the total profit is the same by either method of accounting. There are
differences in the reported profit in Period 1 and in Period 2, but these are merely timing
differences which cancel out over a longer period of time (in this example, over the two periods).
Absorption costing. The absorption rate for fixed production overhead is $1,500/1,500 units = $1
per unit. The fully absorbed cost per unit = $(4+1) = $5.
Period 1
$
Sales
Production costs
Variable
Fixed
Add: opening
inventory b/f
(300 ×
$5)
Less: closing
inventory c/f
Production cost of
sales
(300 ×
$5)
Period 2
$
7,200
$
$
10,200
Total
$
6,000
1,500
7,500
-
5,600
1,400
7,000
1,500
11,600
2,900
14,500
1,500
7,500
1,500
8,500
-
16,000
1,500
6,000
8,500
14,500
$
17,400
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Period 1
$
-
Under-absorbed
overhead
Total costs
Gross profit
Other costs
Net profit
$
Period 2
$
100
$
Total
$
100
$
6,000
1,200
(500)
700
8,600
1,600
(500)
1,100
14,600
2,800
(1000)
1,800
Period 1
Period 2
Total
Marginal costing
The marginal cost per unit = $4.
$
Sales
Variable
production
cost
Add: opening
inventory b/f
Less: closing
inventory b/f
Variable prod.
Cost of sales
Contribution
Fixed costs
Profit
510
(300 ×
$4)
(300 ×
$4)
$
7,200
$
$
10,200
$
6,000
5,600
11,600
-
1,200
1,200
6,000
1,200
6,800
-
12,800
1,200
4
17,400
4,800
6,800
11,600
2,400
2,000
400
3,400
2,000
1,400
5,800
4,000
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Target costing
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Life cycle costing
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Throughput
accounting
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Environmental
management
accounting
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8
Cost volume profit
(CVP) analysis
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1 Multi-product charts
1.1 Breakeven charts
A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and
margins of safety for a single product only, or at best for a single ‘sales mix’ of products.
Breakeven charts for multiple products can be drawn if a constant product sales mix is assumed.
For example, suppose that FA 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.
A breakeven chart cannot be drawn, because we do not know the proportions of X, Y and Z in the
sales mix.
There are a number of ways in which we can overcome this problem, however. One approach is to
assume a constant product mix.
1.1.1 Output in $ sales and a constant product mix
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; in other words, that the sales mix is ‘fixed’
in these proportions.
We begin by carrying out some calculations.
Budgeted costs
Variable costs of X
Variable costs of Y
Variable costs of Z
Total variable costs
Cost
$
6,000
16,000
15,000
37,000
2,000 × $3
4,000 × $4
3,000 × $5
Fixed costs
Total budgeted costs
X (2,000 × $8)
Y (4,000 ×$6)
Z (3,000 × $6)
Budgeted
revenue
Revenue
$
16,000
24,000
18,000
58,000
10,000
47,000
The breakeven chart can now be drawn.
Costs and
revenue
$'000
60
50
v
Re
u
en
Profit
($11,000 at budget)
e
sts
40
o
al c
Tot
Breakeven point
30
20
Fixed costs
10
0
1,000
5,000
9,000
Sales units
The breakeven point is approximately $27,500 of sales revenue. This may either be read from the
chart or computed mathematically.
(a) The budgeted C/S ratio for all three products together is contribution/sales = $(58,000 –
37,000)/$58,000 = 36.21%.
(b) The required contribution to breakeven is $10,000: the amount of fixed costs. The breakeven
point is $10,000/36.21% = $27,500 (approx) in sales revenue.
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The margin of safety is approximately $(58,000 – 27,500) = $30,500.
1.2 Multi-product P/V chart
The breakeven point of $27,500 from above, could be shown on a P/V chart as follows:
Profit/loss ($'000)
10
Profit
5
Breakeven
Budgeted profit
Breakeven point
($27,500)
0
20
40
58
Revenue
($'000)
5
Loss
10
An addition to the chart would show further information about the contribution earned by each
product individually, so that their performance and profitability can be compared.
Product X
Product Y
Product Z
Total
Contribution
$
10,000
8,000
3,000
Sales
$
16,000
24,000
18,000
C/S ratio
%
62.50
33.33
16.67
21,000
58,000
36.21
By convention, the products are shown individually on a P/V chart from left to right, in order of
the size of their C/S ratio. In this example, Product X will be plotted first, then Product Y and
finally Product Z. A dotted line is used to show the cumulative profit/loss and the cumulative
sales as each product’s sales and contribution in turn are added to the sales mix.
Product
X
X and Y
X, Y and Z
Cumulative sales
$
16,000 ($10,000 contribution $10,000 fixed costs)
40,000
58,000
Cumulative profit
$
8,000
11,000
You will see on the graph which follows that these three pairs of data are used to plot the dotted
line, to indicate the contribution from each product. The solid line which joins the two ends of this
dotted line indicates the average profit which will be earned from sales of the three products in
this mix.
Multi-product P/V chart
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Profit/loss ($'000)
11
Z
8
Profit
Budgeted profit
Y
4
Breakeven
0
4
X
10
20
30
40
50
Breakeven
point
58
Revenue
($'000)
Loss
8
12
The diagram highlights the following points:
(a) Since X is the most profitable in terms of C/S ratio, it might be worth considering an increase
in the sales of X, even if there is a consequent fall in the sales of Z.
(b) Alternatively, the pricing structure of the products should be reviewed and a decision made
as to whether the price of Product Z should be raised so as to increase its C/S ratio (although
an increase is likely to result in some fall in sales volume).
The multi-product P/V chart therefore helps to identify the following.
(a) The overall company breakeven point
(b) Which products should be expanded in output and which, if any, should be discontinued
(c) What effect changes in selling price and sales volume will have on the company’s breakeven
point and profit
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9
Limiting factor
analysis
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1 Two potentially limiting factors
You may be asked to deal with situations where two factors are potentially the limiting factor (and
there are also sales demand limitations). The approach in these situations is to find out which
factor (if any) prevents the business from fulfilling maximum sales demand.
Illustration 1: Example
1 Lucky manufactures and sells three products, X, Y and Z, for which budgeted sales demand, unit
selling prices and unit variable costs are as follows:
Budgeted sales demand
Unit sales price
Variable costs: materials
Labour
Unit contribution
X
550 units
$
$
16
8
4
12
Y
500 units
$
$
18
6
6
12
Z
400 units
$
$
14
2
9
11
4
6
3
The organisation has existing inventory of 250 units of X and 200 units of Z, which it is quite
willing to use up to meet sales demand. All three products use the same direct materials and the
same type of direct labour. In the next year, the available supply of materials will be restricted to
$4,800 (at cost) and the available supply of labour to $6,600 (at cost).
Determine what product mix and sales mix would maximise the organisation’s profits in the next
year.
Solution
1 The correct answer is:
There are two scarce resources that may be a limiting factor: direct materials and direct labour.
However, this is not certain. Because there is a limit to sales demand, either of the following may
apply.
• There is no limiting factor at all, except sales demand.
• There is only one scarce resource that prevents the full potential sales demand being
achieved.
Step 1 Establish which of the resources, if any, is scarce.
Budgeted sales
Inventory in hand
Minimum production to meet demand
X
Y
Z
Total required
Total available
(Shortfall)/Surplus
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Minimum production to
meet sales demand
Units
300
500
200
X
Units
550
250
300
Y
Units
500
0
500
Z
Units
400
200
200
Required materials
at cost
$
2,400
3,000
400
5,800
4,800
Required labour at
cost
$
1,200
3,000
1,800
6,000
6,600
(1,000)
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Materials are a limiting factor, but labour is not.
Step 2 Rank X, Y and Z in order of contribution earned per $1 of direct materials consumed.
X
Y
Z
$
$
$
Unit contribution
4
6
3
Cost of materials
8
6
2
Contribution per $1 materials
$0.50
$1.00
$1.50
Ranking
3rd
2nd
1st
Step 3 Determine a production plan. Z should be manufactured up to the limit where units
produced plus units held in inventory will meet sales demand; then Y should be produced second
and X third, until all the available materials are used up.
Ranking
1st
2nd
3rd
Product
Z
Y
X
Sales demand less
units held
Units
200
500
300
Production
quantity
Units
200
500
175
Total available
Materials cost
($2)
($6)
($8)
$
400
3,000
1,400*
4,800
* Balancing amount using up total available
Step 4 Draw up a budget. The profit-maximising budget is as follows:
Products
Units
Z opening
inventory
Z production
200
Material
cost/unit
$
Total material Contribution per $1
cost
of material
$
$
Total
contribution
$
200
400
$2
800
$1.50
1,200
Y production
500
$6
3,000
$1.00
3,000
X opening
inventory
X production
250
$8
3,400
$0.50
Total contribution
1,700
175
425
5,900
2 Non-financial considerations in make or buy decisions
Before management can make a final decision on whether they will manufacture a product inhouse, or source it from external suppliers, a number of non-financial factors should be
considered. The main issues are as follows:
Control. When a product is manufactured in-house, the company has control over quality,
delivery times, reliability and price stability. By outsourcing, the company becomes dependent
on an external supplier, despite having no influence in the external company.
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Customer perception. Customers may attach importance to producing goods or services inhouse, such as providing local call centre services, and in situations where customers are making
a concerted effort to support local business.
Opportunity cost. A business can prevent the under utilisation of employee skills by outsourcing
low skilled tasks and reallocating staff to more specialised activities.
3 Shadow prices
3.1 Limiting factors and shadow prices
Whenever there are limiting factors, there are opportunity costs. These are the benefits forgone
by using a limiting factor in one way instead of in the next most profitable way.
For example, suppose that an organisation provides two services, X and Y, which earn a
contribution of $24 and $18 per unit respectively. Service X requires four labour hours, and service
Y two hours. Only 5,000 labour hours are available, and potential demand is for 1,000 of each of
X and Y.
Labour hours are a limiting factor, and with X earning $6 per hour and Y earning $9 per hour, the
profit-maximising decision would be as follows:
Y
X (balance)
Services
1,000
750
Hours
2,000
3,000
5,000
Contribution
$
18,000
18,000
36,000
Priority is given to Y because the opportunity cost of providing Y instead of more of X is $6 per
hour (X’s contribution per labour hour), and since Y earns $9 per hour, the incremental benefit of
providing Y instead of X would be $3 per hour.
If extra labour hours could be made available, more X (up to 1,000) would be provided, and an
extra contribution of $6 per hour could be earned. Similarly, if fewer labour hours were available,
the decision would be to provide fewer X and to keep provision of Y at 1,000, and so the loss of
labour hours would cost the organisation $6 per hour in lost contribution. This $6 per hour, the
marginal contribution-earning potential of the limiting factor at the profit-maximising output
level, is referred to as the shadow price (or dual price) of the limiting factor.
Note that the shadow price only applies on the assumption that the extra unit of resource can be
obtained at its normal variable cost. The shadow price also indicates the amount by which
contribution could fall if an organisation is deprived of one unit of the scarce resource.
The shadow price of a resource is its internal opportunity cost. This is the marginal contribution
towards fixed costs and profit that can be earned for each unit of the limiting factor that is
available.
Exam focus point
Depending on the resource in question, shadow prices enable management to make better
informed decisions about the payment of overtime premiums, bonuses, premiums on small
orders of raw materials, and so on, in order to obtain additional units of a limiting resource.
4 Slack
4.1 Example
A company makes boxes (B) and tins (T). Contribution per box is $5 and per tin is $7. A box
requires three hours of machine processing time, 16kg of raw materials and six labour hours. A tin
requires 10 hours of machine processing time, 4kg of raw materials and six labour hours. In a
given month, 330 hours of machine processing time, 400kg of raw material and 240 labour hours
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are available. The manufacturing technology used means that at least 12 tins must be made every
month. The constraints are:
3B + 10T < 330
16B + 4T < 400
6B + 6T < 240
T > 12
B>0
The solution is not shown in detail here, but the optimal solution is found to be to manufacture
and sell 10 Bs and 30 Ts.
If we substitute these values into the inequalities representing the constraints, we can determine
whether the constraints are binding or whether there is slack.
Machine time:
(3 × 10) + (10 × 30) = 330 = availability
Constraint is binding.
Raw materials:
(16 × 10) + (4 × 30) = 280 < 400
There is slack of 120kg of raw materials.
Labour:
(6 ×10) + (6 × 30) = 240 = availability
Constraint is binding.
If a minimum quantity of a resource must be used or produced and, at the optimal solution, more
than that quantity is produced, there is a surplus on the minimum requirement. This is shown here
in the production of tins where the optimal production is 30 tins but T ≥ 12. There is, therefore, a
surplus of 18 tins over the minimum production requirement.
You can see from this that slack is associated with ‘less than or equal to’ constraints and surplus
with ‘more than or equal to’ constraints. Machine time and labour are binding constraints so they
have been used to their full capacity. It can be argued that if more machine time and labour
could be obtained, more boxes and tins could be produced and contribution increased.
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Pricing decisions
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1 Influences on price
In the modern world, there are many more influences on price than cost (eg competitors, product
range, quality).
Influence
Explanation/Example
Price sensitivity
Sensitivity to price levels will vary among purchasers. Those that can pass
on the cost of purchases will be the least sensitive and will therefore
respond more to other elements of perceived value. For example, a
business traveller will be more concerned about the level of service in
looking for a hotel than price, provided that it fits the corporate budget. In
contrast, a family on holiday are likely to be very price sensitive when
choosing an overnight stay.
Price perception
Price perception is the way customers react to prices. For example,
customers may react to a price increase by buying more. This could be
because they expect further price increases to follow (they are ‘stocking
up’).
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
If an organisation distributes products or services to the market through
independent intermediaries, such intermediaries are likely to deal with a
range of suppliers and their aims concern their own profits rather than
those of suppliers.
Competitors
In some industries (such as petrol retailing) pricing moves in unison; in
others, price changes by one supplier may initiate a price war.
Competition is discussed in more detail below.
Suppliers
If an organisation’s suppliers notice a price rise for the organisation’s
products, they may seek a rise in the price for their supplies to the
organisation.
Inflation
In periods of inflation, the organisation may need to change prices to
reflect increases in the prices of supplies, labour, rent, and so on.
Newness
When a new product is introduced for the first time, there are no existing
reference points, such as customer or competitor behaviour; pricing
decisions are most difficult to make in such circumstances. It may be
possible to seek alternative reference points, such as the price in another
market where the new product has already been launched, or the price
set by a competitor.
Incomes
If incomes are rising, price may be a less important marketing variable
than product quality and convenience of access (distribution). When
income levels are falling and/or unemployment levels rising, price will be
more important.
Product range
Products are often interrelated, being complements to each other or
substitutes for one another. The management of the pricing function is
likely to focus on the profit from the whole range rather than the profit on
each single product.
For example, a very low price is charged for a loss leader to make
consumers buy additional products in the range which carry higher profit
margins (eg selling razors at very low prices while selling the blades for
them at a higher profit margin).
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Influence
Explanation/Example
Ethics
Ethical considerations may be a further factor, for example whether or not
to exploit short-term shortages through higher prices.
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Short-term decisions
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1 Non-financial factors
1.1 Examples of non-quantifiable factors
Non-quantifiable factors in decision-making will vary with the circumstances and nature of the
opportunity being considered. Here are some examples:
Factors
Details
Availability of cash
An opportunity may be profitable, but there must be sufficient
cash to finance any purchases of equipment and build‑up of
working capital.
Inflation
The effect of inflation on the prices of various items may need
to be considered, especially where a fixed price contract is
involved in the decision: if the income from an opportunity is
fixed by contract, but the costs might increase with inflation,
the contract’s profitability would be overstated unless inflation
is taken into account.
Employees
Any decision involving the shutdown of a plant, creation of a
new work shift, or changes in work procedures or location will
require acceptance by employees, and ought to consider
employee welfare.
Customers
Decisions about new products or product closures, the quality
of output or after‑sales service will inevitably affect customer
loyalty and customer demand. It is also important to remember
that a decision involving one product may have repercussions
on customer attitudes towards a range of products.
Competitors
In a competitive market, some decisions may stimulate a
response from rival companies. For example, the decision to
reduce selling prices in order to raise demand may not be
successful if all competitors take similar action.
Timing
There might be a choice in deciding when to take up an
opportunity. The choice would not be ‘accept or reject’; there
would be three choices:
•
•
•
Accept an opportunity now.
Do not accept the opportunity now, and wait before doing
so.
Reject the opportunity.
Suppliers
Some decisions will affect suppliers, whose long‑term goodwill
may be damaged by a decision to close a product line
temporarily. Decisions to change the specifications for
purchased components, or change inventory policies so as to
create patchy, uneven demand might also put a strain on
suppliers. In some cases, where a company is the supplier’s
main customer, a decision to reduce demand or delay
payments for goods received might drive the supplier out of
business.
Feasibility
A proposal may look good in financial terms, but technical
experts or departmental managers may have some
reservations about their ability to carry it out.
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Factors
Details
Flexibility and internal
control
Decisions to subcontract work or to enter into a long‑term
contract have the disadvantages of inflexibility and lack of
controllability. Where requirements may be changeable, it
would be preferable to build flexibility into the organisation of
operations.
Unquantified opportunity
costs
Even where no opportunity costs are specified, it is probable
that other opportunities would be available for using the
resources to earn profit. It may be useful to qualify a
recommendation by stating that a given project would appear
to be viable on the assumption that there are no other more
profitable opportunities available.
Political pressures
Some large companies may suffer political pressures applied
by the Government to influence their investment or
disinvestment decisions.
Legal and ethical
constraints
A decision might occasionally be rejected because of doubts
about the legality or ethics of the proposed action.
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Risk and uncertainty
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1 Market research
Market research into customer habits, attitudes or intentions can be used to reduce uncertainty.
Market research involves tackling problems. The assumption is that these problems can be solved,
no matter how complex the issues are, if the researcher follows a line of enquiry in a systematic
way without losing sight of the main objectives. Gathering and analysing all the facts will
ultimately lead to better decision-making.
1.1 The role of market research
Market research is a widespread activity. Organisations in the private sector, the public sector
and the not for profit sector, rely on research to inform and improve their planning and decisionmaking.
Market research enables organisations to understand the needs and opinions of their customers
and other stakeholders. Armed with this knowledge, they are able to make better quality decisions
and provide better products and better services.
Thus, research influences what is provided and the way it is provided. It reduces uncertainty and
monitors performance. A management team that possesses accurate information relating to the
marketplace will be in a strong position to make the best decisions in an increasingly competitive
world.
Decision-makers need data to reduce uncertainty and risk when planning for the future and to
monitor business performance. Market researchers provide the data that helps them to do this.
An organisation wanting market research information will typically hire the services of a firm that
specialises in market research. This firm will plan the market research exercise so as to gather
information or opinions from a selected sample of individuals (or organisations). The information
obtained can then be analysed both qualitatively and statistically.
2 Focus group
Despite the rise in big data and use of algorithms to make predictions, focus groups are still used
in marketing to obtain qualitative data about customer or consumer attitudes. They are used, for
example, to obtain marketing information about attitudes to a new product or to a new
advertisement for a product. They may be used in the early stages of product development, when
an organisation is trying to assess the strength of consumer attitudes and to find out in detail
what they think of it.
Participants in a focus group are recruited on the basis of similar demographics, lifestyles, buying
attitudes or other behaviour, so that the views provided by the group may be regarded as typical
of the target market for the product.
Like market research, focus groups reduce uncertainty by providing information, and the
information will influence decisions about designing and marketing a product.
3 Simulation
Exam focus point
You will not be required to develop a simulation model in your exam. The following example is
provided so that you can understand how simulation models are developed.
3.1 Example: Simulation and spreadsheets
A supermarket sells a product for which the daily demand varies. An analysis of daily demand
over a period of about a year shows the following probability distribution.
Demand per day (units)
35
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Probability
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37
38
39
40
0.20
0.25
0.30
0.08
0.07
1.00
To develop a simulation model in which one of the variables is daily demand, we would assign a
group of numbers to each value for daily demand. The probabilities are stated to two decimal
places, and so there must be 100 random numbers in total, 00–99 (we use 00–99 rather than 1–
100 so that we can use two-digit random numbers.) Random numbers are assigned in proportion
to the probabilities, so that a probability of 0.1 gets 10% of the total numbers to be assigned; that
is, 10 numbers: 0, 1, 2, 3, 4, 5, 6, 7, 8 and 9.
The assignments would therefore be as follows:
Demand per day (units)
35
36
37
38
39
40
Probability
0.10
0.20
0.25
0.30
0.08
0.07
Numbers assigned
00-09
10-29
30-54
55-84
85-92
93-99
When the simulation model is run, random numbers will be generated to derive values for daily
demand. For example, if the model is used to simulate demand over a ten-day period, the random
numbers generated might be as follows: 19007174604721296802
The model would then assign values to the demand per day as follows:
Day
1
2
3
4
5
6
7
8
9
10
Random number
19
00
71
74
60
47
21
29
68
02
Demand (units)
36
35
38
38
38
37
36
36
38
35
You might notice that on none of the ten days is the demand 39 or 40 units, because the random
numbers generated did not include any value in the range 85–99. When a simulation model is
used, there must be a long enough run to give a good representation of the system and all its
potential variations.
3.2 Uses of simulation
In the example above, the supermarket would use the information to minimise inventory holding
without risking running out of the product. This will reduce costs but avoid lost sales and profit.
A supermarket can also use this technique to estimate queues at checkout desks, with predicted
lengths of waiting time determining the number of staff required.
4 Standard deviation
Risk can be defined as variability of return, or the range of possible outcomes.
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For example, it can be measured by the possible variations of outcomes around the mean. The
standard deviation compares each of the actual outcomes with the mean outcome. It then
calculates how far on average the actual outcomes deviate from the mean.
Standard deviation = 𝜎 =
∑(𝑥−𝑥)2
𝑛
Where
𝑥 is the mean
x represents each possible outcome
In general, the larger the standard deviation value in relation to the mean, the more dispersed the
data.
Illustration 1: Standard deviation
The sales of Product D by ABC Co for the last week were as follows:
Day
Units sold (x)
Monday
10
Tuesday
15
Wednesday
17
Thursday
12
Friday
11
Saturday
20
Sunday
13
Total
98
1 Required
What is the standard deviation of sales of Product D for the week?
Solution
1 The correct answer is:
3.30
There are 7 observations, therefore n = 7
Calculate the mean: 98/7 = 14 units
Day
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Sunday
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Units sold (x)
10
15
17
12
11
20
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(x - x̅)
-4
1
3
-2
-3
6
-1
(x - x̅)2
16
1
9
4
9
36
1
Day
Total
Units sold (x)
98
(x - x̅)2
76
(x - x̅)
Using the formula:
𝑆𝐷 =
∑(𝑥−𝑥)2
=
𝑛
76
7 = 3.30
4.1 Coefficient of variation
Coefficient of variation measures the standard deviation as a percentage of the mean. It is
particularly useful for comparing the dispersion of two distributions. The higher the percentage,
the higher the dispersion.
𝜎
Coefficient of variation = 𝑚𝑒𝑎𝑛
Illustration 2: Coefficient of variation
1 Required
What is the coefficient of variation for ABC Co (using the information from the Illustration above)?
Solution
1 The correct answer is:
24%
Using the formula: standard deviation / mean
Coefficient of variation = 3.30/14=0.2357
Multiplied by 100 this is 24%
ABC Co could compare this to other products to see which one has the most volatile sales.
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Budgetary systems
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1 Objectives of budgeting systems
A budget is a plan which will assist in achieving objectives.
Purpose of budgetary control:
P
– Planning
R
– Responsibility
I
– Integration and co-ordination
M – Motivation
E
– Evaluation and control
A budgetary planning and control system is essentially a system for ensuring communication,
coordination and control within an organisation. Communication, co-ordination and control are
general objectives: more information is provided by an inspection of the specific objectives of a
budgetary planning and control system.
Objective
Comment
Ensure the achievement of the organisation’s
objectives
Objectives are set for the organisation as a
whole, and for individual departments and
operations within the organisation. Quantified
expressions of these objectives are then drawn
up as targets to be achieved within the
timescale of the budget plan.
Compel planning
This is probably the most important feature of
a budgetary planning control system.
Planning forces management to look ahead,
to set out detailed plans for achieving the
targets for each department, operation and
(ideally) each manager and to anticipate
problems. It thus prevents management from
relying on ad hoc or uncoordinated planning
which may be detrimental to the performance
of the organisation.
Communicate ideas and plans
A formal system is necessary to ensure that
each person affected by the plans is aware of
what they are supposed to be doing.
Communication might be one-way, with
managers giving orders to subordinates, or
there might be a two way dialogue and
exchange of ideas.
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Objective
Comment
Co-ordinate activities
The activities of different departments or subunits of the organisation need to be
coordinated to ensure maximum integration
of effort towards common goals. This concept
of coordination implies, for example, that the
purchasing department should base its
budget on production requirements and that
the production budget should be in turn
based on sales expectations. Although
straightforward in concept, coordination is
remarkably difficult to achieve, and there is
often sub-optimality and conflict between
departmental plans in the budget so that the
efforts of each department are not fully
integrated into a combined plan to achieve
the company’s set targets.
Provide framework for responsibility
accounting
Budgetary planning and control systems
require that managers of budget centres are
made responsible for the achievement of
budget targets for the operations under their
personal control.
Establish a system of control
A budget is a yardstick against which actual
performance is measured and assessed.
Control over actual performance is provided
by the comparisons of actual results against
the budget plan. Departures from budget can
then be investigated and the reasons for the
departures can be divided into controllable
and uncontrollable factors.
Motivate employees to improve their
performance
The interest and commitment of employees
can be retained via a system of feedback of
actual results, which lets them know how well
or badly they are performing. The
identification of controllable reasons for
departures from budget with managers
responsible provides an incentive for
improving future performance.
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1.1 The planning and control cycle
Identify objectives
Step 1
Identify alternative courses of action (strategies)
that might contribute towards achieving the objectives
Step 2
Evaluate each strategy
Step 3
Choose alternative courses of action
Step 4
Implement the long-term plan in the form of the annual budget
Step 5
Measure actual results and compare with the plan
Step 6
Respond to divergences from plan
Step 7
Planning process
Control process
1.2 Other aspects of budget preparation
The following are other key points about budget preparation, included here as revision material:
Point
Detail
Long-term plan
The starting point; this will show what the budget has to achieve (the
introduction of new production, the required return, and so on) and
outline how it is to be done. It will also contain general guidelines on
allowable price increases like wage rates. The long-term policy needs to
be communicated to all managers responsible for preparing budgets
so that they are aware of the context within which they are budgeting
and how their area of responsibility is expected to contribute.
Limiting factor
This is the factor in the budget that limits the scale of operations. The
limiting factor is often sales demand, but it may be production
capacity when sales demand is high or when a key production resource
is in short supply. Budgeting cannot proceed until the budget for the
limiting factor has been prepared, since this affects all the other
budgets.
Budget manual
A budget manual is a guide or instruction document to assist
functional managers with preparing their functional budgets. It shows
how figures and forecasts for the budget should be calculated, and
gives other practical information. It is likely to include proformas
showing how the information is to be presented. If budgeting is done
with spreadsheets, layouts and computations may be preprogrammed, requiring only the entry of the figures. It may include a
flow diagram showing how individual budgets are interlinked and
specify deadlines by which first drafts must be prepared.
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Point
Detail
Sales budget
This contains information on the expected volume of sales (based on
estimates or market research), the sales mix, and selling prices. The
total revenues indicated will be used to compile the cash budget,
although this information needs to be adjusted to allow for the
expected timing of receipts. The volume of sales indicates the level of
production required and the extent of spending on distribution and
administration.
Production capacity
The level of sales anticipated is matched against opening inventory and
desired closing inventory to establish the level of production. From this
can be calculated the need for materials (again allowing for opening
and closing inventory), labour and machine hours. In other words,
production budgeting is done in terms of physical resources initially
and costed afterwards. At this stage, too, it is likely that needs for new
capital expenditure will be identified. This information will be used in
preparing the capital budget.
Functional budgets
Functional budgets are budgets for the different departments or
functions within the organisation. Budgets for production-related
functions, such as purchasing, engineering and inspection and testing,
may be based on the budgeted volume of production. Budgets for
other areas of the organisation, such as distribution and
administration, may take the anticipated sales level as their point of
reference. Vehicle costs, carriage costs, stationery and communication
costs and, above all, staff costs feature in these budgets. Some
budgeted, such as the budget for research and development (R&D)
spending, may be entirely discretionary and set at a level that
management consider the organisation can or should afford.
Discretionary costs
Training and R&D are known as ‘discretionary costs’ and have special
features.
Consolidation and
coordination
This can begin once all parts of the organisation have submitted their
individual budgets. It is most unlikely that all the budgets will be in line
with each other at the first attempt. Areas of incompatibility must be
identified, and the budgets modified in consultation with individual
managers. Spreadsheets are invaluable at this stage, both for the
consolidation itself and to allow changes to be made quickly and
accurately.
Cash budget
This can only be prepared at this stage because it needs to take
account of all the plans of the organisation and translate them into
expected cash flows. Cash must be available when it is needed to
enable the plans to be carried out. Overdraft facilities may need to be
negotiated in advance, or some activities may need to be deferred until
cash has been collected.
Master budget
The final stage, once all the necessary modifications have been made,
is to prepare a summary of all the budgets in the form of a master
budget, which generally comprises a budgeted statement of profit or
loss, a budgeted statement of financial position and a budgeted
statement of cash flow. The master budget is never flexed, no matter
what happens during the year, so it is a fixed point of reference.
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Quantitative analysis
in budgeting
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1 Derivation of the learning rate
Illustration 1: Derivation of the learning rate
1 BL is planning to manufacture a new product: product A. Development tests suggest that 60% of
the variable manufacturing cost of product A will be affected by a learning and experience curve.
This learning effect will apply to each unit produced and continue at a constant rate of learning
until cumulative production reaches 4,000 units, when learning will stop. The unit variable
manufacturing cost of the first unit is estimated to be $1,200 (of which 60% will be subject to the
effect of learning), while the average unit variable manufacturing cost of four units will be $405.
Required
Calculate the rate of learning that is expected to apply.
Solution
1 The correct answer is:
Let the rate of learning be r.
Cumulative production
Cumulative average cost
$
720 (= 60% × $1,200)
720 × r
720 r2
1
2
4
 $720r2 =
$405
2
r
= $405/$720 = 0.5625
r
= 0.75
The rate of learning is 75%.
2 The relevance of learning curve effects in management
accounting
Learning curve theory can be used to:
(a) Calculate the marginal (incremental) cost of making extra units of a product
(b) Quote selling prices for a contract, where prices are calculated at cost plus a percentage
mark up for profit. An awareness of the learning curve can make all the difference between
winning contracts and losing them, or between making profits and selling at a loss making
price
(c) Prepare realistic production budgets and more efficient production schedules
(d) Prepare realistic standard costs for cost control purposes
Considerations to bear in mind include:
(a) Sales projections, advertising expenditure and delivery date commitments. Identifying a
learning curve effect should allow an organisation to plan its advertising and delivery
schedules to coincide with expected production schedules. Production capacity obviously
affects sales capacity and sales projections.
(b) Budgeting with standard costs. Companies that use standard costing for much of their
production output cannot apply standard times to output where a learning effect is taking
place. This problem can be overcome in practice by:
(i) Establishing standard times for output, once the learning effect has worn off or become
insignificant; and
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(c)
(d)
(e)
(f)
(g)
(h)
(ii) Introducing a ‘launch cost‘ budget for the product for the duration of the learning
period.
Budgetary control. When learning is still taking place, it would be unreasonable to compare
actual times with the standard times that ought eventually to be achieved when the learning
effect wears off. Allowances should be made accordingly when interpreting labour efficiency
variances.
Cash budgets. Since the learning effect reduces unit variable costs as more units are
produced, it should be allowed for in cash flow projections.
Work scheduling and overtime decisions. To take full advantage of the learning effect, idle
production time should be avoided, and work scheduling/overtime decisions should pay
regard to the expected learning effect.
Pay. Where the workforce is paid a productivity bonus, the time needed to learn a new
production process should be allowed for in calculating the bonus for a period.
Recruiting new labour. When a company plans to take on new labour to help with increasing
production, the learning curve assumption will have to be reviewed.
Market share. The significance of the learning curve is that, by increasing its share of the
market, a company can benefit from shop floor, managerial and technological ‘learning’ to
achieve economies of scale.
3 Limitations of learning curve theory
Learning curve theory has some limitations.
(a) The learning curve phenomenon is not always present.
(b) It assumes stable conditions at work which will enable learning to take place. This is not
always practicable; for example, because of labour turnover.
(c) It must also assume a certain degree of motivation among employees.
(d) Breaks between repeating production of an item must not be too long, or workers will ‘forget‘
and the learning process will have to begin all over again.
(e) It may be difficult to obtain accurate data to decide what the learning curve is.
(f) Production techniques may change, or product design alterations may be made, so that it
takes a long time for a ‘standard‘ production method to emerge, to which a learning effect
will apply.
(g) For purposes of planning and control, production management and workers may resist
attempts to plan for reductions in the average production time, because this will put them
under pressure to achieve the expected reductions. The workforce may expect some form of
bonus as a reward for achieving reductions in time.
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Budgeting and
standard costing
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1 Deriving standards
1.1 Settings standards for materials costs
The costs of direct materials per unit of raw material will be estimated by the purchasing
department from their knowledge of the following:
• 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
The standard cost ought to include an allowance for bulk purchase discounts, if these are
available on all or some of the purchases, and it may have to be a weighted average price of the
differing prices charged for the same product by alternative suppliers.
A decision must also be taken as to how to deal with price inflation. Suppose that a material costs
$10 per kilogram at the moment and, during the course of the next 12 months, it is expected to go
up in price by 20% to $12 per kilogram. What standard price should be selected?
(a) If the current price of $10 per kilogram is used in the standard, the reported price variance
will become adverse as soon as prices go up, which could be very early in the year. If prices
go up gradually rather than in one big jump, it would be difficult to select an appropriate
time for revising the standard.
(b) If an estimated mid-year price of, say, $11 per kilogram is used, price variances should be
favourable in the first half of the year and adverse in the second half, again assuming prices
rise gradually. Management would find it difficult to assess on a monthly basis whether
variances are excessive. However, a switch in variance sign from favourable to adverse would
be expected in month six or seven (and not sooner).
Standard costing is therefore more difficult in times of inflation, but it is still worthwhile.
• Usage and efficiency variances will still be meaningful.
• Inflation is measurable: there is no reason why its effects cannot be removed.
• Standard costs can be revised, so long as this is not done too frequently
1.2 Setting standards for labour costs
Direct labour rates per hour will be set by reference to the payroll and to any agreements on pay
rises with trade union representatives of the employees. A separate hourly rate or weekly wage will
be set for each different labour grade/type of employee and an average hourly rate will be
applied for each grade (even though individual rates of pay may vary according to age and
experience).
Similar problems to those which arise when setting material standards in times of high inflation
can be met when setting labour standards.
1.3 Setting standards for material usage and labour efficiency
To estimate the materials required to make each product (material usage) and also the labour
hours required (labour efficiency), technical specifications must be prepared for each product by
production experts (either in the production department or the work study department).
1.4 Setting standards for overheads
When standard costs are fully absorbed standard production costs (standard costs can be used
in both marginal and absorption costing systems), the absorption rate of fixed production
overheads will be predetermined and based on budgeted fixed production overhead and planned
production volume.
Production volume will depend on two factors.
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(a) Production capacity (or ‘volume capacity’) measured perhaps in standard hours of output (a
standard hour being the amount of work achievable at standard efficiency levels in an hour),
which in turn reflects direct production labour hours
(b) Efficiency of working, by labour or machines, allowing for rest time and contingency
allowances
Suppose that a department has a workforce of ten people, each of whom works a 36-hour week
to make standard units, and each unit has a standard time of two hours to make. The expected
efficiency of the workforce is 125%.
(a) Budgeted capacity, in direct labour hours, would be 10 × 36 = 360 production hours per week.
(b) Budgeted efficiency is 125% so that the workforce should take only 1 hour of actual
production time to produce 1.25 standard hours of output.
(c) This means in our example that budgeted output is 360 production hours × 125% = 450
standard hours of output per week. At 2 standard hours per unit, this represents production
activity or volume of 225 units of output per week.
1.5 Setting standards for sales price and margin
The standard selling price will depend on several factors including the following:
• Anticipated market demand
• Competing products
• Manufacturing costs
• Inflation estimates
The standard sales margin is the difference between the standard cost and the standard selling
price.
2 Flexible budgets and performance management
The wrong approach to budgetary control is to compare actual results against a fixed budget.
Suppose that a company manufactures a single Product: Z. Budgeted results and actual results
for June 20X2 are shown as follows:
Production and sales (units)
Sales revenue (a)
Direct materials
Direct labour
Maintenance
Depreciation
Rent and rates
Other costs
Total costs (b)
Profit (a) – (b)
Budget
Actual
results
2,000
$
20,000
6,000
4,000
1,000
2,000
1,500
3,600
18,100
1,900
3,000
$
30,000
8,500
4,500
1,400
2,200
1,600
5,000
23,200
6,800
Variance
$
10,000
2,500
500
400
200
100
1,400
5,100
4,900
(F)
(A)
(A)
(A)
(A)
(A)
(A)
(F)
(a) Here, the variances are meaningless for control purposes. Costs were higher than budget
because the output volume was also higher; variable costs would be expected to increase
above the costs budgeted in the fixed budget. There is no information to show whether
control action is needed for any aspect of costs or revenue.
(b) For control purposes, it is necessary to know the answers to the following.
(i) Were actual costs higher than they should have been to produce and sell 3,000 Zs?
(ii) Was actual revenue satisfactory from the sale of 3,000 Zs?
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The correct approach to budgetary control is as follows:
(a) Identify fixed and variable costs
(b) Produce a flexed budget using marginal costing techniques
Let’s suppose that we have the following estimates of cost behaviour for the company.
(a) Direct materials, direct labour and maintenance costs are variable.
(b) Rent and rates and depreciation are fixed costs.
(c) Other costs consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and sold.
Now that the cost behaviour patterns are known, a budget cost allowance can be calculated for
each item of expenditure. This allowance is shown in a flexed budget as the expected expenditure
on each item for the relevant level of activity. The budget cost allowances are calculated as
follows:
(a) Variable cost allowances
= original budgets × (3,000 units/2,000 units)
Eg material cost allowance
= $6,000 × 3/2 = $9,000
(b) Fixed cost allowances
= as original budget
(c) Semi-fixed cost allowances = budgeted fixed costs + (3,000 units × variable cost per unit)
Eg other cost allowances
= $1,600 + (3,000 × $1) = $4,600
The budgetary control analysis should be as follows:
Production and sales (units)
Sales revenue
Variable costs
Direct materials
Direct labour
Maintenance
Semi‑variable costs
Other costs
Fixed costs
Depreciation
Rent and rates
Total costs
Profit
Fixed
budget
(a)
2,000
$
20,000
Flexed
budget
(b)
3,000
$
30,000
Actual
results
(c)
3,000
$
30,000
Budget
variance
(b) - (c)
6,000
4,000
1,000
9,000
6,000
1,500
8,500
4,500
1,400
500
1,500
100
(F)
(F)
(F)
3,600
4,600
5,000
400
(A)
2,000
1,500
18,100
1,900
2,000
1,500
24,600
5,400
2,200
1,600
23,200
6,800
200
100
1,400
1,400
(A)
(A)
(F)
(F)
$
0
Note. (F) denotes a favourable variance and (A) an adverse or unfavourable variance.
We can analyse the above as follows.
(a) In selling 3,000 units, the expected profit should not have been the fixed budget profit of
$1,900, but the flexed budget profit of $5,400. Instead, actual profit was $6,800, ie $1,400
more than we should have expected. One of the reasons for the improvement is that, given
output and sales of 3,000 units, costs were lower than expected (and sales revenue exactly
as expected).
$
500 (F)
1,500 (F)
100 (F)
400 (A)
Direct materials cost variance
Direct labour cost variance
Maintenance cost variance
Other costs variance
Fixed cost variances
Depreciation
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$
100 (A)
1,400 (F)
Rent and rates
(b) Another reason for the improvement in profit above the fixed budget profit is the sales volume
(3,000 Zs were sold instead of 2,000).
$
Sales revenue increased by
Variable costs increased by:
Direct materials
Direct labour
Maintenance
Variable element of other costs
Fixed costs are unchanged
Profit increased by
$
10,000
3,000
2,000
500
1,000
6,500
3,500
Profit was therefore increased by $3,500 because sales volumes increased.
(c) A full variance analysis statement would be as follows:
$
Fixed budget profit
Variances
Sales volume
Direct materials cost
Direct labour cost
Maintenance cost
Other costs
Depreciation
Rent and rates
$
1,900
3,500 (F)
500 (F)
1,500 (F)
100 (F)
400 (A)
200 (A)
100 (A)
4,900
6,800
Actual profit
(F)
If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary or whether the
plan needs amending in the light of actual events.
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Variance analysis
Essential reading
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1 Basic variances
•
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•
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•
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A 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.
When actual results are better than expected results, we have a favourable variance (F). If
actual results are worse than expected results, we have an adverse variance (A).
The selling price variance measures the effect on expected profit of a selling price being
different from the 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 measures the increase or decrease in expected profit as a result of
the sales volume being higher or lower than budgeted. It is calculated as the difference
between the budgeted sales volume and the actual sales volume multiplied by the standard
profit per unit.
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 divided into the following two sub-variances.
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.
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 divided into two sub-variances.
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.
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
divided into two sub-variances.
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.
Fixed production overhead total variance is the difference between fixed production overhead
incurred and fixed production overhead absorbed. In other words, it is the under- or overabsorbed fixed production overhead.
Fixed production overhead expenditure variance is the difference between the budgeted fixed
production overhead expenditure and actual fixed production overhead expenditure.
Fixed production overhead volume variance is the difference between actual and budgeted
production/volume multiplied by the standard absorption rate per unit.
Fixed production 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
(that is, worked) multiplied by the standard absorption rate per hour.
Fixed production 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 and control system.
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Illustration 1: Various variances
1 A company produces and sells one product only, the Thing, the standard cost for one unit being
as follows:
$
200
30
30
50
Direct material A – 10 kg at $20 per kg
Direct material B – 5 litres at $6 per litre
Direct wages – 5 hours at $6 per hour
Fixed production overhead
Total standard cost
310
The fixed overhead included in the standard cost is based on an expected monthly output of 900
units. Fixed production overhead is absorbed on the basis of direct labour hours.
During April the actual results were as follows:
Production
800 units
Material A
7,800 kg used, costing $159,900
Material B
4,300 litres used, costing $23,650
Direct wages
4,200 hours worked for $24,150
Fixed production overhead
$47,000
(a) Calculate price and usage variances for each material.
(b) Calculate labour rate and efficiency variances.
(c) Calculate fixed production overhead expenditure and volume variances and then subdivide
the volume variance.
Solution
1 The correct answer is:
(a) Price variance – Material A
Take the actual quantity of materials purchased/used and compare the actual prices paid for the
materials with their standard price.
7,800 kg should have cost (× $20)
but did cost
Price variance (actual cost exceeds standard cost)
$
156,000
159,900
3,900
(A)
Usage variance - Material A
Take the actual quantity of units produced and compare the actual quantity of materials used in
their production with the standard quantity that should have been used. The variance is
converted into a monetary value at the standard price per unit of material.
800 units should have used (× 10 kg)
but did use
Usage variance in kg (actual usage less than standard)
× standard cost per kilogram
Usage variance in $
8,000kg
7,800kg
200
x $20
$4,000
(F)
(F)
Price variance – Material B
4,300 litres should have cost (× $6
but did cost
$
25,800
23,650
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$
Price variance
2,150
(F)
Usage variance - Material B
$
4,000
4,300
300
x $6
1,800
800 units should have used (× 5 l)
but did use
Usage variance in litres
× standard cost per litre
Usage variance in $
(A)
(A)
(b) Labour rate variance
Take the number of labour hours worked and paid for, and compare the actual amount paid with
the standard rate for the hours worked.
4,200 hours should have cost (× $6)
but did cost
Rate variance (actual cost less than the standard rate)
$
25,200
24,150
1,050
(F)
Labour efficiency variance
Take the actual quantity of units produced and compare the actual time to produce them with the
standard time. The variance is converted into a monetary value at the standard rate per labour
hour.
800 units should have taken (× 5 hrs)
but did take
Efficiency variance in hours (actual time longer than
standard)
× standard rate per hour
Efficiency variance in $
4,000 hrs
4,200 hrs
200
(A)
x $6
$1,200
(A)
(c) Fixed overhead expenditure variance
This is the difference between budgeted and actual fixed costs.
Budgeted expenditure ($50 × 900)
Actual expenditure
Expenditure variance (actual spending higher than
budgeted)
$
45,000
47,000
2,000
$
(A)
Fixed overhead volume variance
This is calculated when the standard cost is a full production cost that includes absorbed fixed
overhead. It is not calculated in a system of standard marginal costing; it is the difference
between the budgeted and actual production volumes. It is converted into a money value at the
standard production overhead cost per unit.
Budgeted production at standard rate (900 × $50)
Actual production at standard rate (800 × $50)
Volume variance in units (output less than budget)
Standard production overhead cost per unit
Volume variance in $
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Units
900
800
100
$50
$5,000
(A)
(A)
The volume variance may be analysed into an efficiency and a capacity variance. Fixed overhead
efficiency variance + capacity variance = volume variance
Fixed overhead volume efficiency variance
This is the same as the labour efficiency variance in hours. It is converted into a monetary value at
the standard production overhead rate per hour.
800 units should have taken (× five hrs)
but did take
Volume efficiency variance in hours
× standard absorption rate per hour
Volume efficiency variance
4,000 hrs
4,200 hrs
200
x $10
$2.00
(A)
(A)
Fixed overhead volume capacity variance
This is the difference between the budgeted hours of work (budgeted capacity) and the actual
hours worked in production. It is converted into a monetary value at the standard production
overhead rate per hour.
Budgeted hours
Actual hours
Volume capacity variance in hours
× standard absorption rate per hour ($50 ÷ 5)
4,500 hrs
4,200 hrs
300
x $10
$3,000
(A)
(A)
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1.1 Reasons for variances
Variance
Favourable
Adverse
Calculation
Material
price
Unforeseen
discounts received
Price increase
Price
Careless
purchasing
Based on actual
purchases
Change in
material
standard
What should it have cost?
X
What did it cost?
(X)
Greater care in
purchasing
Change in
material standard
$
X
Material
usage
Material used of
higher quality than
standard
made of material
Errors in allocating
material to jobs
Labour rate
Use of workers at
a lower rate of pay
than standard
Defective
material
Excessive waste
Theft
Stricter quality
control
Errors in
allocating
material to jobs
Wage rate
increase
Usage
Kg
Based on actual
production
What should have been
used?
X
What was used?
(X)
X
standard cost per kg
$X
Rate
$
Based on actual hours
paid
What should it have cost?
X
What did it cost?
(X)
X
Idle time
Labour
Possible if idle time
has been built into
the budget
Output produced
more quickly than
expected, because
of work motivation,
better quality
of equipment or
materials, better
learning rate
Errors in allocating
time to jobs
588
Hrs
Machine
breakdown
Idle time
Hours worked
X
Non-availability
of material
Hours paid
(X)
Illness or injury to
worker
standard rate per hour
$X
Lost time in
excess of
standard allowed
Hrs
Based on actual
production
Output lower
than standard
set because of
lack of training,
substandard
material, etc
How long should it have
taken?
X
How long did it take?
(X)
Errors in
allocating time
to jobs
standard rate per hour
X
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$X
Variance
Favourable
Adverse
Calculation
Overhead
expenditure
Savings in costs
incurred
Increase in cost
of services
Based on actual hours
worked
$
More economical
use of services
Excessive use of
services
What should it have cost?
X
What did it cost?
(X)
Overhead
volume
Production or level
of activity greater
than budgeted
Change in type
of services used
X
Production or
level of activity
less than
budgeted
Units
Budgeted units
X
Actual units
(X)
X
per unit
Fixed
overhead
capacity
Production or level
of activity greater
than budgeted
Production or
level of activity
less than
budgeted
$X
Hrs
Budgeted hrs worked
X
Actual hrs worked
(X)
X
per hour
Selling price Unplanned price
increase
Unplanned price
increase
X
$
For the quantity sold
What revenue should have
been generated
X
Actual revenue
(X)
X
Sales
volume
Additional demand
Unexpected fall
in demand
Budgeted sales
X
Production
Actual sales
(X)
Units
X
standard profit per unit
X
1.2 Operating statements
KEY
TERM
Operating statements: An operating statement is a regular report for management which
compares actual costs and revenues with budgeted figures and shows variances.
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. Sales variances are
reported first, and 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.
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Illustration 1: Operating statement
1 A company 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 widget, is as follows:
STANDARD COST CARD – WIDGET
Direct materials
Direct wages
Variable overheads
Fixed overhead
Standard cost
Standard profit
Standard selling price
0.5 kg at $4 per kg
2 hours at $2.00 per hour
2 hours at $0.30 per hour
2 hours at $3.70 per hour
$
2.00
4.00
0.60
7.40
14.00
6.00
20.00
Budgeted output for January was 5,100 units. Actual results for January 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 January.
Solution
1 The correct answer is:
(a)
2,300 kg of material should cost (× $4)
but did cost
Material price variance
$
9,200
9,800
600
(A)
(b)
4,850 Widgets should use (× 0.5 kg)
but did use
Material usage variance in kg
× standard cost per kg
Material usage variance in $
2,425kg
2,300kg
125
x $4
$500
(F)
(F)
(c)
8,500 hours of labour should cost (× $2)
but did cost
Labour rate variance
17,000
16,800
200
(d)
4,850 Widgets should take (× 2 hrs)
but did take (active hours)
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(F)
Labour efficiency variance in hours
× standard cost per hour
Labour efficiency variance in $
1,700
x $2
$3,400
(F)
$1,000
(A)
(F)
(e)
Idle time variance 500 hours (A) × $2
(f)
8,000 hours incurring variable o/hd expenditure should cost
(× $0.30)
but did cost
Variable overhead expenditure variance
2,400
2,600
200
(A)
$510
(F)
37,740
42,300
4,560
(A)
35,890
37,740
1,850
(A)
97,000
95,600
1,400
(A)
(g)
Variable overhead efficiency variance is the same as the
Labour efficiency variance:
1,700 hours (F) × $0.30 per hour
(h)
Budgeted fixed overhead (5,100 units × 2 hrs × $3.70)
Actual fixed overhead
Fixed overhead expenditure variance
(i)
Actual production at standard rate (4,850 units × $7.40)
Budgeted production at standard rate (5,100 units × $7.40)
Fixed overhead volume variance
(j)
4,850 Widgets should have sold for (× $20)
but did sell for
Selling price variance
(k)
Budgeted sales volume (in units)
Actual sales volume (in units)
Sales volume variance in units
× standard profit per unit
Sales volume variance in $
5,100
4,850
250
x $6
$1,500
$
Budgeted profit (5,100 units × $6 profit)
Selling price variance
Sales volume variance
1,400
1,500
Actual sales ($95,600) less the standard cost of
sales (4,850 × $14)
(A)
(A)
$
30,600
(A)
(A)
2,900
27,700
(A)
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OPERATING STATEMENT FOR JANUARY
$
Budgeted profit
Sales variances: Price
Volume
$
30,600
1,400
1,500
(A)
(A)
2,900
27,700
Actual sales minus the standard cost of sales
(A)
Cost variances
(F)
$
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
(A)
$
600
500
200
3,400
1,000
200
510
4,560
1,850
8,210
4,610
Actual profit for January
3,600
(A)
24,100
Check
$
Sales
Materials
Labour
Variable overhead
Fixed Overhead
$
95,600
9,800
16,800
2,600
42,300
71,500
24,100
Actual profit
If the company operated a marginal costing system, there would be no fixed overhead volume
variance and the sales volume variance would be $3,350 (A).
The standard contribution per unit is $(20 – 6.60) = $13.40, therefore the sales volume variance of
250 units (A) is valued at (× $13.40) = $3,350 (A).
The other variances are unchanged, therefore, an operating statement might appear as follows:
OPERATING STATEMENT FOR JANUARY
$
Budgeted profit
Budgeted fixed production costs
Budgeted contribution
Sales variances: Volume
Price
$
30,600
37,740
68,340
3,350
1,400
$
(A)
(A)
4,750
Actual sales ($95,600) minus the
standard
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(A)
$
$
(F)
(A)
$
63,590
Variable cost of sales (4,850 × $6.60)
Variable cost variances
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
600
500
200
3,400
1,00
200
510
4,610
Actual contribution
Budgeted fixed production overhead
Expenditure variance
Actual fixed production overhead
Actual profit
1,800
2,810
66,400
37,740
4,560
(F)
(A)
42,300
24,100
Note. The profit here is the same as the profit calculated by standard absorption costing because
there were no changes in inventory levels. Absorption costing and marginal costing do not always
produce an identical profit figure.
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Planning and
operational variance
analysis
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1 The learning curve
Illustration 1: Variances and the learning curve
1 Num Co hires temporary workers on six-month contracts 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 (five 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.
Required
Calculate the labour efficiency planning and operational variances after taking account of the
learning effect.
Note. The learning index for a 90% learning curve is –0.1520.
Solution
1 The correct answer is:
First, we calculate the revised hours for the actual production:
Y = axb
Y = the cumulative average time for the first x units
a = the time to make the first unit = 5 hours
x = the cumulative number of units produced = 520 units
b = the index of learning = –0.1520
Therefore Y = 5 × 520-0.1520 = 1.9326
Therefore revised time for 520 units = 1,005 hours
Labour efficiency planning variance
520 units of product should take: original standard (× 5)
520 units of product should take: revised standard
Labour efficiency planning variance in hours
Original standard rate per hour
Labour efficiency planning variance in $
Hours
2,600
1,005
1,595 (F)
$20
$31,900 (F)
Labour efficiency operational variance
520 units of product should take
They did take
Labour efficiency (operational variance in hours)
Original standard rate per hour
Labour efficiency (operational variance in $)
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Hours
1,005
1,092
87 (A)
$20
$1,740 (A)
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Performance analysis
and behavioural
aspects
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1 Using variance analysis
1.1 Analysing past performance with variance analysis
Variance analysis compares actual performance with a budget or standard cost. Differences
between actual results and the budget or standard are reported in monetary terms as variances,
and variances can be used to reconcile budgeted profit to actual profit in an operating statement.
The previous chapters have focused mainly on the techniques of calculating variances. 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.
Basic principles of variance reporting are that:
(a) 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.
(b) 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.
1.1.1 Responsibility for planning variances
It was explained in the previous chapter that planning variances arise when a budget or standard
cost is revised. ‘Errors’ in the budget or standard cost are attributable to the managers (planners)
who prepared the budget or standard cost. 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. An unexpected increase in the market price for materials, for example, is beyond the
control of planners. Similarly, an unexpected collapse in market demand for an industry’s
products, resulting in an adverse sales volume planning variance, cannot usually be ‘blamed’ on
planners.
Even so, planning variances, where they occur, should be identified separately. Operational
managers should be held responsible only for variances that may be realistically attributable to
differences between actual performance and a realistic budget or standard. In other words,
operational managers should be held responsible for operational variances. Unless they were also
involved in the budgeting or standard-setting process, operational managers are not responsible
for planning variances.
1.1.2 Responsibility for operational variances
Responsibility for operational variances should be traced to the managers who are in a position of
authority and control over operations where the variances occur. Operational management
responsibility for variances depends on the organisation structure and the division of authority
and responsibility between management.
For example, 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.
You should be able to identify the managers responsible for operational variances. A general
guide is given in the table below:
Variance
Responsibility
Sales price variance
Sales or marketing management
Sales volume variance
Normally sales or marketing management,
however, if sales are less than budget due to
problems with production, the production
manager is responsible
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Variance
Responsibility
Material price variance
The manager responsible for purchasing
materials
Material usage variance
Normally the production manager
Labour rate variance
The manager responsible for pay rates. This
may be senior management or human
resources management. However, the
production manager will be responsible for
any adverse rate variances caused by
working overtime and paying employees a
premium rate per hour.
Labour efficiency variance
Normally the production manager
Idle time variance
This depends on the cause of the idle time. It
may be caused by lack of sales orders (sales
management responsibility), inefficient
production management (production
management responsibility) or delays in
deliveries of key raw material (buying
manager responsibility).
1.2 Using variance analysis to improve future performance
Variance analysis is not simply a method of analysing past performance. It should 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. So, for example, if an adverse labour
efficiency variance of $10,000 is reported one month, and the production manager takes
measures to improve efficiency:
(a) 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.
(b) 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.
1.2.1 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.
(a) Favourable as well as adverse variances should be investigated, with a view to taking control
action if they seem significant. Control action to improve poor performance may seem an
obvious requirement. However, control action to reinforce favourable performance should also
be expected from management.
(b) Variances need not be investigated if they seem insignificant. For example, variances that are
less than, say, 5% of the budget or standard cost amount may be disregarded, because they
fall within an acceptable tolerance limit.
(c) 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. Instead of relying on
variances reported in a single month, management may monitor cumulative variances over a
period of time and identify those that should be investigated on the basis of performance or
trend over a number of months.
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1.2.2 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 benefits arising from
improved performance are sufficient to justify the cost of investigating the causes of the variance
and taking control action.
This is a reason why insignificant variances are not investigated.
1.2.3 Improving performance
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, so you may need to use common sense and judgement in dealing with any question on
this topic. 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
Adverse labour efficiency variance
Consider providing training for the workforce,
with the objective of improving labour
efficiency and reducing wastage of materials.
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Performance
measurement
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1 Non-financial performance indicators (NFPIs)
1.1 Which NFPIs should be measured?
The most useful NFPIs for measuring aspects of operational performance will vary between
different types of business and different business circumstances. While with financial
performance measures it is possible to list the most commonly used measures or ratios, this is not
so easy with NFPIs.
Given an exam question in which you are asked to comment on non-financial aspects of the
performance of an organisation, you will need to use your judgement and try to identify the most
suitable measures for the organisation in the question.
As a general guide, NFPIs may be measurements of the following aspects of performance:
(a) Quality of production: wastage rates or percentage of rejects in production
(b) Speed or efficiency, such as output per hour: average time taken per unit of activity
(c) Delivery: average time between taking an order and delivery to the customer
(d) Reliability: percentage of calls answered within a given target time; number of equipment
failures or amount of ‘down time’
(e) Customer satisfaction: number of complaints
(f) Innovation: number of new products developed and launched on to the market
With non-financial indicators, anything can be measured and compared if it is meaningful to do
so. The measures should be tailored to the circumstances of the business.
2 Methods to encourage a long-term view
Steps that could be taken to encourage managers to take a long-term view, so that the ‘ideal’
decisions are taken, include the following:
(a) Making short-term targets realistic. If budget targets are unrealistically tough, a manager
will be forced to make trade-offs between the short- and long-term.
(b) Providing sufficient management information to allow managers to see what trade-offs they
are making. Managers must be kept aware of long-term aims as well as shorter-term (budget)
targets.
(c) Evaluating managers’ performance in terms of contribution to long-term as well as shortterm objectives.
(d) Link managers’ rewards to share price. This may encourage goal congruence.
(e) Set quality-based targets as well as financial targets. Multiple targets can be used.
3 Steps to improvement
3.1 Analyse performance
Performance is analysed by comparing actual results with a target (such as a budget) or with
performance in previous time periods.
The purpose of analysing performance in this way is to identify whether there are any aspects of
performance that are worse than the target or worse than the previous year, where there may
be some cause for concern.
Where performance is more or less as expected or in line with previous years, there should be no
cause for concern, and no reason to investigate this aspect of performance in any detail.
In the exam, you will probably need to calculate some ratios to identify areas for concern.
3.2 Identify reasons for unexpected performance or poor performance
Having identified aspects of performance that may be a cause for some concern, the next
requirement is to consider possible reasons for actual results, and why for example performance is
worse this year than last year.
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To identify possible reasons for disappointing performance, you will have to apply your
judgement and common sense to the facts in an exam ‘case study’. This is very important.
4 The balanced scorecard
4.1 Perspectives
The scorecard is ‘balanced’, as managers are required to think in terms of all four perspectives to
prevent improvements being made in one area at the expense of another.
Important features of this approach are as follows:
(a) It looks at both internal and external matters concerning the organisation.
(b) It is related to the key elements of a company’s strategy.
(c) Financial and non-financial measures are linked together.
4.2 Example
An example of how a balanced scorecard might appear is offered below. Arguably, there are too
many performance targets here for each of the four perspectives, but this balanced scorecard is a
good illustration of issues that may be considered as critical to the organisation’s success.
Financial perspective
Customer perspective
Goals
Measures
Goals
Measures
Survive
Cash flow
New products
Succeed
Monthly sales growth and
operating income by division
Percentage of sales from
new products
Prosper
Increase market share and
ROI
Responsive
supply
On-time delivery (defined
by customer)
Preferred
supplier
Share of key accounts'
purchases
Ranking by key accounts
Customer
partnership
Number of cooperative
engineering efforts
Internal business perspective
Innovation and learning perspective
Goals
Measures
Goals
Measures
Technology
capability
Manufacturing configuration
vs competition
Technology
leadership
Time to develop next
generation of products
Manufacturing
excellence
Cycle time
Unit cost
Yield
Manufacturing
learning
Process time to
maturity
Product focus
Design
productivity
Silicon efficiency
Engineering efficiency
Percentage of products
that equal 80% sales
Time to market
New product
introduction
Actual introduction
schedule vs plan
New product introduction
vs competition
4.3 Example: Balanced scorecard and not for profit organisations
Balanced scorecards are used most in private sector organisations, where reward systems may be
based on success in achieving targets in each of the four perspectives. It is also possible, however,
to use a balanced scorecard in not for profit organisations.
Not for profit organisations such as charities are likely to have significantly different goals in
comparison to profitable businesses. The following are goals that may be relevant to a charity:
Financial perspective
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•
•
Increase income from charitable donations
Improve margins
Internal business perspective
• Reduce overheads
• Claim back tax on gift aid
Customer perspective
• Continued donor support
• Donor involvement in initiatives
Innovation and learning perspective
• More projects supported
• More fundraise
• More money pledged
Required
Suggest some performance measures for each of the goals outlined above.
Solution
The balanced scorecard for the charity may appear as follows:
Financial perspective
GOALS
MEASURES (KPI)
Income from charitable donations
Improved margins
Value of donations received
Gross profit margin
Net profit margin
Customer perspective
GOALS
MEASURES (KPI)
Continued donor support
Donor involvement in initiatives
Number of pledges given and direct debits set
up
Footfall at fundraising and charity dinners
Internal business perspective
GOALS
MEASURES (KPI)
Reduce overheads
Claim back tax
Lower overheads as a percentage of income
Tax reclaimed as a percentage of income
Innovation and learning perspective
GOALS
MEASURES (KPI)
More projects supported
More fundraisers
More money pledged
Number of projects given support
Number of fundraisers recruited
Amount of donations promised
Note. KPI = Key Performance Indicator
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5 Building block model
Fitzgerald and Moon’s building blocks for dimensions, standards and rewards attempt to
overcome the problems associated with performance measurement of service businesses.
5.1 Dimensions of performance
Dimensions of performance are the aspects of performance that are measured. Fitzgerald and
Moon suggested that there are six aspects to performance measurement that link performance to
corporate strategy.
Some performance measures that might be used for each of these dimensions are as follows:
Dimension of performance
Possible measure of performance
Financial performance
Profitability
Profit growth
Gross profit margin, net profit margin
Competitiveness
Growth in sales
Retention rate for customers
Success rate in converting enquiries into sales
Service quality
Number of complaints
Customer satisfaction, as revealed by
customer opinion surveys
Flexibility
Mix of different types of work done by
employees
Speed in responding to customer requests
Resource utilisation
Efficiency/productivity measures
Capacity utilisation rates
Innovation
Number of new services offered within the
previous year or two years
Fitzgerald and Moon also suggested that the dimensions of performance should distinguish
between the ‘results’ of actions taken in the past and ‘determinants’ of future performance.
(a) Financial performance and measures of competitiveness are performance measures that
have resulted from measures taken in the past.
(b) Quality, flexibility, resource utilisation and innovation are all aspects of performance that will
determine the success (or otherwise) of the organisation in the future.
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Divisional
performance and
transfer pricing
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1 ROI and new investments
If investment centre performance is judged by ROI, we should expect the managers of investment
centres to decide to undertake new capital investments only if these new investments are likely to
increase the ROI of their centre.
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.
For example, if investment centre A currently has assets of $1,000,000 and expects to earn a
profit of $400,000, how would the centre’s manager view a new capital investment which would
cost $250,000 and yield a profit of $75,000 pa?
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, say 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, in these circumstances, be motivated to do not what is best for the organisation
as a whole, but what is best for his or her division.
2 RI versus ROI: marginally profitable investments
Residual income will increase if a new investment is undertaken which earns a profit in excess of
the imputed interest charge on the value of the asset acquired. Residual income will go up even if
the investment only just exceeds the imputed interest charge, and this means that ‘marginally
profitable’ investments are likely to be undertaken by the investment centre manager.
In contrast, when a manager is judged by 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.
2.1 Example: ROI versus residual income
Suppose that Department H has the following profit, assets employed and an imputed interest
charge on operating assets:
$
30,000
Operating profit
Operating assets
Imputed interest (12%)
Return on investment
Residual income
$
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:
$
31,400
Total operating income
Total operating assets
Imputed interest (12%)
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$
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Return on investment
Residual income
28.5%
18,200
If the Department H manager is made responsible for the department’s performance, they would
resist the new investment if they were to be judged on ROI, but would welcome the investment if
they were judged according to RI since there would be a marginal increase of $200 in residual
income from the investment, but a fall of 1.5% in ROI.
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.
3 Problems with transfer pricing
3.1 Maintaining the right level of divisional autonomy
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, as we have seen, a danger with profit centre accounting is that the business
organisation will divide into a number of self-interested segments, each acting at times against
the wishes and interests of other segments. Decisions might be taken by a profit centre manager
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.
3.2 Ensuring divisional performance is measured fairly
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. Consequently, 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.
3.3 Ensuring corporate profits are maximised
When there are disagreements about how much work should be transferred between divisions,
and how many sales the division should make to the external market, there is presumably a profitmaximising 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.
3.4 The ideal solution
Ideally a transfer price should be set at a level that overcomes these problems.
(a) The transfer price should provide an ‘artificial’ selling price that enables the transferring
division to earn a return for its efforts, and the receiving division to incur a cost for benefits
received.
(b) The transfer price should be set at a level that enables profit centre performance to be
measured ‘commercially’. This means that the transfer price should be a fair commercial
price.
(c) The transfer price, if possible, should encourage profit centre managers to agree on the
amount of goods and services to be transferred, which will also be at a level that is consistent
with the aims of the organisation as a whole, such as maximising company profits.
In practice it is difficult to achieve all three aims.
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Further aspects of
performance
management
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1 Problems with performance measurement of not for
profit organisations
(a) Multiple objectives
As we have said, they tend to have multiple objectives, so that even if they can all be clearly
identified it is impossible to say which is the overriding objective.
(b) Measuring outputs
Outputs can seldom be measured in a way that is generally agreed to be meaningful. (For
example, are good exam results alone an adequate measure of the quality of teaching?) Data
collection can be problematic. For example, unreported crimes are not included in data used to
measure the performance of a police force.
(c) Lack of profit measure
If an organisation is not expected to make a profit, or if it has no sales, indicators such as ROI and
RI are meaningless.
(d) Nature of service provided
Many NFPOs provide services for which it is difficult to define a cost unit. For example, what is the
cost unit for a local fire service? This problem does exist for commercial service providers, but
problems of performance measurement are simplified because profit can be used.
(e) Financial constraints
Although every organisation operates under financial constraints, these are more pronounced in
NFPOs. For instance, a commercial organisation’s borrowing power is effectively limited by
managerial prudence and the willingness of lenders to lend, but a local authority’s ability to raise
finance (whether by borrowing or via local taxes) is subject to strict control by central
government.
(f) Political, social and legal constraints
(i) Unlike commercial organisations, public sector organisations are subject to strong
political influences. Local authorities, for example, have to carry out central government’s
policies as well as their own (possibly conflicting) policies.
(ii) The public may have higher expectations of public sector organisations than commercial
organisations. A decision to close a local hospital in an effort to save costs, for example,
is likely to be less acceptable to the public than the closure of a factory for the same
reason.
(iii) The performance indicators of public sector organisations are subject to far more
onerous legal requirements than those of private sector organisations.
(iv) While profit-seeking organisations are unlikely in the long-term to continue services that
make a negative contribution, NFPOs may be required to offer a range of services, even
if some are uneconomical.
1.1 Solutions
1.1.1 Inputs
Performance can be judged in terms of inputs. This is very common in everyday life. If somebody
tells you that their suit cost $750, you would generally conclude that it was an extremely well
designed and good quality suit, even if you did not think so when you first saw it. The drawback is
that you might also conclude that the person wearing the suit had been cheated or was a fool, or
you may happen to be of the opinion that no piece of clothing is worth $750. So it is with the
inputs and outputs of NFPOs.
1.1.2 Judgement
A second possibility is to accept that performance measurement must to some extent be
subjective. Judgements can be made by experts in particular NFP activities or by the persons
who fund the activities.
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1.1.3 Comparisons
Most NFPOs do not face competition but this does not mean that all are unique. Bodies like local
governments, health services, and so on can judge their performance against each other and
against the historical results of their predecessors. And, since they are not competing with each
other, there is less of a problem with confidentiality and so benchmarking is easier.
In practice, benchmarking usually encompasses:
• Regularly comparing aspects of performance (functions or processes) with best practitioners
• Identifying gaps in performance
• Seeking fresh approaches to bring about improvements in performance
• Following through with implementing improvements
• Following up by monitoring progress and reviewing the benefits
1.1.4 Quantitative measures
Unit cost measurements like ‘cost per patient day’ or ‘cost of borrowing one library book’ can
fairly easily be established to allow organisations to assess whether they are doing better or
worse than their counterparts.
Efficiency measurement of inputs and outputs is illustrated in three different situations, as
follows.
(a)
Where input is fixed
Actual output / maximum output obtainable for a given
input
25/30 kilometres per litre =
83.3% efficiency
(a)
Where output is fixed
Minimum output needed for given output / actual
output
55/60 hours to erect
scaffolding = 91.7% efficiency
(a)
Where input and output are both variable
Actual output / actual input
compared with
standard output / standard input
$9,030/7,000 meals = $1.29
per meal
$9,600/7,500 meals = $1.28
per meal
Efficiency = 99.2%
As a further illustration, suppose that at a cost of $40,000 and 4,000 hours (inputs) in an average
year, two police officers travel 8,000 kilometres and are instrumental in 200 arrests (outputs). A
large number of possibly meaningful measures can be derived from these few figures, as the
following table shows:
$40,000
Cost $40,000
Time 4,000
hours
4,000/$40,000 =
6 minutes
patrolling per $1
spent
Kilometres 8,000
8,000/$40,000
= 0.2 of a
kilometre per $1
4,000 hours
8,000
kilometres
200 arrests
$40,000/4,000 =
$10 per hour
$40,000/8,000
= $5 per
kilometre
$40,000/200 =
$200 per arrest
4,000/8,000 = ½
hour to patrol 1
kilometre
4,000/200 = 20
hours per arrest
8,000/4,000 = 2
kilometres
patrolled per
hour
8,000/200 = 40
kilometres per
arrest
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Arrests 200
$40,000
4,000 hours
8,000
kilometres
200/$40,000 = 1
arrest per $200
200/4,00 = 1
arrest every 20
hours
200/8,000 = 1
arrest every 40
kilometres
200 arrests
These measures do not necessarily identify cause and effect (do teachers or equipment produce
better exam results?) or personal responsibility and accountability. Actual performance needs to
be compared as follows:
(a) With standards, if there are any
(b) With targets
(c) With similar external activities
(d) With indices
(e) With similar internal activities
(f) Over time, as trends
NFPOs are forced to use a wide range of indicators and can be considered early users of a
balanced scorecard approach (covered in Chapter 19).
2 The 3Es
The assessment of economy, efficiency and effectiveness should be a part of the normal
management process of any organisation, public or private.
(a) Management should carry out performance reviews as a regular feature of their control
responsibilities.
(b) Independent assessments of management performance can be carried out by ‘outsiders’,
perhaps an internal audit department, as value for money audits (VFM audits).
VFM is important whatever level of expenditure is being considered. It may be seen as an
approach to fairly spreading costs in public expenditure across services and is necessary to
ensure that the desired impact is achieved with the minimum use of resources.
2.1 Economy
Economy is concerned with the cost of inputs, and is achieved by obtaining those inputs at the
lowest acceptable cost. Economy does not mean straightforward cost cutting, because
resources that are of a suitable quality to provide the service to the desired standard must be
acquired. Cost cutting should not sacrifice quality to the extent that service standards fall to an
unacceptable level. Economising by buying poor quality materials, labour or equipment is a ‘false
economy’.
2.2 Efficiency
Efficiency means the following:
(a) Maximising output for a given input; for example, maximising the number of transactions
handled per employee or per $1 spent
(b) Achieving the minimum input for a given output. For example, a government department
may be required to pay unemployment benefit to millions of people; efficiency will be
achieved by making these payments with the minimum labour and computer time.
2.3 Effectiveness
Effectiveness means ensuring that the outputs of a service or programme have the desired
impacts; in other words, finding out whether they succeed in achieving objectives and, if so, to
what extent.
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2.4 Studying and measuring the 3Es
Economy, efficiency and effectiveness can be studied and measured with reference to the
following:
(a) Inputs
(i) Money
(ii) Resources – the labour, materials, time, and so on consumed, and their cost
For example, a VFM audit into state secondary education would look at the efficiency and
economy of the use of resources for education (the use of schoolteachers, school buildings,
equipment, cash) and whether the resources are being used for their purpose: what is the
pupil/teacher ratio and are trained teachers being fully used to teach the subjects they have been
trained for?
(b) Outputs; in other words, the results of an activity, measurable as the services actually
produced, and the quality of the services.
In the case of a VFM audit of secondary education, outputs would be measured as the number of
pupils taught and the number of subjects taught per pupil; how many examination papers are
taken and what is the pass rate; what proportion of students go on to further education at a
university or college.
(c) Impacts, which are the effects that the outputs of an activity or programme have in terms of
achieving policy objectives.
Policy objectives might be to provide a minimum level of education for all children up to the age of
16, and to make education relevant for the children’s future jobs and careers. This might be
measured by the ratio of jobs vacant to unemployed school leavers. A VFM audit could assess to
what extent this objective is being achieved.
As another example from education, suppose that there is a programme to build a new school in
an area. The inputs would be the costs of building the school, and the resources used up; the
outputs would be the school building itself; and the impacts would be the effect that the new
school has on education in the area it serves.
3 External factors
3.1 Stakeholders
3.1.1 Internal stakeholders: employees and management
Because employees and management are so intimately connected with the company, their
objectives are likely to have a strong influence on how it is run. They are interested in the following
issues:
(a) Management and employees have a special interest in the organisation’s continued existence.
(b) Managers and employees have individual interests and goals which can be harnessed to the
goals of the organisation.
• Jobs/careers
• Benefits
• Promotion
• Money
• Satisfaction
For managers and employees, an organisation’s social obligations will include the provision of
safe working conditions and anti-discrimination policies.
3.1.2 Connected stakeholders
Increasing shareholder value should assume a core role in the strategic management of a
business. If management performance is measured and rewarded by reference to changes in
shareholder value, shareholders will be happy because managers are likely to encourage longterm share price growth.
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Connected
stakeholders
Interests to defend
Shareholders (corporate
strategy)
•
•
Increase in shareholder wealth, measured by profitability, P/E
ratios, market capitalisation, dividends and yield
Risk
Bankers (cash flows)
•
•
Security of loan
Adherence to loan agreements
Suppliers (purchase
strategy)
•
•
•
Profitable sales
Long-term relationship
Payment for goods
Customers (product
market strategy)
•
•
Goods as promised
Future benefits
Even though shareholders are deemed to be interested in return on investment and/or capital
appreciation, many want to invest in ethically sound organisations.
3.1.3 External stakeholders
External stakeholder groups – the Government, local authorities, pressure groups, the community
at large, professional bodies – are likely to have quite diverse objectives.
External stakeholders
Interests to defend
Government
•
•
•
Jobs
Training
Tax
Interest/pressure
groups/charities/’civil
society’
•
•
Pollution
Rights
It is external stakeholders in particular who induce social and ethical obligations.
3.1.4 Performance measures
Organisations may need to develop performance measures to ensure that the needs of
stakeholders are met.
Stakeholders
Measure
Employees
Morale index (a way to measure employee morale)
Shareholders
Share price, dividend yield
Government
Percentage of products conforming to environmental
regulations
Customers
Warranty cost, percentage of repeat customers
There is a strong link here to the balanced scorecard approach and the need to have a range of
non-financial performance indicators as well as financial performance indicators.
3.2 Economic environment
When designing performance measures, organisations should consider the current economic
environment to put their performance into context. Some of the external factors they should
consider are:
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Economic growth
• Has the economy grown or is there a recession?
• How has demand for goods/services been affected?
Local economic trends
• Are local businesses rationalising or expanding?
• Are office/factory rents increasing/falling?
• In what direction are house prices moving?
• Are labour rates on the increase?
Inflation
• Is a high rate making it difficult to plan, owing to the uncertainty of future financial returns?
Inflation and expectations of inflation help to explain short-termism.
• Is the rate depressing consumer demand?
• Is the rate encouraging investment in domestic industries?
• Is a high rate leading employees to demand higher wages to compensate for a fall in the value
of their wages?
Interest rates
• How do these affect consumer confidence and liquidity, and therefore demand?
• Is the cost of borrowing increasing, thereby reducing profitability?
Exchange rates
• What impact do these have on the cost of overseas imports?
• Are prices that can be charged to overseas customers affected?
Government fiscal policy
• Are consumers increasing/decreasing the amount they spend due to tax and government
spending decisions?
• How is the Government’s corporation tax policy affecting the organisation?
• Is sales tax (VAT) affecting demand?
Government spending
• Is the organisation a supplier to the Government (such as a construction firm) and therefore
affected by the level of spending?
3.3 Competition
We considered the effects of competitors’ behaviour in Chapter 5 when we looked at pricing
strategies. Performance management must consider information on competitors’ prices and cost
structures, and identify which features of an organisation’s products add the most value.
Management accounting information has to be produced quickly and be up to date so that
managers can react quickly and effectively to changing market conditions.
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Further question
practice
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Section A questions
1
Required
Which of the following is often used to protect an intranet from unauthorised access by an
external hacker?
 Anti-virus software
 Data encryption
 Firewall
 Passwords
2
Required
When an organisation networks a cluster of computers together to form an organisation-wide
network, it is said to operate which of the following?
 An internet
 An intranet
 Wi-Fi
 An ethernet
3
Required
Which of the following correctly describes a management information system?
 A system which measures and corrects the performance of activities of subordinates in order
to make sure that the objectives of an organisation are being met and the plans devised to
attain them are being carried out
 A system by which managers ensure that information is obtained and used effectively and
efficiently in the accomplishment of the organisation’s objectives
 A system which involves selecting appropriate information so that management can prepare a
long-term plan to attain the objectives of the organisation
 A collective term for the hardware and software used to drive a database system with the
outputs, both to screen and print, being designed to provide easily assimilated information for
management
4
Seon Co runs a chain of fashion retail stores. A key element of its commercial success comes from
being able to identify customer trends, and respond to them more quickly than its competitors.
Required
Which TWO of the following are potential sources of big data for Seon Co?
 Online video clips of clothes being shared by customers
 Daily transactions records from stores
 Inventory records from the chain’s central warehouse
 Keywords from conversations about fashion on social media
 The number and level of discounts Seon Co has to offer on its products
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5
The following statements have been made about activity-based costing.
(a) Unlike traditional absorption costing, ABC identifies variable overhead costs for allocation to
product costs.
(b) ABC can be used as an information source for budget planning based on activity rather than
incremental budgeting.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
6
Ohno Co uses activity based costing and produces three products called EM, TM and GM.
Ohno Co expects to incur the following indirect production costs next year:
Cost pools
Machine set up costs
Material ordering costs
$
328,800
266,000
Cost driver
Number of batches (ie set ups)
Number of purchase orders
The following information also applies:
Product
Budgeted production (units)
Batch size (units)
Number of purchase orders per batch
EM
40,000
400
3
TM
32,000
500
2
GM
44,000
400
4
Required
What is the cost per machine set-up?
$
7
A company has developed a new product and has estimated the costs as follows:
• Direct materials: 50kg required at a cost of $2.50 per kg
• Direct labour: 25% chance that each unit will take 1.5 hours, 30% chance that each unit will
take two hours and 45% chance that each unit will take 2.5 hours.
• Labour is paid at a rate of $15 per hour.
• Variable overheads will be incurred at a rate of $8 per labour hour.
• The company believes it will be able to sell the product at $200 per unit and it requires a profit
margin of 25%.
Required
What is the value of the cost gap for this product?
$
8
S Company is a manufacturer of multiple products and uses target costing. It has been noted
that Product P currently has a target cost gap and the company wishes to close this gap.
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Required
Which of the following may be used to close the target cost gap for Product P?
 Use overtime to complete work ahead of schedule
 Substitute current raw materials with cheaper versions
 Raise the selling price of P
 Negotiate cheaper rent for S Company’s premises
9
A furniture manufacturer wants to calculate a target cost for a new table. The table will be priced
at $600. The company requires a 7% profit margin on sales.
Required
What is the target cost of the table?
$
10
The following statements have been made about life cycle costing.
(a) Life cycle costing is needed in order to plan for the maximum length of commercial life for
new products.
(b) Life cycle costing is particularly suited to businesses that manufacture products with long life
cycles and who have significant research and development costs.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
11
The following statements have been made about life cycle costing:
(a) Clean up costs should be included when assessing the profitability of a product.
(b) It is useful for organisations that develop products with a relatively short life.
Required
Which of the above statements is/are correct?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
12
Moonface is developing a new piece of technology with the following expected costs:
Number of units made and sold
R&D costs
Marketing costs
634
Year 1
3,000
$’000
4,750
250
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Year 2
16,000
$’000
250
188
Year 3
20,000
$’000
Year 4
4,000
$’000
125
25
Production costs
Disposal costs
2,400
14,400
15,000
3,400
750
Required
What is the life cycle cost per unit?
$
13
The following production budget is for a company that makes two products: A and B. The
company’s budgeted output and sales are restricted by a maximum number of 3,500 direct
labour hours available in the budget period.
Output and sales
Direct labour hours per unit
Budgeted direct material cost per unit
Budgeted direct labour cost per unit
Budgeted production overhead cost per unit
Budgeted sale price per unit
Product A
2,000 units
0.5
$ per unit
8.00
8.00
19.50
40.00
Product B
10,000 units
0.25
$ per unit
5.00
4.00
8.00
25.00
Required
If the company were to use a throughput accounting system, what would be the throughput
accounting ratio (TPAR) for Product B (to 2dp)?
14
The following data relates to a manufacturing company. At the beginning of August, there was no
inventory. During August, 2,000 units of Product X were produced, but only 1,750 units were sold.
The financial data for Product X August were as follows:
$
40,000
12,600
9,400
22,500
6,000
19,300
Materials
Labour
Variable production overheads
Fixed production overheads
Variable selling costs
Fixed selling costs
Total costs for X for August
109,800
Required
The value of inventory of X at 31 August using a throughput accounting approach is:
 $5,000
 $6,175
 $6,575
 $13,725
15
Required
What is the cost of waste called in flow cost accounting?
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



System costs
Environment-related costs
Delivery and disposal costs
The cost of negative products
16
Required
Which of the following environmental costs should NOT be included in an environmental cost
budget?
 Cost of cleaning up contaminated sites
 Costs of using pollution-prevention methods and technology
 Cost of fines for environmental contamination
 Cost of recycling waste
17
Required
Which of the following environmental costs is an external environmental cost?
 Licence fees
 Payments of fines and charges
 Costs of monitoring emissions
 Traffic congestion
18
The following statements have been made about cost classifications.
(a) Repairs under warranty are an external failure cost
(b) Lower selling price for sub quality goods is an internal failure cost
Required
Which of the above statements is/are correct?
 (a) only
 (b) only
 Both (a) and (b)
 Neither (a) nor (b)
19
A product has the following costs:
$
15
9
16
Direct materials
Direct labour
Variable overheads
Fixed overheads are $9,000 per month. Budgeted sales per month are 450 units to allow the
product to break even.
Required
Fill in the blank in the sentence below.
The mark-up which needs to be added to marginal cost to allow the product to break even at the
budgeted units is ________________%
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20
HG plc manufactures four products. The unit cost, selling price and bottleneck resource details
per unit are as follows.
Selling price
Material
Labour
Variable overhead
Fixed overhead
Product W
$
56
22
15
12
4
Product X
$
67
31
20
15
2
Product Y
$
89
38
18
18
8
Product Z
$
96
46
24
15
7
Required
Assuming that labour is a unit variable cost, if budgeted unit sales are in the ratio W : 2, X : 3, Y :
3, Z : 4 and monthly fixed costs are budgeted to be $15,000, the number of units of W that would
be sold per month at the budgeted breakeven point is nearest to:
 106 units
 142 units
 212 units
 283 units
21
Co X makes two products, Y and Z, which it sells in the ratio 4:2. (This ratio is based on the sales
revenue.) The sales prices and variable costs of Y and Z are as follows:
Y
Z
Sales price
$61
$95
Variable costs
$42
$63
Fixed costs for the business are $200,000.
Required
What is the breakeven revenue for the business (to the nearest whole number)?
 $322,000
 $612,000
 $620,000
 $857,000
22
The following draft annual budget has been prepared for the machining room of a production
centre. The machining room makes four components which are then transferred to an assembly
and fitting department.
Variable cost per unit
Fixed cost per unit
Hours per unit
Cost of buying from external
supplier
Budgeted production (units)
W
$20
$25
3 hours
$60
X
$15
$20
2 hours
$46
Y
$8
$16
1 hour
$24
Component
Z
$15
$30
1.5 hours
$48
4,000
3,000
6,000
2,000
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The machining room has a maximum capacity of 24,000 hours per year, but any quantity of any
of the components can be purchased from an external supplier if required. It is essential that the
budgeted quantities of all four components be delivered to the assembly and fitting department.
This means that some of the budgeted requirement for components will have to be purchased
externally.
Required
In order to optimise the financial return, which component should be purchased externally?
 Component W
 Component X
 Component Y
 Component Z
23
A company makes two products, X and Y, with the same machines and the same direct labour
workforce. The following information is available for the next budget period.
Labour hours
per unit
0.6 hours
0.5 hours
Product X
Product Y
Machine hours
per unit
0.3 hours
0.2 hours
During the period, there will be a maximum of 20,000 machine hours and 48,000 direct labour
hours available, and these resources could be limiting factors on output and sales.
Required
If linear programming is used to determine the optimum production quantities of Product X and
Product Y, which of the following would be a constraint in the linear programming model?
 0.3x + 0.2y < 48,000
 0.5x + 0.2y < 20,000
 0.6x + 0.3y < 20,000
 0.6x + 0.5y < 48,000
24
ABC Co makes three products. Budget information is as follows:
A
B
C
$
$
$
Selling price
50
68
94
Material A
20
30
40
Material B
5
8
10
Labour
10
5
15
Demand (units)
1,000
2,000
3,000
Material A is in short supply and ABC Co only have 10,000kg available. Material A costs $10 per
kg.
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Required
What is the optimum production plan for ABC Co?
 1000 As, 0 Bs and 2,975 Cs
 0 As, 2,000 Bs and 3,000 Cs
 1,000 As, 2,000 Bs and 500 Cs
 1,000 As, 2,000 Bs and 3,000 Cs
25
A company currently sells a product for $40 and at this price, demand is 16,000 units per month.
It has been estimated that for every $3 increase or reduction in the price, monthly demand will fall
or increase by 2,000 units.
Required
What is the formula for the demand curve for this product?
 48 – 0.0001875Q
 64 – 0.0015Q
 64 – 0.003Q
 64 – 0.015Q
26
Required
Which of the following pricing policies is the most appropriate for a new product for which the
price elasticity of demand is expected to be inelastic?
 Marginal cost plus
 Market skimming
 Penetration pricing
 Price discrimination
27
A product has the following costs:
$
8
10
4
Direct materials
Direct labour
Variable overheads
Fixed overheads are $15,000 per month. Budgeted sales per month are 500 units.
Required
What is the profit mark up (the nearest whole percentage) which needs to be added to marginal
cost to establish a selling price that will allow the product to breakeven?
%
28
Required
When is a market penetration pricing policy appropriate?
 If a product is new and different
 If demand is highly elastic
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 If demand is inelastic
 If there is no possibility of economies of scale
29
A company uses its direct labour workforce to make a product for which the sales price and unit
cost are as follows:
$
80
10
20
4
30
Selling price
Direct materials
Direct labour (two hours)
Variable overheads (two hours)
Fixed overheads (two hours)
The workforce is operating at full capacity and it is not possible to obtain any additional labour
hours in the near future. A customer has asked the company to perform a special job that would
require 20 hours of direct labour time.
Required
What would be the relevant cost of diverting labour from its existing work to perform the special
job for the customer?
$
30
A company wants to decide whether to make its materials in-house or whether to sub-contract
production to an external supplier. In the past, it has made four materials in-house, but demand in
the next year will exceed in-house production capacity of 8,000 units. All four materials are made
on the same machines and require the same machine time per unit: machine time is the limiting
production factor. The following information is available:
Material
Units required
Variable cost of in-house
manufacture
Directly attributable fixed cost
expenditure
Cost of external purchase
W
4,000
$8 per unit
X
2,000
$12 per unit
Y
3,000
$9 per unit
Z
4,000
$10 per unit
$5,500
$8,000
$6,000
$7,000
$9 per unit
$18 per unit
$12 per unit
$12 per unit
Required
If a decision is made solely on the basis of short-term cost considerations, what materials should
the company purchase externally?
 4,000 units of W and 1,000 units of Z
 4,000 units of W and 4,000 units of Z
 3,000 units of Y and 2,000 units of Z
 1,000 units of Y and 4,000 units of Z
31
Jetson Co produces three products:
Sales price
Material cost
George
$60
$15
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Elroy
$75
$30
Jane
$85
$22
Labour cost @ $6 per hour
Demand
$33
10,000 units
$27
8,000 units
$48
9,000 units
Labour is restricted to 120,000 hours. In order to meet demand, Jetson is considering using a
subcontractor to produce the products that cannot be produced in-house due to the restriction on
labour hours. The subcontractor has prepared the following quote:
George = $55
Elroy = $66
Jane = $82
Required
Calculate the number of units of George that will be manufactured in-house.
 0
 2,181
 7,819
 10,000
32
The following pay-off table shows the monthly contribution that would be earned from each of
four mutually exclusive options (options A – D) given three different outcome situations. It is not
possible to predict or estimate the probability of each outcome scenario.
Required
If the choice of option is made on the basis of the minimax regret criterion, which option will be
selected?
Outcome
situation
Option A
Option B
Option C
Option D
Outcome 1
32,000
40,000
25,000
22,000
Outcome 2
50,000
40,000
80,000
60,000
Outcome 3
75,000
38,000
50,000
52,000




Option A
Option B
Option C
Option D
33
A company can choose from four mutually exclusive investment projects. The return on the project
will depend on market conditions.
The table below details the returns for each possible outcome:
Poor
Average
Good
A
$400,000
$470,000
$600,000
B
$700,000
$550,000
$300,000
C
$450,000
$500,000
$800,000
D
$360,000
$400,000
$550,000
Required
If the company applies the maximin rule it will invest in:
 Project A
 Project B
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 Project C
 Project D
34
A supplier will supply Company A with batches of 100 units, but daily demand is unpredictable.
Company A has prepared a payoff table to reflect the expected profits if different quantities are
purchased and in differing market demand conditions.
Market
conditions
Profitability
Purchase
100
Purchase
200
Purchase
300
Purchase
400
Weak
15%
50
(100)
(200)
(250)
Average
25%
120
120
250
100
Strong
50%
90
200
300
400
Exceptional
10%
80
300
400
500
Required
If the maximin criteria is applied, how many units would be purchased from the supplier?
 100
 200
 300
 400
35
The following statements have been made about budgeting.
(a) An incremental budget is a budget which is designed to change as the volume of output
changes.
(b) Zero-based budgeting is used to compare the incremental cost and related benefits of
activities.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
36
Required
Which of the following is a characteristic of feedback?
 It is used mainly for planning purposes.
 It is secondary data.
 It comes from internal sources within the organisation.
 It consists entirely of financial information.
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37
Required
A budget that is continuously updated by adding a further accounting period (a month or a
quarter) when the earlier accounting period has expired is known as a:
 Zero base budget
 Rolling budget
 Periodic budget
 Flexible budget
38
A company incurs the following costs at various activity levels:
Total cost
$
250,000
312,500
400,000
Activity level
units
5,000
7,500
10,000
Required
Using the high-low method what is the variable cost per unit?
 $25
 $30
 $35
 $40
39
The total cost of production for two levels of activity is as follows:
Level 1
3,000
6,750
Production (units)
Total cost ($)
Level 2
5,000
9,250
The variable production cost per unit and the total fixed production cost both remain constant in
the range of activity shown.
Required
What is the level of fixed costs?
 $2,000
 $2,500
 $3,000
 $3,500
40
The first unit of an entirely new product took 160 labour hours to make and the labour cost was
$3,200. Four units have now been produced and it is thought that a 75% learning curve applies to
the work.
Required
What will be the expected labour cost of the fifth unit to be produced?
 $1,004
 $1,231
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 $1,641
 $1,800
41
Required
Which of the following statements about standard costing is NOT correct?
 Standard costing is less applicable in a modern manufacturing environment where a large
proportion of total costs are overhead costs that are fixed in the short-term.
 Managers expect to access up to date performance information on-line, and standard costing
systems do not easily provide this.
 Management may prefer alternative methods of performance reporting instead of standard
costing.
 Managers no longer rely on formal budgetary control reports to monitor performance.
42
Required
Which type of standard cost is most useful for monitoring trends in performance over time?
 Attainable standard
 Basic standard
 Current standard
 Ideal standard
43
Required
Which of the following describes a ‘basic standard’ within the context of budgeting?
 A standard which is kept unchanged over a period of time
 A standard which is based on current price levels
 A standard set at an ideal level, which makes no allowance for normal losses, waste and
machine downtime
 A standard which assumes an efficient level of operation, but which includes allowances for
factors such as normal loss, waste and machine downtime
44
Spendthrift Co purchased 6,850kg of material at a total cost of $32,195. The material price
variance was $1,370 adverse.
Required
The standard price per kg was $
(to the nearest cent)
45
A standard unit of product contains two materials: P and Q. The standard direct materials cost is:
Material P
Material Q
Total direct material cost
644
0.1 kg at $8 per kg
0.3 kg at $4 per kg
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$
0.8
1.2
2.0
Management can control the mix of the materials and so, in standard costing variance reports,
direct materials variances are reported as mix and yield variances.
In the period just ended, 45,000 units of finished products were made. They used 6,900kg of
Material P, which cost $7 per kg, and 12,600kg of Material Q, which cost $5 per kg.
Required
What was the adverse direct materials yield variance?
$
46
In the budget period just ended, a very large adverse direct materials usage variance has been
reported. Control action should be taken.
Required
Which of the following actions might help to improve materials usage rates?
 Alter the mix of materials to a cheaper mix.
 Reduce the sale price of the company’s products.
 Switch to a cheaper materials supplier.
 Give production staff some training.
47
The following data have been extracted from the budget working papers of WR Co:
Activity (machine hours)
Overhead cost
$
13,468
14,162
15,549
16,242
10,000
12,000
16,000
18,000
In November 20X3, the actual activity was 13,780 machine hours and the actual overhead cost
incurred was $14,521. Give your answer to the nearest $10.
Required
Calculate the total overhead expenditure variance for November 20X3
$
(Favourable/Adverse)
48
Required
Which of the following would NOT explain a favourable direct materials usage variance?
 Using a higher quality of materials than that specified in the standard
 A reduction in materials wastage rates
 An increase in suppliers’ quality control checks
 Achieving a lower output volume than budgeted
49
A company sells a single product. Budgeted and actual sales data for the period just ended are as
follows:
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Budget
Actual results
Sales
20,000 units
17,000 units
Sales price per unit
$50
$48
Cost per unit
$40
$42
The budget was based on an expectation that the company would maintain its 20% share of the
market. It was subsequently recognised that the actual market size, due to unforeseen changes in
customer buying behaviour, was only 90,000 units. It was therefore decided to report sales
volume variances as a market share variance and a market size variance.
Required
What was the market share variance, and should this be controllable by operational sales
managers?
 $6,000 (A): controllable by operational managers
 $10,000 (A): controllable by operational managers
 $18,000 (A): not controllable by operational managers
 $20,000 (A): not controllable by operational managers
50
SG Co budgeted to make and sell 900 units of Product M during September. The standard selling
price per unit of M is $27. At the beginning of September, a new competitor entered the market
and SG Co was forced to reduce the selling price in order to maintain sales volumes. By the end of
September, 900 units had been sold for a total of $18,000. In retrospect it is decided that a
realistic standard selling price for September, given the unexpected extra competition, was $18
per unit.
Required
Calculate the sales price planning variance.
$
(Adverse/Favourable)
51
Required
Which of the following variances should a production manager be held responsible for?
 Material price planning variance
 Material price operational variance
 Material usage planning variance
 Material usage operational variance
52
Required
In which of the following circumstances are participative budgets likely to be effective?
(a) In very large organisations
(b) During periods of economic affluence
(c) When an organisation’s different units act autonomously
(d) In newly-formed organisations
 (d) only
 (a) and (b)
 (a), (b) and (c)
 (a), (b), (c) and (d)
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53
Participation by staff in the budgeting process is often seen as an aid to the creation of a realistic
budget and to the motivation of staff. There are, however, limitations to the effectiveness of such
participation.
Required
Which of the following illustrates one of these limitations?
 Participation allows staff to buy into the budget.
 Staff suggestions may be ignored leading to de-motivation.
 Staff suggestions may be based on local knowledge.
 Budgetary slack can be built in by senior manager as well as staff.
54
Required
Which of the following statements about budgeting and motivation are true?
(a) A target is more motivating than no target at all.
(b) The problem with a target is setting an appropriate degree of difficulty.
(c) Employees who are challenged tend to withdraw their commitment.
 All of them
 (b) and (c) only
 (a) and (b) only
 (c) only
55
The following statements have been made about a balanced scorecard (BSC) performance
reporting system.
(a) There must be just one key performance indicator (KPI) for each of the four perspectives of
performance.
(b) A performance target to reduce the amount of wastage in production would relate to the
innovation and learning perspective of the BSC.
Required
Which of the above statements is/are true?
 (a) only
 (b) only
 Neither (a) nor (b)
 Both (a) and (b)
56
Required
Which of the following elements in the Building Block model of performance management
(Fitzgerald and Moon) relates to setting standards of performance?
 Achievability
 Competitiveness
 Controllability
 Motivation
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57
A government department is responsible for monitoring the performance of schools providing
education for pupils aged between 11 and 18.
There is a separate government department that sets final examinations that help determine entry
to university and support pupils’ job applications.
The head teachers at individual schools are responsible for teaching and submitting selected
pupils for these examinations.
Required
Which of the following statements is valid in the context of this scenario?
 Poor performance in terms of financial indicators should be ignored if a school is performing
well in non-financial terms.
 Non-financial performance indicators cannot be manipulated by school head teachers.
 It is generally valid to compare the pass rates of different schools in the final examinations.
 Non-financial indicators are generally more important than financial indicators in the public
sector
58
The following information relates to an investment centre, which is a separate product division in a
large company:
Net current assets
Non-current assets
$
60,000
240,000
Profit before depreciation
Depreciation
50,000
10,000
Required
The company’s cost of capital is 10%. What is the most appropriate measure of the centre’s Return
on Investment (ROI)?
 3.3%
 13.3%
 16.7%
 20.8%
59
There are two profit centres: A and B. Profit centre A transfers a product to profit centre B but
could also sell the product in an external market at a price of $30. The marginal cost of making
the product in profit centre A is $8 per unit and the full cost is $14 per unit. There would be a
variable cost of $1 per unit for sales and distribution to customers in the external market, but no
such costs for internal transfers.
Required
To avoid disputes between the profit centre managers, what should be the transfer price for the
product?
$
648
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60
A government body uses measures based on the 3Es to measure value for money generated by a
publicly funded hospital. It considers the most important performance measure to be ‘cost per
successfully treated patient’.
Which of the 3Es best describes the above measure?
 Externality
 Economy
 Efficiency
 Effectiveness
61
Required
Which TWO of the following are most likely to be performance measures for a not for profit
organisation?
(a) Efficient resource allocation.
(b) Return on investment (ROI) and residual income (RI)
(c) Minimising the cost of resources used.
(d) Success measured against competition
 (a) and (b)
 (b) and (c)
 (c) and (d)
 (a) and (c)
62
Required
Which of the following is an example of an internal stakeholder?
 Shareholders
 Employees
 Suppliers
 Financiers
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Section B questions
63 Southcott
Southcott Co is a firm of financial consultants which offers short revision courses on taxation and
auditing for professional examinations. The firm has budgeted annual overheads totalling
$152,625. Until recently, the firm has applied overheads on a volume basis, based on the number
of course days offered. The firm has no variable costs and the only direct costs are the
consultants’ own time which they divide equally between their two courses.
The following information relates to the past year and is expected to remain the same for the
coming year:
Course
Auditing
Taxation
1
No of courses
sold
50
30
Duration
of course
2 days
3 days
No of enquiries
per course
175
70
No of brochures
printed per course
300
200
All courses run with a maximum number of students (30), as it is deemed that beyond this number
the learning experience is severely diminished, and the same centre is hired for all courses at a
standard daily rate. The firm has the human resources to run only one course at any one time.
Required
Calculate the overhead cost per course for auditing using traditional volume based absorption
costing to the nearest dollar.
$
The firm is considering the possibility of adopting an activity based costing (ABC) system and has
identified the overhead costs as follows:
Details of overheads
$
62,500
27,125
63,000
Centre hire
Enquiries administration
Brochures
Total
2
152,625
Required
Calculate the overhead cost of centre hire which would be allocated to an auditing course under
activity based costing to the nearest dollar.
3
$
Required
Calculate the overhead cost of brochure printing which would be allocated to a taxation course
under activity based costing to the nearest dollar.
4
$
Required
Calculate the overhead cost of enquiries administration which would be allocated to a taxation
course under activity based costing.
5
$
A member of Southcott Co’s finance team has said that activity based costing (ABC) provides
more accurate product costs than a traditional absorption costing system. He gave a number of
statements supporting this claim.
Required
Which of the following statements does NOT support his claim?
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



ABC uses cost drivers to allocate overhead costs to products by cost pool
ABC identifies value added and non-value added activities
ABC assigns overheads to each major activity
ABC uses both volume based and non-volume based cost drivers
64 Bottlenecks
F Co makes and sells two products, A and B, each of which passes through the same automated
production operations. The following estimated information is available for Period 1:
Product unit data
Direct material cost ($)
Variable production overhead cost ($)
A
2
28
B
40
4
Original estimates of production/sales of Products A and B are 120,000 units and 45,000 units
respectively. The selling prices per unit for A and B are $60 and $70 respectively.
Maximum demand for each product is 20% above the estimated sales levels.
Total fixed production overhead cost is $1,470,000. This is absorbed by Products A and B at an
average rate per hour based on the estimated production levels.
1
2
3
4
5
One of the production operations has a maximum capacity of 3,075 hours which has been
identified as a bottleneck, limiting the overall estimated production/sales of Products A and B. The
bottleneck hours required per product unit for Products A and B are 0.02 and 0.015 respectively.
Required
Using limiting factor analysis, calculate the contribution per bottleneck hour of Product B to the
nearest dollar.
$
Required
If F Co chooses to prioritise Product B, calculate the value (in $) of the maximum net profit.
Required
Using throughput analysis, calculate the return per bottleneck hour of Product A.
$
Required
Assume that the variable overhead cost, based on the value (in $) which applies to the original
estimated production/sales mix, is now considered to be fixed for the short/intermediate term. If F
Co choose to prioritise the manufacture of Product A, calculate the value (in $) of the maximum
net profit using throughput analysis.
$
Required
The throughput return per hour of Product B is $2,000. Calculate the throughput accounting ratio
for Product B (to 2 dp).
65 Bench Co
Bench Co has developed two new products, Product A and Product B. The first batch of 15 units of
Product A will take 350 labour hours to produce. There will be an 80% learning curve that will
continue until 390 units have been produced. Batches after this level will each take the same
amount of time as the 26th batch. The batch size will always be 15 units.
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For Product B, the company has estimated that a 75% learning curve will apply. The time to
produce the first unit was 1,600 hours.
Note. The learning index for an 80% learning curve is –0.3219. The learning index for a 75%
learning curve is –0.415
1
Ignore the time value of money.
Required
Calculate the cumulative average time per batch for the first 26 batches of Product A (give your
answer to two dp).
hours
2
Required
The total time for the first 16 batches of Product A was 2,500 hours. What was the actual learning
rate (closest to the nearest %)?
%
3
Required
What is the expected time to produce the 9th unit of Product B (give your answer to the nearest
hour)?
hours
4
5
Required
Which THREE of the following conditions are necessary for learning curve theory to apply?
 A relatively new product.
 A manual, rather than mechanised production process.
 A relatively complex production process.
 Production in batches of equal size.
 Constant labour wage rates.
Required
Which of the following statements is FALSE in relation to learning curve theory?
 The learning curve theory states that the average time per unit produced is assumed to
decease by a constant percentage every time total output doubles
 When a certain level of units hasve been produced, the learning process comes to an end and
any extra units produced tend to take the same amount of time
 The formula for the learning curve is Y = aX b where Y is the cumulative average time per unit
to produce X units, X is the cumulative number of units, a is the time taken for the first unit of
output, and b is the index of learning.
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Section C questions
66 AB (36 mins)
AB produces a consumable compound X, used in the preliminary stage of a technical process that
it installs in customers’ factories worldwide. An overseas competitor, CD, offering an alternative
process which uses the same preliminary stage, has developed a new compound, Y, for that stage
which is both cheaper in its ingredients and more effective than X.
At present, CD is offering Y only in its own national market, but it is expected that it will not be
long before it extends its sales overseas. Both X and Y are also sold separately to users of the
technical process as a replacement for the original compound that eventually loses its strength.
This replacement demand amounts to 60% of total demand for X and would do so for Y. CD is
selling Y at the same price as X ($64.08 per kg).
AB discovers that it would take 20 weeks to set up a production facility to manufacture Y at an
incremental capital cost of $3,500 and the comparative manufacturing costs of X and Y would be:
Direct materials
Direct labour
X
$ per kg
17.33
7.36
Y
$ per kg
4.01
2.85
24.69
6.86
AB normally absorbs departmental overhead at 200% of direct labour: 30% of this departmental
overhead is variable directly with direct labour cost. Selling and administration overhead is
absorbed at one half of departmental overhead.
The current sales of X average 74kg per week and this level (whether of X or of Y if it were
produced) is not expected to change over the next year. Because the direct materials for X are
highly specialised, AB has always had to keep large inventories in order to obtain supplies. At
present, these amount to $44,800 at cost. Its inventory of finished X is $51,900 at full cost.
Unfortunately, neither X nor its raw materials have any resale value whatsoever: in fact, it would
cost $0.30 per kg to dispose of them.
Over the next three months, AB is not normally busy and, in order to avoid laying off staff, has an
arrangement with the trade union whereby it pays its factory operators at 65% of their normal
rate of pay for the period while they do non-production work. AB assesses that it could process all
its relevant direct materials into X in that period, if necessary.
1
There are two main options open to AB.
• To continue to sell X until all its inventories of X (both of direct materials and of finished
inventory) are exhausted, and then start sales of Y immediately afterwards.
• To start sales of Y as soon as possible and then to dispose of any remaining inventories of X
and/or its raw materials.
Required
Recommend, with supporting calculations, which of the two main courses of action suggested is
the more advantageous from a purely cost and financial point of view.
2
(10 marks)
Required
Identify three major non-financial factors that AB would need to consider in making its eventual
decision as to what to do.
3
(6 marks)
Required
Suggest one other course of action that AB might follow, explaining what you consider to be its
merits and demerits when compared with your answer at (a) above.
(4 marks)
(Total = 20 marks)
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67 Stow Health Centre (36 mins)
Stow Health Centre specialises in the provision of sports/exercise and medical/dietary advice for
clients. The service is provided on a residential basis and clients stay for whatever number of days
suits their needs.
Budgeted estimates for the year ending 30 June 20X1 are as follows:
• The maximum capacity of the centre is 50 clients per day for 350 days in the year.
• Clients will be invoiced at a fee per day. The budgeted occupancy level will vary with the client
fee level per day and is estimated at different percentages of maximum capacity as follows.
•
1
2
Client fee
per day
Occupancy level
Occupancy as
percentage of
maximum capacity
$180
High
90%
$200
Most likely
75%
$220
Low
60%
Variable costs are also estimated at one of three levels per client day. The high, most likely and
low levels per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices of goods and
services.
Required
Prepare a summary which shows the budgeted contribution earned by Stow Health Centre for the
year ended 30 June 20X1 for each of nine possible outcomes.
(6 marks)
Required
State the client fee strategy for the year to 30 June 20X1 which will result from the use of each of
the following decision rules.
(a) Maximax
(b) Maximin
(c) Minimax regret
Your answer should explain the basis of operation of each rule. Use the information from your
answer to (1) as relevant and show any additional working calculations as necessary.
3
(10 marks)
The probabilities of variable cost levels occurring at the high, most likely and low levels provided in
the question are estimated as 0.1, 0.6 and 0.3 respectively.
Required
Using the information available, determine the client fee strategy which will be chosen where
maximisation of expected value of contribution is used as the decision basis.
(4 marks)
(Total = 20 marks)
68 NYE Co (36 mins)
NYE Co manufactures three standard products which it sells to several large wholesale chains.
Production is highly automated and occurs in large batches. Goods are shipped to customers in
slightly smaller batches. Details of a typical month’s output are as follows:
Units of output
Production machine hours (PMH) per unit of output
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Product X
50,000
0.3 PMH
Product Y
100,000
0.2 PMH
Product Z
225,000
0.4 PMH
Production batch size (units)
Shipment batch size (units)
1,250
1,000
2,000
1,000
3,750
2,500
Two types of indirect labour are employed – four quality control inspectors (at a cost of $4,000
each per month) and nine administrators (at a monthly cost of $3,500 each). Each employee
works a standard 180 hours per month.
The role of the quality control staff is to inspect a sample from each batch of output produced.
The standard inspection time is four hours per batch. The administrators perform two tasks –
shipment processing work (which takes three hours per batch shipped) and monitoring of
production (at a rate of 1 hour of administrator time for every 600 units of output).
In addition to the production machinery (which has a capacity of 100,000 production machine
hours [PMH] per month) there are two additional types of specialised machinery which perform
automated production setup and automated shipment loading procedures. Details of these two
machines are provided as follows:
Monthly capacity
Usage rates
1
2
Production setup machinery
800 hours
5 hours per batch produced
Shipment loading machinery
520 hours
2 hours per batch shipped
Required
Use activity based budgeting to assess whether the resources currently owned or employed by
the company are sufficient to meet typical monthly output. Comment on any significant
surplus/shortfall in resource.
(14 marks)
Required
Briefly outline THREE advantages that may be claimed for the use of activity based budgeting
rather than a traditional incremental budgeting system.
(6 marks)
(Total = 20 marks)
69 McDreamy (36 mins)
McDreamy is in an industry sector which is recovering from the recent recession. The directors of
the company hope next year to be operating at 85% of capacity, although currently the
company is operating at only 65% of capacity. 65% of capacity represents output of 10,000 units
of the single product which is produced and sold. One hundred direct workers are employed on
production for 200,000 hours in the current year.
The flexed budgets for the current year are as follows:
Capacity level
55%
65%
75%
$
$
$
Direct materials
846,200
1,000,000
1,153,800
Direct wages
1,480,850
1,750,000
2,019,150
Production overhead
596,170
650,000
703,830
Selling and distribution overhead
192,310
200,000
207,690
Administration overhead
120,000
120,000
120,000
Total costs
3,235,530
3,720,000
4,204,470
Profit in any year is budgeted to be 16.67% of sales.
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The following percentage increases in costs are expected for next year.
Direct materials
Direct wages
Variable production overhead
Variable selling and distribution overhead
Fixed production overhead
Fixed selling and distribution overhead
Administration overhead
1
Increase %
6.0
3.0
7.0
7.0
10.0
7.5
10.0
Required
Prepare for next year a flexible budget statement on the assumption that the company operates
at 85% of capacity; your statement should show both contribution and profit.
2
(12 marks)
Required
State THREE problems which may arise from the change in capacity level.
3
(3 marks)
Required
Explain what is meant by the principle of controllability.
(5 marks)
(Total = 20 marks)
70 Truffle Co (36 mins)
Truffle Co makes high quality, hand-made chocolate truffles which it sells to a local retailer. All
chocolates are made in batches of 16, to fit the standard boxes supplied by the retailer. The
standard cost of labour for each batch is $6.00 and the standard labour time for each batch is
half an hour. In November, Truffle Co had budgeted production of 24,000 batches; actual
production was only 20,500 batches. 12,000 labour hours were used to complete the work and
there was no idle time. All workers were paid for their actual hours worked. The actual total labour
cost for November was $136,800. The production manager at Truffle Co has no input into the
budgeting process.
At the end of October, the managing director decided to hold a meeting and offer staff the choice
of either accepting a 5% pay cut or facing a certain number of redundancies. All staff
subsequently agreed to accept the 5% pay cut with immediate effect.
At the same time, the retailer requested that the truffles be made slightly softer. This change was
implemented immediately and made the chocolates more difficult to shape. When recipe changes
such as these are made, it takes time before the workers become used to working with the new
ingredient mix, making the process 20% slower for at least the first month of the new operation.
1
The standard costing system is only updated once a year in June and no changes are ever made
to the system outside of this.
Required
Calculate the total labour rate and total labour efficiency variances for November, based on the
standard cost provided above.
2
(4 marks)
Required
Analyse the total labour rate and total labour efficiency variances into component parts for
planning and operational variances in as much detail as the information allows.
3
(8 marks)
Required
Assess the performance of the production manager for the month of November.
(8 marks) (Total = 20 marks)
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71 Divisional performance measures (36 mins)
1
2
3
Required
Compare and contrast the use of residual income and return on investment in divisional
performance measurement, stating the advantages and disadvantages of each.
(7 marks)
Division Y of Chardonnay currently has capital employed of $100,000 and earns an annual profit
after depreciation of $18,000. The divisional manager is considering an investment of $10,000 in
an asset which will have a ten-year life with no residual value and will earn a constant annual
profit after depreciation of $1,600. The cost of capital is 15%.
Required
Calculate the following and comment on the results:
(a) The return on divisional investment before and after the new investment
(b) The divisional residual income before and after the new investment (8 marks)
Required
Explain the potential benefits of operating a transfer pricing system within a divisionalised
company.
(5 marks)
(Total = 20 marks)
72 Non-profit seeking organisations (36 mins)
(a) The absence of the profit measure in non-profit seeking organisations causes problems for
the measurement of their efficiency and effectiveness.
(i) Explain why the absence of the profit measure should be a cause of the problems
referred to. (8 marks)
(ii) Explain how these problems extend to activities within business entities which have a
profit motive. Support your answer with examples. (4 marks)
(b) A public health clinic is the subject of a scheme to measure its efficiency and effectiveness.
Among a number of factors, the ‘quality of care provided’ has been included as an aspect of
the clinic’s service to be measured. Three features of ‘quality of care provided’ have been
listed.
• Clinic’s adherence to appointment times
• Patients’ ability to contact the clinic and make appointments without difficulty
• The provision of a comprehensive patient health monitoring programme
(i) Suggest a set of quantitative measures which can be used to identify the effective level
of achievement of each of the features listed. (6 marks)
(ii) Indicate how these measures could be combined into a single ‘quality of care’ measure.
(2 marks)
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Further question
solutions
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1
The correct answer is:
Firewall
Passwords are used to prevent access to files and programs within a system, rather than
preventing access to the system at all.
2
The correct answer is:
An internet
An intranet is effectively a private network within an organisation, used to share information
internally.
3
The correct answer is:
A collective term for the hardware and software used to drive a database system with the outputs,
both to screen and print, being designed to provide easily assimilated information for
management
This is the correct definition of a management information system.
4
The correct answers are:
•
Online video clips of clothes being shared by customers
•
The number and level of discounts Seon Co has to offer on its products
Although the data obtained from the other options could all be valuable to Seon Co’s managers in
analysing the company’s performance, they are all data sets which we would expect to be
available from ‘traditional’ database software within the company.
One of the key benefits big data can provide for a business is the insights it can give in terms of
identifying trends and patterns, and gaining a deeper understanding of customer requirements.
Social media can be a key source of such data – for example, by identifying what sorts of designs
customers are commenting on favourably and which are receiving less favourable feedback.
5
The correct answer is:
(b) only
ABC is a method of absorption costing that uses cost drivers to calculate absorption rates per unit
of overhead activity. It then apportions overhead costs to products. It is not a technique for
identifying variable overhead costs.
ABC can be used as a basis for preparing budgets. This approach to budgeting is called activity
based budgeting (ABB).
6
The correct answer is:
$1,200
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659
Cost per machine set-up = machine set up costs / total number of batches
Total number of batches =
40,000 units
32,000 units
44,000 units
400 units + 500 units + 400 units = 274 batches
Cost per machine set-up =
$328,800
274 = $1,200
7
The correct answer is:
$23.30
Direct materials
Labour time
Labour cost
Variable overhead
Total expected cost
Target cost
Cost gap
=
=
=
=
=
=
=
50 × $2.50 =
(0.25 × 1.5) + (0.3 × 2) + (0.45× 2.5) =
2.1 × $15 =
2.1 × $8 =
$173.30
200 – (200 ×0.25) =
173.3 – 150 =
$125
2.1 hours
$31.50
$16.80
$150
$23.30
8
The correct answer is:
Substitute current raw materials with cheaper versions
Reducing the target cost gap should focus on ways of reducing the direct or variable costs of the
product. This can be achieved by using a cheaper, substitute raw material, but without affecting
product quality. Reducing fixed overhead costs is not a way of reducing the gap. Using overtime is
likely to increase costs and the target cost gap. Raising the selling price does not affect the cost
gap directly, although it may lead to a reassessment of the target cost.
9
The correct answer is:
$558
Profit required = 7% × $600 = $42
Target cost = $600 – $42 = $558
10
The correct answer is:
Neither (a) nor (b)
Life cycle costing does not have as an objective the maximisation of the commercial life of new
products. Costs are estimated on the basis of the expected life of a product.
Life cycle costing is particularly suited to businesses that manufacture products with short life
cycles and who have significant research and development costs.
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11
The correct answer is:
Both (a) and (b)
Life cycle costing is the accumulation of costs of a product’s entire life cycle. Products that are
not expected to be profitable after allowing for clean up costs should not be considered.
Life cycle costing can be very useful for organisations that continually develop products with a
relatively short life, where it may be possible to estimate sales volumes and prices with reasonable
accuracy.
12
The correct answer is:
$966
$’000
5,000
588
35,200
750
41,538
43
966
R&D costs (4,750 + 250)
Marketing (250 + 188 + 125 + 25)
Production (2,400 + 14,400 + 15,000 + 3,400)
Disposal
Total life cycle costs
Total production (‘000 units)
Cost per unit
13
The correct answer is:
1.60
Total factory costs: [2,000 units × $(8 + 19.50)] + [10,000 × $(4 + 8)] = $175,000
Factory cost per unit of bottleneck resource = $175,000/3,500 hours = $50
Product B throughput per unit = $25 – $5 = $20
Product B throughput per unit of bottleneck resource = $20/0.25 = $80
TPAR = $80/$50 = 1.60
14
The correct answer is:
$5,000
The total cost of producing 2,000 units using a throughput approach is:
$
40,000
Materials
The cost per unit is $20 ($40,000 ÷ 2,000).
For the remaining inventory of 250 units the cost would be 250 × $20 = $5,000
15
The correct answer is:
The cost of negative products
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661
In flow cost accounting, a distinction is made between positive and negative products, but a cost
is attributed to each. Cost consists of materials, system costs and delivery and disposal costs.
16
The correct answer is:
Cost of fines for environmental contamination
A company may incur costs for contamination of the environment, but this cost should not be
included within budgeted (and so ‘acceptable’) environmental costs
17
The correct answer is:
Traffic congestion
This is an external environmental impact and the cost is picked up by the rest of society. The
other costs are internal costs
18
The correct answer is:
Both (a) and (b)
Both statements are true. Repairs after the products have left the factory are an external failure
cost. Having to reduce the price before the products leave the factory are an internal failure cost.
19
The correct answer is:
Breakeven point is when total contribution equals fixed costs.
At breakeven point, $9,000 = 450 (selling price – $40)
∴ $20 = price – $40
∴ Price = $60
∴ Mark-up = ((60 – 40) /40) × 100% = 50%
20
The correct answer is:
283 units
Contribution per mix
= (2 × $7) + (3 ×$1) + (3 × $15) + (4 × $11) = $106
∴ Breakeven point in number of mixes = $15,000/$106 = 141.5
∴ Number of W sold at breakeven point = 2 × 141.5 = 283 units
If you chose 142, you took the breakeven number of mixes but did not multiply by two to get the
number of units of W as there are two units of W in each mix.
If you chose 106 units then this is the contribution per mix. You did not go on then to calculate the
BE point or number of units of W.
If you chose 212 you simply multiplied the contribution per mix by two and missed out the
intermediate stage of calculating the breakeven point.
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21
The correct answer is:
$620,000
Breakeven sales revenue = fixed costs/weighted average c/s ratio
Contribution Y: $61 – $42 = $19
Contribution Z: $95 – $63 = $32
Total contribution for mix = ($19 × 4) + ($32 ×2) = $140
Total sales = ($61 ×4) + ($95 ×2) = $434
C/S ratio = 140/434 = 0.3226
Breakeven revenue = $200,000/0.3226 = $619,963 or $620,000 rounded up
22
The correct answer is:
Component W
Additional cost of external purchase
Hours saved
Extra cost per hour saved
Ranking for external purchase
W
$40
3
$13.3
1st
Component
Y
Z
$16
$33
1
1.5
$16
$22
3rd
4th
X
$31
2
$15.5
2nd
23
The correct answer is:
0.6x + 0.5y < 48,000
The two maximum constraints would be:
0.6x + 0.5y < 48,000 and 0.3x + 0.2y < 20,000
24
The correct answer is:
1,000 As, 2,000 Bs and 500 Cs
Selling price
Material A
Material B
Labour
Contribution per unit
Kg of Mat A per unit
Contribution per
Kg of Mat A
Rank
A
$
50
(20)
(5)
(10)
15
2
7.5
B
$
68
(30)
(8)
(5)
25
3
8.33
C
$
94
(40)
(10)
(15)
29
4
7.25
2
1
3
Optimal production plan:
kg
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Available
Make max number of Bs
Make max number of As
(2,000 ×3)
(1,000 ×2)
Use rest to make Cs @ 4 kg
2,000÷4 = 500
10,000
(6,000)
(2,000)
2,000
(2,000)
25
The correct answer is:
64 – 0.0015Q
Price at which demand is 0 = $40 + (16,000/2,000) × $3 = $64
When P = a – bQ, b = 3/2,000 = 0.0015
26
The correct answer is:
Market skimming
If demand is expected to be inelastic with regard to price, low prices are not going to affect
market demand significantly, so market skimming will almost certainly result in profit
maximisation. Price discrimination will not offer any benefit when demand is price inelastic.
27
The correct answer is:
136%
Breakeven point is when total contribution equals fixed costs.
At breakeven point, $15,000 = 500 (price - $22)
So, $30 = price – $22
So, $52 = price
So, profit mark up = ($52 – $22) / $22 × 100% = 136%
28
The correct answer is:
If demand is highly elastic
If demand is highly elastic, it responds well to low prices.
If a product is new and different, market skimming would be more appropriate. Customers would
be prepared to pay high prices so as to be one up on other people who do not own the product.
Market penetration pricing is appropriate if there are significant economies of scale to be
achieved from a high volume of output, so that quick penetration into the market is desirable in
order to gain unit cost reductions.
29
The correct answer is:
$700
$ per hour
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Labour cost
Variable overhead cost
Lost contribution (80 – 34)/2
Relevant cost per hour
10
2
23
35
Total relevant cost = 20 hours × $35 = $700
30
The correct answer is:
4,000 units of W and 4,000 units of Z
W
X
Y
Z
$
$
$
$
Extra cost per
unit of
external
purchase
1
6
3
2
Total extra
cost of
external
purchase
4,000
12,000
9,000
8,000
Fixed costs
saved by not
making inhouse
(5,500)
(8,000)
(6,000)
(7,000)
Difference
(1,500)
4,000
3,000
1,000
It would save $1,000 in cash to buy Material W externally. If full production can be achieved for
the other materials, only W would be purchased externally. However, there is insufficient capacity
to produce all three materials in-house.
If in-house production of Material Z is reduced to 3,000 units, the additional cost of external
purchase would be only $6,000, so that $1,000 would be saved by purchasing all of Z externally.
The easiest way of understanding this is to look at the total costs associated with Product Z
depending on which course of action is chosen:
• Buy them all in ($12 × 4,000 units) = $48,000
• Buy in 1,000 ($12 × 1,000) = $12,000 and make the remaining 3,000 ($10 × 3,000) +
7,000 specific fixed costs = $49,000
Therefore, it is best to buy all 4,000 units despite having the capacity to make 3,000.
31
The correct answer is:
2,181
Labour is a limiting factor. Therefore, to determine the order of production the saving per limiting
factor of manufacturing in-house for each product must be calculated:
George
Elroy
Jane
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$
$
$
Subcontractor
55
66
82
Variable costs
48
57
70
Saving
7
9
12
Labour hours
5.5
4.5
8.0
Saving/hour
1.27
2.00
1.50
Elroy has the greatest saving of manufacturing in-house per labour hour so should be prioritised
to be manufactured in-house, followed by Jane, then George.
8,000 units of Elroy = 36,000 hrs (84,000 hours remaining)
9,000 units of Jane = 72,000 hrs (12,000 hours remaining)
12,000 hrs / 5.5 hrs per George = 2,181 units of George can be produced in-house
32
The correct answer is:
Option D
Regret table:
Outcome
situation
Option A
Option B
Option C
Option D
$
$
$
$
Outcome 1
8,000
0
15,000
18,000
Outcome 2
30,000
40,000
0
20,000
Outcome 3
0
37,000
25,000
23,000
Max regret
30,000
40,000
25,000
23,000
Project C
$450,000
Project D
$360,000
The lowest maximum regret is $23,000.
33
The correct answer is:
The correct answer is: Project C.
Maximin = maximise the minimum achievable return.
The minimum achievable returns for each project are:
Project A
$400,000
Project B
$300,000
The maximum return from these is $450,000, project C.
34
The correct answer is:
100
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Market
condition
s
Probabilit
y
Purchas
e 100
Purchas
e 200
Purchas
e 300
Purchas
e 400
Weak
15%
50
(100)
(200)
(250)
Average
25%
120
120
250
100
Strong
50%
90
200
300
400
Exceptional
10%
80
300
400
500
50
(100)
(200)
(250)
Minimum
return
Therefore, choose to purchase 100 as this has the lowest, minimum return.
35
The correct answer is:
(b) only
The definition in Statement (a) is a definition of a flexible budget. Incremental decision packages
in ZBB are used to measure the incremental cost of an activity or incremental activity, and to
assess the benefits that this will provide. Incremental decision packages can be ranked according
to the net benefit they will provide.
36
The correct answer is:
It comes from internal sources within the organisation.
Feedback is used mainly for control reporting purposes. It is primary data. It comes from internal
sources within the organisation. It may consist of both financial and non-financial information.
37
The correct answer is:
Rolling budget
Sometimes this is known as a continuous budget as the budget period is continually being
extended.
38
The correct answer is:
$30
Highest
Lowest
Activity level
Units
10,000
5,000
Cost
$
400,000
250,000
5,000
150,000
Variable cost per unit = $150,000 / 5,000 units = $30
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667
39
The correct answer is:
$3,000
Production
Total cost
Units
$
Level 2
5,000
9,250
Level 1
3,000
6,750
2,000
2,500
Variable cost per unit = $2,500 / 2,000 units
= $1.25 per unit
Fixed overhead = $9,250 – ($1.25 × 5,000) = $3,000
40
The correct answer is:
$1,004
Y = axb
Time taken for the first unit of output (a) = 160
Learning index (b) = log 0.75/log 2 = –0.1249387/0.30103 = –0.4150374
Time to produce the first 4 units
Cumulative average time for first 4 units = 160 ×4- 0.4150374 = 160 × 0.5625 = 90 hours
Total time for first four units = 4 × 90 hours = 360 hours
Time to produce the first 5 units
Cumulative average time for first 5 units = 160 × 5- 0.4150374 = 160 × 0.5127449 = 82.03918 hours
Total time for first five units = 5 × 82.03918 hours = 410.196 hours
Time to produce the 5th unit = (410.196 – 360) = 50.2 hours
Cost per hour = $3,200/160= $20 per hour
Cost for 5th unit = 50.2 hours × $20 = $1,003.92
41
The correct answer is:
Managers no longer rely on formal budgetary control reports to monitor performance.
Formal arrangements for monitoring performance are very widely used. Budgetary control
reporting (if not standard costing variance reports) is an effective way of providing control
information and performance information.
42
The correct answer is:
Basic standard
A basic standard is left unchanged, so that changes in variances over time indicate a trend in
prices and efficiency over time.
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43
The correct answer is:
A standard which is kept unchanged over a period of time
A basic standard is a long-term standard which remains unchanged over the years and is used to
show trends. The descriptions given in the distracters describe a current standard, an ideal
standard, and an attainable standard respectively.
44
The correct answer is:
Required
The standard price per kg was $4.50 (to the nearest cent)
Standard cost of material purchased – actual cost of material purchased = price variance
Standard cost
= $32,195 – $1,370
= $30,825
Standard price per kg
= $30,825/6,850
= $4.50
45
The correct answer is:
$7,500
Units
48,750
45,000
3,750 (A)
$2
$7,500 (A)
19,500 kg should yield (÷0.4)
but did yield
Yield variance in units
× Standard material cost per unit of output
Yield variance in $
46
The correct answer is:
Give production staff some training.
Adverse materials usage may be caused partly by inefficiencies or errors by production staff.
Training may improve their ability to do the work and improve materials usage rates.
47
The correct answer is:
$260 Favourable
The overhead cost given, includes both fixed and variable costs. Fixed and variable budgeted
overhead costs can be separated using the high/low method.
High
Low
Hours
18,000
10,000
$
16,242
13,468
8,000
2,774
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The variable cost per machine hour can be estimated as $2,774/8,000 = $0.34675
The fixed cost is $10,000, being the difference between variable overheads of 10,000 × 0.34675
and total cost of $13,468.
The total overhead variance for November is: Fixed overhead + variable overhead for quality
achieved - total actual overhead cost incurred.
Budgeted cost ($10,000 + 13,780 × $0.34675)
Total actual overhead cost incurred
$
14,778
14,521
(F)
257
48
The correct answer is:
Achieving a lower output volume than budgeted
The direct materials usage variance compares the standard material usage for the actual
production with the actual material used. This means that the budgeted output volume is not
relevant because it is not included in the calculation of the variance.
Using higher quality materials and increasing quality control checks are both likely to lead to a
reduction in wastage rates which will lead to lower usage and a favourable materials usage
variance.
49
The correct answer is:
$10,000 (A): controllable by operational managers
In retrospect, the market size was 90,000 units and if the company maintained a 20% market
share it would have sold 18,000 units.
Market share variance:
Units
Expected sales to maintain market share
18,000
Actual sales
17,000
Market share variance in sales units
1,000 (A)
Standard profit per unit
$10
Market share variance in $ profit
$10,000 (A)
50
The correct answer is:
$8,100 Adverse
670
Original standard selling price per unit
$27
Revised standard selling price per unit
$18
Performance Management
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Planning variance per unit
$9 (A)
× sales volume in units
× 900
Sales price planning variance
$8,100 (A)
51
The correct answer is:
Material usage operational variance
Material usage variances are in the production manager’s control. Material price variances are
usually the responsibility of the purchasing manager.
Operational variances can be controlled by a line manager. In this instance the production
manager can control efficiencies within the production process, influencing the operational
variance. Planning variances are attributable to the manager responsible for approving the
original standard, usually a more senior director
52
The correct answer is:
(a), (b) and (c)
Imposed budgets are likely to be most effective in newly-formed organisations, but participative
budgets are likely to be effective in all other organisations.
53
The correct answer is:
Staff suggestions may be ignored leading to de-motivation.
Psuedo-participation occurs when managers pretend to involve staff but actually ignore their
input. This may lead to a less realistic budget and will certainly be de-motivating if the staff
involved find out what is going on.
54
The correct answer is:
(a) and (b) only
It is generally agreed that the existence of some form of target or expected outcome is a greater
motivation than no target at all. Therefore (a) is true. The establishment of a target, however,
raises the question of the degree of difficulty or challenge of the target. Therefore (b) is true. If the
performance standard is set too high or too low, sub-optimal performance could be the result.
The degree of budget difficulty is not easy to establish. It is influenced by the nature of the task,
the organisational culture and personality factors. Some people respond positively to a difficult
target. Others, if challenged, tend to withdraw their commitment. So, (c) is not true.
55
The correct answer is:
Neither (a) nor (b)
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There can be (and usually are) several key performance indicators for each of the four
perspectives of performance. A performance target to reduce the amount of wastage in
production would relate to the internal perspective of the BSC.
56
The correct answer is:
Achievability
There are three aspects to setting standards in the Building Block model: ownership, achievability
and equity (fairness).
57
The correct answer is:
Non-financial indicators are generally more important than financial indicators in the public
sector
The public sector is funded by government therefore financial indicators involving profit will be of
little use in measuring performance.
58
The correct answer is:
13.3%
($40,000/$300,000) × 100% = 13.3%
59
The correct answer is:
$29
The transfer price should be the opportunity cost for profit centre B of not being able to sell the
product in the external market. This is the external market price minus the variable selling and
distribution cost: $30 – $1 = $29.
60
The correct answer is:
Efficiency
61
The correct answer is:
(a) and (c)
Not for profit organisations do not usually measure themselves against competition. However,
sometimes they use benchmarking against similar departments or organisations. Not for profit
organisations do not use ROI or RI.
62
The correct answer is:
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Employees
The others are all connected stakeholders
63 Southcott
1
The correct answer is:
$1,607
No of courses sold
Duration of course (days)
No of course days
Auditing
50
2
100
Taxation
30
3
90
Total
190
Overhead cost per course day = $152,625 /190 = $803.29
Overhead cost per course
Auditing
2
$803.29 × 2 days = $1,606.58
The correct answer is:
$658
Overhead cost of centre hire per auditing course using activity based costing
Centre hire cost per course day = $62,500 / 190 = $328.95
Number of days per auditing course = 2
Centre hire cost per auditing course = 2 × $328.95 = $657.90
3
The correct answer is:
$600
Brochure cost per brochure printed =
$63,000
(50 × 300) + (30 × 200)
= $3 brochure
Number of brochures printed per taxation course = 200
Cost of brochure printing allocated to a taxation course = 200 × $3 = $600
4
The correct answer is:
$175
Enquiries administration cost per enquiry =
$27,125 / (50 × 175) + (30 × 70) = $2.50
Number of enquiries per taxation course = 70
Cost of enquiries allocated to a taxation course = 70 × $2.50 = $175
5
The correct answer is:
ABC identifies value added and non-value added activities
The results of ABC must be interpreted by management before they can be used to identify which
activities add value and which do not.
The other statements explain why ABC gives more accurate information than traditional
absorption costing.
64 Bottlenecks
1
The correct answer is:
$1,733
We are told that one of the production operations is the bottleneck, limiting production/sales.
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B
$
40
4
44
70
Direct material cost
Variable production overhead cost
Selling price
Contribution per unit
26
0.015
$1,733
1
Bottleneck hours per unit
Contribution per bottleneck hour
2
The correct answer is:
$3,331,500
Determine profit-maximising product mix
Prod
uct
Hours
Hours
required
available
Units of
Demand
production
B
45,000 × 1.2 = 54,000
(× 0.015)
810
810
(÷0.015)
54,000
A
120,000×1.2 = 144,000
(× 0.02)
2,880
2,265
(÷ 0.02)
113,250
3,690
3,075
Maximum profit calculation
Total
Product
Units
Contribution per unit
contribution
$
A
113,250
× $30
3,397,500
B
54,000
×$26
1,404,000
4,801,500
3
Less: fixed production overhead
1,470,000
Maximum net profit
3,331,500
The correct answer is:
$2,900
Throughput return per production hour of the bottleneck resource = (selling price – material
cost)/hours on the bottleneck resource
Rank products on the basis of throughput return per bottleneck hour
A
$
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4
Selling price
60
Material cost
2
Throughput return
58
Bottleneck hours per unit
0.02
Return per bottleneck hour
$2,900
The correct answer is:
$3,732,000
Determine profit-maximising product mix
Product
Demand
A
B
144,000
54,000
Hours
required
2,880
810
Hours
available
2,880
195 (bal)
3,690
3,075
Units of
production
(÷ 0.02)
144,000
(÷ 0.015)
13,000
Maximum profit calculation:
Product
Units
Throughput
return (per
unit)
Total return
$
A
B
Total throughput return
Less: overhead costs shown as
variable in limiting factor analysis
((120,000 × $28) + (45,000 × $4))
fixed
Maximum net profit
5
144,000
13,000
× $58
× $30
8,352,000
390,000
8,742,000
(3,540,000)
(1,470,000)
3,732,000
The correct answer is:
1.23
TA ratio = throughput return per hour/conversion cost per hour
Conversion cost per hour
= overhead costs/bottleneck hours
= $(3,540,000 + 1,470,000)/3,075
= $1,629.27
∴
TA ratio for B = $2,000/ $1,629.27 = 1.2275 = 1.23 (to 2dp)
65 Bench Co
1
The correct answer is:
122.63 hours
Cumulative average time per batch for the first 54 batches
Y = axᵇ
Where Y = the cumulative average time per unit to produce x units
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x = the cumulative number of units
a = the time taken for the first unit of output
b = the index of learning (logLR/log2)
The cumulative average time per batch, with a learning curve of 80% is therefore
Y = aX⁻⁰·³²¹⁹
where a = the time for the first batch (350 hours) and X is the number of the batch. For the 26th
batch, X = 26.
Y = 350 × 26⁻⁰·³²¹⁹
= 350 × 0.35036 = 122.63
The cumulative average time per batch for the first 26 batches is 122.63 hours.
2
The correct answer is:
82%
Batches
Total time
Average time/unit
1
350
350
2
350 ×r
4
350 × r2
8
350 × r3
16
350 × r4
2,500
2,500 = 16 × 350 r4
2,500/(16 × 350) = r4
r = 0.82 or 82%
3
The correct answer is:
385 hours
Cumulative average time for the first 8 units = 1,600 ×75% ×75% ×75% = 675 hours
Cumulative average time for the first 9 units = axb where a = 1,600, x = 9, and b = –0.415
Cumulative average time for the first 9 units = 1,600 × 9–0.415
= 1,600 × 0.401748 = 642.7968
Total time for first 9 units
Total time for first 8 units
4
(9 × 642.7968)
(8 ×675)
hours
5,785
5,400
385
The correct answers are:
•
A relatively new product.
•
A manual, rather than mechanised production process.
•
A relatively complex production process.
If a product is relatively new it means that workers are still learning.
If a process is manual (as opposed to one that is mechanised), learning can reduce the time
taken.
If the production process is relatively complex, there are processes and techniques to learn.
Production can be in batches of any size – equal sizes just make the calculations easier.
Changing labour rates do not affect the application of learning curve theory.
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5
The correct answer is:
The learning curve theory states that the average time per unit produced is assumed to decease
by a constant percentage every time total output doubles
The important word ‘cumulative’ is missing and the sentence should read:
The learning curve theory states that the cumulative average time per unit produced is assumed
to decrease by a constant percentage every time total output doubles.
Cumulative average time means the average time per unit for all units produced so far, back to
and including the first unit made.
66 AB (36 mins)
1
The correct answer is:
Full cost of production per kg of X
$
17.33
7.36
14.72
Direct materials
Direct labour
Production overhead (200% of labour)
39.41
The quantity of inventory in hand is therefore $51,900/$39.41 = 1,317kg
At a weekly sales volume of 74kg, this represents 1,317/74 = about 18 weeks of sales
It will take 20 weeks to set up the production facility for Y, and so inventory in hand of finished X
can be sold before any Y can be produced. This finished inventory is therefore irrelevant to the
decision under review; it will be sold whatever decision is taken.
The problem therefore centres on the inventory in hand of direct materials. Assuming that there is
no loss or wastage in manufacture and so 1kg of direct material is needed to produce 1kg of X,
inventory in hand is $44,800/$17.33 = 2,585kg.
This would be converted into 2,585kg of X, which would represent sales volume for 2,585/74 = 35
weeks.
If AB sells its existing inventories of finished X (in 18 weeks) there are two options.
• To produce enough X from raw materials for two more weeks, until production of Y
can start, and then dispose of all other quantities of direct material – ie 33 weeks’
supply.
• To produce enough X from raw materials to use up the existing inventory of raw
materials, and so delay the introduction of Y by 33 weeks
The relevant costs of these two options
• Direct materials. The relevant cost of existing inventories of raw materials is $(0.30). In
other words, the ‘cost’ is a benefit. By using the direct materials to make more X, the
company would save $0.30 per kg used.
• Direct labour. It is assumed that, if labour is switched to production work from nonproduction work in the next three months, they must be paid at the full rate of pay,
and not at 65% of normal rate. The incremental cost of labour would be 35% of the
normal rate (35% of $7.36 = $2.58 per kg produced).
Relevant cost of production of
Direct materials
Direct labour
Variable overhead (30% of full overhead cost of $14.72)
Cost per kg of X
$
(0.30)
2.58
4.42
6.70
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Relevant cost per kg of Y
Direct materials
Direct labour
Variable overhead (30% of 200% of $2.85)
$
4.01
2.85
1.71
8.57
Note. Y cannot be made for 20 weeks, and so the company cannot make use of spare labour
capacity to produce any units of Y.
It is cheaper to use up the direct material inventories and make X ($6.70 per kg) than to introduce
Y as soon as possible, because there would be a saving of ($8.57 – $6.70) = $1.87 per kg made.
AB must sell X for at least 20 weeks until Y could be produced anyway, but the introduction of Y
could be delayed by a further 33 weeks until all inventories of direct material for X are used up.
The saving in total would be about $1.87 per kg × 74kg per week × 33 weeks = $4,567.
2
The correct answer is:
Non-financial factors that must be considered in reaching the decision
a) The workforce. If the recommended course of action is undertaken, the workforce will produce
enough units of X in the next 13 weeks to satisfy sales demand over the next year (with 18 weeks’
supply of existing finished goods inventories and a further 35 weeks’ supply obtainable from direct
materials inventories). When production of Y begins, the direct labour content of production will
fall to $2.85 per kg – less than 40% of the current effort per kg produced – but sales demand will
not rise. The changeover will therefore mean a big drop in labour requirements in production.
Redundancies seem inevitable, and might be costly. By switching to producing Y as soon as
possible, the redundancies might be less immediate, and could be justified more easily to
employees and their union representatives than a decision to produce enough X in the next three
months to eliminate further production needs for about nine months.
b) Customers’ interests. Product Y is a superior and ‘more effective’ compound than X. It would be
in customers’ interests to provide them with this improved product as soon as possible, instead of
delaying its introduction until existing inventories of direct materials for X have been used up.
c) Competition. CD is expected to start selling Y overseas, and quite possibly in direct competition
with AB. CD has the advantage of having developed Y itself, and appears to use it in the
preliminary stage of an alternative technical process. The competitive threat to AB is twofold:
• CD might take away some of the replacement demand for Y from AB so that AB’s
sales of X or Y would fall.
• CD might compete with AB to install its total technical process into customers’
factories, and so the competition would be wider than the market for compound Y.
3
The correct answer is:
Alternative course of action
• Produce enough units of X in the next 13 weeks to use up existing inventories of direct
materials.
• Start sales of Y as soon as possible, and offer customers the choice between X and Y.
Since X is an inferior compound, it would have to be sold at a lower price than Y.
Merits of this course of action
• The workforce would be usefully employed for the next 13 weeks and then production
of Y would begin at once. Although redundancies would still seem inevitable, the
company would be creating as much work as it could for its employees.
• AB’s customers would be made aware of the superiority of Y over X in terms of price,
and of AB’s commitment to the new compound. AB’s marketing approach would be
both ‘honest’ and would also give customers an attractive choice of buying the
superior Y or, for a time, an inferior X but at a lower price. This might well enhance
AB’s marketing success.
Demerits of this course of action
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•
•
•
•
It is unlikely to be a profit-maximising option, because selling X at a discount price
would reduce profitability.
Customers who get a discount on X might demand similar discounts on Y.
Some customers might query the technical differences between X and Y, and
question why AB has been selling X at such a high price in the past – this might lead
to some customer relations difficulties.
AB must decide when to reduce the price of X, given that Y cannot be made for 20
weeks. The timing of the price reduction might create some difficulties with customers
who buy X just before the price is reduced.
67 Stow Health Centre (36 mins)
1
The correct answer is:
We need to calculate budgeted contribution and so the summary will need to show the various
income (fee) and variable cost levels.
Variable cost per
day
$
95
85
70
$180
$200
Client fee per day
$220
$
1,338,750
1,496,250
1,732,500
$
1,378,125
1,509,375
1,706,250
$
1,312,500
1,417,500
1,575,000
Workings
Number of client days:
Maximum capacity = 50 × 350 = 17,500
High occupancy level = 90% × 17,500 = 15,750
Most likely occupancy level = 75% × 17,500 = 13,125
Low occupancy level = 60% × 17,500 = 10,500
Number of client days × contribution per client day (fee – variable cost) = contribution
2
The correct answer is:
(a) The maximax decision rule involves choosing the outcome with the best possible
result, in this instance choosing the outcome which maximises contribution. The
decision-maker would therefore choose a client fee of $180 per day, which could
result in a contribution of $1,732,500.
(b) The maximin decision rule involves choosing the outcome that offers the least
unattractiveworst outcome, in this instance choosing the outcome which maximises
the minimum contribution. The decision-maker would therefore choose a client fee
of $200 per day, which has a lowest possible contribution of $1,378,125. This is
better than the worst possible outcomes from client fees per day of $180 and $220,
which would provide contributions of $1,338,750 and $1,312,500 respectively.
(c) The minimax regret decision rule involves choosing the outcome that minimises the
maximum regret from making the wrong decision, in this instance choosing the
outcome which minimises the opportunity lost from making the wrong decision.
We can use the calculations performed in (a) to draw up an opportunity loss table.
Client fee per day
$
$95
$
Variable cost per day
$85
$70
$
$
Maximum
regret
$
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180
200
220
39,375 (W1)
0 (W2)
65,625 (W3)
13,125 (W4)
0 (W5)
91,875 (W6)
0 (W7)
26,250 (W8)
157,500 (W9)
39,375
26,250
157,500
The minimax regret decision strategy would be to choose a client fee of $200 to minimise the
maximum regret at $26,250.
Workings
(a) At a variable cost of $95 per day, the best strategy would be a client fee of $200 per
day. The opportunity loss from using a fee of $180 would be ($1,378,125 –
$1,338,750) = $39,375.
(b) The opportunity loss in this case is ($1,378,125 – $1,378,125) = $0.
(c) The opportunity loss in this case is ($1,378,125 – $1,312,500) = $65,625.
(d) At a variable cost of $85 per day, the best strategy would be a client fee of $200 per
day. The opportunity loss from using a fee of $180 would be ($1,509,375 –
$1,496,250) = $13,125.
(e) The opportunity loss in this case is ($1,509,375 – $1,509,375) = 0.
(f) The opportunity loss in this case is ($1,509,375 – $1,417,500) = $91,875.
(g) At a variable cost of $70 per day, the best strategy would be a client fee of $180 per
day. The opportunity loss from using a fee of $180 would be ($1,732,500 –
$1,732,500) = $0.
(h) The opportunity loss in this case is ($1,732,500 – $1,706,250) = $26,250.
(i) The opportunity loss in this case is ($1,732,500 – $1,575,000) = $157,500.
3
The correct answer is:
Expected value of variable costs = (0.1 × $95) + (0.6 × $85) + (0.3 × $70) = $81.50.
We can now calculate an expected value of budgeted contribution at each client fee per day
level.
Variable cost
$81.50
$180
1,551,375
$200
1,553,312.50
Client fee per day
$220
1,454,250
If maximisation of EV of contribution is used as the decision basis, a client fee of $200 per day
will be selected, with an EV of contribution of $1,555,312.50 (although this is very close to the EV of
contribution which results from a client fee of $180).
68 NYE Co (36 mins)
1
The correct answer is:
Step 1 Calculate amount of activities required for typical monthly output
Number of PMH
Number of
batches
produced
Number of
batches
shipped
Product X
15,000 PMH
(50,000 × 0.3)
40
(50,000 /
1,250)
50
(50,000 /
1,000)
Product Y
Product Z
20,000 PMH
90,000 PMH
(100,000 × 0.2) (225,000 × 0.4)
50
60
(100,000 /
(225,000 /
2,000)
3,750)
100
90
(100,000 /
(225,000 /
1,000)
2,500)
Total
125,000
PMH
150
240
Step 2 Calculate the resource required to perform the amount of activities identified in Step 1
Indirect labour
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Quality
control
= 150 batches produced × 4 inspection hours = 600 inspection
hours
Administratio
n
= 240 batches × 3 administration hours = 720 administration
hours
+ 375,000 units of output / 600 = 625 administration hours
= 1,345 administration hours
Machinery
Production machinery
Setup machinery
Shipment loading
machinery
= 125,000 PMH (calculated in Step 1)
= 150 batches produced × 5 hours = 750 hours
= 240 batches shipped × 2 hours = 480 hours
Step 3 Assess whether resources currently owned or employed by the company are sufficient to
meet the requirements identified in Steps 1 and 2
Indirect labour - staff numbers
Number employed at
present
Number required
Surplus/(shortfall)
Quality control inspectors
4 inspectors
Administrators
9 administrators
3.33 inspectors
(600 hours / 180 hours
each)
0.67 inspectors
7.47 administrators
(1,345 hours / 180 hours
each)
1.53 administrators
Machine capacity
Capacity of existing
equipment
Capacity required
Surplus/(shortfall)
Production
machinery
100,000 PMH
Setup Shipment loading
machinery
machinery
800 hours
520 hours
125,000 PMH
(25,000 PMH)
750 hours
50 hours
480 hours
40 hours
From the above, it is clear that the company has too little production machine capacity. Unless
this bottleneck is removed, the budgeted levels of output of some or all of the three products will
not be achieved.
It is also evident that the company has a surplus of administrators. The company currently
employs nine administrators, which is 1.5 more than it needs. Since the cost of employing an
administrator is $3,500 per month, the cost of this spare capacity is $5,250 per month. The
company should consider how this idle time cost can be avoided. Redundancy may be one
option, but only after NYE Co has considered the full long-term consequences (including
redundancy payments).
2
The correct answer is:
Advantages claimed for the use of activity based budgeting include the following:
Resource allocation is linked to a strategic plan for the future, prepared after considering
alternative strategies. Traditional budgets tend to focus on resources and inputs rather than on
objectives and alternatives.
New high priority activities are encouraged, rather than focusing on the existing planning model.
Activity based budgeting focuses on activities. This allows the identification of the cost of each
activity. It also allows the ranking of activities where financial constraints limit the range of
activities that may be achieved.
There is more focus on efficiency and effectiveness and the alternative methods by which they
may be achieved. Activity based budgeting assists in the operation of a total quality philosophy.
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It avoids arbitrary cuts in specific budget areas in order to meet the overall financial targets. Nonvalue added activities may be identified as those which should be eliminated.
It tends to increase management commitment to the budget process. This should be achieved
since the activity analysis enables management to focus on the objectives of each activity.
Identification of primary and secondary activities and non-value added activities should also help
in motivating management in activity planning and control.
69 McDreamy (36 mins)
1
The correct answer is:
Flexible budget statement for next year operating at 85% capacity:
Output
Sales revenue
Variable costs
Direct materials
Direct wages
Variable production overhead
Variable selling and distribution overhead
Workings
1 13,077 units
$
9
2
3
4
5
$
5,911,484
1,386,162
2,357,129
489,734
69,962
4,302,987
1,608,497
Contribution
Fixed costs
Production overhead
Selling and distribution overhead
Administration overhead
6
7
8
330,000
161,250
132,000
623,250
Profit
985,247
Workings
1. 65% of capacity = 10,000 units
100% of capacity = 10,000 / 0.65 = 15,385 units
 85% of capacity = (10,000 / 0.65) × 0.85 = 13,077 units
75% of capacity = 11,538
 55% of capacity = 8,462
2. Current direct material cost per unit = $1,000,000 ÷ 10,000
= $100 per unit
 Flexible budget allowance for next year = $100 × 1.06 × 13,077
= $1,3876,162
3. Current direct wages cost per unit = $1,750,000 ÷ 10,000
= $175 per unit
 Flexible budget allowance for next year = $175 × 1.03 × 13,077
= $2,357,129
4. Production overhead increases by $53,830 for an increase in activity of (10,000 – 8,462) units.
Variable cost per unit = $35
Variable overhead allowance for 85% capacity
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= 13,077 × $35
Plus 7% increase
= $457,695
$32,039
Total allowance
$489,734
5. Selling overhead increases by $7,690 for an increase in activity of (10,000 – 8,462) units.
Variable cost per unit = $5
Variable overhead allowance for 85% capacity
= 13,077 × $5
Plus 7% increase
Total allowance
= $65,385
$4,577
$69,962
6.
$
650,000
350,000
300,000
30,000
Total production overhead at 65% activity
Less variable overhead (10,000 × $35 (W4))
Fixed overhead this year
Plus 10% increase
Total allowance
330,000
7.
$
Total selling overhead at 65% activity
200,000
Less variable overhead (10,000 × $5 (W5))
50,000
Fixed overhead this year
150,000
Plus 7.5% increase
11,250
Total allowance
161,250
8. Administration overhead = $120,000 × 1.1 = $132,000
9. The cost and selling price structure is as follows.
%
100.00
16.67
83.33
Sales price
Profit
Cost
 Profit as a percentage of cost = (16.67/83.33) ×100% = 20% of cost
$
Total cost ($4,302,987 + $623,250)
Profit at 20% of cost
985,247
 Sales value
2
4,926,237
5,911,484
The correct answer is:
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Three problems which may arise from the change in capacity level are as follows.
• There is likely to be a requirement for additional cash for working capital, for example
inventory levels and debtors will probably increase. This additional cash may not be
available.
• It will probably be necessary to recruit more direct labour. The activities involved in
advertising, interviewing and training may lead to increased costs.
• It may be necessary to reduce the selling price to sell the increased volume. This
could have an adverse effect on profits.
3
The correct answer is:
The principle of controllability is that managers of responsibility centres should only be held
accountable for costs over which they have some influence.
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.
Budgetary control and budget centres are therefore part of the overall system of responsibility
accounting within an organisation.
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
Care must be taken to distinguish between controllable costs and uncontrollable costs in variance
reporting. The controllability principle is that managers of responsibility centres should only be
held accountable for costs over which they have some influence. From a motivation point of view
this is important because it can be very demoralising for managers who feel that their
performance is being judged on the basis of something over which they have no influence. It is
also important from a control point of view in that control reports should ensure that information
on costs is reported to the manager who is able to take action to control them.
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the
managers most capable of controlling them. As a system of accounting, it therefore distinguishes
between controllable and uncontrollable costs.
Most variable costs within a department are thought to be controllable in the short term because
managers can influence the efficiency with which resources are used, even if they cannot do
anything to raise or lower price levels.
A cost which is not controllable by a junior manager might be controllable by a senior manager.
For example, there may be high direct labour costs in a department caused by excessive overtime
working. The junior manager may feel obliged to continue with the overtime to meet production
schedules, but their senior may be able to reduce costs by hiring extra full-time staff, thereby
reducing the requirements for overtime.
A cost which is not controllable by a manager in one department may be controllable by a
manager in another department. For example, an increase in material costs may be caused by
buying at higher prices than expected (controllable by the purchasing department) or by
excessive wastage (controllable by the production department) or by a faulty machine producing
rejects (controllable by the maintenance department).
Some costs are non-controllable, such as increases in expenditure items due to inflation. Other
costs are controllable, but in the long-term rather than the short-term. For example, production
costs might be reduced by the introduction of new machinery and technology, but in the shortterm, management must attempt to do the best they can with the resources and machinery at
their disposal.
70 Truffle Co (36 mins)
1
The correct answer is:
Labour variances
Standard cost per labour hour = $6.00 / 0.5 = $12.00
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Labour rate variance
12,000 hours of work should have cost (× $12 per hr)
but did cost
Labour rate variance
$
144,000
136,800
7,200 (F)
Labour efficiency variance
20,500 batches should have taken (×0.5
hrs)
But did take
Efficiency variance in hours
× Standard rate per hour
Efficiency variance
2
10,250 hrs
12,000 hrs
1,750 hrs (A)
× $12
$21,000 (A)
The correct answer is:
Planning and operational variances
Labour rate planning variance
$
Standard rate
Revised rate ($12 × 0.95)
Variance
× actual hours paid (12,000)
Labour rate planning variance
12.00
11.40
0.60 (F)
× 12,000
$7,200 (F)
Labour rate operational variance
Revised cost of actual hours (12,000 ×
$12 × 95%)
Actual cost of actual hours
Labour rate operational variance
$
136,800
136,800
$nil
Labour efficiency planning variance
Standard hours for actual production
(20,500 × 0.5 hrs per batch)
Revised hours for actual production
(20,500 batches × 0.5 hrs per batch
× 1.2)
Variance
× standard rate per hour
Labour efficiency planning variance
$
10,250 hrs
12,300 hrs
2,050 hrs (A)
× $12
$24,600 (A)
Labour efficiency operational value
20,500 batches should have taken
(20,500 × 0.5 × 1.2)
But did take
12,300 hrs
12,000 hrs
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300 hrs (F)
Variance
× standard rate per hour
Labour efficiency operational variance
× $12
$3,600 (F)
Alternative solution
The following solution, calculating the labour efficiency operational variance using the revised
standard rate per hour, and the labour rate planning variance based on revised hours for actual
production also scored full marks.
Note that whilst this approach does not reconcile to the labour rate and efficiency variances, it
does reconcile to the total labour variance ($13,800 adverse).
Labour rate planning variance
$
12.00
Standard rate
Revised rate ($12 × 0.95)
11.40
Variance
0.60 (F)
× revised hours for actual production
(12,300)
× 12,300
Labour rate planning variance
$7,380 (F)
Labour rate operational variance
$
Revised cost of actual hours (12,000 ×
$12 × 95%)
136,800
Actual cost of actual hours
136,800
Labour rate operational variance
$nil
Labour efficiency planning variance
Standard hours for actual production
(20,500 × 0.5 hrs per batch)
Revised hours for actual production
(20,500 batches × 0.5 hrs per batch
× 1.2)
Variance
× standard rate per hour
Labour efficiency planning variance
Labour efficiency operational variance
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$
10,250 hrs
12,300 hrs
2,050 hrs (A)
× $12
$24,600 (A)
$
3
20,500 batches should have taken
(20,500 × 0.5 × 1.2)
12,300 hrs
but did take
12,000 hrs
Variance
300 hrs (F)
× revised standard rate per hour
× $11.40
Labour efficiency operational variance
$3,420 (F)
The correct answer is:
Performance of the production manager for the month of November
The total labour rate variance calculated in part (a) suggests that the production manager has
managed to secure labour at a lower rate than budgeted (favourable variance of $7,200).
However, the total labour efficiency variance (adverse variance of $21,000) would appear to
indicate that they have been extremely poor at controlling their staff’s efficiency.
These variances should be split into planning and operational variances to give a truer indication
of performance. Planning variances arise due to inaccurate planning and/or faulty standards
(factors that are outside the control of production manager). Therefore, the production manager
should only be assessed on operational variances.
Labour rate
The labour rate operational variance was $nil. This means that the workforce were paid the
agreed reduced rate of $11.40 per hour. It is unlikely that the production manager paid anyone for
overtime, as this would have increased the hourly rate.
The production manager cannot take credit for the favourable total labour rate variance. The
labour rate planning variance of $7,200 indicates that the reduced labour rate was beyond the
production manager’s control and was secured by the company.
Labour efficiency
The total labour efficiency variance is $21,000 adverse.
The planning variance is $24,600 adverse. This is because the standard labour time per batch
was not updated in November to reflect the fact that it would take longer to produce the truffles
as a result of the retailer requesting the truffles to be made slightly softer. The production
manager cannot be held responsible for this variance.
In contrast, the operational variance is $3,600 favourable. When the truffle recipe changed in
November, it was expected that the production process would take 20% longer for the first month
as the workers became used to working with the new ingredient mix. The workers actually took
less than the 20% extra time predicted, yielding a favourable operational variance. The
production manager can take credit for this variance.
In summary, the production manager performed well in the month of November.
71 Divisional performance measures (36 mins)
1
The correct answer is:
The residual income (RI) for a division is calculated by deducting from the divisional profit an
imputed interest charge, based on the investment in the division.
The return on investment (ROI) is the divisional profit expressed as a percentage of the investment
in the division.
Both methods use the same basic figure for profit and investment, but residual income produces
an absolute measure whereas the return on investment is expressed as a percentage.
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Both methods suffer from disadvantages in measuring the profit and the investment in a division
which include the following:
• Assets must be valued consistently at historical cost or at replacement cost. Neither
valuation basis is ideal.
• Divisions might use different bases to value inventory and to calculate depreciation.
• Any charges made for the use of head office services or allocations of head office
assets to divisions are likely to be arbitrary.
In addition, return on investment suffers from the following disadvantages:
• Rigid adherence to the need to maintain ROI in the short-term can discourage
managers from investing in new assets, since average divisional ROI tends to fall in
the early stages of a new investment. Residual income can overcome this problem by
highlighting projects which return more than the cost of capital.
• It can be difficult to compare the percentage ROI results of divisions if their activities
are very different: residual income can overcome this problem through the use of
different interest rates for different divisions.
2
The correct answer is:
Return on divisional investment (ROI)
Divisional profit
Divisional investment
Divisional ROI
Before investment
$18,000
$100,000
18.0%
After investment
$19,600
$110,000
17.8%
The ROI will fall in the short-term if the new investment is undertaken. This is a problem which
often arises with ROI.
Divisional residual income
Divisional profit
Less imputed interest: $100,000 × 15%
$110,000 × 15%
Residual income
Before investment
$
18,000
15,000
After investment
$
19,600
16,500
3,000
3,100
The residual income will increase if the new investment is undertaken. The use of residual income
has highlighted the fact that the new project returns more than the cost of capital (16% compared
with 15%).
3
The correct answer is:
Potential benefits of operating a transfer pricing system within a divisionalised company
• It can lead to goal congruence by motivating divisional managers to make decisions,
which improve divisional profit and improve profit of the organisation as a whole.
• Transfer prices can be set at a level that enables divisional performance to be
measured ‘commercially’. A transfer pricing system should therefore report a level of
divisional profit that is a reasonable measure of the managerial performance of the
division.
• It should ensure that divisional autonomy is not undermined. A well-run transfer
pricing system helps to ensure that a balance is kept between divisional autonomy to
provide incentives and motivation, and centralised authority to ensure that the
divisions are all working towards the same target, the benefit of the organisation as a
whole.
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72 Non-profit seeking organisations (36 mins)
1 The correct answer is:
(a)
(i) Effectiveness refers to the use of resources so as to achieve desired ends or objectives or
outputs. In a profit-making organisation, objectives can be expressed financially in terms
of a target profit or return. The organisation, or profit centres within the organisation,
can be judged to have operated effectively if they have achieved a target profit within a
given period. In non-profit seeking organisations, effectiveness cannot be measured in
this way. The organisation’s objectives cannot be expressed in financial terms at all, and
non-financial objectives need to be established. The effectiveness of performance could
be measured in terms of whether targeted non-financial objectives have been achieved,
but there are several problems involved in trying to do this.
(1) The organisation might have several different objectives which are difficult to
reconcile with each other. Achieving one objective might only be possible at the
expense of failing to achieve another. For example, schools have the objective of
providing education. They teach a certain curriculum, but by opting to educate
students in some subjects, there is no time available to provide education in other
subjects.
(2) A non-profit seeking organisation will invariably be restricted in what it can achieve
by the availability of funds. The health service, for example, has the objective of
providing health care, but since funds are restricted there is a limit to the amount of
care that can be provided, and there will be competition for funds between different
parts of the service.
(3) The objectives of non-profit seeking organisations are also difficult to establish
because the quality of the service provided will be a significant feature of their
service. For example, a local authority has, amongst its various different objectives,
the objective of providing a rubbish collection service. The effectiveness of this
service can only be judged by establishing what standard or quality of service is
required.
(4) With differing objectives, none of them directly comparable, and none that can be
expressed in profit terms, human judgement is likely to be involved in deciding
whether an organisation has been effective or not. This is most clearly seen in
government organisations where political views cloud opinion about the
government’s performance.
Efficiency refers to the rate at which resources are consumed to achieve desired
ends. Efficiency measurements compare the output produced by the organisation
with the resources employed or used up to achieve the output. They are used to
control the consumption of resources, so that the maximum output is achieved by a
given amount of input resources, or a certain volume of output is produced within
the minimum resources being used up
In profit-making organisations, the efficiency of the organisation as a whole can be
measured in terms of return on capital employed. Individual profit centres or
operating units within the organisation can also have efficiency measured by
relating the quantity of output produced, which has a market value and therefore a
quantifiable financial value, to the resources (and their costs) required to make the
output.
In non-profit seeking organisations, output does not usually have a market value,
and it is therefore more difficult to measure efficiency. This difficulty is compounded
by the fact that since these organisations often have several different objectives, it
is difficult to compare the efficiency of one operation with the efficiency of another.
For example, with the police force, it might be difficult to compare the efficiency of a
serious crimes squad with the efficiency of the traffic police, because each has its
own ‘outputs’ that are not easily comparable in terms of ‘value achieved’.
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In spite of the difficulties of measuring effectiveness and efficiency, control over the
performance of non-profit seeking organisations can only be satisfactorily achieved
by assessments of ‘value for money’ (economy, efficiency and effectiveness).
(ii) The same problems extend to support activities within profit-motivated organisations,
where these activities are not directly involved in the creation of output and sales.
Examples include research and development, the personnel function, the accountancy
function and so on.
◦
◦
◦
◦
Examples
Some of the outputs of these functions cannot be measured in market values.
The objectives of the functions are not easily expressed in quantifiable terms
Within the personnel department, outputs from activities such as training and some
aspects of recruitment can be given market price values by estimating what the same
services would cost if provided by an external organisation. Other activities, however, do
not have any such market valuation. Welfare is an example. Its objective is to provide
support for employees in their personal affairs, but since this objective cannot easily be
expressed as quantifiable targets, and does not have a market price valuation, the
effectiveness and efficiency of work done by welfare staff cannot be measured easily.
Within the accountancy department, outputs from management accountants are
management information. This does not have an easily-measured market value, and
information’s value depends more on quality than quantity. The contribution of
management accounting to profitability is difficult to judge, and so the efficiency and
effectiveness of the function are difficult to measure.
(b)
(i)
◦
◦
◦
◦
◦
◦
◦
A problem with these measures is that there is an implied assumption that all patients
will be at the clinic by their appointed time. In practice, this will not always be the case.
(2) Patients’ ability to contact the clinic and make appointments
Percentage of patients who can make an appointment at their first preferred time, or at
the first date offered to them
Average time from making an appointment to the appointment date
Number of complaints about failure to contact the clinic, as a percentage of total
patients seen
If the telephone answering system provides for queuing of calls, the average waiting for
answer times for callers and the percentage of abandoned calls
(3) Comprehensive monitoring programme
◦
Measures might be based on the definition of each element or step within a
monitoring programme for a patient. It would then be possible to measure the
following:
Percentage of patients receiving every stage of the programme (and percentage
receiving every stage but one, every stage but two, and so on)
If each stage has a scheduled date for completion, the average delay for patients in the
completion of each stage
◦
◦
◦
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To measure effectiveness, we need to establish objectives or targets for performance.
Since these cannot be expressed financially, non-financial targets must be used. The
effective level of achievement could be measured by comparing actual performance
against target.
(1) Adherence to appointment times
Percentage of appointments kept on time
Percentage of appointments no more than 10 minutes late
Percentage of appointments kept within 30 minutes of schedule
Percentage of cancelled appointments
Average delay in appointments
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(ii) A single quality of care measure would call for subjective judgements about the
following:
◦ The key objective/objectives for each of the three features of service
◦ The relative weighting that should be given to each
The objectives would have to be measured on comparable terms and, since monetary values are
inappropriate, an index based on percentage or a points-scoring system of measurement might
be used. A target index or points score for achievement could then be set, and actual results
compared against the target.
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Appendix 1:
Exam formulae
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Demand curve
P = a -bQ
b = Change in price / Change in quantity
a = price when Q = 0
MR = a - 2bQ
Learning curve
Y = axb
Where Y
694
= the cumulative average time per unit to produce X units
a
= the time taken for the first unit of output
x
= the cumulative number of units
b
= the index of learning (log LR/log 2)
LR
= the learning rate as a decimal
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Index
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3
Effectiveness, 469
3Es, 469
Efficiency, 469
Encryption, 9
A
Absorption costing, 501
Enterprise resource planning systems (ERP
systems), 26
Activity base costing, 41
Environment related costs, 112
Activity based budgeting, 292
Environmental detection costs, 110
Activity based costing (ABC), 42
Environmental driven costs, 112
Advanced manufacturing technology, 41
Environmental external failure costs, 110
Algorithm, 28
Environmental internal failure costs, 110
Anthony’s hierarchy, 21
Ata analytics, 28
Environmental management accounting
(EMA), 109
Avoidable costs, 213
Environmental prevention costs, 110
Executive information systems (EIS), 26
B
Expected values, 252
Big data, 28
Extranet, 7
Binding constraint, 89
Bottleneck resource, 89
F
Bottom-up budgeting, 282
Factory costs, 92
Breakeven point, 129, 129
Feasible region, 163
Budgetary slack, 287
Firewalls, 9
Fixed budget, 283
C
Flexible budget, 283
Cloud computing, 7
Flexible budgets, 331
Committed costs , 214
Flow cost accounting, 112
Complementary products, 200
Focus groups, 252
Confidential information, 9
Functional analysis, 59
Constraint, 163
Contingent costs, 111
G
Contribution/Sales ratio, 129
Goal congruence, 23
Control, 3
H
Controllable costs, 331
High-low method, 309
Conventional costs, 111
Conversion cost, 92
I
Cost pools, 42
Image and relationship costs, 111
Customer relationship management systems
(CRM systems), 27
Incremental budgeting, 286
D
Incremental packages, 288
Database controls, 9
Decision package’, 287
Decision-making, 3
Direct cost, 500
Direct data capture, 5
Incremental costs and revenues, 196
Indirect cost, 500
Indirect costs of internal information, 5
Information systems, 3
Input/output flow analysis, 112
Intermediate product, 443
Internet, 6
E
Intranets, 6
Economy, 469
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L
R
Learning curve theory, 310
Residual income, 435
Life cycle costing, 75, 113
Responsibility accounting, 331
Limiting factor, 153
Return on investment (ROI), 434
Liquidity, 408
Risk, 251
Logical access systems, 9
Risk averse, 251
Risk neutral, 251
M
Risk seeker, 251
Machine learning (ML), 28
Management (or tactical) control, 21
S
Management by exception’, 327
Sales mix variance, 349
Management information systems (MIS), 26
Sales quantity variance, 349
Margin of safety, 129
Sensitivity analysis, 268
Market research, 252
Shadow price, 157
Maximax criterion, 258
Short-termism, 412
Maximin decision rule, 257
Simulation, 271
Minimax regret rule, 260
Slack, 175
Mix variance, 343
Sources of information, 10
Multi-product breakeven point, 134
Stakeholders, 471
Mutually exclusive packages, 288
Standard cost, 327
Standard costing, 327
N
Standard deviation, 271
Networks, 6
Strategic decisions, 21
Non-quantifiable objectives, 468
Strategic management accounting, 22
Not for profit organisations, 467
Strategic planning, 21
Notional costs, 214
Sunk costs, 214
O
Surplus, 175
Objective function, 163
T
Operating statements, 589
Operational control (or operational planning),
21
Target cost, 59
Target cost gap, 60
Opportunity costs, 213
Target costing, 59
Overhead, 500
Target profit , 130
Theory of constraints, 89
P
Throughout accounting, 91
Pay-off tables (profit tables), 253
Top down budgeting, 282
Penetration pricing, 199
Transaction processing system (TPS), 25
Performance hierarchy, 281
Transfer price, 441
Planning, 3
Potentially hidden costs, 111
U
Price elasticity of demand (PED), 189
Uncertain events, 251
Price skimming, 199
V
Probabilistic budgeting, 298
Value analysis, 61
Product line, 200
Value for money (VFM), 469
Value of elasticity, 189
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Volume based discount, 197
Volume discount, 200
W
Wireless technology, 6
Y
Yield variance, 343
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Bibliography
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Anthony, R. N. (1965) Planning and control systems: A framework for analysis, 1st edition. Boston,
Division of Research, Harvard Business School.
Bennett, P. and James, P. (2000) The green bottom line: environmental accounting for
management: current practice and future trends, 2nd edition. Sheffield, Greenleaf Publishing
Limited.
Big data: are we making a big mistake? Financial Times (2014). [Online]
https://www.ft.com/content/21a6e7d8-b479-11e3-a09a-00144feabdc0 [Accessed 25 September
2019].
Cooper, R. (1990a) Cost classifications in unit-based and activity-based manufacturing cost
systems, Journal of Cost Management, Fall, 4-14
DHL, (December 2013). Big Data in Logistics: A DHL perspective on how to move beyond the hype.
[Online] Available from:
http://www.dhl.com/content/dam/downloads/g0/about_us/innovation/CSI_Studie_BIG_DATA.pdf
[Accessed 13 September 2019]
Drury, C. (2005) Management and cost accounting, 6th edition. London, Thomson Learning.
Drury, C., Braund, S., Osborne, P. and Tayles, M. (1993) A survey of management accounting
practices in UK manufacturing companies, ACCA Research Paper, Chartered Association of
Certified Accountants
Fitzgerald, L. and Moon, P. (1996) Performance measurement in service industries: Making it work.
1st edition. Chartered Institute of Management Accountants.
Goldratt, E.M. and Cox, J. (1992) The Goal. 2nd edition. London, Gower Publishing Ltd.
Gray, R.H. and Bebbington, J. (2001) Accounting for the environment, 2nd edition. London, SAGE
publications Ltd.
Hope, J. and Fraser, R. (2003) Beyond Budgeting, 1st edition. Harvard Business School Publishing
Corporation.
Kotler, P. and Armstrong, G. (2010) Principles of Marketing. 13th edition. London, Pearson
Education Ltd
McKinsey & Company (2011). Big data: The next frontier for innovation, competition, and
productivity. [Online] Available from: http://www.mckinsey.com/business-functions/businesstechnology/our-insights/big-data-the-next-frontier-for-innovation [Accessed 13 September 2019]
United States Environmental Protection Agency (1995) An introduction to environmental
accounting as a business management tool [Online]. Available from:
https://archive.epa.gov/parchive/web/pdf/busmgt.pdf [Accessed 25 September 2019].
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Glossary
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Chapter 1: Managing Information
Control: Control is used in the sense of monitoring something to keep it on course (like the
‘controls’ of a car) not merely in the sense of imposing restraints or exercising power over
something.
Decision-making: Decision-making means choosing between various alternatives. This and
planning are virtually inseparable: you decide to plan in the first place and the plan you make is a
collection of decisions.
Information systems: An information system is a combination of hardware, software and
communications capability, where information is collected, processed and stored.
Planning: Planning means formulating ways of proceeding.
Chapter 2: Information systems and data analytics
Algorithm: A set of instructions or rules used to solve a problem (especially by a computer).
Big data analytics: 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.
Enterprise resource planning systems (ERP systems): Enterprise resource planning systems
(ERP systems) 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.
Executive information systems (EIS): Executive information systems (EIS) provide a generalised
computing and communication environment for senior managers to support strategic decisions.
Management information systems (MIS): Management information systems (MIS) generate
information for monitoring performance (eg productivity information) and maintaining coordination (eg between purchasing and accounts payable).
Machine learning (ML): A subset of artificial intelligence where a system learns automatically how
to predict outcomes based on data, without being explicitly programmed to do so.
Management (or tactical) control: Management (or tactical) control is the process by which
managers assure that resources are obtained and used effectively and efficiently in the
accomplishment of the organisation’s objectives. It is sometimes called ‘tactics’ or ‘tactical
planning’.
Operational control (or operational planning): Operational control (or operational planning) is
the process of assuring that specific tasks are carried out effectively and efficiently.
Strategic decisions: Strategic decisions are long-term decisions and are characterised by their
wide scope, wide impact, relative uncertainty and complexity.
Strategic management accounting: Strategic management is a form of management accounting
in which emphasis is placed on information about factors which are external to the organisation,
as well as non-financial and internally generated information.
Strategic planning: The process of deciding on objectives of the organisation changes the
resources used to attain these objectives, and the policies that are to govern the acquisition, use
and disposition of these resources.
Transaction processing system (TPS): A transaction processing system (TPS) collects, stores,
modifies and retrieves the transactions of an organisation.
Chapter 3: ABC
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.
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Activity based costing (ABC): Activity based costing 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 on the basis of the
product’s usage of the factor driving the overheads.
Cost driver: Cost driver is a factor that has most influence on the cost of an activity.
Direct cost: A direct cost is a cost that can be traced in full to the product, service or department
that is being costed.
Indirect cost or overhead: An indirect cost or 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 or exclusively to the product, service or department.
Marginal cost: Marginal cost is the cost of one unit of a product/service which could be avoided if
that unit were not produced/provided.
Marginal costing: Marginal costing is an alternative to absorption costing. Only variable costs
(marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are
charged in full against the profit of the period in which they are incurred. In marginal costing,
closing inventories are valued at marginal (variable) production cost whereas, in absorption
costing, inventories are valued at their full production cost which includes absorbed fixed
production overhead. If the opening and closing inventory levels differ in an accounting period,
the profit reported for the period will differ between absorption costing and marginal costing.
But in the long run, total profit for a company will be the same whichever costing method is
used because, in the long run, total costs will be the same by either method of accounting. The
different costing methods merely affect the reported profit for individual accounting periods.
Chapter 4: Target costing
Target costing: Target costing involves setting a target cost by subtracting a desired profit margin
from a target selling price, setting a target cost by subtracting a desired profit margin from a
target selling price.
Target cost: Target cost involves setting a target cost by subtracting a desired profit margin from
a target selling price. setting a target cost by subtracting a desired profit margin from a target
selling price.
Value analysis: Value analysis involves examining the factors which affect the cost of a product or
service, so as to devise ways of achieving the intended purpose most economically at the required
standards of quality and reliability.
Chapter 5: Lifecycle costing
Life cycle costing: Life cycle costing is the accumulation of costs over a product’s entire life.
Chapter 6: Throughput
Bottleneck resource or binding constraint: Bottleneck resource (or binding constraint) is a process
which has a lower capacity than preceding or subsequent activities, thereby limiting throughput.
Factory costs or conversion costs: These are all costs except direct material cost (ie all costs
except totally variable costs).
Throughout Accounting (TA): Throughput accounting is an approach to production management
which aims to maximise throughput contribution, while also reducing inventory and operational
expenses.
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Theory of constraints: The theory of constraints (TOC) is a production system where the key
financial concept is the maximisation of throughput while keeping conversion and investment
costs to a minimum. Throughput contribution (or throughput return or throughput) = sales
revenue - direct material cost
Chapter 7: Environmental Accounting Management
Environmental driven costs: Environment driven costs are costs that are caused by events in the
environment but usually hidden in general overheads, such as an increase in electricity costs.
Environmental management accounting (EMA): Environmental management accounting (EMA)
is the generation and analysis of both financial and non-financial information in order to support
internal environmental management processes.
Environment related costs: Environment related costs are costs that can be attributed to a cost
centre such as a waste treatment centre.
Life cycle costing: Environmental costs are considered from the design stage of a new product
right up to the end of life costs such as decommissioning and removal. The consideration of future
disposal or remediation costs at the design stage may influence the design of the product itself,
saving on future costs.
Chapter 8: CVP
Breakeven point: Breakeven point is the level of sales at which there is neither profit nor loss.
Chapter 9: Limiting factor analysis
Constraint: This is an “activity, resource or policy that limits the ability to achieve objectives”
(CIMA Official Terminology).
Feasible region: This is “The area contained within all of the constraint lines shown on a graphical
depiction of a linear programming problem. All feasible combinations of output are contained
within or located on the boundaries of the feasible region” (CIMA Official Terminology).
Objective function: This is a quantified statement of the aim of a resource allocation decision.
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’. (CIMA Official Terminology)
Slack: Slack occurs when maximum availability of a resource or other constraining factor is not
used.
Surplus: Surplus occurs when more than a minimum requirement is used: surplus is the excess over
the minimum amount of constraint, where the constraint is a ‘more than or equal to’ constraint.
Chapter 10: Pricing decisions
Complementary products: 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.
Incremental costs and revenues: Incremental costs and revenues are the difference between costs
and revenues for the corresponding items under each alternative being considered.
Penetration pricing: 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.
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Price 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.
Price elasticity of demand (PED): Measures the extent of the change in market demand for a
product or service in response to a change in its price.
Price skimming: Price skimming involves charging high prices when a new product is first
launched on the market, in order to maximise short-term profitability.
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.
Value of elasticity: If the result of the formula, in absolute terms, is less than one, the demand is
inelastic. If the result of the formula in absolute terms is greater than one, the demand is elastic.
Volume based discount: A volume-based discount is a discount given for buying in bulk.
Volume discount: A volume discount is a reduction in price given for larger than average
purchases.
Chapter 11: Short-term decisions
Relevant costs: The costs that should be used for decision-making are referred to as relevant
costs.
Outsourcing: Outsourcing is the use of external suppliers for finished products, components or
services. This is also known as contract manufacturing or subcontracting.
Chapter 12: Risk
Market research: 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.
Maximax criterion: The maximax criterion looks at the best possible results. Maximax means
‘maximise the maximum profit’. The decision with this rule is to choose the option that could
provide the maximum possible profit.
Maximin decision rule: The maximin decision rule is that a decision-maker should select the
alternative that offers the least unattractive worst outcome. This would mean choosing the
alternative that maximises the minimum profits.
Minimax regret rule: The minimax regret rule aims to minimise the regret from making the wrong
decision. Regret is the opportunity lost through making the wrong decision.
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.
Risk: Risk involves situations or events that may or may not occur, but whose probability of
occurrence can be calculated statistically and the frequency of their occurrence predicted from
past records. Thus, insurance deals with risk.
Risk averse: A risk averse decision maker acts on the assumption that the worst outcome might
occur.
Risk neutral: A risk neutral decision-maker is concerned with what will be the most likely outcome.
This involves using expected values (EV) and selecting the strategy with the highest EV.
Risk seeker: A risk seeker is a decision maker who is interested in the best outcomes no matter how
small the chance that they may occur.
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.
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Uncertain events: Uncertain events are those whose outcome cannot be predicted with statistical
confidence.
Chapter 13: Budgetary systems
Activity based budgeting: Uses the costs determined using activity based costing (ABC) as a
basis for preparing budgets.
Bottom-up budgeting: Bottom-up budgeting is when the budgeting process starts at a relatively
low level of management.
Budget: A budget: is a quantified plan of action for a forthcoming accounting period. Note that
a budget is a plan of what the organisation is aiming to achieve and what it has set as a target,
whereas a forecast is an estimate of what is likely to occur in the future.
Feedback: Feedback occurs when the results (outputs) 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.
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.
Flexible budget: A flexible budget is a budget which, by recognising different cost behaviour
patterns, is changed as the volume of output and sales changes. It recognises cost behaviour
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.
Incremental budgeting: This is where the budget is based on the current year’s budget (or results)
plus an extra amount for estimated growth or inflation.
Rolling budget: This is defined as “A budget continuously updated by adding a further
accounting period (month or quarter) when the earliest accounting period has expired. Its use is
particularly beneficial where future costs and/or activities cannot be forecast accurately” (CIMA
Official Terminology).
Top down budgeting: Top-down budgeting is when budget targets are set at senior management
level for the organisation as a whole and for each major department or activity within the
organisation.
Zero-based budgeting: This is a method of budgeting that requires each cost element to be
specifically justified, as though the activities to which the budget relates were being undertaken
for the first time.
Chapter 14: Quantitative analysis in budgeting
Learning curve theory: 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.
Chapter 15: Budgetary standard costing
Attainable standard: An attainable standard is 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.
Basic standard: A basic standard is a long-term standard which remains unchanged over the
years and is used to show trends.
Current standard: A current standard is a standard based on current working conditions (current
wastage, current inefficiencies).
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Ideal standard: An ideal standard is a standard which can be attained under perfect operating
conditions: no wastage, no inefficiencies, no idle time, no breakdowns.
Responsibility accounting: 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 organisation.
Standard cost: A standard cost is an estimated unit cost.
Standard costing: 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.
Chapter 16: Variance analysis
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.
Operating statements: An operating statement is a regular report for management which
compares actual costs and revenues with budgeted figures and shows variances.
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. Sales variances are
reported first, and 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.
Sales mix variance: The sales mix variance occurs when the proportions of the various products
sold are different from those in the budget.
Sales quantity variance: The sales quantity variance shows the difference in contribution/profit
because of a change in sales volume from the budgeted volume of sales.
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.
Chapter 19: Performance measurement
Liquidity: Liquidity is the amount of cash a company can obtain quickly to settle its debts (and
possibly to meet other unforeseen demands for cash payments too).
Short-termism: Short-termism is when there is a bias towards short-term rather than long-term
performance.
Chapter 20: Divisional performance
Intermediate product: An intermediate product is one used as a component in another product;
for example, car headlights or food additives.
Residual income: Residual income is a measure of the centre’s profits after deducting a notional
or imputed interest cost.
Return on investment (ROI): ROI shows how much profit has been made in relation to the amount
of capital invested and is calculated as (profit/capital employed) × 100%.
Transfer price: 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.
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Chapter 21: Further aspects:
Economy: Economy is attaining the appropriate quantity and quality of inputs at the lowest cost.
Effectiveness: Effectiveness is the relationship between an organisation’s outputs and its
objectives.
Efficiency: Efficiency is the relationship between inputs and outputs.
Stakeholders: Stakeholders are groups of people or individuals who have a legitimate interest
in the activities of an organisation. They include customers, employees, the community,
shareholders, suppliers and lenders.
Value for money (VFM): Value for money (VFM) means providing a service in a way which is
economical, efficient and effective.
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